Lecture 34

In the long run, real GDP grows around 5% per year on average. In the short run however, it fluctuates around its trend. A recession is a period of falling real incomes and rising unemployment. A depression is a severe recession.

• Economic fluctuations are irregular and unpredictable.
  These short-run economic fluctuations are often called business cycles. The name is somewhat leading since the fluctuations do not actually cycle, and are very unpredictable.
• Most macroeconomic quantities fluctuate together.
  As a result, it does not matter too much which variable we use to monitor economic activity. It should be noted that while they fluctuate together, they do fluctuate by different amounts.
• As output falls, unemployment rises.
  This makes sense because when firms produce less goods and services, they lay off workers, which increases the number of unemployed.

Explaining these fluctuations is difficult, and the theory of economic fluctuations is controversial. We usually use the model of aggregate demand and aggregate supply. This differs from classical long-run theories.
In the short run, changes in nominal variables (like \(\text{P}\)) can affect real variables (like \(\text{Y}\)).

The aggregate demand curve shows the quantity of all goods and services demanded in the economy (by households, firms, the government, and customers abroad) at a given price level (\(P\) on the vertical axis and \(Y\) on the horizontal).
The aggregate demand curve slopes downward. Why is this? If \(P\) rises,

• \(\text{C}\) falls (the wealth effect). People can buy fewer goods and services with the money they hold, so real wealth is lower, people feel poorer, and \(\text{C}\) falls.
• interest rate \(\text{I}\) rises (the interest rate effect). Wealth falls, so people are more hesitant to lend money, which increases interest rates.It discourages investment spending and decreases the demand for goods and services.
• \(\text{NX}\) increases (the exchange rate effect). Interest rates rise, so foreign investors desire more Indian bonds, the Indian exchange rate appreciates, and \(\text{NX}\) increases.
  We may assume that \(G\) is fixed by the government policy.

The aggregate demand curve can shift due to

• changes in consumption, due to a stock market boom/crash or tax hikes/cuts, etc.
• changes in investment, due to firms buying new equipment or expectations changing.
• changes in government spending.
• changes in \(\text{NX}\), due to booms/recessions in countries that buy exports, or appreciation/depreciation from international speculation in the foreign exchange market.

If any of the above decrease, the curve shifts to the left (the quantity of goods/services demanded at a certain price level drops).

The aggregate supply curve shows the quantity of the total quantity of goods and services firms produce and sell at any given price level. It is upward sloping in the short run and vertical in the long run.
First, let us look at the long run.
In the long run, the real GDP depends on the supplies of labour, capital, natural resources, and available technology. Since these do not significantly change in the long run, the aggregate supply is constant and the curve is vertical. What could cause a shift of the long-run aggregate supply curve?

The natural rate of output (\(Y_N\)) is the amount of output the economy produces when unemployment is at its natural rate. It is determined by the economy’s stocks of labour, capital, natural resources, and level of technology, which remain somewhat constant in the long run (an increase in \(P\) does not affect any of these) – this is a consequence of classical dichotomy.