Aggregate Demand and Aggregate Supply

1. 20 Aggregate Demand andAggregate Supply

2. Aggregate Demand & Aggregate Supply • Economic activity • Fluctuates from year to year • Economic fluctuation • Business cycle • Recession • Economic contraction • Period of declining real incomes and rising unemployment • Depression • Severe recession

3. 3 Key Facts About Economic Fluctuations • Economic fluctuations are irregular and unpredictable • i.e, fluctuations (around the trend) = business cycles (booms/recessions) • Most macroeconomic quantities fluctuate together • GDP (growth rate) - Investment (I) – Unemployment Rate (U) – Inflation (∏) • As output falls, unemployment rises

4. Economic “Fluctuations” Irregular and Unpredictable

5. Economic “Fluctuations” Irregular and Unpredictable

6. 1 A look at short-run economic fluctuations (a) This figure shows real GDP in panel (a), investment spending in panel (b), and unemployment in panel (c) for the U.S. economy using quarterly data since 1965. Recessions are shown as the shaded areas. Notice that real GDP and investment spending decline during recessions, while unemployment rises.

7. 1 A look at short-run economic fluctuations (b) Note that real GDP and investment spending decline during recessions. Although I accounts for only 15-20% of GDP; it accounts for 50% of the decline in GDP during a recession

8. 1 A look at short-run economic fluctuations (c) . Recessions are shown as the shaded areas. Notice that real GDP and investment spending decline during recessions, while unemployment rises.

9. Explaining Short-Run Economic Fluctuations • The assumptions of Classical economists • Austrian school (Hayek, von Mises) • Monetarists (Friedman, Univ of Chicago, “Fresh Water”) • Classical dichotomy • Separation of variables into • Real variables – can’t be affected by Monetary Policy • Nominal variables – can be affected, but no real economic inpact • Monetary neutrality – does not have “real” effects • Changes in the money supply • Affect nominal variables • Does not affect real variables

10. Explaining Short-Run Economic Fluctuations • Classical Economist Focus on the “Long-Run” • Classical theory holds • Changes in money supply • Affect prices, nominal interest rates and other nominal variables • Does not affect real GDP, unemployment, real interest rates, or other real variables

11. 4 The long-run aggregate-supply curve (Classical View) Price Level Long-run aggregate supply P1 P2 1. A change in the price level . . . Quantity of Output Natural rate of output 2. . . . does not affect the quantity of goods and services supplied in the long run Classical View – Supply determines equilibrium (real Y -> thereby U)

12. Figure 11-5 Classical Theory and Increases in Aggregate Demand

13. Explaining Short-Run Economic Fluctuations • The reality of short-run fluctuations • Short-run • Assumption of monetary neutrality - no longer appropriate (can affect real variables in short-run due to sticky prices/wages or “surprises” • Real and nominal variables are highly intertwined • Changes in the money supply • Can temporarily push real GDP away from its long-run trend

14. Explaining Short-Run Economic Fluctuations • Model of aggregate demand & aggregate supply • Model that most economists use to explain short-run fluctuations in economic activity • Around its long-run trend • Aggregate-demand curve • Shows the quantity of goods and services • That households, firms, the government, and customers abroad • Want to buy at each price level • Downward sloping

15. Figure 11-7 Demand-Determined Equilibrium Real GDP at Less Than Full Employment Keynes assumed prices will not fall when aggregate demand falls

16. Figure 11-8 Real GDP and the Price Level, 1934–1940

17. 6 Tradeoff between Inflation and Unemployment? Annual data from 1961 to 1968 shows a negative relationship between inflation and unemployment (inflation = stimulative monetary (M1) and fiscal (G) policy)

18. Explaining Short-Run Economic Fluctuations • Model of aggregate demand & aggregate supply • Aggregate-supply curve • Shows the quantity of goods and services • That firms choose to produce and sell • At each price level • Upward sloping (very different from Classical) • Similar factors that shift micro-based supply curve (input prices, technology) also shift AS curve • E.g., OPEC oil prices

19. Equilibrium: SR and LR Supply

20. The Aggregate-Demand Curve • Why the aggregate-demand (AD) curve slopes downward and real GNP increases • Y = C + I + G + NX • Three effects: • Wealth effect (C ): decrease in prices – consumable income increases • Interest-rate effect (I): need less money to buy goods -> increase loanable funds -> interest rate decreases • Exchange-rate effect (NX) -> dec in interest rate -> depreciaion of $ • Assumption: government spending (G) • Fixed by policy

21. 3 The aggregate-demand curve Price Level P1 P2 1. A decrease in the price level . . . Aggregate demand Quantity of Output Y1 Y2 2. . . . increases the quantity of goods and services demanded A fall in the price level from P1 to P2 increases the quantity of goods and services demanded from Y1 to Y2. There are three reasons for this negative relationship. As the price level falls, real wealth rises, interest rates fall, and the exchange rate depreciates. These effects stimulate spending on consumption, investment, and net exports. Increased spending on any or all of these components of output means a larger quantity of goods and services demanded.

