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Aggregate Demand &
Aggregate Supply
Chapter 33
outline
3 key facts of economic fluctuations Basic model – Aggregate DD & SS Aggregate DD
-why it is downward sloping
- why it shifts Aggregate SS Long run
- why it shifts
outline
Aggregate SS short run
-why it is upward sloping
- why it shifts Effect of shift in Aggregate DD & SS Policy responses
Short-Run Economic Fluctuations
Economic activity fluctuates from year to year. In most years production of goods and
services rises. In some years normal growth does not occur,
causing a recession.
A recession is a period of declining real GDP, falling incomes, and rising unemployment.
A depression is a severe recession.
Three Key Facts About Economic Fluctuations
Economic fluctuations are irregular and unpredictable. Fluctuations in the economy are often called
the business cycle.
Most macroeconomic variables fluctuate together.
As output falls, unemployment rises.
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
Economic Fluctuations are irregular
Recessions
(b) Investment Spending
Billions of1992 Dollars
300
400
500
600
700
800
900
1,000
$1,100
Investment spending
1965 1970 1975 1980 1985 1990 1995
Economic variables fluctuate together
Recessions
(c) Unemployment Rate
Unemployment rate
0
2
4
6
8
10
12
1965 1970 1975 1980 1985 1990 1995
Percent ofLabor Force
Output falls, unemployment rises
The Basic Model of Economic Fluctuations
Economist use the model of aggregate demand and aggregate supply to explain short-run fluctuationsThe aggregate demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level.The aggregate supply curve shows the quantity of goods and services that firms produce and sell at each price level.
4 steps for analyzing macroeconomic Fluctuations
1. Decide whether the event shift aggregate demand or supply curve
2. Decide in which direction the curve shifts
3. Use diagram to see how shift changes output & price level
4. Use diagram to see how economy moves from short run equilibrium to long run equilibrium
Aggregate Demand and Aggregate Supply...
Equilibriumoutput
Quantity ofOutput
PriceLevel
0
Equilibriumprice level
Aggregatesupply
Aggregatedemand
The Aggregate-Demand Curve...
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...
aggregate demand for goods and services.
Y = C + I + G + NX
Why the Aggregate Demand Curve Is Downward Sloping
The Price Level and Consumption: The Wealth Effect
The Price Level and Investment: The Interest Rate Effect
The Price Level and Net Exports: The Exchange-Rate Effect
Cont…. WEALTH EFFECT : decrease in the price level
makes consumers feel more wealthy, which in turn encourages them to spend more.
INTEREST RATE EFFECT : A lower price level reduces the interest rate, which encourages greater spending on investment goods.
EXCHANGE RATE EFFECT : When a fall in the Indian price level causes Indian interest rates to fall, the real exchange rate depreciates, which stimulates India net exports.
Why Aggregate demand curve shift
Quantity ofOutput
PriceLevel
0
Aggregatedemand, D1
P1
Y1
D2
Y2
shift arises because of
C , I , G , NX
The Long-Run Aggregate Supply Curve
In the long run, the aggregate-supply curve is vertical.
The long-run aggregate supply curve is vertical at the natural rate of output.
This level of production is also referred to as potential output or full-employment output.
The Long-Run Aggregate- Supply Curve...
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…
Why the Long-Run Aggregate Supply Curve Might Shift
Shifts arising from Labor Shifts arising from Capital Shifts arising from Natural
Resources Shifts arising from Technological
Knowledge
1. In the long-run, technological progress shifts long-run aggregate supply...
LRAS2000LRAS1990
Long-Run Growth and Inflation...
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...
The Short-Run Aggregate Supply Curve...
Quantity ofOutput
Price Leve
l
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
Why the Short-Run Aggregate Supply Curve Slopes Upward in
the Short Run
The Sticky-Wage Theory The Sticky-Price Theory The Misperceptions Theory
Why the Short run Aggregate Supply Curve Might Shift
Shifts arising from Labor, Capital, Natural Resources, Technology.
Shifts arising from the Expected Price Level.An increase in the expected price level reduces the quantity of goods and services supplied because higher wages to be paid, high cost so less production
A decrease in the expected price level raises the quantity of goods and services supplied because lower wage, low cost so more production.
Effect of shift in Aggregate Demand
In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services.
In the long run, shifts in aggregate demand affect the overall price level but do not affect output.
1. A decrease inaggregate demand…
AD2
A Contraction in Aggregate Demand...
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.
.
Effect of shift in Aggregate Supply
A decrease in one of the determinants of aggregate supply shifts the curve to the left: Output falls below the natural rate of
employment. – (stagnation) Unemployment rises. The price level rises. – (inflation) Adverse shifts in aggregate supply cause
stagflation—a combination of recession and inflation.
1. An adverse shift in the short-run aggregate-supply curve…
AS2
Long-runaggregate
supplyShort-run aggregatesupply, AS1
Quantity ofOutput
PriceLevel
0
Aggregate demand
A
Y1
P1
An Adverse Shift in Aggregate Supply...
3. …and the price level to rise.
P2
2. …causes output to fall…
B
Y2
Policy Responses to Recession
Policymakers may respond to a recession in one of the following ways: Do nothing and wait for prices and wages to
adjust. Take action to increase aggregate demand by
using monetary and fiscal policy.
AS2
1. When short-run aggregate supply falls…
Accommodating an Adverse Shift in Aggregate Supply...
Quantity ofOutput
Natural rateof output
PriceLevel
0
Short-run aggregate supply, AS1
Aggregate demand, AD1
Long-run aggregate
supply
AP1
P2
P3
3....which causes the price level to rise
4. …but keeps output at its natural rate.
C 2. …policymakers canaccommodate the shiftby expanding aggregatedemand…AD2