AggregateDemandandAggregateSupply

Short-RunEconomicFluctuations

◆Economicactivityfluctuatesfromyeartoyear.◆ Inmostyearsproductionofgoodsandservicesrises.◆ Onaverageoverthepast50years,productionintheU.S.economyhasgrownbyabout3percentperyear.

◆ Insomeyearsnormalgrowthdoesnotoccur,causingarecession.

Short-RunEconomicFluctuations

◆Arecession isaperiodofdecliningrealGDP,fallingincomes,andrisingunemployment.◆Adepression isasevererecession.

ThreeKeyFactsAboutEconomicFluctuations

◆Economicfluctuationsareirregularandunpredictable.◆ Fluctuationsintheeconomyareoftencalledthebusinesscycle.

◆Mostmacroeconomicvariablesfluctuatetogether.◆Asoutputfalls,unemploymentrises.

Recessions

(a) Real GDP

Billions of1992 Dollars

1965 1970 1975 1980 1985 1990 19952,5003,0003,5004,0004,5005,0005,5006,0006,500

$7,000Real GDP

A Look At Short-Run Economic Fluctuations

ThreeKeyFactsAboutEconomicFluctuations

◆Mostmacroeconomicvariablesfluctuatetogether.◆Mostmacroeconomicvariablesthatmeasuresometypeofincomeorproductionfluctuatecloselytogether.

◆ Althoughmanymacroeconomicvariablesfluctuatetogether,theyfluctuatebydifferentamounts.

Recessions

(b) Investment Spending

Billions of1992 Dollars

300400500600700800900

1,000$1,100

Investment spending

1965 1970 1975 1980 1985 1990 1995

A Look At Short-Run Economic Fluctuations

ThreeKeyFactsAboutEconomicFluctuations

◆Asoutputfalls,unemploymentrises.◆ ChangesinrealGDPareinverselyrelatedtochangesintheunemploymentrate.

◆ Duringtimesofrecession,unemploymentrisessubstantially.

Recessions

(c) Unemployment Rate

Unemployment rate

0

2

4

6

8

10

12

1965 1970 1975 1980 1985 1990 1995

Percent ofLabor Force

A Look At Short-Run Economic Fluctuations

HowtheShortRunDiffersFromtheLongRun

◆Mosteconomistsbelievethatclassicaltheorydescribestheworldinthelongrunbutnotintheshortrun.◆ Changesinthemoneysupplyaffectnominalvariablesbutnotrealvariablesinthelongrun.

◆ Theassumptionofmonetaryneutralityisnotappropriatewhenstudyingyear-to-yearchangesintheeconomy.

TheBasicModelofEconomicFluctuations

◆Twovariablesareusedtodevelopamodeltoanalyzetheshort-runfluctuations.◆ Theeconomy’soutputofgoodsandservicesmeasuredbyrealGDP.◆ TheoverallpricelevelmeasuredbytheCPIortheGDPdeflator.

TheBasicModelofEconomicFluctuations

Economistusethemodelofaggregatedemand andaggregatesupply toexplainshort-runfluctuationsineconomicactivityarounditslong-runtrend.

TheBasicModelofEconomicFluctuations

◆Theaggregatedemandcurve showsthequantityofgoodsandservicesthathouseholds,firms,andthegovernmentwanttobuyateachpricelevel.

TheBasicModelofEconomicFluctuations

◆Theaggregatesupplycurve showsthequantityofgoodsandservicesthatfirmsproduceandsellateachpricelevel.

AggregateDemandandAggregateSupply...

Equilibriumoutput

Quantity ofOutput

PriceLevel

0

Equilibriumprice level

Aggregatesupply

Aggregatedemand

TheAggregateDemandCurve

◆ThefourcomponentsofGDP(Y)contributetotheaggregatedemandforgoodsandservices.

Y = C + I + G + NX

TheAggregate-DemandCurve...

Quantity ofOutput

PriceLevel

0

Aggregatedemand

P1

Y1 Y2

P2

2. …increases the quantity of goods and services demanded.

