Aggregate Demand and Aggregate Supply

1. 20 Aggregate Demand and Aggregate Supply

2. 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. • These fluctuations are known as the business cycle.

3. Short-Run Economic Fluctuations • Business cycle has the stages of expansion – rising GDP, and • recession - a period of declining real GDP, and rising unemployment. • depression - a severe recession (more than four quarters).

4. Figure 1 A Look At Short-Run Economic Fluctuations (a) Real GDP Billions of 1996 Dollars $10,000 9,000 Real GDP 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1965 1970 1975 1980 1985 1990 1995 2000

5. EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS • How the Short Run Differs from the Long Run • 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 in the long run. • The assumption of monetary neutrality is not appropriate when studying year-to-year changes in the economy.

6. The Basic Model of Economic Fluctuations • The Basic Model of Aggregate Demand and Aggregate Supply • Model of aggregate demand and aggregate supply is used to explain short-run fluctuations in economic activity around its long-run trend. • It focuses on behavior of real GDP and inflation

7. Aggregate supply Equilibrium price level Aggregate demand Equilibrium output Figure 2 Aggregate Demand and Aggregate Supply... Price Level Quantity of 0 Output

8. THE AGGREGATE-DEMAND CURVE • Represents spending in the economy • The four components of GDP (Y) from the expenditure approach contribute to the aggregate demand for goods and services. Y = C + I + G + NX

9. P P2 1. A decrease Aggregate in the price demand level . . . Y Y2 2. . . . increases the quantity of goods and services demanded. Figure 3 The Aggregate-Demand Curve... Price Level Quantity of 0 Output

10. Why the Aggregate-Demand Curve Is Downward Sloping • The Price Level and Consumption: The Wealth Effect • The Price Level and Investment: The Interest Rate Effect • The Price Level and Net Exports: The Exchange-Rate Effect

11. Why the Aggregate-Demand Curve Is Downward Sloping • The Price Level and Consumption: The Wealth Effect • A decrease in the price level 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.

12. Why the Aggregate-Demand Curve Is Downward Sloping • The Price Level and Investment: The Interest Rate Effect • A lower price level reduces money demand, which reduces the interest rate, leading to greater spending on investment goods. • This increase in investment spending means a larger quantity of goods and services demanded.

13. Why the Aggregate-Demand Curve Might Shift • 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 in the economy may 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.

14. Why the Aggregate-Demand Curve Might Shift • Shifts arising from • Consumption • Investment • Government Purchases • Net Exports

15. Price Level D2 Aggregate demand, D1 Y2 Quantity of Output Shifts in the Aggregate Demand Curve P1 0 Y1

16. THE AGGREGATE-SUPPLY CURVE • In the long run, the aggregate-supply curve is vertical. • In the short run, the aggregate-supply curve is upward sloping.

17. THE AGGREGATE-SUPPLY CURVE • The Long-Run Aggregate-Supply Curve • In the long run, an economy’s 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. • The price level does not affect these variables in the long run.

18. Long-run aggregate supply P P2 2. . . . does not affect 1. A change the quantity of goods in the price and services supplied level . . . in the long run. Figure 4 The Long-Run Aggregate-Supply Curve Price Level Quantity of 0 Natural rate Output of output

19. 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 GDP or full-employment output.

20. Why the Long-Run Aggregate-Supply Curve Might Shift • Shifts arising • Labor • Capital • Natural Resources • Technological Knowledge

21. 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.

22. Short-run aggregate supply P P2 2. . . . reduces the quantity 1. A decrease of goods and services in the price supplied in the short run. level . . . Y2 Y Figure 6 The Short-Run Aggregate-Supply Curve Price Level Quantity of 0 Output

23. Why the Aggregate-Supply Curve Slopes Upward in the Short Run • The Sticky-Wage Theory • The Sticky-Price Theory • The Misperceptions Theory

24. Why the Aggregate-Supply Curve Slopes Upward in the Short Run • The Sticky-Wage Theory • Nominal wages are slow to adjust, or are “sticky” in the short run: • Wages do not adjust immediately to a rise in the price level. • A higher price level makes labor relatively cheaper. • This allows some firms to increase the quantity of goods and services supplied.

25. The Sticky-Price Theory • Prices of some goods and services adjust sluggishly in response to changing economic conditions: • An unexpected rise in the price level leaves some firms with lower-than-desired prices. • This increases sales, which induces firms to increase the quantity of goods and services they produce.

26. Why the Aggregate-Supply Curve Slopes Upward in the Short Run • 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 firm only sees its own price, and mistakes inflationary effect for greater relative price of its product • These misperceptions induce suppliers to increase the quantity of goods and services supplied.

27. Why the Short-Run Aggregate-Supply Curve Might Shift • Shifts arising • Labor • Capital • Natural Resources. • Technology. • Expected Price Level.

28. Long-run aggregate Short-run supply aggregate supply A Equilibrium price Aggregate demand Natural rate of output Figure 7 The Long-Run Equilibrium Price Level Quantity of 0 Output

29. 2. . . . causes output to fall in the short run . . . Short-run aggregate supply, AS AS2 3. . . . but over time, the short-run A aggregate-supply P curve shifts . . . B P2 1. A decrease in aggregate demand . . . P3 C Aggregate demand, AD AD2 Y2 Y 4. . . . and output returns to its natural rate. Figure 8 A Contraction in Aggregate Demand Price Level Long-run aggregate supply Quantity of 0 Output

30. The Effects of a Shift in Aggregate Supply • 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.

31. 1. When short-run aggregate supply falls . . . Short-run AS2 aggregate supply, AS P3 C 2. . . . policymakers can accommodate the shift P2 by expanding aggregate A 3. . . . which demand . . . P causes the price level AD2 to rise 4. . . . but keeps output further . . . at its natural rate. Figure 11 Accommodating an Adverse Shift in Aggregate Supply Price Level Long-run aggregate supply Aggregate demand, AD Quantity of 0 Natural rate Output of output