Bài giảng Macroeconomics - Chapter 4: Short-run economic fluctuation (Part 1) - Nguyễn Thùy Dung

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SHORT-RUN ECONOMIC 
FLUCTUATION
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4.1
Aggregate Demand and 
Aggregate Supply
▪ Economic fluctuations and their characteristics
▪ The model of aggregate demand and 
aggregate supply
▪ Shifts in the AD curve and AS curve.
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Short-Run Economic Fluctuations
▪ In short run, GDP fluctuates around its trend
▪ Short-run economic fluctuations are called business cycles
▪ Recessions: periods of falling real incomes 
and rising unemployment
▪ Depressions: severe recessions
Recession
Depression
Prosperity
Recovery
and fall in production output of goods 
Recovery: That's when the economy is 
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3 Facts About Economic Fluctuations
Fact 1: Economic fluctuations are irregular & unpredictable.
- Recessions are of different durations and do not occur 
with any regularity
Fact 2: Most macroeconomic quantities fluctuate together.
Fact 3: As output falls, unemployment rises. 
- Many variables fluctuate along with GDP: corporate 
profits, investment, consumption, stock prices
- When firms cut back on production, they don’t need as 
many workers. 
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The Basic Model of 
Economic Fluctuations
▪ Most economists use the model of 
aggregate demand and aggregate supply 
to study fluctuations. 
▪ The model focuses on the behavior of 2 variables:
- The economy’s quantity of output, which can be 
measured by real GDP.
- The economy’s price level, which can be measured 
by the CPI or the GDP deflator
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Model of AS-AD
P
Y
AD
SRAS
P1
Y1
The price 
level
Real GDP, the 
quantity of output
The model 
determines the 
eq’m price level
and eq’m output 
(real GDP).
“Aggregate 
Demand”
“Short-Run 
Aggregate 
Supply”
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The Aggregate-Demand (AD) Curve
The AD curve shows the 
quantity of all g&s 
demanded in the economy 
at any given price level.
P
Y
AD
P1
Y1
P2
Y2
Y = C + I + G + NX
Assume G fixed by 
govt policy. 
➔ Slope of AD 
depend on C, I, NX
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1. The Wealth Effect (P and C)
Suppose P rises and people’s real incomes are 
unchanged
▪ The dollars people hold buy fewer g&s, so 
consumers feel less wealthy. 
▪ Consumer will spend less or C falls. 
➔This decrease in consumer spending means 
smaller quantities of g&s demanded.
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2. The Interest-Rate Effect (P and I)
Suppose P rises. 
▪ Real value of consumers’ money holdings falls 
▪ People need more money to make their 
purchases → Demand for money  → interest 
rates  → Firms & household will borrow less 
or I falls.
➔ Decreases the quantity of g&s demanded.
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3. The Exchange-Rate Effect (P and NX)
Suppose P rises. 
▪ Interest rates rise → Foreign investors desire 
more domestic investments →Higher demand 
for $ US → $ US appreciates. 
▪ Foreign goods become less expensive than 
domestic goods → imports become cheaper →
NX falls.
➔ The decrease in NX spending means a smaller 
quantity of g&s demanded.
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The Slope of the AD Curve: Summary
An increase in P
reduces the quantity of 
g&s demanded because:
P
Y
AD
P1
Y1
▪ the wealth effect 
(C falls)
P2
Y2
▪ the interest-rate effect 
(I falls)
▪ the exchange-rate effect 
(NX falls)
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Why the AD Curve Might Shift
Any event that changes 
C, I, G, or NX
– except a change in P, 
will shift the AD curve. 
Example: 
A stock market boom 
makes households feel 
wealthier, C rises and 
AD curve shifts right. 
P
Y
AD1
AD2
Y2
P1
Y1
If firms become more optimistic 
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What happens to the AD curve in each of the 
following scenarios?
A. A ten-year-old investment tax credit expires. 
B. The U.S. exchange rate falls. 
C. A fall in prices
D. State governments decrease their sales taxes
A C T I V E L E A R N I N G 1
The Aggregate-Demand curve
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A C T I V E L E A R N I N G 1
Answer
A. A ten-year-old investment tax credit expires. 
I falls, AD curve shifts left. 
B. The U.S. exchange rate falls. 
NX rises, AD curve shifts right. 
C. A fall in prices 
Move down along AD curve
D. State governments decrease their sales taxes
C rises, AD shifts right. 
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The Aggregate-Supply (AS) Curves
The AS curve shows the 
total quantity of g&s 
firms produce and sell at 
any given price level. 
P
Y
SRAS
LRAS
AS is: 
▪ upward-sloping 
in short run
▪ vertical in long run
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The Long-Run Aggregate-Supply Curve (LRAS)
Human Capital (H)
Natural Resources 
(N)
Technological 
knowledge (A)
Labor (L)
Capital (K)
Output in 
long-run 
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The Long-Run Aggregate-Supply Curve (LRAS)
The natural rate of output (YN) is 
the amount of output the economy 
produces when unemployment is 
at its natural rate. 
Any changes of determinants of 
YN will shift LRAS
An increase in P does not affect 
any of these, so, does not affect YN. 
