Analyzing Macroeconomic Fluctuations

Two Causes of Economic Fluctuations

Now that we have introduced the model of aggregate demand Opens in new window and aggregate supply Opens in new window, we have the basic tools we need to analyze fluctuations in economic activity Opens in new window.

In particular, we can use what we have learned about aggregate demand and aggregate supply to examine the two basic causes of short-run fluctuation: shifts in aggregate demand and shifts in aggregate supply.

To keep things simple, we assume the economy begins in long-run equilibrium, as shown in Figure I.
The Long-Run Equilibrium Figure I, The Long-Run Equilibrium | Source: Slideplayer Opens in new window

Output and the price level are determined in the long run by the intersection of the aggregate-demand curve and the long-run aggregate-supply curve, shown as dotted point in the middle of the figure.

At this point, output is at its natural level. Because the economy is always in a short-run equilibrium. That is, when an economy is in its long-run equilibrium, the expected price level must equal the actual price level so that the intersection of aggregate demand with short-run aggregate supply is the same as the intersection of aggregate demand with long-run aggregate supply.

The Effects of a Shift in Aggregate Demand

Suppose that a wave of pessimism suddenly overtakes the economy. The cause might be a scandal in the White House, a crash in the stock market, or the outbreak of war overseas.

Because of this event, many people lose confidence in the future and alter their plans. Households cut back on their spending and delay major purchases, and firms put off buying new equipment.

What is the macroeconomic impact of such a wave of pessimism?

In answering this question, we can follow three steps economists use to analyze supply and demand in specific markets.

  1. First, we determine whether the event affects aggregate demand or aggregate supply.
  2. Second, we determine the direction that the curve shifts.
  3. Third, we use the diagram of aggregate demand and aggregate supply to compare the initial and the new equilibrium.

The new wrinkle is that we need to add a fourth step: We have to keep track of a new short-run equilibrium, a new long-run equilibrium, and the transition of a new short-run equilibrium, a new long-run equilibrium, and the transition between them.

The table following, summarizes the four steps to analyzing economic fluctuations.

Four Steps for Analyzing Macroeconomic Fluctuations
  1. Decide whether the event shifts the aggregate-demand curve or the aggregate-supply curve (or perhaps both).
  2. Decide the direction in which the curve shifts.
  3. Use the diagram of aggregate demand and aggregate supply to determine the impact on output and the price level in the short run.
  4. Use the diagram of aggregate demand and aggregate supply to analyze how the economy moves from its new short-run equilibrium to its new long-run equilibrium.

The first two steps are straightforward. First, because the wave of pessimism affects spending plans, it affects the aggregate-demand curve.

Second, because households and firms now want to buy a smaller quantity of goods and services for any given price level, the event reduces aggregate demand. As Figure II (8) shows, the aggregate-demand curve shifts to the left from AD1 to AD2.

Contraction in Aggregate Demand Figure II, Contraction in Aggregate | Source: Slideplayer Opens in new window

With this figure, we can perform step three: By comparing the initial and the new equilibrium, we can see the effects of the fall in aggregate-supply curve, AS1, going from Point A to Point B. As the economy moves between these two points, output falls from Y1 to Y2 and the price level falls from P1 to P2.

The falling level of output indicates that the economy is in a recession. Although not shown in the figure, firms respond to lower sales and production by reducing employment. Thus, the pessimism that caused the shift in aggregate demand is, to some extent, self-fulfilling: Pessimism about the future leads to falling incomes and rising unemployment.

Now comes step four—the transition from the short-run equilibrium to the new long-run equilibrium. Because of the reduction in aggregate demand, the price level initially falls from P1 to P2. The price level is thus below the level that people were expecting (P1) before the sudden fall in aggregate demand.

People can be surprised in the short-run but they will not remain surprised. Over time, their expectations catch up with this new reality, and the expected price level falls as well.

The fall in the expected price level alters wages, prices, and perceptions, which in turn influences the position of the short-run aggregate-supply curve.

For example, according to the sticky-wage theory Opens in new window, once workers and firms come to expect a lower level of prices, they start to strike bargains for lower nominal wages; the reduction in labor costs encourages firms to hire more workers and expand production at any given level of prices.

Thus, the fall in the expected price level shifts the short-run aggregate-supply curve to the right from AS1 to AS2 in Figure II (8). This shift allows the economy to approach point C, where the new aggregate-demand curve (AD2) crosses the long-run aggregate-supply curve.

In the new long-run equilibrium, point C, output is back to its natural level. The economy Opens in new window has corrected itself: The decline in output is reversed in the long run, even without action by policymakers.

Although the wave of pessimism has reduced aggregate demand, the price level has fallen sufficiently (to P3) to offset the shift in the aggregate-demand curve, and people have come to expect this new lower price level as well.

Thus, in the long run, the shift in aggregate demand is reflected fully in the price level and not at all in the level of output. In other words, the long-run effect of a shift in aggregate demand is a nominal change (the price level is lower) but not a real change (output is the same).

What should policymakers do when faced with a sudden fall in aggregate demand?

In this analysis, we assumed they did nothing. Another possibility is that, as soon as the economy heads into recession (moving from point A to point B) Opens in new window, policymakers could take action to increase aggregate demand.

As we noted earlier, an increase in government spending or an increase in the money supply would increase the quantity of goods and services demanded at any price and, therefore, would shift the aggregate-demand curve to the right.

If policymakers act with sufficient speed and precision, they can offset the initial shift in aggregate demand, return the aggregate-demand curve to AD1, and bring the economy back to point. If the policy is successful, the painful period of depressed output and employment can be reduced in length and severity.

The next series of lesson discusses in more detail the ways in which monetary and fiscal policy influence aggregate demand Opens in new window, as well as some of the practical difficulties in using these policy instruments.

To sum up, this story about shifts in aggregate demand has three important lessons:

  • In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services.
  • In the long run, shifts in aggregate demand affect the overall price level but do not affect output.
  • Because policymakers influence aggregate demand, they can potentially mitigate the severity of economic fluctuations.

In the whole of this series we have achieved two goals. First, we have discussed some of the important facts about short-run fluctuations in economic activity.

Second, we have introduced a basic model to explain those fluctuations, called the model of aggregate demand Opens in new window and aggregate supply Opens in new window. We continue our study of this model in the next series Opens in new window to understand more fully what causes fluctuations in the economy and how policymakers might respond to these fluctuations.