Overview • Three key factors about economic fluctuations. • The aggregate demand and aggregate supply model. • The aggregate demand curve. • The aggregate supply curve. • Equilibrium in the SR & long-run.
Short-Run Economic Fluctuations • Economic activity fluctuates from year to year. In some years, the production of goods and services rises. In other years normal growth does not occur, leading to recession. • A recession is a situation of declining real GDP, falling incomes and rising unemployment for two consecutive quarters.
Three Key Facts About Economic Fluctuations • Economic Fluctuations are Irregular and Unpredictable. • Recessions occur with unpredictable frequency and duration. • Most Macroeconomic Variables Fluctuate Together. • Most macroeconomic variables are closely related and move together.
Three Key Facts About Economic Fluctuations • As Output Falls, Unemployment Rises. • Changes in real GDP and the unemployment rate are inversely related. • Labour demand depends on output. • Y= f(K,L) Y is GDP
Economic Fluctuations • Although there remains some debate about how to analyze short-run fluctuations, most economists use the model of aggregate demand and aggregate supply.
Model of Economic Fluctuations • Two variables are used in developing a model to analyze the short-run fluctuations: 1. The economy’s output of goods and services, measured by real GDP 2. The overall price level, measured by the CPI or GDP deflator • The Model: Aggregate Demand and Aggregate Supply
The Aggregate Demand and Aggregate Supply Model Price Level SR Aggregate Supply PE Aggregate Demand QE Quantity of Output
Aggregate Demand and Aggregate Supply • The Aggregate Demand Curve shows the quantity of goods and services that households, firms and the government are willing to buy at different prices. • The Aggregate Supply Curve shows the quantity of goods and services that firms would be willing to produce and sell at different prices.
ECONOMIC “BUBBLES” • An economic bubble is the commonly used term for an economic cycle that is characterized by a rapid expansion followed by a contraction, often in a dramatic fashion.
The Aggregate Demand Curve • The aggregate demand for goods and services is: Y = C + I + G + NX • Why is the aggregate demand curve downward sloping? 1. Pigou’s Wealth Effect 2. Keynes’ Interest Rate Effect 3. Real Exchange Rate Effect
Downward Slope of AD: 1. Pigou’s Wealth Effect: • If P declines “Consumers feel wealthier, which stimulates the demand for consumption goods.” • A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more. • The increase in consumer spending means a larger quantity of goods and services demanded.
Downward Slope of AD: 2. Keynes’ Interest-Rate Effect: • “The lower the price level, the less money households need to hold to buy the goods and services they want.” MD down • A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded.
Downward Slope of AD: 3. Real Exchange-Rate Effect: • “When prices of Canadian goods go down, foreigners buy more of our goods and we purchase less of their goods.” • When a fall in the Canadian price level causes the real exchange rate to depreciate, this stimulates Canadian net exports, thereby increasing the quantity of goods and services demanded.
Slope of AD • The aggregate demand for goods and services is: Y = C + I + G + NX • Why is the aggregate demand curve downward sloping? 1. Pigou’s Wealth Effect 2. Keynes’ Interest Rate Effect 3. Real Exchange Rate Effect
Factors that might shift Aggregate Demand • Shifts in the aggregate demand curve may arise because of: 1. Changes in spending plans by consumers or firms. C, I, NX 2. Changes in fiscal or monetary policy. G “Anything that causes buyers to want to purchase more or less than before will cause the aggregate demand schedule to shift.”
Shift in AD: not caused by changes in the price level. Wealth decline could decrease C: Higher interest Rates could decrease I. G declines, NX declines [AD1 to AD3]
SHIFTS IN AD • Y-AXIS—Price level • X-axis—Quantity of output (real GDP) • Initial AD is AD1 • Shifts right to AD2 • Caused by changes in C, I, G, NX (spending) DIAGRAM
Real GDP Growth Canada u=7.8% 2007 was 6.0 2009 was8.3 US u=9% 2007was 4.6 2009was 9.3
AD questions What happens to the AD curve in each of the following scenarios? A. A ten-year-old investment tax credit expires. B. The Canadian exchange rate falls. C. A fall in prices increases the real value of consumers’ wealth. D. Provincial governments reduce their sales taxes.
