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 • Most macroeconomic quantities fluctuate together • As output falls, unemployment rises

4. 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.

5. 1 A look at short-run economic fluctuations (b) 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.

6. 1 A look at short-run economic fluctuations (c) 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. 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

8. 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

9. 2 Aggregate demand and aggregate supply Price Level Aggregate supply Equilibrium price level Aggregate demand Quantity of Output Equilibrium output Economists use the model of aggregate demand and aggregate supply to analyze economic fluctuations. On the vertical axis is the overall level of prices. On the horizontal axis is the economy’s total output of goods and services. Output and the price level adjust to the point at which the aggregate-supply and aggregate-demand curves intersect.

10. The Aggregate-Demand Curve • Why the aggregate-demand (AD) curve slopes downward • Y = C + I + G + NX • Three effects: • Wealth effect (C ) • Interest-rate effect (I) • Exchange-rate effect (NX) • Assumption: government spending (G) • Fixed by policy

11. The Aggregate-Demand Curve • Why the AD curve slopes downward • A fall in price level • Increases quantity of goods& services demanded • Because: • Consumers are wealthier - stimulates the demand for consumption goods • Interest rates fall - stimulates the demand for investment goods • Currency depreciates - stimulates the demand for net exports

12. 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.

13. 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 • Increase in consumer spending • Aggregate demand - shift right

14. 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 • Money supply • Increase in investment • Aggregate demand - shift right

15. 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

16. 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 • International speculators – change in exchange rate • Increase in net exports • Aggregate demand - shift right

17. 1 The aggregate-demand curve: summary (b) .

18. 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

19. 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.

20. The Aggregate Supply Curve • Why the LRAS curve might shift • Natural rate of output • Production of goods and services • That an economy achieves in the long run • When unemployment is at its normal rate • Potential output • Full-employment output

21. 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

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

23. 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

24. 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

25. 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

26. 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

27. The Aggregate Supply Curve • Why the aggregate-supply (AS) curve slopes upward in the short-run • 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

28. 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.

29. 2 The short-run aggregate-supply curve: summary (a)

30. 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

31. 2 The short-run aggregate-supply curve: summary (b)

32. 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

33. 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.

34. 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

35. 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.

36. 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 . . .

37. Two big shifts in aggregate demand: Great Depression and World War II • Early 1930s: large drop in real GDP • The Great Depression • Largest economic downturn in U.S. history • From 1929 to 1933 • Real GDP fell by 27% • Unemployment rose from 3 to 25% • Price level fell by 22% • Cause: decrease in aggregate demand • Decline in money supply (by 28%) • Decreasing: consumer spending, investment spending

38. Two big shifts in aggregate demand: Great Depression and World War II • Early 1940s: large increase in real GDP • Economic boom • World War II • More resources to the military • Government purchases increased • Aggregate demand – increased 1939 - 1944 • Doubled the economy’s production of goods and services • 20% increase in the price level • Unemployment fell from 17 to 1%

39. 9 U.S. real GDP growth since 1900 Over the course of U.S. economic history, two fluctuations stand out as especially large. During the early 1930s, the economy went through the Great Depression, when the production of goods and services plummeted. During the early 1940s, the United States entered World War II, and the economy experienced rapidly rising production. Both of these events are usually explained by large shifts in aggregate demand.

40. The recession of 2001 • 2001: Recession • Unemployment rate • December 2000: 3.9% • August 2001: 4.9% • June 2003: 6.3% • January 2005: 5.2% • Three events – decrease in aggregate demand • The end of dot-com bubble in stock market • Stock prices fell (25%) • Reduced consumer & investment spending • Aggregate-demand curve - shifted to left

41. The recession of 2001 • Three events – decrease in aggregate demand • Terrorist attacks on September 11, 2001 • Stock market fell (12%) in one week • Increased uncertainty about the future • Aggregate-demand curve – shifted further to left • Series of corporate accounting scandals • Enron and WorldCom • Stock market fell • Aggregate-demand curve – shifted further to left

42. The recession of 2001 • 2001: Recession • Policymakers - quick to respond • The Fed - expansionary monetary policy • Interest rates fell; Federal funds rate fell • Stimulated spending • Congress • Tax cut in 2001; Immediate tax rebate; Tax cut in 2003 • To stimulate consumer & investment spending • Aggregate-demand curve – shifted to right • Offset the three contractionary shocks

43. Two Causes of Economic Fluctuations • The effects of a shift in aggregate supply • Start: long run equilibrium • Firms – increase in production costs • Aggregate supply curve – shifts left • Short-run • Output falls & Price level rises • Stagflation • Long-run, if AD is held constant • Short-run AS shifts back to right • Output – natural rate • Price level - falls

44. 10 An adverse shift in aggregate supply 3. . . . and the price level to rise Price Level Long-run aggregate supply 1. An adverse shift in the short-run aggregate-supply curve . . . AS2 2. . . . causes output to fall . . . Short-run aggregate supply, AS1 B A P1 P2 Aggregate demand Quantity of Output Y1 Y2 When some event increases firms’ costs, the short-run aggregate-supply curve shifts to the left from AS1 to AS2. The economy moves from point A to point B. The result is stagflation: Output falls from Y1 to Y2, and the price level rises from P1 to P2.

45. Two Causes of Economic Fluctuations • The effects of a shift in aggregate supply • Start: long run equilibrium • Firms – increase in production costs • Aggregate supply curve – shifts left • Short-run • Output falls and Price level rises • Long-run • Policymakers – shift AD to right • Output – natural rate • Price level – rises

46. 2. . . . policymakers can accommodate the shift by expanding aggregate demand . . . 11 3. . . . which causes the price level to rise further . . . Accommodating an adverse shift in aggregate supply 4. . . . but keeps output at its natural rate. Price Level Long-run aggregate supply 1. When short-run aggregate supply falls . . . AS2 Short-run aggregate supply, AS1 C A P2 P3 P1 Aggregate demand, AD1 AD2 Quantity of Output Y1 Faced with an adverse shift in aggregate supply from AS1 to AS2, policymakers who can influence aggregate demand might try to shift the aggregate-demand curve to the right from AD1 to AD2. The economy would move from point A to point C. This policy would prevent the supply shift from reducing output in the short run, but the price level would permanently rise from P1 to P3.

47. Oil and the economy • Economic fluctuations in the U.S. economy • Since 1970 • Some: originated in the oil fields of the Middle East • Some event - reduces the supply of crude oil flowing from Middle East • Price of oil - rises around the world • Aggregate-supply curve – shifts left • Stagflation • Mid-1970s • Late-1970s

48. Oil and the economy • Some event – increases the supply of crude oil from Middle East • Price of oil decreases • Aggregate-supply curve – shifts right • Output – rapid growth • Unemployment – falls • Inflation rate – falls

49. Oil and the economy • Recent years: World market for oil – not an important source of economic fluctuations • Conservation efforts • Changes in technology • 2008 - world oil prices – rising significantly • Increased demand from a rapidly growing China