Business Cycles• Business Cycles have consistent indicators, but are unpredictable in nature

• Expansionary periods

• Business is good, large amounts of customers, profits grow

• Contractionary periods

• Business is bad, GDP falls, declining sales, dwindling profits

Chapter 33 – Aggregate Demand and Aggregate Supply

GDP

Three Key Facts About Economic FluctuationsReal GDP• Real GDP is the most commonly used economic indicator to measure short-run changes in the economy•Fall in real GDP, fall in personal income, corporate profits, consumer spending, investment spending, retail sales, home sales, auto sales, etc.

Three Key Facts About Economic FluctuationsGDP and Unemployment•Real GDP declines, unemployment rises

•Contraction/Recession begins, unemployment rises

•Recession ends, recovery/expansion, unemployment rates fall

GDP

Explaining Short-Run Economic Fluctuations Monetary Neutrality does not apply in the short run

(6 months, 1 year)

◦ Real and nominal variables are highly intertwined in the short run

◦ Changes in the money supply can temporarily push real GDP away from its long-run trend

“Economic Stimulus Package”

Who Can Prevent A Recession From Becoming A Depression?

Monetary Policy of the Fed

Fiscal Policy of the Federal Government

Model of aggregate demand & aggregate supply Model used to explain short-run fluctuations in economic activity

around its long-run trend Aggregate – a sum, gross amount, of all supply and demand in an

economy Two axes:

Economy’s output of goods and services (Real GDP) Average level of prices (CPI or GDP Deflator)

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PriceLevel

Real GDP

Equilibriumprice level (PL)

Aggregate supply (AS)

Aggregate demand (AD)

EquilibriumOutput (Y)

Quantity ofOutput

PriceLevel

0

Aggregatedemand

P

Y Y2

P2

1. A decreasein the pricelevel . . .

2. . . . increases the quantity ofgoods and services demanded.

Aggregate Demand Aggregate demand curve

◦ Sum of C+I+G+NX (real GDP) at each price level

◦ Downward sloping

◦ Low price levels increase the quantity of goods and services demanded, vice versa

CIGNX

Why the AD Curve Might Shift? C - Shifts arising from changes in consumption

◦ Increases in spending – people have more disposable income

◦ Decreases in spending – people become more concerned with saving for retirement

I - Shifts arising from changes in investment

◦ Change in firm investing – tax policy, pessimism about the economy in future, high interest rates

G - Shifts arising from changes in government purchases

◦ Congress increases/decreases spending NX - Shift arising from changes in net exports

◦ Global recessions would cause a decrease in demand for U.S. products

What Shifts the Aggregate Demand Curve?

PriceLevel

Quantity of Output

A B C

Situation Change in AD New AD Curve

Congress cuts taxes

Business spending decreases

Government spending increases; no new taxes

Survey shows consumer confidence jumps

Stock collapses; investors lose billions

President cuts defense spending by 20%; no increase in domestic spending

C

A

C

C

A

A

The Aggregate Supply Curve AS curve – total quantity of goods and services firms can produce and

sell at any given price level Shape of AS curve depends on time horizon (short/long run) Short run - Aggregate-supply curve is upward sloping What shifts the curve?

http://www.usatoday.com/story/news/nation/2013/10/19/us-oil-imports-opec-embargo/2997499/◦ Temporary changes in Land, Labor, Capital◦ 1973 Supply Shock

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What Shifts the Aggregate Supply Curve?

PriceLevel

Quantity ofOutput

A B C

Situation Change in AS

New AS Curve

Unions grow more aggressive; wage rates increase

OPEC successfully increases oil prices

Labor productivity increases dramatically

Giant natural gas discovery decreases energy prices

Computer technology brings new efficiency

Research shows that improved schools have increased the skills of American workers

A

A

C

C

C

C

Aggregate Demand

Consumer Spending Government Spending Investment Spending Foreign Spending (x-m)

