Economic Fluctuations

Explanations for Short-Run Economic Fluctuations

Describing what happens to economies as they fluctuate over time is easy. Attempting to explain what causes these fluctuations can give one early grey hairs, as it isn’t straightforward.

Indeed, the theory of economic fluctuations remains controversial. In this post, we begin to develop the model that most economists use to explain short-run fluctuations in economic activity.

The Assumptions of Classical Economics

According to classical economic theory, money is neutral. That is, changes in the quantity of money affect nominal variables such as the price level but not real variables such as output.

Most economists accept this conclusion as a description of how the economy works in the long run but not in the short run.

In a sense, money does not matter in a classical world. If the quantity of money in the economy were to double, everything would cost twice as much, and everyone’s income would be twice as high.

But so what?

The change would be nominal (by the standard meaning of “nearly insignificant”). The things that people really care about—whether they have a job, how many goods and services they can afford, and so on—would be exactly the same.

This classical view is sometimes described by the saying, “Money is a veil.” That is, nominal variables are often expressed in units of money. But what’s important are the real variables and the economic forces that determine them.

According to classical theory, to understand these real variables, we need to look behind the veil.

The Reality of Short-Run Fluctuations

Do these assumptions of classical macroeconomic theory apply to the world in which we live?

The answer to this question is of central importance to understanding how the economy works.

Most economists believe that classical theory describes the world in the long run but not in the short run.

Consider again the impact of money on the economy. Most economists believe that, beyond a period of several years, changes in the money supply affect prices and other nominal variables but do not affect real GDP, unemployment, and other real variables — just as classical theory says.

When studying year-to-year changes in the economy Opens in new window, however, the assumption of monetary neutrality Opens in new window is no longer appropriate. In the short run, real and nominal variables are highly intertwined, and changes in the money supply can temporarily push real GDP away from its long-run tend.

Even the classical economists themselves, such as David Hume, realized that classical economic theory did not hold in the short-run.

From his vantage point in 18th century England, Hume observed that when the money supply expanded after gold discoveries, it took some time for prices to rise, and in the meantime, the economy enjoyed higher employment and production.

To understand how the economy works in the short run, we need a new model, which focuses on how real and nominal variables interact.

The Model of Aggregate Demand and Aggregate Supply

Our model of short-run economic fluctuations focuses on the behavior of two variables.

Notice that output is a real variable, whereas the price level is a nominal variable. By focusing on the relationship between these two variables, we are departing from the classical assumption that real and nominal variables can be studied separately.

Figure I, Aggregate demand and aggregate supply Figure I, Aggregate Demand and Aggregate Supply

We analyze fluctuations in the economy as a whole with the model of aggregate demand and aggregate supply, which is illustrated in Figure 1.

On the vertical axis is the overall price level in the economy. On the horizontal axis is the overall quantity of goods and services produced in the economy. The aggregate demand curve Opens in new window shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level.

The aggregate-supply curve Opens in new window shows the quantity of goods and services that firms produce and sell at each price level. According to this model, the price level and the quantity of output adjust to bring aggregate demand and aggregate supply into balance.

It is tempting to view the model of aggregate demand and aggregate supply as nothing more than a large version of the model of market demand and market supply. But in fact, this model is quite different.

When we consider demand and supply in a specific market—ice cream, for instance—the behavior of buyers and sellers depends on the ability of resources to move from one market to another.

When the price of ice cream rises, the quantity demanded falls because buyers will use their incomes to buy products other than ice cream. Similarly, a higher price of ice cream raises the quantity supplied because firms that produce ice cream can increase production by hiring workers away from other parts of the economy.

This microeconomic Opens in new window substitution from one market to another is impossible for the economy as a whole. After all, the quantity that our model is trying to explain—real GDP—measures the total quantity of goods and services produced by all firms in all markets.

To understand why aggregate-demand curve slopes downward and why the aggregate-supply curve slopes upward, we need a macroeconomic theory Opens in new window that explains the total quantity of goods and services demanded and the total quantity of goods and services supplied. Developing such a theory is our next task Opens in new window.