Aggregate Demand and Aggregate Supply

Short-Run Economic Fluctuations

Economic activity fluctuates from year to year.
In most years production of goods and services rises. On average over the past 50 years, production in the U.S. economy has grown by about 3 percent per year. In some years normal growth does not occur, causing a recession.

A recession is a period of declining real incomes, and rising unemployment. Since 1965, the U.S. economy has suffered six recessions. A depression is a severe recession. The Great Depression occurred in 1929-1941 when output fell by about 30 percent and unemployment rose to 25 percent.

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS

Economic fluctuations are irregular and unpredictable.

Fluctuations in the economy are often called the business cycle. Stylized model of the business cycle.

Most macroeconomic variables fluctuate together. As output falls, unemployment rises.

Figure 1 A Look At Short-Run Economic Fluctuations

(a) Real GDP
Billions of 1996 Dollars $10,000

9,000
8,000 7,000 6,000 5,000 4,000 3,000

Real GDP

2,000 1965

1970

1975

1980

1985

1990

1995

2000

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THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS

Most macroeconomic variables fluctuate together.
Most macroeconomic variables that measure some type of income or production fluctuate closely together. Although many macroeconomic variables fluctuate together, they fluctuate by different amounts.

Figure 1 A Look At Short-Run Economic Fluctuations

(b) Investment Spending Billions of 1996 Dollars $1,800 1,600 1,400 1,200 1,000 Investment spending

800
600

400
200 1965 1970 1975 1980 1985 1990 1995 2000

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THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS

As output falls, unemployment rises.
Changes in real GDP are inversely related to changes in the unemployment rate. During times of recession, unemployment rises substantially.

Figure 1 A Look At Short-Run Economic Fluctuations

(c) Unemployment Rate Percent of Labor Force 12 10 8 6 4 2 0 1965 Unemployment rate

1970

1975

1980

1985

1990

1995

2000

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EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS

Short-run versus the long-run: Price Flexibility
LR: Most economists believe that classical theory describes the world in the long run but not in the short run.
Changes in the money supply affect nominal variables but not real variables = Monetary is neutral. The aggregate supply curve is vertical and prices adjust fully.

SR: Most economists believe that prices do not adjust fully in the short-run and therefore output will change.
Changes in the money supply can affect real variables in the short-run = Money is not neutral. Aggregate supply is upward sloping.

Therefore, aggregate demand as well as aggregate supply are important in determining output and prices in the shortrun.

The Basic Model of Economic Fluctuations

Two variables are used to develop a model to analyze the short-run fluctuations.
The economys output of goods and services measured by real GDP. The overall price level measured by the CPI or the GDP deflator.

The Basic Model of Aggregate Demand and Aggregate Supply

Economist use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.

 The Basic Model of Aggregate Demand and Aggregate Supply

The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level.

The Basic Model of Aggregate Demand and Aggregate Supply

The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.

Figure 2 Aggregate Demand and Aggregate Supply...

Price Level

Aggregate supply

Equilibrium price level

Aggregate demand

Equilibrium output

Quantity of Output
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THE AGGREGATE-DEMAND CURVE

The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX

Figure 3 The Aggregate-Demand Curve...

Price Level

P2 1. A decrease in the price level . . . 0 Y Y2 Aggregate demand

Quantity of Output

2. . . . increases the quantity of goods and services demanded.

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Why the Aggregate-Demand Curve Is Downward Sloping

The AD is not downward sloping for the reasons a demand curve in microeconomics is downward sloping (substitution and income effects) Remember our analysis of the Wealth Portfolio If P falls the value of money increases, people are then holding excess cash balances so they either spend it or lend it:
Spend it : The Price Level and Consumption: The Wealth Effect Lend it: The Price Level and Investment: The Interest Rate Effect The result of lend it: The Price Level and Net Exports: The Exchange-Rate Effect

 The Price Level and Consumption: The Wealth Effect

A decrease in the price level increases the value of money in ones portfolio and makes consumers feel more wealthy, which in turn encourages them to spend more. This increase in consumer spending means larger quantities of goods and services demanded. P VofM wealth spend it C AD

 The Price Level and Investment: The Interest Rate Effect

A lower price level increases the value of cash holdings and wealth, people lend more, this reduces the interest rate, which encourages greater spending on investment goods. This increase in investment spending means a larger quantity of goods and services demanded. P VofM wealth lend it SLF r I AD

 The Price Level and Net Exports: The ExchangeRate Effect

A lower price level increases the value of cash holdings and wealth, people lend more, this reduces the interest rate, NCO increases the supply of dollars increases, the real exchange rate depreciates, which stimulates U.S. net exports. The increase in net export spending means a larger quantity of goods and services demanded. P VofM wealth lend it SLF r S$ eP/P* NX AD