Aggregate Supply

Factory Corn Field Apple Store Pizza Joint

Aggregate Demand or Supply?Scenario AD or AS

1. A factory

2. A printing press

3. A woman buys a hamburger for her child

4. A U.S. company sells a jet to a foreign country

5. A company builds a new factory

6. Trees

7. A corn field

8. A coal mine

9. Students purchase tickets for a football game

10. Two newlyweds buy a house

ASAS

ADAD

AD

AS

AS

AS

ADAD

AD AS Scenarios1. A significant increase in world oil prices

2. Government announces a large increase in spending on health and education

3. Average wage rises way above inflation for the third month running

4. Exchange rate appreciation knocks export hopes for manufacturing

5. US productivity levels at their highest level for 10 years

6. A booming stock market leads to highest rate of retail sales in a century

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PriceLevel

Real GDP

Ple

AS

AD

Y

AS1

Y1

Ple1

AD AS Scenarios1. A significant increase in world oil prices

2. Government announces a large increase in spending on health and education

3. Average wage rises way above inflation for the third month running

4. Exchange rate appreciation knocks export hopes for manufacturing

5. US productivity levels at their highest level for 10 years

6. A booming stock market leads to highest rate of retail sales in a century

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PriceLevel

Real GDP

Ple

AS

AD

Y

AD1

Y1

Ple1

AD AS Scenarios1. A significant increase in world oil prices

2. Government announces a large increase in spending on health and education

3. Average wage rises way above inflation for the third month running

4. Exchange rate appreciation knocks export hopes for manufacturing

5. US productivity levels at their highest level for 10 years

6. A booming stock market leads to highest rate of retail sales in a century

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PriceLevel

Real GDP

Ple

AS

AD

Y

AS1

Y1

Ple1

AD AS Scenarios1. A significant increase in world oil prices

2. Government announces a large increase in spending on health and education

3. Average wage rises way above inflation for the third month running

4. Exchange rate appreciation knocks export hopes for manufacturing

5. US productivity levels at their highest level for 10 years

6. A booming stock market leads to highest rate of retail sales in a century

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PriceLevel

Real GDP

Pe

AS

AD

Y AD1Y1

Pe1

AD AS Scenarios1. A significant increase in world oil prices

2. Government announces a large increase in spending on health and education

3. Average wage rises way above inflation for the third month running

4. Exchange rate appreciation knocks export hopes for manufacturing

5. US productivity levels at their highest level for 10 years

6. A booming stock market leads to highest rate of retail sales in a century

20

PriceLevel

Real GDP

Ple

AS

AD

Y

AS1

Y1

Ple1

AD AS Scenarios1. A significant increase in world oil prices

2. Government announces a large increase in spending on health and education

3. Average wage rises way above inflation for the third month running

4. Exchange rate appreciation knocks export hopes for manufacturing

5. US productivity levels at their highest level for 10 years

6. A booming stock market leads to highest rate of retail sales in a century

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PriceLevel

Real GDP

Ple

AS

AD

Y

AD1

Y1

Ple1

Videos

2010 AP® MACROECONOMICS FREE-RESPONSE

3. How does each of the following changes affect the real gross domestic product and price level of an open economy in the short run? Graph and explain each.

(a) An increase in the price of crude oil, an important natural resource

(b) A technological change that increases the productivity of labor

(c) An increase in spending by consumers(d) A decrease in government spending to offset a deficit

• a) GDP will fall and the price level will rise, because the increase in the price of oil raises input costs and causes the short-run aggregate supply curve to shift to the left.

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PriceLevel

Real GDP

Ple

AS

AD

Y

AS1

Y1

Ple1

• b) Real GDP will rise and the price level will fall, because the increase in labor productivity reduces unit input costs and causes the short-run aggregate supply curve to shift to the right.

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PriceLevel

Real GDP

Ple

AS

AD

Y

AS1

Y1

Ple1

• (c) Real GDP will rise and the price level will rise, because the increase in spending causes the aggregate demand curve to shift to the right.

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PriceLevel

Real GDP

Ple

AS

AD

Y

AD1

Y1

Ple1

• (d) Real GDP will fall and the price level will fall, because the decrease in spending causes the aggregate demand curve to shift to the left.