1. A decrease in the price level...

WhytheAggregateDemandCurveIsDownwardSloping

◆ThePriceLevelandConsumption:TheWealthEffect◆ThePriceLevelandInvestment:TheInterestRateEffect◆ThePriceLevelandNetExports:TheExchange-RateEffect

ThePriceLevelandConsumption:TheWealthEffect

◆Adecreaseinthepricelevelmakes consumersfeelmorewealthy,whichinturnencouragesthemtospendmore.

◆Thisincreaseinconsumerspendingmeanslargerquantitiesofgoodsandservicesdemanded.

ThePriceLevelandInvestment:TheInterestRateEffect

◆Alowerpricelevelreducestheinterestrate,whichencouragesgreaterspendingoninvestmentgoods.

◆Thisincreaseininvestmentspendingmeansalargerquantityofgoodsandservicesdemanded.

ThePriceLevelandnetExports:TheExchange-RateEffect

◆WhenafallintheU.S.pricelevelcausesU.S.interestratestofall,therealexchangeratedepreciates,whichstimulatesU.S.netexports.

◆Theincreaseinnetexportspendingmeansalargerquantityofgoodsandservicesdemanded.

WhytheAggregateDemandCurveMightShift

◆Thedownwardslopeoftheaggregatedemandcurveshowsthatafallinthepricelevelraisestheoverallquantityofgoodsandservicesdemanded.◆Manyotherfactors,however,affectthequantityofgoodsandservicesdemandedatanygivenpricelevel.◆Whenoneoftheseotherfactorschanges,theaggregatedemandcurveshifts.

WhytheAggregateDemandCurveMightShift

◆ShiftsarisingfromConsumption◆ShiftsarisingfromInvestment◆ShiftsarisingfromGovernmentPurchases◆ShiftsarisingfromNetExports

ShiftsintheAggregateDemandCurve...

Quantity ofOutput

PriceLevel

0

Aggregatedemand, D1

P1

Y1

D2

Y2

TheAggregateSupplyCurve

◆Inthelongrun,theaggregate-supplycurveisvertical.◆Intheshortrun,theaggregate-supplycurveisupwardsloping.

TheLong-RunAggregateSupplyCurve

◆Inthelong-run,aneconomy’sproductionofgoodsandservicesdependsonitssuppliesoflabor,capital,andnaturalresourcesandontheavailabletechnologyusedtoturnthesefactorsofproductionintogoodsandservices.◆Thepriceleveldoesnotaffectthesevariablesinthelongrun.

TheLong-RunAggregate- SupplyCurve...

Quantity ofOutput

Natural rateof output

Price Level

0

Long-runaggregate

supplyP1

P2 2. …does not affect the quantity of goods and services supplied in the long run.

1. A change in the price level…

TheLong-RunAggregateSupplyCurve

◆Thelong-runaggregatesupplycurveisverticalatthenaturalrateofoutput.◆Thislevelofproductionisalsoreferredtoaspotentialoutput orfull-employmentoutput.

WhytheLong-RunAggregateSupplyCurveMightShift

◆Anychangeintheeconomythataltersthenaturalrateofoutputshiftsthelong-runaggregate-supplycurve.◆Theshiftsmaybecategorizedaccordingtothevariousfactorsintheclassicalmodelthataffectoutput.

WhytheLong-RunAggregateSupplyCurveMightShift

◆ShiftsarisingfromLabor◆ShiftsarisingfromCapital◆ShiftsarisingfromNaturalResources◆ShiftsarisingfromTechnologicalKnowledge

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

LRAS2000LRAS1990

Long-RunGrowthandInflation...

Quantity ofOutput

Price Level

0

P1980

Y1980

AD1980

P2000

P1990

LRAS1980

2. …and growth in the money supply shifts aggregate-demand...

AD2000

AD1990

4. …and ongoing inflation.

Y1990 Y2000

3. …leading to growth in output...

Long-RunGrowthandInflation

Short-runfluctuationsinoutputandpricelevelshouldbeviewedasdeviationsfromthecontinuinglong-runtrends.

WhytheShort-RunAggregateSupplyCurveSlopesUpwardintheShortRun

◆Intheshortrun,anincreaseintheoveralllevelofpricesintheeconomytendstoraisethequantityofgoodsandservicessupplied.◆Adecreaseinthelevelofpricestendstoreducethequantityofgoodsandservicessupplied.

