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Figure 23.2 (Macro 10) The First Step of an Economic Fluctuation

Figure 23.2 (Macro 10) The First Step of an Economic Fluctuation

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1. Changes in Aggregate Demand…. (cont.)

1b. The decisions of individual firms depend on

capacity utilization. Firms generally increase or

decrease production, not prices, in the short run or

over the business cycle.

Firms have the ability to vary production over a range

of utilization, for example, between 70 and 90 percent.

High utilization rates in factories and unemployment

below the natural rate occur during booms, while the

opposite occurs in recessions.

Firms respond to changes in demand through changes

in production in all areas, not just in manufacturing.

For example, construction employment is quite

sensitive to changes in demand.



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1. Changes in Aggregate Demand…. (cont.)

• 1c. The explanation of why changes in demand

result in changes in production relies on two factors.

• 1c.1 Firms operate with limited information,

uncertain about whether an increase in demand is

permanent or temporary. Firms are often reluctant to

raise prices because of uncertainty and an implicit

contract with customers. Similar arrangements with

workers lead to nominal wage rigidities.



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1. Changes in Aggregate Demand…. (cont.)

• 1c.2 The response of the typical firm is illustrated

in Figure 23.3. Demand is uncertain: It can be

high, medium, or low. The flexible price

assumption views the firm as adjusting price;

under the sticky price assumption, the firm adjusts

quantity. If demand becomes certain or is viewed

as permanent, a firm is more likely to adjust price

than quantity.



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Figure 23.3 (Macro 10)

Alternative Short-Run Responses of a Typical Firm to a Change in Demand



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1. Changes in Aggregate Demand…. (cont.)

• 1d. Another explanation of economic fluctuations

is the real business cycle theory. Under this

explanation, the source of economic fluctuations is

found in frequent shifts in potential GDP. This

would mean that the determinants of aggregate

supply (labor, capital, and technology) must shift

frequently. However, these determinants tend to

change slowly over time.



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Figure 23.2 (Macro 10) The First Step of an Economic Fluctuation

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