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Chapter 33 – Aggregate Demand and Aggregate Supply. Three Key Facts About Economic Fluctuations (Business Cycle). Fact 1 – Economic Fluctuations Are Irregular and Unpredictable Business Cycles have consistent indicators, but are unpredictable in nature Expansionary periods

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three key facts about economic fluctuations business cycle

Chapter 33 – Aggregate Demand and Aggregate Supply

Three Key Facts About Economic Fluctuations (Business Cycle)

Fact 1 – Economic Fluctuations Are Irregular and Unpredictable

Business Cycles have consistent indicators, but are unpredictable in nature

Expansionary periods

Business is good, large amounts of customers, profits grow

Contractionary periods

Business is bad, GDP falls, declining sales, dwindling profits

three key facts about economic fluctuations

Three Key Facts About Economic Fluctuations

Fact 2 – Most Macroeconomic Quantities Fluctuate Together

Real GDP is the most commonly used economic indicator to measure short-run changes in the economy

Fall in real GDP, fall in personal income, corporate profits, consumer spending, investment spending, retail sales, home sales, auto sales, etc.

three key facts about economic fluctuations1

Three Key Facts About Economic Fluctuations

Fact 3 – As Output Falls, Unemployment Rises

An economy’s output is strongly correlated with utilization of its labor force

Real GDP declines, unemployment rises

Contraction/Recession, unemployment rises

Recession ends, recovery/expansion, unemployment rates fall

GDP

explaining short run economic fluctuations
Explaining Short-Run Economic Fluctuations
  • Monetary Neutralitydoes not apply in the short run (6 months, 1 year)
    • Real and nominal variables are highly intertwined in the short run
      • “Keep Our Educators Working” bailout of 2009
    • Changes in the money supply can temporarily push real GDP away from its long-run trend
model of aggregate demand aggregate supply
Model of aggregate demand & aggregate supply

Price

Level

  • Model used to explain short-run fluctuations in economic activity around its long-run trend
  • Aggregate – a sum, gross amount, of all supply and demand in an economy
  • Two axes:
    • Economy’s output of goods and services
    • Average level of prices (CPI or GDP Deflator)

Aggregate supply (AS)

Equilibrium

price level

Aggregate demand (AD)

Quantity of

Output

Equilibrium

output

aggregate demand
Aggregate Demand

Price

Level

  • Aggregate demand curve
  • Sum of C+I+G+NX (real GDP) at each price level
  • Downward sloping
  • Low price levels increase the quantity of goods and services demanded, vice versa

Aggregate demand (AD)

Quantity of

Output

CIGNX

why is the ad curve downward sloping
Why is the AD Curve Downward Sloping?

Price

Level

  • Wealth effect – when prices levels fall consumers feel wealthier, when price levels are high they feel poorer
  • Interest rate effect – a lower price level reduces interest rates, which stimulates the demand for big ticket consumer goods and investment
  • Exchange Rate effect – currency depreciates, which makes U.S. exports more competitive internationally, vice versa

Aggregate demand (AD)

Quantity of

Output

CIGNX

why the ad curve might shift
Why the AD Curve Might Shift?
  • C - Shifts arising from changes in consumption
    • Increases in spending – people have more disposable income
    • Decreases in spending – people become more concerned with saving for retirement
  • I - Shifts arising from changes in investment
    • Change in firm investing – tax policy, pessimism about the economy in future, high interest rates
  • G - Shifts arising from changes in government purchases
    • Congress increases/decreases spending
  • NX - Shift arising from changes in net exports
    • Global recessions would cause a decrease in demand for U.S. products
what shifts the aggregate demand curve
What Shifts the Aggregate Demand Curve?

A

C

B

Price

Level

C

Quantity of

Output

A

C

C

A

A

the aggregate supply curve
The Aggregate Supply Curve
  • AS curve – total quantity of goods and services firms can produce and sell at any given price level
  • Shape of AS curve depends on time horizon
  • Short run - Aggregate-supply curve is upward sloping
  • What shifts the curve?
    • Temporary changes in Land, Labor, Capital
what shifts the aggregate supply curve
What Shifts the Aggregate Supply Curve?

A

C

B

Price

Level

A

Quantity of

Output

A

C

C

C

C

aggregate demand or supply
Aggregate Demand or Supply?

