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Dynamic Change, Economic Fluctuations in the
AS-AD ModelCh 10
Analyze the impact of unanticipated changes in aggregate demand and short run aggregate supply
Evaluate the economy’s self-correcting mechanism
Chapter 10 Objectives
Anticipated change – foreseen in time to make adjustments
Unanticipated change – not foreseen, appropriate adjustments were not made
Anticipated/Unanticipated Change
Aggregate Demand
Price Level
P2
AD
P1
Y1Y2
A change in the price level represents a movement along the curve
Output
Aggregate Demand
Price Level
AD0
Changes in things besides the price level shift the curve and (AD1) increase or (AD2) decrease aggregate demand
Output
AD1
AD2
1. Increases in real wealth shift AD right◦ a. Stock market◦ b. Housing prices
◦ Example: The 1990s “new economy”
Aggregate Demand Shifters
2. When the interest rate falls, AD shifts right because borrowing (for consumption and investment) becomes cheaper
Aggregate Demand Shifters
3. When people are optimistic about the future, AD shifts right◦ Consumer sentiment index◦ “Animal Spirits” – Keynes◦ “Irrational Exuberance” – Greenspan
Aggregate Demand Shifters
4. When expected inflation is high, AD shifts right◦ Less incentive to save, spend now
5. If other countries’ incomes are rising, AD shifts right◦ Demand for U.S. exports increases as other
countries prosper◦ The larger the trade sector, the bigger the shift
Aggregate Demand
6. When the dollar depreciates, AD shifts right◦ Imports become more expensive◦ Exports become cheaper◦ So, NX will rise
Aggregate Demand Shifters
AD Shifters SummaryIncrease in AD (shift right) Decrease in AD (shift left)
↑ in real wealth, stock mkt, housing prices
↓ in real wealth, stock mkt, housing prices
↓ in real interest rate ↑ in real interest rate
Optimism about the future Pessimism about the future
↑ in expected inflation ↓ expected inflation
↑ real incomes abroad ↓ real incomes abroad
↓ value of nation’s currency ↑ value of nation’s currency
Permanent change in production conditions◦ Shift LRAS◦ Shift SRAS
Temporary change in production conditions◦ Shift SRAS
Aggregate Supply LR and SR
Long Run Aggregate Supply Shift
Price Level
LRAS1
Output (real GDP)
An increase in the economy’s production capacity will shift LRAS right
LRAS2
Improvements in resource base◦ Physical capital investment◦ Human capital investment
Improvements in technology Institutional and government policy changes
◦ Easy to conduct business◦ Enforce contracts fairly◦ Protect private property rights
LRAS Shift Right Ch 16 Sources of Economic
Growth
LRAS Shifters SummaryIncrease in LRAS (shift right) Decrease in LRAS (shift left)
↑ in supply of resources ↓ in supply of resources
Technology and productivity improvements
Technology and productivity deteriorations
Institutional changes that improve efficiency of resource use
Institutional changes that reduce efficiency of resource use
Note: Rightward shifts are much more common in the U.S. than leftward shifts, thank goodness!
Aggregate Supply in the Short Run
Price Level
P2
SRAS
P1
Y2Y1
Increase in price level will increase quantity supplied in the short run
Output
Aggregate Supply in the Short Run
Price Level
SRAS0
Changes in things besides the price level shift the curve and (SRAS1) increase or (SRAS2) decrease short run aggregate supply
Output (real GDP)
SRAS1SRAS2
1. When resource prices fall, SRAS shifts right◦ If the change is long-term, LRAS will shift also
2. When expected inflation is low, SRAS shifts right◦ No benefit from holding onto goods to sell at a
later date
SR Aggregate Supply Shifters
3. Favorable supply shocks shift SRAS right◦ Supply shock – unexpected event that
temporarily increases or decreases aggregate supply
◦ Examples: OPEC increases output, favorable growing conditions
SR Aggregate Supply Shifters
SRAS Shifters SummaryIncrease in SRAS (shift right) Decrease in SRAS (shift left)
↓ in resource prices (production costs)
↑ in resource prices (production costs)
↓ in expected inflation ↑ in expected inflation
Favorable supply shocks like good weather or lower prices of oil
Unfavorable supply shocks like bad weather or higher prices of oil
Holding fiscal and monetary policy constant Ceteris Paribus (one change at a time)
Reminders
Do not cause equilibrium disruptions Decision makers plan for change No booms and busts
Graph long run, steady economic growth: ◦ Long run equilibrium is the same as short run
equilibrium (no disequilibrium) Higher output Lower price level
Anticipated Changes and AD-AS
Steady Economic Growth
Price Level
LRAS1 LRAS2
Output
SRAS2
AD
YF1 YF2
E1
E2
P1
P2
SRAS1
Cause equilibrium disruptions, disequilibrium◦ Increase in AD◦ Decrease in AD◦ Increase in SRAS◦ Decrease in SRAS
No economic growth is occurring◦ Booms and busts◦ LRAS will not shift
Graphing◦ What is the short run equilibrium?◦ How do we return to long run equilibrium?