22. The Aggregate-Demand Curve • Why the AD curve might shift • Changes in consumption, C • Events - change how much people want to consume at a given price level • Level of taxation (decrease in income taxes, increases spendable income -> increase C) • Decrease C: increase in the savings rate (marginal propensity to save) during a recession • Increase in Income (Y) -> increase in consumer spending (C) -> growing economy

23. The Aggregate-Demand Curve • Why the AD curve might shift • Changes in investment, I • Events - change how much firms want to invest at a given price level • Better technology • Tax policy (tax credits for I, faster depreciation) or credits for increased Savings (taxed at lower rate) • Money supply, Federal Discount Rate, Budget deficit/surplus • Increase in investment • Aggregate demand - shift right

24. The Aggregate-Demand Curve • Why the AD curve might shift • Changes in government purchases, G • Policy makers – change government spending at a given price level • Build new roads • Increase in government purchases • Aggregate demand - shift right • Or decreases in government purchases • AD curve shifts left • Impact on BuDeficit -> “crowding out”?

25. The Aggregate-Demand Curve • Why the AD curve might shift • Decreases in government purchases Costs of government sequester • low 0.1 percent growth in personal income attributed todefense furloughs, more than 650,000 workers, • a 0.5 percent decline in government pay, reduced wages by $7.7 billion that month, • Without sequester, income growth would have been closer to 1.2 percent.

26. The Aggregate-Demand Curve • Why the AD curve might shift • If it sequester were reversed, the non-partisan Congressional Budget Office has estimated that as many as 1.6 million jobs would be added and GDP would get a boost of as much as 1.2 percent. Even the deficit would be in better shape if the cuts were undone.

27. The Aggregate-Demand Curve • Why the AD curve might shift • Changes in net exports, NX • Events - change net exports for a given price level • Recession in Europe –decrease demand US goods • International speculators – change in exchange rate • Increase in net exports • Decrease in exchange rate; US goods cheaper • Aggregate demand - shift right

28. The Aggregate Supply Curve • Long run • Aggregate-supply curve is vertical • Short run • Aggregate-supply curve is upward sloping • Why the aggregate-supply curve (LRAS) is vertical in the long run • Price level does not affect the long-run determinants of GDP: • Supplies of labor, capital, and natural resources • Available technology

29. 4 The long-run aggregate-supply curve Price Level Long-run aggregate supply P1 P2 1. A change in the price level . . . Quantity of Output Natural rate of output 2. . . . does not affect the quantity of goods and services supplied in the long run In the long run, the quantity of output supplied depends on the economy’s quantities of labor, capital, and natural resources and on the technology for turning these inputs into output. Because the quantity supplied does not depend on the overall price level, the long-run aggregate-supply curve is vertical at the natural rate of output.

30. The Aggregate Supply Curve • Why the LRAS curve might shift • Any change in natural rate of output • Changes in labor • Quantity of labor – increases • Aggregate supply – shifts right • Natural rate of unemployment – increases • Aggregate supply – shifts left

31. The Aggregate Supply Curve • Why the LRAS curve might shift • Changes in capital • Capital stock – increase • Aggregate supply – shifts left • Physical capital • Human capital

32. The Aggregate Supply Curve • Why the LRAS might shift • Changes in natural resources • New discovery of natural resource • Aggregate supply – shifts right • Weather • Availability of natural resources

33. The Aggregate Supply Curve • Why the LRAS curve might shift • Changes in technology • New technology, for given labor, capital and natural resources • Aggregate supply – shifts right • International trade • Government regulation

34. The Aggregate Supply Curve • Using AD and LRAS to depict long-run growth and inflation • In long run: both AD and LRAS curve shift • Continual shifts of LRAS curve to right • Technological progress • AD curve shifts to right • Monetary policy • The Fed increases money supply over time • Result: • Continuing growth in output • Continuing inflation

35. 5 Price Level Long-run aggregate supply, LRAS1980 Long-run growth and inflation in the model of aggregate demand and aggregate supply LRAS1990 LRAS2000 3. . . . leading to growth in output . . . 2. . . . and growth in the money supply shifts aggregate demand . . . P1980 P1990 P2000 1. In the long run, technological progress shifts long-run aggregate supply… 4. . . . and ongoing inflation AD1980 AD1990 AD2000 Quantity of Output Y2000 Y1980 Y1990 As the economy becomes better able to produce goods and services over time, primarily because of technological progress, the long-run aggregate-supply curve shifts to the right. At the same time, as the Fed increases the money supply, the aggregate-demand curve also shifts to the right. In this figure, output grows from Y1980 to Y1990 and then to Y2000, and the price level rises from P1980 to P1990 and then to P2000. Thus, the model of aggregate demand and aggregate supply offers a new way to describe the classical analysis of growth and inflation

