AGGTRATE DEMAND & AGGRAGATE SUPPLY

Introduction Economic activity fluctuates from year to year. In most years production of goods and services rises. On average over the past 50 years, production in the Indian economy has grown by about average 4.7 percent per year. In some years normal growth does not occur, causing a recession.

Introduction A recession is a period of declining real incomes, and

rising unemployment. A depression is a severe recession.

Three Facts about Economic Fluctuations Economic fluctuations are irregular and

unpredictable. Fluctuations in the economy are often called the

business cycle. Most macroeconomic variables fluctuate together. As output falls, unemployment rises.

Most macroeconomic variables fluctuate together. Most macroeconomic variables that measure some type of income or production fluctuate closely together. Although many macroeconomic variables fluctuate together, they fluctuate by different amounts.

Figure 1 A Look At Short-Run Economic Fluctuations(a) Real GDPBillions of 1996 Dollars $10,000

9,0008,000 7,000 6,000 5,000 4,000 3,000

Real GDP

2,000 1965

1970

1975

1980

1985

1990

1995

2000

Copyright 2004 South-Western

Figure 1 A Look At Short-Run Economic Fluctuations(b) Investment Spending Billions of 1996 Dollars $1,800 1,600 1,400 1,200 1,000 Investment spending

800600

400200 1965 1970 1975 1980 1985 1990 1995 2000

Copyright 2004 South-Western

As output falls, unemployment rises. Changes in real GDP are inversely related to changes in the unemployment rate. During times of recession, unemployment rises substantially.

Figure 1 A Look At Short-Run Economic Fluctuations(c) Unemployment Rate Percent of Labor Force 12 10 8 6 4 2 0 1965 Unemployment rate

1970

1975

1980

1985

1990

1995

2000

Copyright 2004 South-Western

EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS The Reality of Short Run Fluctuations:

Most economists believe that classical theory describes the world in the long run but not in the short run. Changes in the money supply affect nominal variables but not real variables in the long run. The assumption of monetary neutrality is not appropriate when studying year-to-year changes in the economy.

The economys output of goods and services measured

by real GDP. The overall price level measured by the CPI or the GDP deflator.

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. The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level. The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.

Figure 2 Aggregate Demand and Aggregate Supply...Price Level

Aggregate supply

Equilibrium price level

Aggregate demand

0

Equilibrium output

Quantity of OutputCopyright 2004 South-Western

One has to understand here that its a relationship

between nominal variable ( i.e. Price) & real variable (i.e. Quantity)

THE AGGREGATE DEMAND CURVE Basically demand curve shows the change in demand

due to the change in the price of the goods & services. The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX If we assume that government purchase is fixed by the policy & other three components depends on the economic condition we can show the graph of aggregate demand as follows.

Figure 3 The Aggregate-Demand Curve...Price Level

P

P2 1. A decrease in the price level . . . 0 Y Y2 Aggregate demand

Quantity of Output

2. . . . increases the quantity of goods and services demanded.Copyright 2004 South-Western

Why the 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

The Price Level and Consumption: The Wealth

Effect

A decrease in the price level makes consumers feel

more wealthy, which in turn encourages them to spend more. This increase in spending by consumer means more demand for goods & services. In this exercise only purchasing power of the money

will change. Meance you will spend the same amount but you will get more goods due to low price.

The Price Level and Investment: The Interest Rate Effect: Due to the lower prices person will always wish to hold lesser amount of money with him (because he is able to have more goods in lesser amount of money, so no need to hold large amount) He perhaps will keep this amount with bank to earn good saving interest or he will lend it to some one. Banks will be able to give more number of loans(because banks will be heaving more money due to deposit like this) Thus the lower price level always increases the demand of spending (by cash or by loan).

The Price Level and Net Exports: The Exchange-

Rate Effect The lower price of goods & services finally will bring

down the interest rate, due to which few people will be motivated to invest abroad. This higher rate of cross boundary investment will bring demand for the more foreign currency than the domestic one, which will depreciate the value of the domestic currency. It will result in expansive imported goods & relatively cheaper domestic goods Automatically demand for the domestic goods will increase.

Why the Aggregate-Demand Curve Might Shift: The downward slope of the aggregate demand curve

shows that if price level falls it will raises the overall demand of goods and services. Many other factors, however, affect the quantity of

goods and services demanded at any given price level. When one of these other factors changes, the aggregate

demand curve shifts. This shift may arise because of Consumption, Investment, Govt. Purchases, Net Export

Shifts in the Aggregate Demand Curve PriceLevel

P1

D2Aggregate demand, D1 0

Y1

Y2

Quantity of Output

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.

As we know that supply of the goods & services

depends on the factors of the production. We also discussed that price only give effect on the

nominal variables (price) not real variables.(quantity) So in the two different situation in the long run, where

price will be different due to the supply of the money, but production of goods & services will be the same. This is true for all basic necessity.