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PriceLevel

Real GDP

Pe

AS

AD

Y AD1Y1

Pe1

The Aggregate Supply Curve In the Long-Run (LRAS) the supply is vertical

◦ Conceptually, the same as the Production Possibilities Curve◦ An economy’s production of goods and services (real GDP) is based on

the factors of production not on price levels Land, Labor, Capital determine what is possible to produce

◦ LRAS – shows potential output/full employment/natural rate of output

◦ Shows what the economy produces when unemployment is at its natural/normal rate (5-6%)Price

Level

Quantity of Output (GDP)

Long-runAggregate

Supply (LRAS)

Natural rate of output (GDP)Full Employment 5-6%

Consumer Goods

Cap

ital G

oods

Why the LRAS Curve Might Shift Permanent changes in the following: Changes in Labor

◦ Immigration increase quantity of labor, shift right

◦ Emigration, workers leave for jobs abroad, shift left

Changes in Capital

◦ Increase capital stock (machinery, factories, operating equipment), shift right

◦ Decrease productivity (generational trend to bypass college education), shift left

Changes in Natural Resources

◦ Discovery of oil, shift to right

◦ Cold weather destroys crops, shift to left Changes in Technological Knowledge

◦ Innovations (computer, internet, handheld devices), shift right

◦ Government policies (environmental concerns, patents, workers safety), shift to left

Why The Short Run Aggregate-Supply Curve Slopes Upward Key difference in the economy in the short and long run is behavior of AS

◦ Long run, price level does not affect economic output

◦ Short run, price level does affect economic output Period of a year or two, an increase in price levels raises output Price levels increase, suppliers want to supply more, vice versa

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PriceLevel

Quantity of Output

P2

Short-runaggregate

supply

Y1

P1

Y2

1. A decreasein the pricelevel . . .

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

Why The Short Run Aggregate-Supply Curve Slopes Upward Key difference in the economy in the short and long run is behavior of AS

◦ Long run, price level does not affect economic output

◦ Short run, price level does affect economic output Period of a year or two, an increase in price levels raises output Price levels increase, suppliers want to supply more, vice versa

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PriceLevel

Quantity of Output

P2

Short-runaggregate

supply

Y1

P1

Y2

1. An increasein the pricelevel . . .

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

Why the AS curve slopes upward in short-run Sticky-wage theory - nominal wages are slow to adjust to

changing economic conditions Wages are “sticky” in short run Can affect long-term contracts: workers and firms (up to

3 years) Nominal wages are based on expected prices Don’t respond immediately when actual price level is

different from what was expected, causing input costs for the firm to increase

32

Sticky-price theory - prices of some goods & services slow to adjust to changing economic conditions

Menu costs, firms’ costs of adjusting prices

33

Why the AS curve slopes upward in short-run

Misperceptions theory - changes in the overall price level can temporarily mislead suppliers about changes in individual markets

Suppliers respond to changes in level of prices change quantity supplied of goods and services

34

Why the AS curve slopes upward in short-run

The Long-Run EquilibriumPriceLevel

Quantity of Output

Long-runaggregate

Supply (LRAS)

Natural rateof output (Qfe, Y)

5-6% Unemployment

Short-runaggregate

Supply (SRAS)

AggregateDemand (AD)

EquilibriumPrice (Ple)

A

• Long-Run-Equilibrium• AD intersects with SRAS and LRAS(point A).• Expected price level has adjusted to equal the actual price level. • Full Employment (natural rate of output), wage Equilibrium

The Economy Compared to a Car The economy is like a car…

You can drive 120mph but is not sustainable ◦ Extremely low unemployment, 2%

Driving 20mph is too slow; the car can go faster ◦ High unemployment, 10%

Some cars have the capacity to drive faster than others◦ Industrial nations vs. 3rd world

nations If the engine (technology) or gas

mileage (productivity) increase then the car can move at even higher speeds◦ Increase in LRAS/PPC

The government/Fed’s job is to brake or speed up when needed; promote things that will improve the engine◦ Shift the LRAS/PPC left/outward

Recessionary and Inflationary GapsPriceLevel

Quantity of Output(GDP)

LRAS

Qfe (5-6%)

SRAS

AD

Q1(7.9%)

PriceLevel

Quantity of Output(GDP)

LRAS

Qfe (5-6%)

SRAS

AD

Q1(2%)

• Recessionary Gap• Underperforming economy

(contraction/recession)• Not at full employment• Unused resources• Falling Prices

