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Short-Run Economic Fluctuations - Coggle Diagram
Short-Run Economic Fluctuations
Business Cycle
Short-run fluctuations in an economy’s output and unemployment
Long-Run Output And Unemployment
The normal level of output is called potential output, and the normal unemployment rate is the natural rate. These variables are also called the long-run levels of output and unemployment.
Unemployment rate (U
), Percentage of the labor force without jobs
Natural rate of unemployment (U*)
, Normal or average level of unemployment
Potential output (Y*)
, The normal or average level of output, as determined by resources and technology.
Boom And Recessios
Output Fluctuations
Economic boom period when actual output exceeds potential output.
Recession period when actual output falls below potential output.
Output gap (Y) percentage difference between actual and potential output
Unemployment Fluctuations
, the close relationship between unemployment and output. nemployment is low when output is high (in booms) and high when output is low (in recessions).
Okun’s law
, captures the relative sizes of output and unemployment fluctuations over the business cycle. The equation says that the output gap falls
by 2 percentage points when unemployment rises 1 point above the natural rate
Aggregate Expenditure
This variable is total spending on an economy’s goods and services by people, firms, and governments. Total spending
varies over time, causing the business cycle.
Y = AE = C+I+G+NX
The role of the Interest Rate
A rise in the real interest rate reduces aggregate expenditure.
Conversely, a fall in the interest rate raises AE.
Effects on Spending
Consumption A higher real interest rate encourages people to save.
Higher saving means lower spending on consumption. S
Investment A higher real interest rate makes it more expensive for
firms to finance investment projects. Thus, investment spending falls
Net exports
An increase in the real interest rate reduces a country’s net
capital outflows, which in turn raises the real exchange rate.
Monetary Policy and Equilibrium Output
However, in the short run, the central bank’s control of the nominal interest
rate allows it to control the real rate as well.
Equilibrium Output
We can now see how the equilibrium level of output
is determined in the short run.
Any event that changes aggregate expenditure for a given interest rate is called an expenditure shock. An
expenditure shock
causes the AE curve to shift.
Types of Expenditure Shocks
Government spending
Taxes
A tax increase means consumers have less income left to spend.
Consumption falls, shifting the AE curve to the left.
Consumer confidence
, If consumers fear trouble, they save more for
a rainy day when their incomes might fall.
New technologies Investment spending depends partly on whether
firms see good investment opportunities
Changes in bank lending Many firms depend on banks to finance investment. Sometimes banks reduce their lending sharply, an event called a credit crunch, and firms are forced to cut investment.
Foreign business cycles Booms and recessions are contagious: a change
in one country’s output affects the output of its trading partners
Fluctuations In The Inflation Rate
Expected Inflation
Determines Expected Inflation
Rational Expectations
Adaptive Expectations
Choosing an Assumption
The Effect Of Output
The Phillips Curve
Remember our earlier assumption that inflation equals
expected inflation. We now modify this assumption to account for the
effect of output. We assume that inflation equals expected inflation when
output is at potential. With normal levels of production, firms raise prices at
the expected inflation rate to keep relative prices stable.
. The key idea behind the Phillips curve
is that an economic boom raises inflation and a recession reduces it
Equations for the Phillips Curve
The Phillips Curve with Adaptive Expectations
Supply Shocks
Is an event that
causes a major change in firms’ production costs. An adverse supply shock
raises costs, and a beneficial supply shock reduces costs. In the short run, these
shocks cause changes in the inflation rate.
Supply Shocks and the Phillips Curve
, An adverse supply shock
raises inflation for any given levels of expected inflation and output.
The Complete Economy
Now put the two curves together to get a complete view of short-run economic fluctuations: the
aggregate ecpenditure/Phillips curve model
The AE/PC model assumes a negative relationship between the interest
rate and output (the AE curve) and a positive relationship between output
and inflation (the Phillips curve).
Long-Run Monetary Neutrality
In the long-run, monetary polity usually does not affect real variables, those taht are adjusted for inflation, such as real GDP and rea interest rates
Output and Unemployment
Output deviates from potential
during booms and recessions, but it returns to potential in the long run.
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