AS

AS

AD

AD

AD

AS

AS

AS

AD

AD

ad as scenarios
AD AS Scenarios

Price

Level

  • A significant increase in world oil prices
  • Government announces a large increase in spending on health and education
  • Average wage rises way above inflation for the third month running
  • Exchange rate appreciation knocks export hopes for manufacturing
  • US productivity levels at their highest level for 10 years
  • A booming stock market leads to highest rate of retail sales in a century

AS

AS1

Pe1

Pe

AD

Quantity of

Output

Y1

Y

ad as scenarios1
AD AS Scenarios

Price

Level

  • A significant increase in world oil prices
  • Government announces a large increase in spending on health and education
  • Average wage rises way above inflation for the third month running
  • Exchange rate appreciation knocks export hopes for manufacturing
  • US productivity levels at their highest level for 10 years
  • A booming stock market leads to highest rate of retail sales in a century

AS

Pe1

Pe

AD

AD1

Quantity of

Output

Y

Y1

ad as scenarios2
AD AS Scenarios

Price

Level

  • A significant increase in world oil prices
  • Government announces a large increase in spending on health and education
  • Average wage rises way above inflation for the third month running
  • Exchange rate appreciation knocks export hopes for manufacturing
  • US productivity levels at their highest level for 10 years
  • A booming stock market leads to highest rate of retail sales in a century

AS

AS1

Pe1

Pe

AD

Quantity of

Output

Y1

Y

ad as scenarios3
AD AS Scenarios

Price

Level

  • A significant increase in world oil prices
  • Government announces a large increase in spending on health and education
  • Average wage rises way above inflation for the third month running
  • Exchange rate appreciation knocks export hopes for manufacturing
  • US productivity levels at their highest level for 10 years
  • A booming stock market leads to highest rate of retail sales in a century

AS

Pe1

Pe

AD

AD1

Quantity of

Output

Y

Y1

ad as scenarios4
AD AS Scenarios

Price

Level

  • A significant increase in world oil prices
  • Government announces a large increase in spending on health and education
  • Average wage rises way above inflation for the third month running
  • Exchange rate appreciation knocks export hopes for manufacturing
  • US productivity levels at their highest level for 10 years
  • A booming stock market leads to highest rate of retail sales in a century

AS

AS1

Pe1

Pe

AD

Quantity of

Output

Y1

Y

ad as scenarios5
AD AS Scenarios

Price

Level

  • A significant increase in world oil prices
  • Government announces a large increase in spending on health and education
  • Average wage rises way above inflation for the third month running
  • Exchange rate appreciation knocks export hopes for manufacturing
  • US productivity levels at their highest level for 10 years
  • A booming stock market leads to highest rate of retail sales in a century

AS

Pe1

Pe

AD

AD1

Quantity of

Output

Y

Y1

the aggregate supply curve1
The Aggregate Supply Curve

Price

Level

  • In the Long-Run (LRAS) the supply is vertical
    • Conceptually, the same as the Production Possibilities Curve
    • An economy’s production of goods and services (real GDP) is based on the factors of production not on price levels
      • Land, Labor, Capital determine what is possible to produce
    • LRAS – shows potential output/full employment/natural rate of output
    • Shows what the economy produces when unemployment is at its natural/normal rate (5-6%)

Long-run

Aggregate

Supply (LRAS)

Capital Goods

Quantity of Output (GDP)

Natural rate

of output (GDP)Full Employment 5-6%

Consumer Goods

why the lras curve might shift
Why the LRAS Curve Might Shift
  • Changes in Labor
    • Immigration increase quantity of labor, shift right
    • Emigration, workers leave for jobs abroad, shift left
  • Changes in Capital
    • Increase capital stock (machinery, factories, operating equipment), shift right
    • Decrease productivity (generational trend to bypass college education), shift left
  • Changes in Natural Resources
    • Discovery of oil, shift to right
    • Cold weather destroys crops, shift to left
  • Changes in Technological Knowledge
    • Innovations (computer, internet, handheld devices), shift right
    • Government policies (environmental concerns, patents, workers safety), shift to left
the long run equilibrium
The Long-Run Equilibrium

Long-run

aggregate

Supply (LRAS)

Price

Level

Short-run

aggregate

Supply (SRAS)

A

Equilibrium

Price (Ple)

Aggregate

Demand (AD)

Quantity of Output

Natural rate

of output (Qfe, Y)

5-6% Unemployment

  • Long-Run-Equilibrium
    • AD intersects with SRAS and LRAS(point A).
    • Expected price level has adjusted to equal the actual price level.
    • Full Employment (natural rate of output), wage Equilibrium
recessionary and inflationary gaps
Recessionary and Inflationary Gaps

Price

Level

Price

Level

LRAS

LRAS

SRAS

SRAS

AD

AD

Q1

(8.2%)

13.4 – T

Q1

(2%)

18 – T

  • Recessionary Gap
    • Underperforming economy (contraction/recession)
    • Not at full employment
    • Unused resources
    • Falling Prices

Quantity of Output(GDP)

Quantity of Output(GDP)

  • Inflationary Gap
    • Overperforming economy (expansion)
    • Above full employment
    • Quickly Rising Prices

Qfe

(5-6%)

GDP – 14 T

Qfe

(5-6%)

GDP – 14 T

four step process for modeling as ad
Four Step Process For Modeling AS&AD
  • First, determine whether the event affects AD or AS
  • Second, determine which way the curve shifts
  • Third, use AD & AS to compare initial & new equilibrium
  • Fourth, examine the transition between SRAS and LRAS

The Aggregate Demand and Aggregate Supply Model at Long-Run Equilibrium

effects of a shift in ad
Effects of a Shift in AD

Price

Level

LRAS

  • Scenario: The economy is experiencing a recession

*Assume long-run equilibrium*

    • Step 1 – AD or AS affected?AD
    • Step 2 – Which direction will the curve shift?Left
    • Step 3 – Plot the new EP (B)
    • Step 4 – Examine transition between SRAS and LRAS (C)

SRAS1

SRAS2

C

B

3. . . . Over time, nominal wages come down, price levels decrease(cost of doing business), and the short-run aggregate-supply curve shifts, bringing us back to long-run equilibrium. . .

