Economic Fluctuations

key terms

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aggregate demand

aggregate supply

capital

GDP

labor

unemployment

Temporary movements of economic variables away from their natural position. When the movements away from the natural position are caused by unexpected changes, there has been a shock to the economy. 

Economic fluctuations are evident in a graph of GDP for the United States.

As you can see there is a general trend showing potential GDP (the level of GDP that corresponds to the amount of labor and capital available in the economy – see the long-run aggregate supply curve growing at a fairly constant rate over time. There are, however, points in time where real GDP is above the growth line (see 1999) and points of time where it is below the growth line (see 1983).  These movements way from the natural growth line are economic fluctuations.

Policy makers and the general population are most often concerned with fluctuations in output, inflation , unemployment.  Economists think about fluctuations in terms of what is called aggregate demand and aggregate supply. If we place the aggregate demand curve (AD) along with the short-run aggregate supply curve (SRAS) and long-run aggregate supply curve (LRAS) on the same graph, we can find the overall price level as well as the level of output (or GDP) in the economy. Once we know the level of output and how it changes, we can also find the level of unemployment and how it changes using Okun's Law .

As illustrated in this graph, the intersection of the three lines represents the economy in long-run equilibrium. At this point the economy is producing at the level that labor, capital, and technology would dictate according to the long-run aggregate supply curve (YN). The economy is at its natural rate. The natural rate can change through time if there are changes to the long-run aggregate supply curve. In fact, continual technological advancements have caused the long-run aggregate supply curve to persistently move to the right. This is the reason for the growth in potential GDP shown in the United States. The economy represented in the graph above would correspond to an economy where real GDP is equal to potential GDP. We are concerned with fluctuations around the natural rate (when real GDP is not equal to potential GDP), so for simplicity’s sake, assume that the long-run aggregate supply curve remains fixed in the short run.

Fluctuations around the natural rate occur when changes to the aggregate demand curve or changes to the short-run aggregate supply curve lead to a short-run equilibrium that is different from the natural rate (YN). When these changes are unexpected they are called shocks.

Aggregate demand shock:

What would happen if Al Qaeda were to declare a truce with the West? Everyone feels pretty happy about the future and decides to go buy things. This is a positive consumer confidence shock, leading to a shift in the aggregate demand curve.

At the short-run equilibrium (a), output (Y2) is greater than the natural rate (YN) and the price level has risen (from P1 to P2).  The result of the increase in consumer confidence is a short-run increase in output and inflation.

Short run to long run:

The economy will not stay at this point (a) forever.  Eventually, all the reasons for a short-run aggregate supply curve will disappear (businesses can eventually change their prices or renegotiate a new wage contract). So in the long run there is no short-run aggregate supply curve.

The economy must be in equilibrium and thus cannot stay at point (a). In the long run, the businesses that decided to produce more in the short run because they couldn’t change their price find that they are overworking their machines and workers and would rather increase their price. So when they can, they cut production back to the natural level and prices rise. We move along the new aggregate demand curve to point (b) with permanently higher prices (P3) at the same level of output as before the shock (YN).

Policy:

The policy makers may find that the initial rise in price is harmful and would like to undo the resultant inflation. They can use either monetary policy or fiscal policy to move the aggregate demand curve back to its original position. In terms of monetary policy, the central bank could increase interest rates (by lowering the money supply). That would cause a decrease in investment and thus a shift back of the aggregate demand curve. The fiscal authority, on the other hand, could either increase taxes or decrease spending. Either policy move would bring aggregate demand back to its original position. The economy would return to the original price level and level of output (b).

Short-run aggregate supply shock:

What effect might the floods of 2008 in the Midwest have on the economy? The flood destroyed the crops of many farmers, adversely affecting the short-run aggregate supply curve.

In the short run the economy moves to point (a). Output falls below the natural rate and prices rise. This combination of low output and inflation is called stagflation. Without any intervention the economy would eventually return to the original point were the aggregate demand curve crosses the long-run aggregate supply curve (recall there is no short-run aggregate supply curve in the long run).

Policy:
Policy makers have a dilemma if they want to offset this particular kind of economic fluctuation. Both the monetary and fiscal authorities are limited in that they can only shift the aggregate demand curve. If they increase aggregate demand, they will increase the level of equilibrium output, but they will also push prices even higher. If they decide to decrease aggregate demand, they can reduce the price level but they will also push equilibrium output further away from the natural rate. Fiscal and monetary coordination is helpful during such a situation.

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