The Basic Model of Economic Fluctuations The Basic Model of Aggregate Demand and Aggregate SupplyEconomist use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.

The Basic Model of Economic Fluctuations The Basic Model of Aggregate Demand and Aggregate SupplyThe aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level.

The Basic Model of Economic Fluctuations The Basic Model of Aggregate Demand and Aggregate SupplyThe aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.

Aggregate Demand and Aggregate Supply...Quantity ofOutputPriceLevel0

THE AGGREGATE-DEMAND CURVEThe four components of GDP (Y) contribute to the aggregate demand for goods and services.Y = C + I + G + NX

The Aggregate-Demand Curve...Quantity ofOutputPriceLevel0

Why the Aggregate-Demand Curve Is Downward SlopingThe Price Level and Consumption: The Wealth EffectThe Price Level and Investment: The Interest Rate EffectThe Price Level and Net Exports: The Exchange-Rate Effect

Why the Aggregate-Demand Curve Is Downward SlopingThe Price Level and Consumption: The Wealth EffectA decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more. This increase in consumer spending means larger quantities of goods and services demanded.

Why the Aggregate-Demand Curve Is Downward SlopingThe Price Level and Investment: The Interest Rate EffectA lower price level reduces the interest rate, which encourages greater spending on investment goods.This increase in investment spending means a larger quantity of goods and services demanded.

Why the Aggregate-Demand Curve Is Downward SlopingThe Price Level and Net Exports: The Exchange-Rate EffectWhen a fall in the Indian price level causes Indian interest rates to fall, the real exchange rate depreciates, which stimulates Indian net exports.The increase in net export spending means a larger quantity of goods and services demanded.

Why the Aggregate-Demand Curve Might ShiftThe downward slope of the aggregate demand curve shows that a fall in the price level raises the overall quantity of goods and services demanded.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.

Why the Aggregate-Demand Curve Might ShiftShifts arising from ConsumptionInvestmentGovernment PurchasesNet Exports

Shifts in the Aggregate Demand Curve0P1Y1

THE AGGREGATE-SUPPLY CURVEIn the long run, the aggregate-supply curve is vertical.In the short run, the aggregate-supply curve is upward sloping.

Why the Aggregate-Supply Curve Slopes Upward in the Short RunIn 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 CurveQuantity ofOutputPriceLevel0

Why the Aggregate-Supply Curve Slopes Upward in the Short RunThe Misperceptions TheoryThe Sticky-Wage TheoryThe Sticky-Price Theory

Why the Aggregate-Supply Curve Slopes Upward in the Short RunThe Misperceptions TheoryChanges 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.

Why the Aggregate-Supply Curve Slopes Upward in the Short RunThe Sticky-Wage TheoryNominal 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 TheoryPrices 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 Short-Run Aggregate-Supply Curve Might ShiftShifts arising LaborCapitalNatural Resources.Technology.Expected Price Level.

THE AGGREGATE-SUPPLY CURVEThe Long-Run Aggregate-Supply CurveIn the long run, an economys production of goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services. The price level does not affect these variables in the long run.

The Long-Run Aggregate-Supply CurveQuantity ofOutputNatural rateof outputPriceLevel0

THE AGGREGATE-SUPPLY CURVEThe Long-Run Aggregate-Supply CurveThe long-run aggregate-supply curve is vertical at the natural rate of output.This level of production is also referred to as potential output or full-employment output.

Justifying vertical LRAS in long run(step 1)Theaggregate supply curvedepicts the quantity of real GDP that is supplied by the economy at different price levels. The reasoning used to construct the aggregate supply curve differs from the reasoning used to construct the supply curves for individual goods and services. The supply curve for an individual good is drawn under the assumption that input prices remain constant.

Justifying vertical LRAS in long run ( Step 2)As the price of good X rises, sellers' per unit costs of providing good X do not change, and so sellers are willing to supply more of good X-hence, the upward slope of the supply curve for good X.The aggregate supply curve, however, is defined in terms of the price level. Increases in the price level will increase the price that producers can get for their products and thus induce more output.

Justifying vertical LRAS in long run ( Step 3)But an increase in the price will also have a second effect; it will eventually lead to increases in input prices as well, which,ceteris paribus, will cause producers to cut back.

Justifying vertical LRAS in long run ( Step 4)So, there is some uncertainty as to whether the economy will supply more real GDP as the price level rises. In order to address this issue, it has become customary to distinguish between two types of aggregate supply curves, theshort-run aggregate supply curveand thelong-run aggregate supply curve.