Figure 4 The Long-Run Aggregate-Supply CurvePrice Level Long-run aggregate supply P

P2 1. A change in the price level . . . 0 Natural rate of output

2. . . . does not affect the quantity of goods and services supplied in the long run. Quantity of Output

Copyright 2004 South-Western

Why the Long-Run Aggregate-Supply Curve Might

Shift: The long run level of the production is sometimes called potential output or full employment output Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve. The shifts may be categorized according to the various factors in the classical model that affect output. This shift may arise due to Labor, Capital, Natural Resources, Technological Knowledge

Shifts arising Labor- immigration of the labor Capital-Increase / Decrease in capital stock Natural Resources- Dependency on Natural Resources Technological Knowledge- Change in the technology

Figure 5 Long-Run Growth and Inflation2. . . . and growth in the money supply shifts aggregate demand . . . Price Level

Long-run aggregate supply, LRAS1980 LRAS1990 LRAS2000

P2000 4. . . . and ongoing inflation. P1990

1. In the long run, technological progress shifts long-run aggregate supply . . .

Aggregate Demand, AD2000 P1980 AD1990

AD1980

0

Y1980

Y1990

Y2000

Quantity of Output 3. . . . leading to growth in output . . .Copyright 2004 South-Western

Short-run fluctuations in output and price level

should be viewed as deviations from the continuing long-run trends. In the short run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied. A decrease in the level of prices tends to reduce the quantity of goods and services supplied.

Figure 6 The Short-Run Aggregate-Supply CurvePrice Level

Short-run aggregate supply P

P2 1. A decrease in the price level . . .

2. . . . reduces the quantity of goods and services supplied in the short run.

0

Y2

Y

Quantity of OutputCopyright 2004 South-Western

Why the Aggregate-Supply Curve Slopes Upward in the Short Run: The Misperceptions Theory The Sticky-Wage Theory The Sticky-Price Theory

The Misperceptions Theory Changes in the overall price level temporarily

mislead suppliers about what is happening in the markets in which they sell their output: A lower price level causes misperceptions about relative prices.

These misperceptions induce suppliers to decrease the quantity of goods and services supplied.

The Sticky-Wage Theory

Nominal wages are slow to adjust, or are sticky in the short run: Wages do not adjust immediately to a fall in the price level. A lower price level makes employment and production less profitable. This induces firms to reduce the quantity of goods and services supplied.

The Sticky-Price Theory:

Prices of some goods and services adjust sluggishly in response to changing economic conditions: An unexpected fall in the price level leaves some firms with higher-than-desired prices. This depresses sales, which induces firms to reduce the quantity of goods and services they produce.

Why the Aggregate Supply Curve Might Shift: Because of the high sales price expectation generally

firms rise the wages of the workers to take better out put from them (remember low of supply).. But when the sell price dont rise as per expectation than this higher rate of salary turns in to the financial burden for the firm. So generally, to reduce the cost burden of the production & salary , firms also reduces the production Because of this reduced supply, curve will shift left.

Figure 7 The Long-Run EquilibriumPrice Level Long-run aggregate supply

Short-run aggregate supply

Equilibrium price

A

Aggregate demand 0 Natural rate of output

Quantity of OutputCopyright 2004 South-Western

TWO CAUSES OF ECONOMIC FLUCTUATIONS

Effect of Shifts in Aggregate Demand:Because of the wave of the pessimism (due to any reason) if people prefer to have lesser quantity of goods & services, it will reduces the demand of goods & services. Due to this demand curve will shift left & will create new equilibrium with lower price. In short term due to lower price people will be again motivated to purchase more goods & services, which will again lead to the rise in the supply as well as price. But in long term again equilibrium point will come on the vertical supply curve

Figure 8 A Contraction in Aggregate Demand2. . . . causes output to fall in the short run . . . Price Level Long-run aggregate supply

Short-run aggregate supply, ASAS2 3. . . . but over time, the short-run aggregate-supply curve shifts . . . C 1. A decrease in aggregate demand . . .

P P2 P3 B D

A

Aggregate demand, ADAD2 0 Y2 Y 4. . . . and output returns to its natural rate. Quantity of OutputCopyright 2004 South-Western

Effect of Shifts in Aggregate Supply: A decrease in one of the determinants of aggregate

supply shifts the curve to the left:

Output falls below the natural rate of employment. Unemployment rises. The price level rises.

Figure 10 An Adverse Shift in Aggregate Supply1. An adverse shift in the shortrun aggregate-supply curve . . . Price Level Long-run aggregate supply AS2 Short-run aggregate supply, AS

B P2 A P 3. . . . and the price level to rise.

Aggregate demand0 Y2 Y Quantity of OutputCopyright 2004 South-Western

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

Adverse shifts in aggregate supply cause

stagflationa combination of recession (falling out put) & inflation (rising prices)

Output falls and prices rise. Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.