A

Ple3

Ple1

Ple2

4. . . . and output returns

to its natural rate.

  • A decrease in
  • aggregate demand . . .

AD2

AD1

Quantity of Output

Y2

Y1

2. . . . causes output to fall in the short run, companies lay off workers,

unemployment will rise, cut back on production. . .

effects of a shift in demand
Effects of a Shift in Demand

LRAS

Price

Level

  • Scenario: The economy experiences a boom in the stock market, people have more disposable income to spend

*Assume long-run equilibrium*

    • Step 1 – AD or AS affected?AD
    • Step 2 – Which direction will the curve shift?Right
    • Step 3 – Plot the new EP (B)
    • Step 4 – Examine transition between SRAS and LRAS (C)

A

SRAS1

B

C

Ple3

Ple1

Ple2

SRAS2

Quantity of Output

Y2

Y1

AD2

AD1

important points about ad
Important points about AD
  • Short run, shifts in AD cause fluctuations in output
  • Long run, shifts in AD affect overall price level, but not output because we will always return to long run equilibrium
  • Policymakers can affect AD/AS and reduce the impact of short-run economic fluctuations
effects of a shift in as
Effects of a Shift in AS

3. . . . and the

price level

to rise (stagflation). . .

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

Price

Level

LRAS

4. . . . but keeps output at its natural rate.

1. An adverse shift in the short-run AS curve. . .

  • Scenario: A hurricane hits and reduces the availability of refineries to produce oil

*Assume long-run equilibrium*

    • Step 1 – AD or AS affected?AS
    • Step 2 – Which direction will the curve shift?Left
    • Step 3 – Plot the new EP (B)
    • Step 4 – Examine transition between SRAS and LRAS (C)

SRAS2

SRAS1

C

A

Ple1

Ple3

Ple2

AD1

AD2

B

Quantity of Output

Y1

Y2

Policymakers affect AD through monetary/fiscal policy. . .

important points about as
Important points about AS
  • Short run, shifts in AS can cause stagflation
  • Long run, shifts in AS affect overall price level, but not output
  • Policymakers can reduce the impact of economic fluctuations, but risk increasing price levels
binder check chapter 33
Binder Check Chapter 33
  • An Introduction to Aggregate Supply and Demand
  • Short Run AD and AS
  • Youtube video - (Macro) Episode 24: AD & AS
  • Youtube video - (Macro) Episode 25: Macroeconomic Viewpoints
  • Youtube video - (Macro) Episode 26: Macroeconomic Viewpoints
  • Chapter 33 Mankiw Practice
  • Free Response
  • Daily Tens
  • Notes Chapter 33
  • Terms
extra credit
Extra Credit
  • How are the LRAS model and the PPC model similar?
  • Draw a properly labeled graph of each of the above models to show an underperforming (below full employment) economy.
  • Identify each of the following as being either AS or AD.
    • Oil refineries
    • China imports US soybeans
    • A baseball stadium
    • A customer buys a hotdog at a baseball game
  • Each of the following are current event headlines in the news today. List which of the following will most likely to be affected, AD, SRAS, or LRAS.
    • US drought affects wheat and soybean yields
    • Despite No Fed Action, Interest Rates For Mortgages Drop To Record Lows
    • Stock Market Hit Hard By Lack Of QE3 (quantitative easing 3)
why the short run aggregate supply curve slopes upward
Why The Short Run Aggregate-Supply Curve Slopes Upward

Price

Level

Short-run

aggregate

supply

  • Key difference in the economy in the short and long run is behavior of AS
    • Long run, price level does not affect economic output
    • Short run, price level does affect economic output
      • Period of a year or two, an increase in price levels raises output
      • Price levels increase, suppliers want to supply more, vice versa

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

why the as curve slopes upward in short run
Why the AS curve slopes upward in short-run
  • Sticky-wage theory - nominal wages are slow to adjust to changing economic conditions
      • Wages are “sticky” in short run
      • Can affect long-term contracts: workers and firms (up to 3 years)
      • Nominal wages are based on expected prices
      • Don’t respond immediately when actual price level is different from what was expected, causing input costs for the firm to increase
slide35

Why the AS curve slopes upward in short-run

  • Sticky-price theory - prices of some goods & services slow to adjust to changing economic conditions
      • Menu costs, firms’ costs of adjusting prices
why the as curve slopes upward in short run1
Why the AS curve slopes upward in short-run
  • Misperceptions theory - changes in the overall price level can temporarily mislead suppliers about changes in individual markets
      • Suppliers respond to changes in level of prices change quantity supplied of goods and services