Shifts in the Aggregate-Demand Curve

The downward slope of the aggregate demand curve shows that a fall in the price level raises the overall quantity of goods and services demanded. Many other factors, however, affect the quantity of goods and services demanded at any given price level. When one of these other factors changes, the aggregate demand curve shifts. Shifts arise from autonomous (not related to P or Q in US)
Consumption consumer confidence Investment business confidence Government Purchases Military, Medicare Net Exports ROW incomes

Shifts in the Aggregate Demand Curve Price

Level

P1

D2
Aggregate demand, D1 0

Y1

Y2

Quantity of Output

THE AGGREGATE-SUPPLY CURVE

In the long-run, aggregate-supply curve is vertical. This is the Classical view. In the short run, the aggregate-supply curve is upward sloping. This a modification of the Keynesian view. The Long-Run Aggregate-Supply Curve
In the long run, an economys production of goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services. Q= A F(K/L, H/L, NR/L) The price level does not affect these variables in the long run.

Figure 4 The Long-Run Aggregate-Supply Curve

Price Level Long-run aggregate supply P

P2 1. A change in the price level . . . 0 Natural rate of output

2. . . . does not affect the quantity of goods and services supplied in the long run. Quantity of Output

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THE AGGREGATE-SUPPLY CURVE

The Long-Run Aggregate-Supply Curve
The long-run aggregate-supply curve is vertical at the natural rate of output. This level of production is also referred to as potential output or full-employment output.

Why the Long-Run Aggregate-Supply Curve Might Shift

Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve. The shifts may be categorized according to the various factors in the classical model that affect output. Shifts arising
Labor Capital Natural Resources Technological Knowledge

Figure 5 Long-Run Growth and Inflation

2. . . . and growth in the money supply shifts aggregate demand . . . Price Level

Long-run aggregate supply, LRAS1980 LRAS1990 LRAS2000

P2000 4. . . . and ongoing inflation. P1990

1. In the long run, technological progress shifts long-run aggregate supply . . .

Aggregate Demand, AD2000 P1980 AD1990

AD1980

Y1980

Y1990

Y2000

Quantity of Output 3. . . . leading to growth in output . . .

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A New Way to Depict Long-Run Growth and Inflation

Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends.

Why the Aggregate-Supply Curve Slopes Upward in the Short Run

In the short run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied. A decrease in the level of prices tends to reduce the quantity of goods and services supplied.

Figure 6 The Short-Run Aggregate-Supply Curve

Price Level

Short-run aggregate supply P

P2 1. A decrease in the price level . . .

2. . . . reduces the quantity of goods and services supplied in the short run.

Y2

Quantity of Output
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Why the Aggregate-Supply Curve Slopes Upward in the Short Run

To understand an upward sloping short-run supply curve we need to understand expectations. Specifically, expectations about prices.
Remember nominal interest rates equals the real rate of interest plus the rate of inflation: i=r+%P Borrowers and lenders must form expectations about what prices will be in the future before they agree to lend and borrow. In the macroeconomy, individuals form expectations about the price level (inflation later on).
Workers form Pe when negotiating form nominal wages (W). Business form Pe ,especially about inputs, when setting prices.

 The expected price level Pe is the link between aggregate supply in the short-run and in the longrun. In the long-run P=Pe, people cant be fooled, but in the short-run P can be less than, equal to, or more than Pe. Three theories of upward-sloping short-run aggregate supply:
The Misperceptions Theory The Sticky-Wage Theory The Sticky-Price Theory

 The Misperceptions Theory

Changes in the overall price level temporarily mislead suppliers about what is happening in the markets in which they sell their output: A lower price level causes misperceptions about relative prices.
These misperceptions induce suppliers to decrease the quantity of goods and services supplied.

The Sticky-Wage Theory

The Sticky-Wage Theory
Nominal wages are slow to adjust, or are sticky in the short run:
Wages do not adjust immediately to a fall in the price level. A lower price level makes employment and production less profitable. This induces firms to reduce the quantity of goods and services supplied.

The Sticky-Price Theory

Prices of some goods and services adjust sluggishly in response to changing economic conditions:
An unexpected fall in the price level leaves some firms with higher-than-desired prices. This depresses sales, which induces firms to reduce the quantity of goods and services they produce.

Why the Short-Run Aggregate-Supply Curve Might Shift

Shifts arising
Labor Capital Natural Resources. Technology. Expected Price Level.

An increase in the expected price level reduces the quantity of goods and services supplied and shifts the short-run aggregate supply curve to the left. A decrease in the expected price level raises the quantity of goods and services supplied and shifts the short-run aggregate supply curve to the right.

Figure 7 The Long-Run Equilibrium

Price Level Long-run aggregate supply

Short-run aggregate supply

Equilibrium price

Aggregate demand 0 Natural rate of output

Quantity of Output
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Figure 8 A Contraction in Aggregate Demand

2. . . . causes output to fall in the short run . . . Price Level Long-run aggregate supply

Short-run aggregate supply, AS

AS2 3. . . . but over time, the short-run aggregate-supply curve shifts . . . 1. A decrease in aggregate demand . . .

