Macroeconomics Econ 2301

1. MacroeconomicsEcon 2301 Dr. Frank Jacobson Coach Stuckey

2. Today • Begin Chapter 12- Aggregate Demand and Supply

3. Chapter 12Aggregate Demand and Aggregate Supply

4. During The Semester We Have Seen How The Economy Has Changed During Different Time Period Sometimes Moderately and Sometimes Severely.

5. In This Chapter We Will Look At What Causes Both Short-Run and Long-Run Fluctuations in The Economy.

6. Business cycle Economic activity Time The 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.

7. Important Note:These Business Cycle Fluctuations Are Unpredictable and Follow No Regular Pattern.

8. Fact : Most Macroeconomic Quantities Fluctuate Together.When Real GDP Falls in a Recession So Does Personal Income, Corporate Profits, Consumer Spending, Investment Spending, Production, Home Sales, Auto Sales and Other Items.

9. Investment Spending Varies Greatly Over The Business Cycle. Investment Spending Averages Only About 1/7 of The GDP, Yet, Declines In Investment Account For About 2/3 of The Declines in GDP During Recessions.

10. Restated:When Economic Conditions Deteriorate, Much of The Decline is Attributable To Reductions in Investment Spending Such As On New Factories, Housing, Equipment and Inventories.

11. Fact : As Output Falls, Unemployment Rises.When Firms Choose To Produce A Smaller Quantity of Goods and Services, They Lay Off Workers, Increasing The Unemployment.

12. Explaining Short-Run Economic Fluctuations.

13. Most Economists Believe That Classical Theory Describes The World in The Long Run But Not in The Short Run.

14. In The Short Run, Real and Nominal Variables Are Highly Intertwined, and Changes in The Money Supply Can Temporarily Push Real GDP Away From Its Long Term Trend.

15. Therefore To Explain The Short Run Fluctuations in The Economy and Their Impact; We Must Develop a New Model Based on How Real and Nominal Variables Interact.

16. The Model of Aggregate Demand and Aggregate Supply

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

18. 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

19. Our Model of Short-Run Economic Fluctuations Focuses On The Behavior of Two Variables. The First Variable is The Economy’s Output of Goods and Services as Measured By Real GDP. The Second is The Average Level of Prices, As Measured By The CPI or The GDP Deflator.

20. Notice: That Output is a Real Variable, Whereas The Price Level is a Nominal Variable.

21. Fluctuations in The Economy as a Whole Are Measured With The Model of Aggregate Demand and Aggregate Supply.

22. Model of Aggregate Demand and Aggregate SupplyThe Model That Most Economists Use To Explain Short-Term Fluctuations in Economic Activity Around its Long-Run Trend.

23. The Model of Aggregate Demand and Aggregate Supply

24. On The Vertical Axis is The Overall Price Level in The Economy. On The Horizontal Axis is The Overall Quantity of Goods and Services Produced in The Economy.

25. The 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.

26. According To This Model, The Price Level and The Quantity of Output Adjust To Bring Aggregate Demand and Aggregate Supply Into Balance.

27. This May Look Like The Market Supply and Demand Curves, But Because It Involves All The Goods and Services Supplied and Demanded, Factors Such As Substitutes and Complementary Items Are Not Involved.

28. The Aggregate-Demand Curve

29. The Aggregate-Demand Curve Tells Us The Quantity of All Goods and Services Demanded in The Economy At Any Given Price Level.

30. The Aggregate-Demand Curve is Downward Sloping Indicating That, All Things Being Equal, A Decrease In The Economy’s Overall Level of Prices Raises The Quantity of Goods and Services Demanded and An Increase in Prices Reduces The Quantity of Goods and Services Demanded.

31. Why Does The Aggregate-Demand Curve Slope Downward?

32. Price Level Affects The Quantity of Goods and Services Demanded Relative to The GDP--- For Consumption, Investment and Net Exports.

33. There Are 3 Reasons The Aggregate-Demand Curve is Downward Sloping.

34. Reasons 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.

35. #1 The Price Level and Consumption:A Decrease In The Price Level Raises The Real Value of Money and Makes Consumers Wealthier, Which In Turn Encourages Them To Spend More and Demand More Goods and Services.

36. #2 Price Level and InvestmentA Lower Price Level Reduces The Interest Rate, Encourages Greater Spending on Investment Goods, Thereby Increases The Quantity of Goods and Services Demanded.

37. #3 Price Level and Net ExportsA Fall in U.S. Price Level Causes U.S. Interest Rates To Fall, The Real Value of The Dollar Declines In Foreign Exchange Markets, Which Increases U.S. Net Exports of Goods and Services.

38. Therefore a Decrease in Price Level Increases The Demand for Goods and Services Because: • Consumers Are Wealthier, Which Stimulates the Demand For Consumption Goods. • Interest Rates Fall, Which Stimulates The Demand For Investment Goods. • The Currency Depreciates, Which Stimulates The Demand For Net Exports.

39. These Same Three Effects Work in Reverse to Decrease The Quantity of Goods and Services When The Price Level is Increased.

40. The Overall Aggregate Demand Curve May Shift (Right or Left).

41. Causes of Aggregate-Demand Curve To Shift • Shifts Arising From Changes in Consumption. • Shifts Arising From Changes in Investment • Shifts Arising From Changes in Government Purchase. • Shifts Arising From Changes in Net Exports.

42. Causes of Aggregate-Demand Curve To Shift • Shifts Arising From Changes in Expectations. • Shifts Arising From Changes in Wealth. • Shifts Arising From the Size of Existing Stock of Physical Capital. • Shifts Arising From Changes in Fiscal Policy. • Shifts Arising From Changes in Monetary Policy.

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

44. 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

45. The Aggregate-Supply Curve

46. In The Long Run, The Aggregate-Supply Curve is Vertical, Whereas in The Short Run, The Aggregate-Supply Curve is Upward Sloping.

47. Why The Aggregate-Supply Curve is Vertical in The Long Run.

48. In The Long Run, An Economy’s Production of Goods and Services (Its Real GDP) Depends On Its Supplies of Labor, Capital and Natural Resources and on The Available Technology To Turn These Factors of Production Into Goods and Services.

49. The Aggregate-Supply Curve • The Long-Run Aggregate-Supply Curve is Vertical At The Natural Rate of Output, Which is The Production of Goods and Services That an Economy Achieves in The Long Run When Unemployment is At Its Normal Rate. • This Level of Production is Also Referred To As Potential Output or Full-Employment Output. • The Natural Rate of Output is The Level of Output Towards Which The Economy Gravitates in The Long Run.

50. Natural Rate of OutputThe Production of Goods and Services That An Economy Achieves in The Long Run When Unemployment is At Its Normal Rate.