36. The Aggregate Supply Curve • Why the aggregate-supply (AS) curve slopes upward in the short-run • Basic Microeconomic Theory • Increase in overall level of prices in economy • Tends to raise the quantity of goods and services supplied • Decrease in level of prices • Tends to reduce quantity of goods and services supplied

37. 6 The short-run aggregate-supply curve Price Level Short-run aggregate supply P2 P1 1. A decrease in the price level . . . Quantity of Output Y1 Y2 2. . . . reduces the quantity of goods and services supplied in the short run In the short run, a fall in the price level from P1 to P2 reduces the quantity of output supplied from Y1 to Y2. This positive relationship could be due to sticky wages, sticky prices, or misperceptions. Over time, wages, prices, and perceptions adjust, so this positive relationship is only temporary.

38. The Aggregate Supply Curve • Why the AS curve slopes upward in short-run • Sticky-wage theory • Nominal wages - slow to adjust to changing economic conditions • Long-term contracts: workers and firms • Slowly changing social norms • Notions of fairness - influence wage setting • Nominal wages - based on expected prices • Don’t respond immediately when: • Actual price level – different from what was expected

39. The Aggregate Supply Curve • Why the AS curve slopes upward in short-run • Sticky-wage theory • If price level < expected • Firms – incentive to produce less output • If price level > expected • Firms – incentive to produce more output

40. The Aggregate Supply Curve • Why the AS curve slopes upward in short-run • Sticky-price theory • Prices of some goods & services • Slow to adjust to changing economic conditions • Menu costs • Costs to adjusting prices

41. The Aggregate Supply Curve • Why the AS curve slopes upward in short-run • Misperceptions theory • Changes in the overall price level • Can temporarily mislead suppliers • About changes in individual markets • Changes in relative prices • Suppliers - respond to changes in level of prices • Change - quantity supplied of goods and services

42. The Aggregate Supply Curve • Why the AS curve slopes upward in short-run • Quantity of output supplied = = Natural rate of output + + a(Actual price level – Expected price level) • Where a - number that determines how much output responds to unexpected changes in the price level

43. The Aggregate Supply Curve • Why the short-run AS curve might shift • Changes in labor, capital, natural resources, or technological knowledge • Shift the short-run AS curve • Expected price level increases • Aggregate-supply curve – shifts left

44. 2 The short-run aggregate-supply curve: summary (a)

45. 2 The short-run aggregate-supply curve: summary (b)

46. Two Causes of Economic Fluctuations • Assumption • Economy begins in long-run equilibrium • Long-run equilibrium: • Intersection of AD and LRAS curves • Output - natural rate • Actual price level • And: Intersection of AD and short-run AS curve • Expected price level = Actual price level

47. 7 The long-run equilibrium Price Level Long-run aggregate supply Short-run aggregate supply A Equilibrium price Aggregate demand Quantity of Output Natural rate of output The long-run equilibrium of the economy is found where the aggregate-demand curve crosses the long-run aggregate-supply curve (point A). When the economy reaches this long-run equilibrium, the expected price level will have adjusted to equal the actual price level. As a result, the short-run aggregate-supply curve crosses this point as well.

48. Two Causes of Economic Fluctuations • The effects of a shift in aggregate demand • Wave of pessimism • Affects aggregate demand • Aggregate demand – shifts left • Short-run • Output falls & Price level falls • Long-run • Short-run aggregate supply curve – shifts right • Output – natural rate • Price level – falls

49. 3 Four steps for analyzing macroeconomic fluctuations Decide whether the event shifts the aggregate demand curve or the aggregate supply curve (or perhaps both). Decide in which direction the curve shifts. Use the diagram of aggregate demand and aggregate supply to determine the impact on output and the price level in the short run. Use the diagram of aggregate demand and aggregate supply to analyze how the economy moves from its new short-run equilibrium to its long-run equilibrium.

50. 8 A contraction in aggregate demand Long-run aggregate supply Price Level Short-run aggregate supply, AS1 AS2 C B A P3 P1 P2 3. . . . but over time, the short-run aggregate-supply curve shifts . . . 4. . . . and output returns to its natural rate. • A decrease in • aggregate demand . . . AD2 Aggregate demand, AD1 Quantity of Output Y1 Y2 A fall in aggregate demand is represented with a leftward shift in the aggregate-demand curve from AD1 to AD2. In the short run, the economy moves from point A to point B. Output falls from Y1 to Y2, and the price level falls from P1 to P2. Over time, as the expected price level adjusts, the short-run aggregate-supply curve shifts to the right from AS1 to AS2, and the economy reaches point C, where the new aggregate-demand curve crosses the long-run aggregate-supply curve. In the long run, the price level falls to P3, and output returns to its natural rate, Y1. 2. . . . causes output to fall in the short run . . .