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Aggregate Demand and Aggregate Supply. Chapter 33. In this chapter, look for the answers to these questions:. What are economic fluctuations? What are their characteristics? How does the model of aggregate demand and aggregate supply explain economic fluctuations? - PowerPoint PPT Presentation

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  • Aggregate Demand and Aggregate SupplyChapter 33

  • In this chapter, look for the answers to these questions:What are economic fluctuations? What are their characteristics?How does the model of aggregate demand and aggregate supply explain economic fluctuations?Why does the Aggregate-Demand curve slope downward? What shifts the AD curve?What is the slope of the Aggregate-Supply curve in the short run? In the long run? What shifts the AS curve(s)? *

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*IntroductionOver the long run, real GDP grows about 3% per year on average. In the short run, GDP fluctuates around its trend.Recessions: periods of falling real incomes and rising unemploymentDepressions: severe recessions (very rare)Short-run economic fluctuations are often called business cycles. 0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • Three Facts About Economic Fluctuations*The shaded bars are recessionsU.S. real GDP, billions of 2000 dollarsFACT 1: Economic fluctuations are irregular and unpredictable.

  • Three Facts About Economic Fluctuations*FACT 2: Most macroeconomic quantities fluctuate together.Investment spending, billions of 2000 dollars

  • Three Facts About Economic Fluctuations*FACT 3: As output falls, unemployment rises.Unemployment rate, percent of labor force

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*Introduction, continuedExplaining these fluctuations is difficult, and the theory of economic fluctuations is controversial. Most economists use the model of aggregate demand and aggregate supply to study fluctuations. This model differs from the classical economic theories economists use to explain the long run. 0

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  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*Classical EconomicsA RecapThe previous chapters are based on the ideas of classical economics, especially:The Classical Dichotomy, the separation of variables into two groups: Real quantities, relative pricesNominal measured in terms of moneyThe neutrality of money: Changes in the money supply affect nominal but not real variables.0

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  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*Classical EconomicsA RecapMost economists believe classical theory describes the world in the long run, but not the short run. In the short run, changes in nominal variables (like the money supply or P ) can affect real variables (like Y or the u-rate). To study the short run, we use a new model.0

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  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*The Model of Aggregate Demand and Aggregate SupplyThe model determines the eqm price leveland eqm output (real GDP).Aggregate DemandShort-Run Aggregate Supply0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*The Aggregate-Demand (AD) CurveThe AD curve shows the quantity of all g&s demanded in the economy at any given price level.0

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  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*Why the AD Curve Slopes DownwardY = C + I + G + NXAssume G fixed by govt policy. To understand the slope of AD, must determine how a change in P affects C, I, and NX. Y10

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  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*The Wealth Effect (P and C )Suppose P rises. The dollars people hold buy fewer g&s, so real wealth is lower. People feel poorer. Result: C falls. 0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*The Interest-Rate Effect (P and I )Suppose P rises. Buying g&s requires more dollars. To get these dollars, people sell bonds or other assets.This drives up interest rates. Result: I falls. (Recall, I depends negatively on interest rates.) 0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*The Exchange-Rate Effect (P and NX )Suppose P rises. U.S. interest rates rise (the interest-rate effect).Foreign investors desire more U.S. bonds.Higher demand for $ in foreign exchange market.U.S. exchange rate appreciates. U.S. exports more expensive to people abroad, imports cheaper to U.S. residents.Result: NX falls. 0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*The Slope of the AD Curve: SummaryAn increase in P reduces the quantity of g&s demanded because:ADP1Y1the wealth effect (C falls)the interest-rate effect (I falls)the exchange-rate effect (NX falls)0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*Why the AD Curve Might ShiftAny event that changes C, I, G, or NX except a change in P will shift the AD curve. Example: A stock market boom makes households feel wealthier, C rises, the AD curve shifts right. 0

