What is Economic Fluctuation?

 Introduction to economic fluctuations

Economic fluctuations present a recurring problem for economists and policymakers. On average, the real GDP of the United States grows between 3 and 3.5 percent per year. But this long-run average hides the fact that the economy’s output of goods and services does not grow smoothly. Growth is higher in some years than in others; sometimes the economy loses ground, and growth turns negative. These fluctuations in the economy’s output are closely associated with fluctuations in employment. When the economy experiences a period of falling output and rising unemployment, the economy is said to be in recession.

GDP and Its Components

The economy’s gross domestic product measures total income and total expenditure in the economy. Because GDP is the broadest gauge of overall economic conditions, it is the natural place to start in analyzing the business cycle.

What determines whether a downturn in the economy is sufficiently severe to be deemed a recession? There is no simple answer. According to an old rule of thumb, a recession is a period of at least two consecutive quarters of declining real GDP. This rule, however, does not always hold. In the most recently revised data, for example, the recession of 2001 had two quarters of negative growth, but those quarters were not consecutive.

Unemployment and Okun’s Law

The business cycle is apparent not only in data from the national income accounts but also in data that describe conditions in the labor market.

What relationship should we expect to find between unemployment and real GDP? Because employed workers help to produce goods and services and unemployed workers do not, increases in the unemployment rate should be associated with decreases in real GDP. This negative relationship between unemployment and GDP is called Okun’s law, after Arthur Okun, the economist who first studied it.

Leading Economic Indicators

Many economists, particularly those working in business and government, are engaged in the task of forecasting short-run fluctuations in the economy. Business economists are interested in forecasting to help their companies plan for changes in the economic environment.

One way that economists arrive at their forecasts is by looking at leading indicators, which are variables that tend to fluctuate in advance of the overall economy. Forecasts can differ in part because economists hold varying opinions about which leading indicators are most reliable.

Short Run and Long Run Differ

Most macroeconomists believe that the key difference between the short run and the long run is the behavior of prices. In the long run, prices are flexible and can respond to changes in supply or demand. In the short run, many prices are “sticky’’ at some predetermined level. Because prices behave differently in the short run than in the long run, various economic events and policies have different effects over different time horizons.

during the time horizon over which prices are sticky, the classical dichotomy no longer holds: nominal variables can influence real variables, and the economy can deviate from the equilibrium predicted by the classical model.

Aggregate demand (AD): is the relationship between the quantity of output demanded and the aggregate price level. In other words, the aggregate demand curve tells us the quantity of goods and services people want to buy at any given level of prices. We examine the theory of aggregate demand in detail in Chapters 10 through 12. Here we use the quantity theory of money to provide a simple, although incomplete, derivation of the aggregate demand curve.

Shifts in the Aggregate Demand Curve: The aggregate demand curve is drawn for a fixed value of the money supply. In other words, it tells us the possible combinations of P and Y for a given value of M. If the Fed changes the money supply, then the possible combinations of P and Y change, which means the aggregate demand curve shifts.

Aggregate supply (AS): is the relationship between the quantity of goods and services supplied and the price level. Because the firms that supply goods and services have flexible prices in the long run but sticky prices in the short run, the aggregate supply relationship depends on the time horizon

The Long Run: The Vertical Aggregate Supply Curve Because the classical model describes how the economy behaves in the long run, we derive the long-run aggregate supply curve from the classical model. Recall from Chapter 3that the amount of output produced depends on the fixed amounts of capital and labor and on the available technology. To show this, we write Y = F(k,l)=y.

The Short Run: The Horizontal Aggregate Supply Curve The classical model and the vertical aggregate supply curve apply only in the long run. In the short run, some prices are sticky and, therefore, do not adjust to changes in demand. Because of this price stickiness, the short-run aggregate supply curve is not vertical.

From the Short Run to the Long Run :We can summarize our analysis so far as follows: Over long periods of time, prices are flexible, the aggregate supply curve is vertical, and changes in aggregate demand affect the price level but not output. Over short periods of time, prices are sticky, the aggregate supply curve is flat, and changes in aggregate demand do affect the economy’s output of goods and services.

Shocks to aggregate demand and aggregate supply cause economic fluctuations. Because the Fed can shift the aggregate demand curve, it can attempt to offset these shocks to maintain output and employment at their natural levels.