Unanticipated Changes and AD-AS
Unanticipated Increase in
Aggregate Demand
Causes: unanticipated ◦ increase in real wealth ◦ fall of the interest rate ◦ optimism about the future ◦ rising incomes abroad, or ◦ depreciation of domestic currency
Unanticipated Increase in AD
Bull Market
Short run◦ Output higher than potential◦ Price level rises unexpectedly◦ Resource prices and interest rates fixed◦ Producer profits are higher than normal
Long run◦ Resource prices, interest rates rise◦ SRAS shifts left◦ Return to full employment, normal profits◦ Price level permanently higher
Unanticipated Increase in AD
Short run equilibrium
Price LevelLRAS
Output (real GDP)
AD1
YF
E1
e2
P100
P105
SRAS1
AD2
Y2
Too Fast
Long run equilibrium
Price LevelLRAS
Output (real GDP)
AD1
YF
E1
e2
P100
P105
SRAS1
AD2
Y2
SRAS2
P110 E2
Unanticipated Decrease in
Aggregate Demand
Causes: unanticipated ◦ decrease in real wealth ◦ rise of the interest rate ◦ pessimism about the future ◦ falling incomes abroad, or ◦ appreciation of domestic currency
Unanticipated Decrease in AD
Bear Market
Short run◦ Output lower than potential◦ Price level falls unexpectedly◦ Resource prices and interest rates fixed◦ Producer profits are lower than normal
Long run◦ Resource prices, interest rates fall◦ SRAS shifts right◦ Return to full employment, normal profits◦ Price level permanently lower
Unanticipated Decrease in AD
Resource prices are “downward sticky”◦ Long term contracts◦ Workers hesitant to accept lower wages◦ Unions
Can make adjustment process slow
Unanticipated Decrease in AD
Short run equilibrium
Price LevelLRAS
Output (real GDP)
AD1
YF
E1
e2
P100
P95
SRAS1
AD2
Y2
Too Slow
Long run equilibrium
Price LevelLRAS
Output (real GDP)
AD1
YF
E1
e2
P100
P95
SRAS1
AD2
Y2
E2
SRAS2
P90
Unanticipated Increase in Short Run Aggregate
Supply
Causes: unanticipated, temporary ◦ Favorable supply shock
Good weather Cheap oil
Unanticipated Increase in SRAS
Short run equilibrium
Price LevelLRAS
Output (real GDP)
AD1
YF
E1
e2
P100
P95
SRAS1
Y2
SRAS2
Best Party Ever!
Long run equilibrium
Price LevelLRAS
Output (real GDP)
AD1
YF
E1
e2
P100
P95
SRAS1
Y2
SRAS2
Well, all good things must come to an end. We had
fun!
Short run◦ Output higher than potential◦ Price level falls unexpectedly◦ Resource prices and interest rates fixed◦ Producer profits are higher than normal
Long run◦ Favorable conditions come to an end◦ SRAS shifts left and returns to original position◦ Return to full employment, normal profits◦ No changes in prices or output in the long run
Unanticipated Increase in SRAS
Unanticipated Decrease in Short Run Aggregate
Supply
Causes: unanticipated, temporary unfavorable supply shock
Unanticipated Decrease in SRAS
Short run◦ Output lower than potential◦ Price level rises unexpectedly◦ Resource prices and interest rates fixed◦ Producer profits are lower than normal
Long run◦ Unfavorable conditions come to an end◦ SRAS shifts right and returns to original position◦ Return to full employment, normal profits◦ No changes in prices or output in the long run
Unanticipated Decrease in SRAS
Short run equilibrium
Price LevelLRAS
Output (real GDP)
AD1
YF
E1
e2
P100
P105
SRAS1
Y2
SRAS2
Ugh, this sucks!
Long run equilibriumWhew! Glad
that’s over. Back to normal
Price LevelLRAS
Output (real GDP)
AD1
YF
E1
e2
P100
P105
SRAS1
Y2
SRAS2
When AD shifts unexpectedly, the long run impacts are seen only in the price level
When SRAS shifts unexpectedly, there are no long run impacts because the change was temporary
When markets are allowed to adjust, we will always return to full employment and output
Summary
Unanticipated changes in AD or SRAS can disrupt the economy
But changes in ◦ Resource prices◦ Interest rates
Return the economy to long run equilibrium
Recessions and Booms
Recession (GDP less than YF)◦ Weak demand for resources causes
unemployment◦ Resource prices then fall◦ Return to full output
Boom (GDP greater than YF)◦ Strong demand for resources causes greater than
normal profits◦ Resource price then rise◦ Return to full output
Resource Market Adjustments
Recession (GDP less than YF)◦ Weak demand for borrowing◦ Interest rates then fall◦ Return to full output
Boom (GDP more than YF)◦ Strong demand for borrowing◦ Drives up interest rates◦ Return to full output
Loanable Funds Market Adjustments
Keynesian Economists: too long! New Classical Economists: not too long at
all!
How long does adjustment take?
Expansions and Recessions, 1950-2009
Period of ExpansionLength
(in Months) Period of RecessionLength
(in Months)
Oct ‘49 to Jul ’53 44 Jul ‘53 to May ’54 10
May ‘54 to Aug ’57 39 Aug ‘57 to Apr ’58 9
Apr ‘58 to Apr ’60 24 Apr ‘60 to Feb ’61 10
Feb ‘61 to Dec ’69 105 Dec ‘69 to Nov ’70 10
Nov ‘70 to Nov ‘73 36 Nov ‘73 to Mar ’75 16
Mar ‘75 to Jan ’80 58 Jan ‘80 to Jul ’80 6
Jul ‘80 to Jul ’81 12 Jul ‘81 to Nov ’82 16
Nov ‘82 to Jul ’90 92 Jul ‘90 Mar ’91 9
Mar ‘91 to Mar ’01 120 Mar ‘01 to Nov ’01 8
Nov ‘01 to Nov ’07 73 Dec ‘07 to June ‘09 18
Analyze the impact of unanticipated changes in aggregate demand and short run aggregate supply
Evaluate the economy’s self-correcting mechanism
Chapter 10 Objectives