P
Y
LRAS1
YN
LRAS2
YN’
to 
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1. In the long-run, 
growth in 
technology shifts 
long-run AS...
LRAS3LRAS2
Long-Run Growth and Inflation...
Quantity of
Output
Price 
Level
0
P1
Y1
AD1
P3
P2
LRAS1
2. and growth in the money 
supply shifts AD...
AD3
AD2
4. and 
ongoing 
inflation.
Y2 Y3
3. leading to growth in output...
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Quantity of
Output
Price 
Level
0
SRAS
Y1
P1
Y2
2. reduces the 
quantity of goods 
and services supplied 
in the short run.
P2
1. A 
decrease 
in the 
price level
Short Run Aggregate Supply (SRAS)
3 theories for the 
upward slope of SRAS
The SRAS curve is upward sloping.
Change in price level affect output in the short run
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1. The Sticky-Wage Theory
▪ Nominal wages adjust slowly to changing 
economic conditions, or are “sticky” in the SR.
▪ Firms and workers set the nominal wage in 
advance based on PE - the expected price level
▪ If P > PE, production is more profitable, 
so firms increase output. 
▪ Higher P causes higher Y, 
so the SRAS curve slopes upward.
Wages do not adjust immediately 
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2. The Sticky-Price Theory
▪ Many prices are sticky in the short run.
▪ Due to menu costs - the costs of adjusting 
prices. 
▪ Examples: cost of printing new menus, 
the time required to change price tags 
▪ Firms set sticky prices in advance based on PE.
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▪ Suppose money supply increase unexpectedly 
→ P will rise. 
▪ Firms with menu costs wait to raise prices. 
Meantime, their prices are relatively low, 
→ increases demand for their products, so they 
increase output.
▪ Hence, higher P is associated with higher Y, 
so the SRAS curve slopes upward.
2. The Sticky-Price Theory
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3. The Misperceptions Theory
▪ Firms may confuse changes in P with changes 
in the relative price of the products they sell.
▪ If P > PE, a firm sees its price rise before realizing 
all prices are rising. 
The firm may believe its relative price is rising, 
and may increase output and employment. 
▪ So, an increase in P can cause an increase in Y, 
making the SRAS curve upward-sloping. 
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Summing up
All three theories suggest that Y deviates from YN
when P deviates from PE.
Y = YN + a (P – PE)
Output
Natural rate 
of output 
(long-run)
a > 0, measures how 
much Y responds to 
unexpected changes 
in P
Actual 
price level
Expected 
price level
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Summing up
P
Y
SRAS
YN
When P > PE
Y > YN
When P < PE
Y < YN
PE
the expected 
price level
Y = YN + a(P – PE)
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Why the SRAS Curve Might Shift
Everything that shifts 
LRAS shifts SRAS, too. 
Also, PE shifts SRAS:
If PE rises, workers & 
firms set higher wages. 
At each P, production 
is less profitable, Y falls, 
SRAS shifts left.
LRASP
Y
SRAS
PE
YN
SRAS
PE
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The Long-Run Equilibrium
In the long-run 
equilibrium, 
PE = P, 
Y = YN , 
and unemployment 
is at its natural rate.
P
Y
AD
SRAS
PE
LRAS
YN
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Economic Fluctuations
▪ Caused by events that shift the AD and/or AS
curves.
▪ 4 steps to analyzing economic fluctuations:
1. Determine whether the event shifts AD or AS.
2. Determine whether curve shifts left or right.
3. Use AD-AS diagram to see how the shift changes 
Y and P in the short run. 
4. Use AD-AS diagram to see how economy 
moves from new SR eq’m to new LR eq’m 
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LRAS
YN
The Effects of a Shift in AD
Event: Stock market crash
1. Affects C, AD curve
2. C falls, so AD shifts left
3. SR eq’m at B. 
P and Y lower,
unemployment higher
4. Over time, PE falls, 
SRAS shifts right,
until LR eq’m at C.
Y and unemployment 
back at initial levels. 
P
Y
AD1
SRAS1
AD2
SRAS2
P1 A
P2
Y2
B
P3 C
unemployment 
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LRAS
YN
The Effects of a Shift in SRAS
Event: Oil prices rise
1. Increases costs, 
shifts SRAS
(assume LRAS constant)
2. SRAS shifts left
3. SR eq’m at point B. 
P higher, Y lower,
unemployment higher
From A to B, stagflation, 
a period of falling 
output and rising prices. 
P
Y
AD1
SRAS1
SRAS2
P1 A
P2
Y2
B
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LRAS
YN
Accommodating an Adverse Shift in SRAS
If policymakers do nothing, 
Expected price level will also 
increase, causes wages to 
increase, SRAS shifts father 
left. 
At some point, this low level 
of output and employment 
will put downward pressure 
on wages 
→ SRAS shifts right until LR 
eq’m back to point A
P
Y
AD1
SRAS1
SRAS2
P1 A
P2
Y2
B
AD2
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LRAS
YN
Accommodating an Adverse Shift in SRAS
P
Y
AD1
SRAS1
SRAS2
P2
Y2
B
AD2
P3 C
Or, policymakers could 
increase AD (from AD1 to 
AD2) and accommodate 
the AS shift until LR eq’m
reach C
Y back to YN, but
P permanently higher