Short-Run Economic Fluctuations Flashcards
Definition of Business cycle:
- short-run (year-to-year) fluctuations in an economy’s output and unemployment
Definition of Unemployment rate (U):
- percentage of the labor force without jobs
Potential output (Y*)
- the normal or average level of output, as determined by resources and technology
Definition of Natural rate of unemployment (U*)
- normal or average level of unemployment
Definition of Economic boom:
- period when actual output exceeds potential output
Definition of Recession:
- period when actual output falls below potential output
Output gap (Y~)
- percentage difference between actual and potential output;
(Y - Y*)/Y* = Ý
Definition of Okun’s law: (Unemployment Fluctuations)
- Relation between output and unemployment over the business cycle:
the output gap falls by 2 percentage points when unemployment rises 1 point above the natural rate;
(Y - Y*)/Y* = 2(U - U*)
Effects of aggregate expendeture :

Definition of Aggregate expenditure (AE):
- total spending on an economy’s goods and services by people, firms, and governments.
- These ideas were developed by the British economist John Maynard Keynes in his 1936 book The General Theory of Employment, Interest, and Money.
Equilibrium output: (graph)

A shift in monetary policy : (graph)

what is “Expenditure shock”?
- event that changes aggregate expenditure for a given interest rate, shifting the AE curve
Types of Expenditure Shocks:
- Government spending
- Taxes
- Consumer confidence
- New technologies
- Changes in bank lending
- Foreign business cycles
what is the meaning of Credit crunch
- a sharp reduction in bank lending
how government spending affect the economy ? ( Expenditure Shocks)
- The goverment can create an Expenditure Shocks when it start consuming more and increasing its share of aggregate consume
what is “Countercyclical monetary policy”?
- adjustments of the real interest rate by the central bank to offset expenditure shocks and thereby stabilize output
Expected inflation formula:
pi = pie
where “pi” is actual inflation and “pie” is expected inflation.
Is adaptive expectations a reasonable assumption?
Supporters make two points:
- For the firm managers who set prices, forecasting that inflation will equal past inflation is an easy shortcut.
- Although adaptive expectations are not the best possible forecasts, they are fairly good ones, adaptive forecasts of inflation have not been far off.
Phillips curve (PC)
- the positive short-run relationship between output and inflation; also, the negative short-run relationship between unemployment and inflation
- inflation equals expected inflation when output is at potential
- The key idea behind the Phillips curve is that an economic boom raises inflation and a recession reduces
Phillips curve (PC) graph

Why can we draw the Phillips curve in two different ways?
- Okun’s law
- which tells us that output and unemploy- ment move in opposite directions over the business cycle
Output Phillips Curve (formula)
pi = pie + X . (Y - Y*)/ Y* ; (X > 0)
- pi mean inflation
- pie mean expected inflation
- X is a positive constant that measures how strongly output affects inflation.
- Y mean output
- Y* is potential output
Unemployment Phillips Curve: (formula)
pi = pie - 2X (U - U*)
- pi mean inflation
- piemean expected inflation
- X is a positive constant that measures how strongly output affects inflation.
- U is the deviation of unemployment from the natural rate.