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  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*The Aggregate-Supply (AS) CurvesThe AS curve shows the total quantity of g&s firms produce and sell at any given price level. AS is: upward-sloping in short runvertical in long run0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*The Long-Run Aggregate-Supply Curve (LRAS)The natural rate of output (YN) is the amount of output the economy produces when unemployment is at its natural rate. YN is also called potential output or full-employment output. YN0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*Why LRAS Is VerticalYN determined by the economys stocks of labor, capital, and natural resources, and on the level of technology.An increase in P does not affect any of these, so it does not affect YN. (Classical dichotomy)YN0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*Why the LRAS Curve Might ShiftAny event that changes any of the determinants of YN will shift LRAS. Example: Immigration increases L, causing YN to rise. YN0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*Why the LRAS Curve Might ShiftChanges in L or natural rate of unemploymentImmigration Baby-boomers retireGovt policies reduce natural u-rate Changes in K or HInvestment in factories, equipmentMore people get college degreesFactories destroyed by a hurricane

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  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*Why the LRAS Curve Might ShiftChanges in natural resourcesDiscovery of new mineral depositsReduction in supply of imported oilChanging weather patterns that affect agricultural productionChanges in technologyProductivity improvements from technological progress

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*Using AD & AS to Depict LR Growth and InflationOver the long run, tech. progress shifts LRAS to the rightY1990and growth in the money supply shifts AD to the right.Y1980Y2000Result: ongoing inflation and growth in output.0

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  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*Short Run Aggregate Supply (SRAS)The SRAS curve is upward sloping:Over the period of 1-2 years, an increase in Pcauses an increase in the quantity of g & s supplied. 0

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  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*Why the Slope of SRAS MattersIf AS is vertical, fluctuations in AD do not cause fluctuations in output or employment. AD1LRASY1If AS slopes up, then shifts in AD do affect output and employment. 0

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  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*Three Theories of SRASIn each, some type of market imperfectionresult: Output deviates from its natural rate when the actual price level deviates from the price level people expected.0

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  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*1. The Sticky-Wage TheoryImperfection: Nominal wages are sticky in the short run, they adjust sluggishly. Due to labor contracts, social norms Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail. 0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*1. The Sticky-Wage TheoryIf P > PE, revenue is higher, but labor cost is not. Production is more profitable, so firms increase output and employment. Hence, higher P causes higher Y, so the SRAS curve slopes upward.0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*2. The Sticky-Price TheoryImperfection: Many prices are sticky in the short run.Due to menu costs, the costs of adjusting prices. Examples: cost of printing new menus, the time required to change price tags Firms set sticky prices in advance based on PE.

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  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*2. The Sticky-Price TheorySuppose the Fed increases the money supply unexpectedly. In the long run, P will rise. In the short run, firms without menu costs can raise their prices immediately. Firms with menu costs wait to raise prices. Meantime, their prices are relatively low, which increases demand for their products, so they increase output and employment. Hence, higher P is associated with higher Y, so the SRAS curve slopes upward.0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*3. The Misperceptions TheoryImperfection: Firms may confuse changes in P with changes in the relative price of the products they sell.If P rises above PE, a firm sees its price rise before realizing all prices are rising. The firm may believe its relative price is rising, and may increase output and employment. So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping. 0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*What the 3 Theories Have in Common:In all 3 theories, Y deviates from YN when P deviates from PE.Y = YN + a (P PE)0

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  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*What the 3 Theories Have in Common:0Y = YN + a (P PE)

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  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*SRAS and LRASThe imperfections in these theories are temporary. Over time, sticky wages and prices become flexiblemisperceptions are correctedIn the LR, PE = P AS curve is vertical0

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  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*SRAS and LRASYNIn the long run, PE = P and Y = YN.0Y = YN + a (P PE)

