Aggregate Demand and Aggregate Supply

Introduction Explaining Short-run Economic Fluctuations Aggregate Demand

The Negative Slope Shifts

Aggregate Demand and Aggregate Supply

Long-run Aggregate Supply

Why It Is Vertical Why It Might Shift

Short-run Aggregate Supply

Why It Is Positively Sloped Why It Might Shift

Two Causes of Recession

Introduction

Over the long run, output has grown at about 3% per year Primarily the result of changes in supply
Growth in productive capacity

We will explain why the economy fluctuates around its long-run trend
i.e. we will focus on short-run fluctuations or business cycles

Explaining Short-Run Economic Fluctuations

The basic model of fluctuations will focus on the price level and output (real GDP) The aggregate demand/aggregate supply model will be used to explain these fluctuations

Explaining Short-Run Economic Fluctuations

Aggregate demand (AD) shows the quantities of goods and services that households, firms, government, and the foreign sector want to buy at various price levels Aggregate supply (AS) shows the quantities of goods and services that firms produce and sell at various price levels

Explaining Short-Run Economic Fluctuations

The interaction of AD and AS determine the equilibrium price level and output Graphics

The Aggregate Demand Curve and Its Negative Slope

Recall that Y = C + I + G + NX G is determined by government policies C, I, and NX depend on economic conditions and the price level There is a negative relationship between C, I, and NX and the price level
This means AD is negatively related to the price level

The Aggregate Demand Curve and Its Negative Slope

Wealth Effect
Explains the negative relation between C & P When the price level declines, money is more valuable (the same $ purchases more g/s) Since money is more valuable, consumers feel more wealthy and spend more

The Aggregate Demand Curve and Its Negative Slope

Interest-Rate Effect
Explains the negative relationship between I&P As the price level falls, money demand falls (dont need to hold as many of our assets as dollars) More money is put into interest bearing accounts

The Aggregate Demand Curve and Its Negative Slope

The interest rate falls As the interest falls, it is less costly to borrow for investment in physical capital Investment increases

The Aggregate Demand Curve and Its Negative Slope

Exchange-Rate Effect
Explains the negative relationship between NX & P As the price level falls, goods and services in the U.S. become relatively less expensive while imports become relatively more expensive Exports increase, imports decrease, NX increase

The Aggregate Demand Curve and Its Negative Slope

The above effects mean that there will be a negative relationship between P & AQD
Note: a change in the price level moves us along AD (it does not shift (change) AD; a change in the price level causes a change in AQD, not AD

Why Aggregate Demand Might Shift

AD can change (shift) if there is a change in C, I, G or NX

Note: these are changes in C, I, G, or NX that are caused by a change in something other than the price level
Study table on page 711

Why Aggregate Demand Might Shift

Shifts arising from consumption
An increase in C will shift AD to the right A decrease in C will shift AD to the left

Shifts arising from investment

An increase in I will shift AD to the right A decrease in I will shift AD to the left

Why Aggregate Demand Might Shift

Shifts arising from government purchases
An increase in G will shift AD to the right A decrease in G will shift AD to the left

Shifts arising from net exports

An increase in NX will shift AD to the right A decrease in NX will shift AD to the left

Long-Run Aggregate Supply

There are two AS curves: long-run aggregate supply (LAS) and short-run aggregate supply (SAS) In the long run, supply is determined by factor supplies, productivity, & technology The price level does not determine supply in the long run

Long-Run Aggregate Supply

Since price does not affect supply in the long run, LAS is a vertical line at the potential level of output (natural level of output/ full employment level of output) Graphics

Why Long-Run Aggregate Supply Might Shift

Any change that alters the potential level of output (the natural rate of unemployment) will shift LAS
Changes in labor, capital, natural resources, productivity, or technology will shift LAS
Labor can change due to a change in the quantity of labor resources; the amount offered can also change due to changes in minimum wage laws & union activities

An increase in LAS is a rightward shift A decrease in LAS is a leftward shift

The Short-Run Aggregate Supply Curve and Its Positive Slope

In the short run, an increase in the price level will increase aggregate quantity supplied This happens because the price level deviates from the price level people expect
If P > Pexp output will increase If P < Pexp output will decrease

The Short-Run Aggregate Supply Curve and Its Positive Slope

The Misperceptions Theory

Developed by Friedman and Lucas Changes in the price level can temporarily mislead people as to how relative prices are changing This misperception causes a positive relationship between P and AQS Example

The Short-Run Aggregate Supply Curve and Its Positive Slope

The Sticky-Wage Theory

Developed by Keynes Nominal wages are sticky and this leads to a positive relation between P & AQS
Sticky nominal wages can occur because of long-term contracts and social norms

Example

The Short-Run Aggregate Supply Curve and Its Positive Slope

The New Sticky-Price Theory

Prices of some g/s are sticky and this leads to a positive relationship between P & AQS
Sticky prices can occur because of menu costs

Example

The Short-Run Aggregate Supply Curve and Its Positive Slope

All three explanations result in a positive relationship between P and QS in the short run
AQS = Natural rate of output + a (Pa Pe)
a: number determining how much output responds to unexpected changes in prices Pa = Pe: output = natural rate Pa > Pe: output increases above natural rate Pa < Pe: output falls above natural rate

Why Short-Run Aggregate Supply Might Shift

All of the variables that shifted LAS will also shift SAS In addition, changes in peoples expectations about prices will shift SAS
If price expectations are revised upward SAS will decrease If price expectations are revised downward SAS will increase

Why Short-Run Aggregate Supply Might Shift

A rightward shift is an increase in SAS A leftward shift is a decrease in SAS Graphics

Recession Caused by a Shift in Aggregate Demand

Suppose the economy is in long-run equilibrium and there is a decrease in AD This will cause a fall in output and an increase in unemployment (recession) Over the long run, the economy will return to a full-employment equilibrium

Recession Caused by a Shift in Aggregate Demand

People will correct misconceptions Price expectations will be revised downward SAS will shift right The price level will fall and output will increase

Graphics

Recession Caused by a Shift in Aggregate Supply

Suppose the economy is in long-run equilibrium and there is a decrease in SAS This will cause a fall in output and an increase in unemployment At the same time, the price level rises The combination of recession & inflation is stagflation

Recession Caused by a Shift in Aggregate Supply

Over the long run, the economy will return to a full-employment equilibrium
As unemployment persists, wages will fall and SAS will increase