AD answers A. A ten-year-old investment tax credit expires. I falls, AD curve shifts left. B. The Canadian exchange rate falls. NX rises, AD curve shifts right. C. A fall in prices increases the real value of consumers’ wealth. Move down along AD curve (wealth-effect). D. Provincial governments reduce sales taxes. C rises, AD shifts right.
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. • LR reflects PPF • Price level does not affect real variables in the LR—neutrality.
The Long-Run Aggregate Supply Curve Price Level SR Aggregate Supply LRS-Output at Full Employment Aggregate Demand Quantity of Output
Shifts in the Long-Run Aggregate Supply Curve • Over time, any change in the factors that determine the long-run aggregate supply will cause the curve to shift. Like PPF • An event that reduces potential output shifts the schedule to the left. • Any change that increases the economy’s potential output will shift the curve to the right. R,T
The Short-Run Aggregate Supply Curve • In the short-run, an increase in the overall level of prices in the economy tends to increase the quantity of goods and services supplied, and a decrease in the level of prices tends to reduce the quantity of goods and services supplied.
Reasons for the Upward Slope of the SR Aggregate Supply Curve • 3 alternative explanations for the upward slope of SRAS. • New Classical Misperceptions Theory • Keynesian Sticky-Wage Theory • New Keynesian Sticky-Price Theory • These are adjustment issues
Slope of SRAS matters • If AS is vertical (LR) then changes in AD do not cause fluctuations in Y or N • If AS slopes up (SR) then changes in AD do affect output and employment
Reasons for the Upward Slope of SRAS • The New Classical Misperceptions Theory: “A higher price level signals to each firm a greater demand for their product inducing them to produce more.” • Changes in the overall price level can temporarily mislead suppliers about what is happening in the markets in which they sell their output. LR costs increase too.
Reasons for the Upward Slope of the Aggregate Supply Curve • Keynesian Sticky-Wage Theory: “The higher product prices cause a temporary decrease in real wages stimulating employment and output.” • Nominal wages are slow to adjust, or are “sticky” in the short-run, thus a higher price level makes employment and production more profitable, which induces firms to increase production. R=W/P
Reasons for the Upward Slope of the Aggregate Supply Curve • New Keynesian Sticky-Price Theory: “Prices that do not increase immediately are temporarily low thereby stimulating spending and output on those goods.” • Prices of some goods and services adjust sluggishly in response to changing economic conditions. • Remember Menu Costs-adjust slower.
3 Theories of SRAS slope ****** Each of the 3 theories implies Y deviates from YN when Pdeviates from PE. • Y = YN +a(P-PE) YN =Natural rate of output (long-run) • P-actual price level • PE-expected price level • P>PE GDP increases
What Might Cause the Aggregate Supply Curve to Shift? • Three factors may lead to a shift in the short-run aggregate supply curve. • Changes in Factor (input) Prices • Changes in Productivity • Legal-Institutional Environment
What Might Cause the Aggregate Supply Curve to Shift? • Changes in factor (input) prices: Changes in the prices of domestic or imported resources will change the cost of producing final goods. • An increase in input prices will shift the supply curve to the left. • A decrease in input prices will shift the supply curve to the right.
What Might Cause the Aggregate Supply Curve to Shift? • Changes in productivity: If changes in the resource markets increase factor productivity, more goods can be made available at a lower cost. New technologies can increase the output per unit of labour or capital and hence make available more final goods.
What Might Cause the Aggregate Supply Curve to Shift? • Legal-institutional environment: Burdensome taxes and counterproductive regulations can increase the cost of production and discourage firms from producing.
Equilibrium in the Long-Run • Equilibrium output and price level are determined by the intersection of the aggregate demand curve and the long-run aggregate supply curve. • Output is at its natural rate and the short-run aggregate supply curve passes through the point of intersection.