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PowerPoint Slides prepared by: Andreea CHIRITESCU
Eastern Illinois University
Aggregate Demand
and Aggregate Supply
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Economic Fluctuations
• Economic activity– Fluctuates from year to year
• Recession– Economic contraction
– Period of declining real incomes and rising unemployment
• Depression– Severe recession
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Economic Fluctuations
• Key facts about economic fluctuations1. Economic fluctuations are irregular and
unpredictable• The business cycle
2. Most macroeconomic variables fluctuate together
• Recessions – economy-wide phenomena • As output falls, income falls and
unemployment rises
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Figure 9
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U.S. Real GDP Growth since 1900
Over the course of U.S. economic history, two fluctuations stand out as especially large. During the early 1930s, the economy went through the Great Depression, when the production of goods and services plummeted. During the early 1940s, the United States entered World War II, and the economy experienced rapidly rising production. Both of these events are usually explained by large shifts in aggregate demand.
Figure 1
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A Look at Short-Run Economic Fluctuations (c)
This figure shows real GDP in panel (a), investment spending in panel (b), and unemployment in panel (c) for the U.S. economy using quarterly data since 1965. Recessions are shown as the shaded areas. Notice that real GDP and investment spending decline during recessions, while unemployment rises.
Short-Run Economic Fluctuations
• AD-AS model– Model of aggregate demand (AD) &
aggregate supply (AS)
– Most economists use it to explain short-run fluctuations in economic activity• Around its long-run trend
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Short-Run Economic Fluctuations
• Aggregate-demand curve– Shows the quantity of goods and services
– That households, firms, the government, and customers abroad
– Want to buy at each price level
– Downward sloping
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Short-Run Economic Fluctuations
• Aggregate-supply curve– Shows the quantity of goods and services
– That firms choose to produce and sell
– At each price level
– Upward sloping
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Figure 2
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Aggregate Demand and Aggregate Supply
PriceLevel
Quantity ofOutput
Equilibriumprice level
Aggregate supply
Aggregate demand
Equilibriumoutput
Economists use the model of aggregate demand and aggregate supply to analyze economic fluctuations. On the vertical axis is the overall level of prices. On the horizontal axis is the economy’s total output of goods and services. Output and the price level adjust to the point at which the aggregate-supply and aggregate-demand curves intersect.
Figure 3
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The Aggregate-Demand Curve
PriceLevel
Quantity of Output
P1
Aggregate demand
Y1
A fall in the price level from P1 to P2 increases the quantity of goods and services demanded from Y1 to Y2. There are three reasons for this negative relationship. As the price level falls, real wealth rises, interest rates fall, and the exchange rate depreciates. These effects stimulate spending on consumption, investment, and net exports. Increased spending on any or all of these components of output means a larger quantity of goods and services demanded.
P2
Y2
1. A decrease in the price level . . .
2. . . . increases the quantity ofgoods and services demanded
Aggregate-Demand Curve
• The AD curve might shift:– Changes in consumption
– Changes in investment
– Changes in government purchases
– Changes in net exports
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Aggregate-Demand Curve
• Changes in government purchases, G– Policymakers – change government
spending at a given price level• Build new roads
– Increase in government purchases • Aggregate demand - shifts right
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Aggregate Supply Curve
• Short run– Aggregate-supply curve is upward sloping
– A higher price raises the quantity of goods and services supplied
• Long run aggregate supply – Recall Chapter 17
• Price level does not affect the long-run determinants of GDP:
– Supplies of labor, capital, and natural resources– Available technology
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Figure 6
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The Short-Run Aggregate-Supply Curve
PriceLevel
Quantity of Output
P2
Short-runaggregate
supply
Y1
In the short run, a fall in the price level from P1 to P2 reduces the quantity of output supplied from Y1 to Y2. This positive relationship could be due to sticky wages, sticky prices, or misperceptions. Over time, wages, prices, and perceptions adjust, so this positive relationship is only temporary.
P1
Y2
1. A decrease in the price level . . .
2. . . . reduces the quantity of goods and services supplied in the short run
Causes of Economic Fluctuations
• Assumption– Economy begins in long-run equilibrium
• Long-run equilibrium:– Intersection of AD and LRAS curves
• Output - natural rate• Actual price level
– Intersection of AD and short-run AS curve• Expected price level = Actual price level
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Exhibit 7
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The Long-Run Equilibrium
PriceLevel
Quantity of Output
The long-run equilibrium of the economy is found where the aggregate-demand curve crosses the aggregate-supply curve (point A).
Short-runaggregate
supply
Aggregatedemand
Equilibriumprice
A
Long- run aggregate
supply
Causes of Economic Fluctuations
• Shift in aggregate demand– Wave of pessimism (stock market crash) –
Aggregate demand shifts left
– Short-run• Output falls• Price level falls
17© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 8
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A Contraction in Aggregate DemandPrice
Level
Quantity of Output
A fall in aggregate demand is represented with a leftward shift in the aggregate-demand curve from AD1 to AD2. In the short run, the economy moves from point A to point B. Output falls from Y1 to Y2, and the price level falls from P1 to P2.
Short-run aggregate supply, AS1
Aggregate demand, AD1
P1 A
AD2
P2
B
Y2
1. A decrease in aggregate demand . . .
2. . . . causes output to fall in the short run . . .
Y1
The Recession of 2008–2009
• 2008-2009, financial crisis, severe downturn in economic activity– Worst macroeconomic event in more than
half a century
• 2006-2008: housing prices began to fall– Substantial rise in mortgage defaults and
home foreclosures
– Financial institutions that owned mortgage-backed securities• Huge losses
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The Recession of 2008–2009
• Three policy actions to shift AD rightward– The Fed
• Cut its target for the federal funds rate from 5.25% in September 2007 to about zero in December 2008
• Started open market operations
– Treasury• Lent loans to banks and became part owner• Government – temporarily became a part owner of
these banks
– January 2009, Barack Obama• $787 billion stimulus bill of government
spending & tax cuts20© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 8b
21© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Effect of Policy ActionsPrice
Level
Quantity of Output
A fall in aggregate demand is represented with a leftward shift in the aggregate-demand curve from AD1 to AD2. In the short run, the economy moves from point A to point B. Output falls from Y1 to Y2, and the price level falls from P1 to P2.
Short-run aggregate supply, AS1
Aggregate demand, AD1
P1 A
AD2
P2
B
Y2
1. A decrease in aggregate demand . . .
2. . . . causes output to fall in the short run . . .
Y1
3. Policy aims at return aggregate demand to AD1 . . .
