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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.

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short run economic fluctuations
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
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
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

Copyright © 2004 South-Western

three key facts about economic fluctuations5
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 fluctuations6
Figure 1 A Look At Short-Run Economic Fluctuations

(b) Investment Spending

Billions of

1996 Dollars

$1,800

1,600

1,400

Investment spending

1,200

1,000

800

600

400

200

1965

1970

1975

1980

1985

1990

1995

2000

Copyright © 2004 South-Western

three key facts about economic fluctuations7
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 fluctuations8
Figure 1 A Look At Short-Run Economic Fluctuations

(c) Unemployment Rate

Percent of

Labor Force

12

10

Unemployment rate

8

6

4

2

0

1965

1970

1975

1980

1985

1990

1995

2000

Copyright © 2004 South-Western

explaining short run economic fluctuations
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 short-run.
the basic model of economic fluctuations
The Basic Model of Economic Fluctuations
  • Two variables are used to develop a model to analyze the short-run fluctuations.
    • The economy’s 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.
slide11
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

Aggregate

supply

Equilibrium

price level

Aggregate

demand

Equilibrium

output

Figure 2 Aggregate Demand and Aggregate Supply...

Price

Level

Quantity of

0

Output

Copyright © 2004 South-Western

the aggregate demand curve
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

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

Copyright © 2004 South-Western

why the aggregate demand curve is downward sloping
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
slide16
The Price Level and Consumption: The Wealth Effect
    • A decrease in the price level increases the value of money in one’s 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↑
slide17
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↑
slide18
The Price Level and Net Exports: The Exchange-Rate 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
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 curve20

Price

Level

D2

Aggregate

demand, D1

Y2

Quantity of

Output

Shifts in the Aggregate Demand Curve

P1

0

Y1

the aggregate supply curve
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 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. 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

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

Copyright © 2004 South-Western

the aggregate supply curve23
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
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

Long-run

money supply shifts

aggregate

aggregate demand . . .

supply,

LRAS

LRAS

LRAS

1980

1990

2000

1. In the long run,

technological

progress shifts

long-run aggregate

P

2000

supply . . .

4. . . . and

ongoing inflation.

P

1990

Aggregate

Demand,

AD

2000

P

1980

AD

1990

AD

1980

Y

Y

Y

1980

1990

2000

3. . . . leading to growth

in output . . .

Figure 5 Long-Run Growth and Inflation

Price

Level

Quantity of

0

Output

Copyright © 2004 South-Western

a new way to depict long run growth and inflation
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
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

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

Copyright © 2004 South-Western

why the aggregate supply curve slopes upward in the short run29
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+%ΔP
  • 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.
slide30
The expected price level Pe is the link between aggregate supply in the short-run and in the long-run.
  • In the long-run P=Pe, people can’t 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
slide31
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
  • 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
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
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

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

Copyright © 2004 South-Western

figure 8 a contraction in aggregate demand

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

Copyright © 2004 South-Western

two causes of economic fluctuations
TWO CAUSES OF ECONOMIC FLUCTUATIONS
  • Shifts in Aggregate Demand
    • In the short run, shifts in aggregate demand cause fluctuations in the economy’s 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 short-

run aggregate-supply curve . . .

Short-run

AS2

aggregate

supply,

AS

B

P2

A

P

3. . . . and

the price

level to rise.

Aggregate demand

Y2

Y

2. . . . causes output to fall . . .

Figure 10 AnAdverse Shift in Aggregate Supply

Price

Level

Long-run

aggregate

supply

Quantity of

0

Output

Copyright © 2004 South-Western

the effects of a shift in aggregate supply
The Effects of a Shift in Aggregate Supply
  • Stagflation
    • Adverse shifts in aggregate supply cause stagflation—a 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 . . .

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

Copyright © 2004 South-Western

short run vs long run adjustment
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.
slide42
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
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
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.
summary45
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.
summary46
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.
summary47
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.
summary48
Summary
  • Events that alter the economy’s 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.
summary49
Summary
  • A second possible cause of economic fluctuations is a shift in aggregate supply.
  • Stagflation is a period of falling output and rising prices.