Economics: Unpredictable Fluctuations and Why They Happen

A recession is a mild period of falling incomes and rising unemployment, and more severe is a depression.

There are 3 key facts for economic fluctuation:

• Economic fluctuations are irregular and unpredictable
• Most macroeconomic quantities fluctuate together (real GDP, personal income, corporate profits, etc.)
• As output falls, unemployment rises

Earlier we talked about classical economics and classical dichotomy and money neutrality. If the nominal variables changed, real variables still wouldn't be changed. A doubling in prices would make everything cost twice as much but wouldn't affect employment, etc. 

However, in the short-run, classical theory does not apply. It always takes time for all prices to adjust. Thus, we build the model of aggregate demand and aggregate supply. On the x-axis is the real GDP, the quantity of output. On the y-axis is the CPI/GDP deflator, the average level of prices. Remember that this is not simply another supply and demand chart, this is macroeconomics. 

The aggregate demand curve slopes downward, but why? Recall that Y = C + I + G + NX. 

• The price level and consumption (wealth effect): a decrease in price level raises the dollar value making consumers wealthier and more willing to spend, increasing quantity demanded.
• The price level and investment (interest rate effect): a decrease in price level decreases interest rate (since households save more as their money is worth more), and causes more investment and thus causes greater quantity of goods/services demanded.
• The price level and net exports (exchange rate effect): a decrease in price level makes the dollar depreciate and increases net exports, thus making the quantity of goods and services demanded increase.

Why might the aggregate demand curve shift?

• changes in consumption (concerns about saving vs. spending)
• changes in investment
• changes in government purchases (e.g. if the government wants to build more highways, it shifts right)
• changes in NX

Now we talk about the aggregate supply curve. In the long run, the aggregate supply curve is vertical because it represents a country's real GDP and depends on its supplies of labor, capital, and natural resources and on its available technology. This agrees with money neutrality (when price level changes, real GDP doesn't change).

The long run aggregate supply curve could shift from:

• changes in labor
• changes in capital
• changes in natural resources
• changes in technological knowledge

Note that short run fluctuations in output and price level should only be viewed as deviations from continuing long term trends of output growth and inflation.

Why does the short term aggregate supply curve slope upwards?

• sticky wage theory: wages are sticky (if prices are low, it is less profitable with the high cost of labor so firms cut workers and production in the short term)
• sticky price theory: prices take time to adjust since there are menu costs
• misperceptions theory: when overall price level drops, an individual could misperceive relative prices dropping and act accordingly. (e.g. farmers noticing wheat prices dropping before other product prices and responding by producing less wheat)

The short term aggregate supply curve shifts from changes in the expected price level. A rise in the expected price level reduces the quantity of goods and services supplied and shifts short tun aggregate supply curve to the left, and this statement works conversely as well.

If the aggregate demand curve shifts, for example to the left, output falls in the short run in order to maintain equilibrium with the short run aggregate supply. Since price level has dropped below expectations, eventually the short term aggregate supply curve shifts to the right, bringing output back to where the graph started at the long run aggregate supply curve. Policy makers could shorten the recession period by trying to increase aggregate demand curve by increasing government spending for example.

If the short run aggregate supply curve shifts, output temporarily decreases and price level increases. (This phenomenon is called stagflation: inflation and reduced output, stagnation). A wage-price spiral could occur, where workers demand more wages as prices increase. This causes an increase in firms' costs and makes the supply curve shift even further to the left. However, this eventually stops when the lower level of output and increased employment finally make wages decrease. The shift eventually then reverses to come back to equilibrium where output is back at the start at the long run aggregate supply curve. Policymakers could potentially mitigate the impact of the aggregate supply curve shift by increasing the aggregate demand so that equilibrium remains at the natural rate of output (called accommodating shift). This still causes an increase in price level though.