Notes on Business Cycles and the Aggregate Demand Supply Model

Changes in GDP, inflation, and unemployment are related through the business cycle.

Business cycle: The more or less regular pattern of expansion (recovery) and contraction (recession) in economic activity around full employment output.

Potential GDP: output that is produced when all factors of production are fully employed.

Output Gap: Measures the difference between actual output and the output that could be produced at full employment, or potential GDP.

Output Gap= Potential output- Actual output.

• Actual output declines relative to potential output during recessionary periods.
• Unemployment increases very quickly during recessions, but recovers very slowly.

Aggregate Demand and Aggregate Supply Model

AD curve: shows combinations of the price level and the level of output for which the demanders of goods and services are in equilibrium.

• The AD curve slopes downward, because as the price level increases, with the nominal money stock held constant, the real money stock decreases. An increase in the nominal money stock shifts the AD curve outward. The vertical shift in the AD curve is proportional to the change in the nominal money stock.
  • The aggregate-demand curve slopes downward for three reasons. The first is the wealth effect: A lower price level raises the real value of households’ money holdings, which stimulates consumer spending. The second is the interest-rate effect: A lower price level reduces the quantity of money households demand; as households try to convert money into interest-bearing assets, interest rates fall, which stimulates investment spending. The third is the exchange-rate effect: As a lower price level reduces interest rates, the dollar depreciates in the market for foreign-currency exchange, which stimulates net exports.

• Any curve will shift due to an exogenous change. Therefore, a change in fiscal or monetary policy will shift the AD curve.

AS Curve: Relationship between the amount of final goods and services produced in the economy and the price level.

• The shapes of the AS curve depend in the time frame being analyzed.
• In the very short-run the Keynesian AS curve is horizontal; indicating that firms will supply whatever amount of goods are demanded at the existing price level.
• The Keynesian AS curve is relevant for the very short run when firms can hire more labor without increasing current wage.
• The Classical AS curve is vertical, indicating that the same amount of goods will be supplied no matter what the price level. It is based on the assumption of full market clearing, so the labor market is in equilibrium with full employment of the labor force.

Keynesian AS curve

Classical AS curve

Aggregate demand policies: Keynesian and Classical

Keynesian:

• In the very short run, the AS curve shifts to the right, output increases, while price level remains constant.

• The assumption that prices and interest rates are fixed implies the aggregate supply curve is flat as shown in the Figure Consequently, any change in aggregate supply (i.e., a rightward or leftward shift) will have no effect on the economy. Aggregate demand is the driving force in the Figure. On the supply side firms simply increase or reduce production at the constant market price to meet the level of demand.

Aggregate demand and non-linear aggregate supply

• The shape of the short run AS curve is assumed to be non-linear. This is because, at low levels of output, more output can be produced without inflationary pressure on prices. The economy has ‘slack’ in it, with unused resources waiting to be used. The AS curve will be horizontal at first, but, as more resources are used, factor prices will start to rise, and less output is possible. This process accelerates up to full employment, where after no more output is possible. Beyond this point AS becomes perfectly inelastic.
• At low levels of output, below potential Y, the AS curve is quite flat. When output is below potential there is very little tendency for prices of goods and wages to fall. Where output is above potential the AS curve is steep and prices tend to rise continuously. In a recession we are on the flat part of AS so demand management policies can be effective at boosting the economy without having much effect on the price level. When economy approaches full employment policy makers must be wary of too much stimulus to avoid running the AD curve up the vertical portion of the AS curve.

Aggregate Demand expansion: the classical case

• The assumption is that there is full market clearing, a shift in the AD curve leads only to a price level increase in the long run.

Supply-side Economics

1.    Supply side economics is based on the idea that cutting taxes will affect both the supply and demand sides of the economy.

2.    As a result of a tax cut, the AD shifts upward to the right and the AS curve shifts to the right. However, the shift in the AS curve will be less than the shift in the AD curve. In the short run the equilibrium also shifts to the right on the constant price line. As a result total tax revenues fall proportionally less than does the tax rate. In the long run the economy (equilibrium) shifts up to intersect AS and AD which increases GDP but only by a very small amount. Total tax revenues fall, and the deficit rises. In addition prices are permanently higher.