Aggregate Demand and Aggregate Supply. Aggregate Demand and Aggregate Supply. Economic fluctuations, also called business cycles, are irregular, recurring movements of GDP away from potential output.
Aggregate Demandand Aggregate Supply • Economic fluctuations, also called business cycles, are irregular, recurring movements of GDP away from potential output. • Keynesian economics is a school of economic thought that provides insights into the economy when it operates away from full employment.
Business Cyclesand Economic Fluctuations • A recession is a period when real GDP falls for two consecutive quarters. It starts at the peak of an increase in output, and ends at a trough, the time at which output stops falling in a recession. • A depression is a prolonged period of decline in output, or a severe recession. During the Great Depression, 1929 through 1933, real GDP fell by over 33%, and unemployment rose to 25%.
Business Cyclesand Economic Fluctuations • The relationship between changes in real GDP and the corresponding changes in unemployment is called Okun’s Law. • According to Okun’s law, for every percentage point that real GDP grows faster than the normal rate of increase in potential output, the unemployment rate falls by one-half of a percentage point.
The Unemployment RateDuring Recessions • During periods of recession, marked by the shaded bars, unemployment rises sharply.
Business Cyclesand Economic Fluctuations • Procyclical economic measures move in conjunction with real GDP. Investment spending, consumption spending and prices of stocks are all procyclical. • Economic measures that fall as real GDP rises are countercyclical. Unemployment is countercyclical.
Sticky Prices andDemand-Side Economics • Prices give the correct signals to all producers in the economy so that resources are used efficiently. • If consumers decide to consume fresh fruit rather than chocolate, the price of fruit will rise and the price of chocolate will fall. • The economy will produce more fresh fruit and less chocolate on the basis of these price signals.
Sticky Prices andDemand-Side Economics • If prices are slow to adjust, then the proper signals are not given quickly enough to producers and consumers. • The short run in macroeconomics is the period of time in which prices do not change very much.
Aggregate Demand • The aggregate demand curve plots the total demand for GDP as a function of the price level. • Demand for GDP comprises the demand for goods and services by all sectors of the economy. • The price level refers to the average of all prices in the economy, as measured by a price index.
The Slope of theAggregate Demand Curve • Aggregate demand slopes downward for several reasons. Among them are: • The wealth effect: as the price level falls, the real value of money increases and people find that they are wealthier. RealityPRINCIPLEWhat matters to people is the real value of money or income–its purchasing power–not the face value of money or income.
The Slope of theAggregate Demand Curve • Aggregate demand also slopes downward for two other reasons: • The interest rate effect: With a given money supply, a lower price level will lead to lower interest rates and higher consumption and investment spending. • The impact of foreign trade: A lower price level makes domestic goods cheaper relative to foreign goods.
Aggregate Demand • The aggregate demand curve plots the total demand for real GDP as a function of the price level.
Aggregate Demand • The aggregate demand curve slopes downward, indicating that aggregate demand increases as the price level falls.
Aggregate Supply • The aggregate supply curve depicts the relationship between the level of prices and real GDP. • We will consider two aggregate supply curves, one corresponding to the long run (the classical aggregate supply curve), and one to the short run (the Keynesian aggregate supply curve).
The Classical Aggregate Supply Curve • In the long run, the level of output, y*, is independent of the price level.
Aggregate Demand andClassical Aggregate Supply • Output and prices are determined at the intersection of AD and AS. • An increase in aggregate demand leads to a higher price level.
Aggregate Demand andKeynesian Aggregate Supply • The Keynesian AS curve is relatively flat because, in the short run, firms adjust output more than they adjust prices.
Aggregate Demand and Keynesian Aggregate Supply • With a Keynesian aggregate supply curve, shifts in aggregate demand lead to changes in output but small changes in prices.
Aggregate Demand andKeynesian Aggregate Supply • The level of output where the Keynesian AS curve intersects the aggregate demand curve need not be the full-employment output. • Output may exceed the level of full employment when demand is very high.
Supply Shocks • Supply shocks are external events that shift the Keynesian aggregate supply curve. • Adverse supply shocks result in lower output, lower employment, and higher prices.
Supply Shocks • Favorable supply shocks are also possible. They lead to the best of both worlds: higher output and lower prices. • Favorable supply shocks allow the economy to grow rapidly without incurring the risk of higher inflation.
Output and Prices in the Short Runand in the Long Run • In the short run, the economy produces at y0, which exceeds potential output yp. • At y0, we have a boom economy.
Output and Prices in the Short Runand in the Long Run • As firms compete for labor and raw materials, wages and prices will tend to rise over time. • This will cause the Keynesian aggregate supply curve to shift upward.
Output and Prices in the Short Runand in the Long Run • The Keynesian aggregate supply will keep rising upward until it intersects the aggregate demand curve at full employment.
Output and Prices in the Short Runand in the Long Run • Adjustments in wages and prices eventually take the economy from short-run Keynesian equilibrium to long-run classical equilibrium at E1.