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*Why the SRAS Curve Might ShiftEverything that shifts LRAS shifts SRAS, too. Also, PE shifts SRAS:If PE rises, workers & firms set higher wages. At each P, production is less profitable, Y falls, SRAS shifts left.YN0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*The Long-Run EquilibriumIn the long-run equilibrium, PE = P, Y = YN , and unemployment is at its natural rate.ADSRASPELRASYN0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*Economic FluctuationsCaused by events that shift the AD and/or AS curves.Four steps to analyzing economic fluctuations:1.Determine whether the event shifts AD or AS.2. Determine whether curve shifts left or right.3. Use AD-AS diagram to see how the shift changes Y and P in the short run. 4. Use AD-AS diagram to see how economy moves from new SR eqm to new LR eqm. 0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*The Effects of a Shift in ADEvent: Stock market crash1. Affects C, AD curve2. C falls, so AD shifts left3. SR eqm at B. P and Y lower, unemp higher4. Over time, PE falls, SRAS shifts right, until LR eqm at C. Y and unemp back at initial levels. A0

    AGGREGATE DEMAND AND AGGREGATE SUPPLY

  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*The Effects of a Shift in SRASEvent: Oil prices rise1. Increases costs, shifts SRAS (assume LRAS constant)2. SRAS shifts left3. SR eqm at point B. P higher, Y lower, unemp higherFrom A to B, stagflation, a period of falling output and rising prices. 0

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  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*Accommodating an Adverse Shift in SRASIf policymakers do nothing, 4. Low employment causes wages to fall, SRAS shifts right, until LR eqm at A.Or, policymakers could use fiscal or monetary policy to increase AD and accommodate the AS shift: Y back to YN, but P permanently higher. 0

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  • AGGREGATE DEMAND AND AGGREGATE SUPPLY*CONCLUSIONThis chapter has introduced the model of aggregate demand and aggregate supply, which helps explain economic fluctuations. Keep in mind: these fluctuations are deviations from the long-run trends explained by the models we learned in previous chapters. In the next chapter, we will learn how policymakers can affect aggregate demand with fiscal and monetary policy. 0

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  • CHAPTER SUMMARYShort-run fluctuations in GDP and other macroeconomic quantities are irregular and unpredictable. Recessions are periods of falling real GDP and rising unemployment. Economists analyze fluctuations using the model of aggregate demand and aggregate supply. The aggregate demand curve slopes downward because a change in the price level has a wealth effect on consumption, an interest-rate effect on investment, and an exchange-rate effect on net exports. *

  • CHAPTER SUMMARYAnything that changes C, I, G, or NX except a change in the price level will shift the aggregate demand curve. The long-run aggregate supply curve is vertical because changes in the price level do not affect output in the long run. In the long run, output is determined by labor, capital, natural resources, and technology; changes in any of these will shift the long-run aggregate supply curve. *

  • CHAPTER SUMMARYIn the short run, output deviates from its natural rate when the price level is different than expected, leading to an upward-sloping short-run aggregate supply curve. The three theories proposed to explain this upward slope are the sticky wage theory, the sticky price theory, and the misperceptions theory. The short-run aggregate-supply curve shifts in response to changes in the expected price level and to anything that shifts the long-run aggregate supply curve.*

  • CHAPTER SUMMARYEconomic fluctuations are caused by shifts in aggregate demand and aggregate supply. When aggregate demand falls, output and the price level fall in the short run. Over time, a change in expectations causes wages, prices, and perceptions to adjust, and the short-run aggregate supply curve shifts rightward. In the long run, the economy returns to the natural rates of output and unemployment, but with a lower price level.*

  • CHAPTER SUMMARYA fall in aggregate supply results in stagflation falling output and rising prices. Wages, prices, and perceptions adjust over time, and the economy recovers.*

    *****Recessions (represented by the shaded bars) are of different durations and do not occur with any regularity. Hence, the common term business cycle is a bit misleading, as cycle implies something more regular and predictable.