Justifying vertical LRAS in long run ( Step 5)Thelong-runis defined as the period when input prices have completely adjusted to changes in the price level of final goods. In the long-run, the increase in prices that sellers receive for their final goods is completely offset by the proportional increase in the prices that sellers pay for inputs.

Justifying vertical LRAS in long run ( Step 6)The result is that the quantity of real GDP supplied by all sellers in the economy is independent of changes in the price level. Hence LRAS is a vertical line, reflecting the fact that long-run aggregate supply is not affected by changes in the price level.

Justifying vertical LRAS in long run ( Step 7) Note that theLAScurve is vertical at the point labeled as thenatural rate of output (natural level of real GDP). The natural rate of output is defined as the level of real GDP that arises when the economy isfully employing allof its available input resources.

Why the Long-Run Aggregate-Supply Curve Might ShiftShifts arising LabourCapitalNatural ResourcesTechnological Knowledge

Long-Run Growth and InflationQuantity ofOutputPriceLevel0

A New Way to Depict Long-Run Growth and InflationShort-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends.

Why the Aggregate Supply Curve Might ShiftAn increase in the expected price level reduces the quantity of goods and services supplied and shifts the short-run aggregate supply curve to the left.A decrease in the expected price level raises the quantity of goods and services supplied and shifts the short-run aggregate supply curve to the right.

The Long-Run EquilibriumQuantity ofOutputPriceLevel0

A Contraction in Aggregate DemandQuantity ofOutputPriceLevel0Long-runaggregatesupply

TWO CAUSES OF ECONOMIC FLUCTUATIONSShifts in Aggregate DemandIn the short run, shifts in aggregate demand cause fluctuations in the economys output of goods and services.In the long run, shifts in aggregate demand affect the overall price level but do not affect output.

TWO CAUSES OF ECONOMIC FLUCTUATIONS An Adverse Shift in Aggregate SupplyA 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.

An Adverse Shift in Aggregate SupplyQuantity ofOutputPriceLevel0Long-runaggregatesupply

The Effects of a Shift in Aggregate SupplyStagflationAdverse shifts in aggregate supply cause stagflationa period of recession and inflation.Output falls and prices rise.Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

The Effects of a Shift in Aggregate SupplyPolicy Responses to RecessionPolicymakers may respond to a recession in one of the following ways:Do nothing and wait for prices and wages to adjust.Take action to increase aggregate demand by using monetary and fiscal policy.

Accommodating an Adverse Shift in Aggregate SupplyQuantity ofOutputNatural rateof outputPriceLevel0Long-runaggregatesupplyAggregate demand, ADCopyright 2004 South-Western

SummaryAll societies experience short-run economic fluctuations around long-run trends. These fluctuations are irregular and largely unpredictable.When recessions occur, real GDP and other measures of income, spending, and production fall, and unemployment rises.

SummaryEconomists analyze short-run economic fluctuations using the aggregate demand and aggregate supply model.According to the model of aggregate demand and aggregate supply, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply.

SummaryThe aggregate-demand curve slopes downward for three reasons: a wealth effect, an interest rate effect, and an exchange rate effect.Any event or policy that changes consumption, investment, government purchases, or net exports at a given price level will shift the aggregate-demand curve.

SummaryIn the long run, the aggregate supply curve is vertical.The short-run, the aggregate supply curve is upward sloping. The are three theories explaining the upward slope of short-run aggregate supply: the misperceptions theory, the sticky-wage theory, and the sticky-price theory.

SummaryEvents that alter the economys ability to produce output will shift the short-run aggregate-supply curve.Also, the position of the short-run aggregate-supply curve depends on the expected price level.One possible cause of economic fluctuations is a shift in aggregate demand.

SummaryA second possible cause of economic fluctuations is a shift in aggregate supply.Stagflation is a period of falling output and rising prices.

*Remove bullet in graph graph needs no additional title???*The order of discussion in Mankiw has been changed. The misperceptions theory must be moved to the bottom of the list. (This may affect the entire order of presentation following this slide.)

*Move this slide so that it follows the next two slides. That puts the discussion in the new order of the text.**For consistency, title this slide, Why the Aggregate supply curves slopes upward in the short run like the previous two slides. Then move The sticky-price theory in large print to the top bullet (like the previous two slides).

*Should title be, Why the short-run aggregate supply

*Bullet three, move the misperceptions theory to the end.