P P2 P3 B

Aggregate demand, AD
AD2 0 Y2 Y 4. . . . and output returns to its natural rate. Quantity of Output
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TWO CAUSES OF ECONOMIC FLUCTUATIONS

Shifts in Aggregate Demand
In the short run, shifts in aggregate demand cause fluctuations in the economys output of goods and services. In the long run, shifts in aggregate demand affect the overall price level but do not affect output.

An Adverse Shift in Aggregate Supply

A decrease in one of the determinants of aggregate supply shifts the curve to the left:
Output falls below the natural rate of employment. Unemployment rises. The price level rises.

Figure 10 An Adverse Shift in Aggregate Supply

1. An adverse shift in the shortrun aggregate-supply curve . . . Price Level Long-run aggregate supply AS2 Short-run aggregate supply, AS

B P2 A P 3. . . . and the price level to rise.

Aggregate demand
0 Y2 Y Quantity of Output
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2. . . . causes output to fall . . .

The Effects of a Shift in Aggregate Supply

Stagflation
Adverse shifts in aggregate supply cause stagflationa period of recession and inflation.
Output falls and prices rise. Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

Policy Responses to Recession

Policymakers may respond to a recession in one of the following ways:
Do nothing and wait for prices and wages to adjust. Take action to increase aggregate demand by using monetary and fiscal policy.

Figure 11 Accommodating an Adverse Shift in Aggregate Supply

1. When short-run aggregate supply falls . . .
Price Level Long-run aggregate supply

AS2

Short-run aggregate supply, AS

P3 P2

C A

3. . . . which P causes the price level to rise further . . . 0

2. . . . policymakers can accommodate the shift by expanding aggregate demand . . .

4. . . . but keeps output at its natural rate. Natural rate of output

AD2
Aggregate demand, AD Quantity of Output
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Short-run vs. Long-run Adjustment

The economy may contract or expand in the short-run, but it will return to the long-run level of output and the natural rate of unemployment (full-employment or YFE). Aggregate supply is the curve that shifts to return the economy to full employment. Given that we have emphasized sticky wages, over other theories of the slope of the AS curve, lets use wage flexibility in the long-run to explain how the AS shifts and returns the economy to YFE The basic idea is that wages will adjust upwards when Yactual> YFE or the unemployment rate is below the natural rate and downwards if Yactual<YFE.

 If Yactual> YFE, Uactual<UNR, this will cause nominal wages (W) to rise in the long-run and the AS will decrease or shift up and to the left. If Yactual< YFE, Uactual>UNR, this will cause nominal wages (W) to fall in the long-run and the AS will increase or shift down and to the right. In both cases, nominal wages will continue to adjust until we return to the UNR and YFE is restored.

Adjustment to Shifts in AD and AS

Positive AD shock, AD, P, Y, Yactual> YFE, Uactual<UNR, W, AS, until Yactual=YFE, Uactual=UNR (Figure 7 above) Negative AD shock, AD, P, Y, Yactual<YFE, Uactual>UNR, W, AS, until Yactual=YFE, Uactual=UNR (Figure 7 above) Positive AS shock, AS, P, Y, Yactual> YFE, Uactual<UNR, W, AS, until Yactual=YFE, Uactual=UNR (Figure 8 above) Negative AS shock, AS, P, Y, Yactual<YFE, Uactual >UNR, W, AS, until Yactual=YFE, Uactual=UNR(Figure 8 above)

Summary
All societies experience short-run economic fluctuations around long-run trends. These fluctuations are irregular and largely unpredictable. When recessions occur, real GDP and other measures of income, spending, and production fall, and unemployment rises.

Summary
Economists analyze short-run economic fluctuations using the aggregate demand and aggregate supply model. According to the model of aggregate demand and aggregate supply, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply.

Summary
The aggregate-demand curve slopes downward for three reasons: a wealth effect, an interest rate effect, and an exchange rate effect. Any event or policy that changes consumption, investment, government purchases, or net exports at a given price level will shift the aggregate-demand curve.

Summary
In the long run, the aggregate supply curve is vertical. The short-run, the aggregate supply curve is upward sloping. The are three theories explaining the upward slope of short-run aggregate supply: the misperceptions theory, the sticky-wage theory, and the sticky-price theory.

Summary
Events that alter the economys ability to produce output will shift the short-run aggregate-supply curve. Also, the position of the short-run aggregate-supply curve depends on the expected price level. One possible cause of economic fluctuations is a shift in aggregate demand.

Summary
A second possible cause of economic fluctuations is a shift in aggregate supply. Stagflation is a period of falling output and rising prices.