    UNITS: Billions of chained 2000 dollarsORIGINAL SOURCE: U.S. Department of Commerce, Bureau of Economic AnalysisWEBSITE WHERE I FOUND THIS DATA: http://research.stlouisfed.org/fred2/SERIES: GDPC1**Point out that investment falls during each recession. This is true of other variables as well: When the economy is in recession, incomes fall, consumer spending falls, profits fall, many stock prices fall, tax revenue falls (causing the budget deficit to rise), and spending on imports falls (causing the trade deficit to shrink).

    UNITS: Billions of chained 2000 dollarsORIGINAL SOURCE: U.S. Department of Commerce, Bureau of Economic AnalysisWEBSITE WHERE I FOUND THIS DATA: http://research.stlouisfed.org/fred2/SERIES NAME: GPDIC1 **During each recession, the unemployment rate rises. When firms cut back on production, they dont need as many workers. Similarly, during expansions, we see the unemployment rate falling as firms increase their output, they need more workers.

    UNITS: Percent of labor force (seasonally adjusted)ORIGINAL SOURCE: U.S. Department of Labor, Bureau of Labor StatisticsWEBSITE WHERE I FOUND THIS DATA: http://research.stlouisfed.org/fred2/ series UNRATENote: The source data was monthly. To be consistent with Figure 1c of the text, I graphed quarterly data, where each quarterly value is a simple average of the three monthly values.****the Classical Dichotomy is what allowed us to study the real variables (like real GDP and its growth rate, the unemployment rate, investment, and the real wage) in separate chapters before we introduced nominal variables (like the price level and money supply). **As in previous chapters, u-rate is short for unemployment rate. **NOTE: In edit mode (what PowerPoint calls Normal view), this slide looks cluttered. But in presentation (or Slide Show) mode, it all works pretty well.

    As in previous chapters, eqm is short for equilibrium.

    Suggestion: Briefly explain each element of the graph as it appears. (Brief is appropriate because each element will be discussed carefully in the following slides.)

    Note that the graph measures a nominal variable (P) on the vertical axis, and a real one (Y) on the horizontal axis. Thus, the graph highlights the breakdown of the classical dichotomy.

    If you are more of a micro person, then please disregard the following.

    Still reading? Then you must be a macro person. Excellent! Heres something you might tell your students. This model LOOKS like the basic supply and demand model from Chapter 4, but theres a big difference. The basic supply & demand model determines the equilibrium price and quantity of a particular good, say, apples. The equilibrium price of apples is extremely important if youre an apple grower. Ask your students to raise their hand if they plan on going into the apple-growing business. Chances are, none will raise their hands. The model of aggregate demand and supply, however, determines the equilibrium price and quantity of EVERYTHING (loosely speaking), i.e., the price level (cost of living) and real GDP (national income). So, the model of aggregate demand and aggregate supply is highly relevant to a broader group of people than just apple growers. How bout them apples! **As in previous chapters, g&s stands for goods and services. ****Note: the wealth effect concerns the impact of a change in P on wealth, not on income. When P falls, we are implicitly assuming that peoples real incomes are unchanged, and we are only considering the impact of the change in their real wealth on their consumption spending.

    After all text on this slide has appeared, you might tell your students that this effect works in reverse, too: a fall in P raises real wealth, which causes consumption to rise.

    **Note: Again, we are holding real income (and everything else) constant.

    Note: At this point, some students will not understand why an increase in household demand for bonds causes interest rates to fall. If you wish, you can explain it now, or you can tell them not to worry about it for now it will be covered in more detail in the following chapter (in the section on the Liquidity Preference Theory).

    After all the text on this slide has appeared, you might tell your students that the interest-rate effect also works in reverse: a decrease in P causes a decrease in interest rates, which increases investment.

    **Again, the exchange-rate effect also works in reverse: A decrease in P causes interest rates and exchange rates to fall, which increases NX.