• Inflationary Gap• Overperforming economy

(expansion)• Above full employment• Quickly Rising Prices

Four Step Process For Modeling AS&ADFirst, determine whether the event affects

AD or ASSecond, determine which way the curve

shiftsThird, use AD & AS to compare initial & new

equilibriumFourth, examine the transition between SRAS

and LRASThe Aggregate Demand and Aggregate Supply Model at Long-Run Equilibrium

Effects of a Shift in AD

PriceLevel

Quantity of Output

LRAS

Y1

SRAS1

AD1

Ple1 A

AD2

Ple2

B

Y2

SRAS2

Ple3

C

1. A decrease in aggregate demand . . .

2. . . . causes output to fall in the short run, companies lay off workers, unemployment will rise, cut back on production. . .

3. . . . Over time, nominal wages come down, price levels decrease(cost of doing business), and the short-run aggregate-supply curve shifts, bringing us back to long-run equilibrium. . .

4. . . . and output returnsto its natural rate.

Scenario: The economy is experiencing a recession

*Assume long-run equilibrium*◦ Step 1 – AD or AS affected? AD◦ Step 2 – Which direction will the curve shift? Left ◦ Step 3 – Plot the new EP (B)◦ Step 4 – Examine transition between SRAS and LRAS (C)

Effects of a Shift in Demand

PriceLevel

Quantity of Output

LRAS

Y1

SRAS1

AD1

Y2

Ple1

A

Scenario: The economy experiences a boom in the stock market, people have more disposable income to spend

*Assume long-run equilibrium*

◦ Step 1 – AD or AS affected? AD

◦ Step 2 – Which direction will the curve shift? Right

◦ Step 3 – Plot the new EP (B)

◦ Step 4 – Examine transition between SRAS and LRAS (C)

Ple3 C

Ple2

B

SRAS2

AD2

Important points about AD Short run, shifts in AD cause fluctuations in short run

output (real GDP) Long run, shifts in AD affect overall price level, but

output returns to long run equilibrium Policymakers can affect AD/AS and reduce the short-

run impact of economic fluctuations

3. . . . and theprice levelto rise (stagflation). . .

Effects of a Shift in AS Scenario: A hurricane hits and reduces the availability of refineries to produce oil

*Assume long-run equilibrium*◦ Step 1 – AD or AS affected? AS◦ Step 2 – Which direction will the curve shift? Left ◦ Step 3 – Plot the new EP (B)◦ Step 4 – Examine transition between SRAS and LRAS (C)

PriceLevel

Quantity of Output

LRAS

Y1

SRAS1

AD1

Ple1A

SRAS2

Ple2

1. An adverse shift in the short-run AS curve. . .

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

AD2

Ple3C

4. . . . but keeps output at its natural rate.

B

Y2

Policymakers affect AD through monetary/fiscal policy. . .

Important points about ASShort run, shifts in AS can cause stagflationLong run, shifts in AS affect overall price

level, but not outputPolicymakers can reduce the impact of

economic fluctuations, but risk increasing price levels

Binder Check Chapter 331. An Introduction to Aggregate Supply and

Demand2. Short Run AD and AS3. Youtube video - (Macro) Episode 24: AD &

AS 4. Youtube video - (Macro) Episode 25:

Macroeconomic Viewpoints5. Youtube video - (Macro) Episode 26:

Macroeconomic Viewpoints6. Chapter 33 Mankiw Practice 7. Free Response8. Daily Tens9. Notes Chapter 3310. Terms

Extra Credit1. How are the LRAS model and the PPC model similar? 2. Draw a properly labeled graph of each of the above models to show

an underperforming (below full employment) economy.3. Identify each of the following as being either AS or AD.

a. Oil refineriesb. China imports US soybeansc. A baseball stadiumd. A customer buys a hotdog at a baseball game

4. Each of the following are current event headlines in the news today. List which of the following will most likely to be affected, AD, SRAS, or LRAS.

a. US drought affects wheat and soybean yieldsb. Despite No Fed Action, Interest Rates For Mortgages Drop To

Record Lowsc. Stock Market Hit Hard By Lack Of QE3 (quantitative easing 3)