TheShort-RunAggregateSupplyCurve...

Quantity ofOutput

Price Level

0

Short-runaggregate

supply

Y1

P1

Y2

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

P2

1. A decrease in the price level

WhytheShort-RunAggregateSupplyCurveSlopesUpwardintheShort

Run

◆TheMisperceptionsTheory◆TheSticky-WageTheory◆TheSticky-PriceTheory

TheMisperceptionsTheory

◆Changesintheoverallpriceleveltemporarilymisleadsuppliersaboutwhatishappeninginthemarketsinwhichtheyselltheiroutput:◆Alowerpricelevelcausesmisperceptionsaboutrelativeprices.◆ Thesemisperceptionsinducesupplierstodecreasethequantityofgoodsandservicessupplied.

TheSticky-WageTheory

◆Nominalwagesareslowtoadjust,orare“sticky”intheshortrun:◆Wagesdonotadjustimmediatelytoafallinthepricelevel.◆ Alowerpricelevelmakesemployment andproductionlessprofitable.

◆ Thisinducesfirmstoreducethequantityofgoodsandservicessupplied.

TheSticky-PriceTheory

◆Pricesofsomegoodsandservicesadjustsluggishlyinresponsetochangingeconomicconditions:◆ Anunexpectedfallinthepricelevelleavessomefirmswithhigher-than-desiredprices.

◆ Thisdepressessales,whichinducesfirmstoreducethequantityofgoodsandservicestheyproduce.

WhytheAggregateSupplyCurveMightShift

◆ShiftsarisingfromLabor◆ShiftsarisingfromCapital◆ShiftsarisingfromNaturalResources.◆ShiftsarisingfromTechnology.◆ShiftsarisingfromtheExpectedPriceLevel.

WhytheAggregateSupplyCurveMightShift

◆Anincreaseintheexpectedpricelevelreducesthequantityofgoodsandservicessuppliedandshiftstheshort-runaggregatesupplycurvetotheleft.◆Adecreaseintheexpectedpricelevelraisesthequantityofgoodsandservicessuppliedandshiftstheshort-runaggregatesupplycurvetotheright.

TheLong-RunEquilibrium

Quantity ofOutput

PriceLevel

0

Short-run aggregatesupply

Long-runaggregate

supply

Aggregatedemand

AEquilibriumprice

Natural rateof output

1. A decrease inaggregate demand…

AD2

AContractioninAggregateDemand...

Quantity ofOutput

PriceLevel

0

Short-run aggregatesupply, AS1

Long-runaggregate

supply

Aggregatedemand, AD1

AP1

Y1

BP2

Y2

2. …causes output to fall in the short run…

AS2

CP3

3. …but over time,the short-run aggregate-supply curve shifts…

4. …and output returnsto its natural rate.

ShiftsinAggregateDemand

◆Intheshortrun,shiftsinaggregatedemandcausefluctuationsintheeconomy’soutputofgoodsandservices.◆Inthelongrun,shiftsinaggregatedemandaffecttheoverallpricelevelbutdonotaffectoutput.

AnAdverseShiftinAggregateSupply

◆Adecreaseinoneofthedeterminantsofaggregatesupplyshiftsthecurvetotheleft:◆ Outputfallsbelowthenaturalrateofemployment.◆ Unemploymentrises.◆ Thepricelevelrises.

1. An adverse shift in the short-run aggregate-supply curve…

AS2

Long-runaggregate

supplyShort-run aggregatesupply, AS1

Quantity ofOutput

PriceLevel

0Aggregate demand

A

Y1

P1

An AdverseShiftinAggregateSupply...

3. …and the price level to rise.

P2

2. …causes output to fall…

B

Y2

Stagflation

◆Adverseshiftsinaggregatesupplycausestagflation—acombinationofrecessionandinflation.◆ Outputfallsandpricesrise.◆ Policymakerswhocaninfluenceaggregatedemandcannotoffsetbothoftheseadverseeffectssimultaneously.

PolicyResponsestoRecession

◆Policymakersmayrespondtoarecessioninoneofthefollowingways:◆ Donothingandwaitforpricesandwagestoadjust.◆ Takeactiontoincreaseaggregatedemandbyusingmonetaryandfiscalpolicy.