    **Note that the red arrow is not equal to the fall in C, but rather to the fall in demand due to the fall in C. The difference is due to the Keynesian multiplier: the initial fall in C causes a fall in Y, which causes a further (but smaller) fall in C, which causes a further (but smaller) fall in Y, and so forth. It might not be appropriate to cover the Keynesian multiplier at this point it will be discussed in the following chapter but mentioning that the red arrow is not the same as the fall in C might prevent students from learning something they will later have to unlearn. Similarly, the green arrow represents not the fall in I, but the fall in demand due to the fall in I. And similarly for the goldish-brown arrow and NX. **A change in P wont shift the AD curve, but will cause a movement along the AD curve. **The slope of the AS curve depends on the time horizon:

    In the short run, the aggregate supply curve is upward-sloping. (SR = short run).

    In the long run, the aggregate supply curve is vertical.

    These slopes will be explained in the following slides.

    **The book does not use the notation YN. I use it here to keep the slides from getting too cluttered, and also to make it easier for students to take notes: its easier for them to write YN than the natural rate of output.**This is review from the chapter Production and Growth. ********In the following chapter, it will be more clear why money supply growth shifts the AD curve rightward. ******Each of these theories provides a reason why the aggregate supply curve might have a positive slope in the short run.

    It would be most helpful if students carefully read this section of the chapter!****If P > PE

    means

    If the actual price level turns out to be higher the price level firms had expected...******Of the three theories, this one seems the least plausible.

    Firms certainly have a strong incentive to not mistake a general price increase for a relative price increase. And information about the price level is costless and available with only a short lag (especially the CPI, which is published monthly and very widely reported the moment it comes out).

    My remarks here are not officially part of the textbook, so they are not supported in the study guide or test bank. Feel free to ignore them. **Economists debate which of these theories is correct. Its possible that each of them contains some element of truth.

    For our purposes here, the similarities between these theories are more important than their differences: all three imply that output deviates from its long-run level (the natural rate of output) when the price level (P) deviates from the level people had expected (PE).

    **The preceding slide introduced an equation of aggregate supply that shows how output deviates from full-employment when the actual price level is different than expected.

    This slide illustrates these concepts using a graph.

    When P = PE, Y = YN

    When P < PE, Y < YN

    When P > PE, Y > YN

    ****Notice that when the price level equals the expected price level, output is equal to its long-run value, the natural rate of output.

    Interpretation:

    In the short run, people may be fooled about the price level, or they may be locked into wages or prices that were set before they knew what the price level would actually be. Hence, in the short run, P may differ from PE.

    But in the long run, expectations catch up to reality, P = PE, and therefore Y = YN, as in the Classical model.

    Thus, our theory of economic fluctuations is basically the Classical model (which we studied for several chapters) augmented with some kind of market imperfection (such as sticky wages). The impact of the market imperfection occurs only in the short run, so the long-run behavior of our model is Classical.

    ******This four-step approach is based on the three-step approach used in Chapter 4 to analyze changes in the basic supply & demand model. **The results from this exercise apply to any event that shifts AD to the left, whether a stock market crash, recession abroad, wave of pessimism, or other.

    The stock market crash reduces consumers wealth, which depresses their spending. The AD curve shifts to the left.

    The new short-run equilibrium is at point B, where P and Y are lower, and hence unemployment is higher. (Remember Fact #3 about economic fluctuations: unemployment and output move in opposite directions.)

    At point B, P < PE. Over time, PE falls, wages fall, and sticky prices become flexible and fall. The SRAS curve moves rightward.

    This process continues until the economy arrives at point C, where GDP and unemployment are back at their natural rates, and PE = P once again.

    Notice that, in the absence of policy intervention, the economy self-corrects. Of course, this process takes time, and policymakers may not want to wait. At point B, policymakers could use fiscal or monetary policy to shift aggregate demand to the right and move the economy back to A. **An increase in oil prices might also affect LRAS. For simplicity, and to be consistent with the textbook, we assume it only affects the SRAS curve.

    *********