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Chap_33 Aggregate Demand & Aggregate Supply

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Text of Chap_33 Aggregate Demand & Aggregate Supply

Aggregate Demand & Aggregate Supply Chapter 33

outline3 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

outlineAggregate SS short run -why it is upward sloping - why it shifts Effect of shift in Aggregate DD & SS Policy responses

Short-Run Economic FluctuationsEconomic In

activity fluctuates from year to year.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 FluctuationsEconomic

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.

Economic Fluctuations are irregular(a) Real GDP Billions of 1992 Dollars 7,000 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500Recessions

Real GDP

1965

1970

1975

1980

1985

1990

1995

Economic variables fluctuate together(b) Investment Spending Billions of 1992 Dollars $1,100 1,000 900 800 700 600 500 400 300 1965 1970 1975 1980Recessions

Investment spending

1985

1990

1995

Output falls, unemployment rises(c) Unemployment Rate Percent of Labor Force 12 10Recessions

86 4 2 0 1965 1970 1975 1980

Unemployment rate

1985

1990

1995

The Basic Model of Economic FluctuationsEconomist use the model of aggregate demand and aggregate supply to explain short-run fluctuations The 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 analyzingmacroeconomic Fluctuations1.

Decide whether the event shift aggregate demand or supply curve Decide in which direction the curve shifts Use diagram to see how shift changes output & price level Use diagram to see how economy moves from short run equilibrium to long run equilibrium

2.3.

4.

Aggregate Demand and Aggregate Supply...Price Level Aggregate supply

Equilibrium price level Aggregate demand 0 Equilibrium output Quantity of Output

The Aggregate-Demand Curve...Price Level

aggregate demand for goods and services.Y = C + I + G + NX

P11. A decrease in the price level...

P2Aggregate demand0

Y1

Y2

2. increases the quantity of goods and services demanded.

Quantity of Output

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. RATE EFFECT : A lower price level reduces the interest rate, which encourages greater spending on investment goods. 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.

INTEREST

EXCHANGE

Why Aggregate demand curve shiftPrice Level

shift arises because ofC , I , G , NX

P1

D2Aggregate demand, D1 0

Y1

Y2

Quantity of Output

The Long-Run Aggregate Supply CurveIn

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 AggregateSupply Curve...Price Level Long-run aggregate supply

P1P21. A change in the price level0

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

Natural rate of output

Quantity of Output

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

Long-Run Growth and Inflation...Price Level 2. and growth in the money supply shifts aggregate-demand...LRAS1980 LRAS1990 LRAS2000

4. and ongoing inflation.

P2000P1990 P1980

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

AD2000 AD1980 AD1990

0

Y1980

Y1990

Y2000

3. leading to growth in output...

Quantity of Output

The Short-Run Aggregate Supply Curve...Price Level Short-run aggregate supply

P11. A decrease in the price level

P2

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

0

Y2

Y1

Quantity of Output

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. arising from the Expected Price Level.

Shifts

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 economys output of goods and services. In the long run, shifts in aggregate demand affect the overall price level but do not affect output.

.

A Contraction in Aggregate Demand...Price Level 2. causes output to fall in the short run Long-run aggregate supply Short-run aggregate supply, AS1

AS2

P1P2B

A

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

P3

C

1. A decrease in aggregate demand

AD0

Aggregate demand, AD1 Quantity of Output

Y2

Y1

2

4. and output returns to its natural rate.

Effect of shift in Aggregate SupplyA

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 stagflationa combination of recession and inflation.

An Adverse Shift in Aggregate Supply...Price Level Long-run aggregate supply 1. An adverse shift in the short-run aggregate-supply curve

AS2

Short-run aggregate supply, AS1

P2 P13. and the price level to rise.

B A

Aggregate demand

0

Y2

Y1

2. causes output to fall

Quantity of Output

Policy Responses to Recession Policymakers may Do

respond to a recession in one of the following ways:nothing and wait for prices and wages to adjust. Take action to increase aggregate demand by using monetary and fiscal policy.

Accommodating an Adverse Shift in Aggregate Supply...Price Level 1. When short-run aggregate supply fallsLong-run aggregate AS 2 supply

Short-run aggregate supply, AS1

P3 P2 P13....which causes the price level to rise 0 4. but keeps output at its natural rate.

C A

2. policymakers can accommodate the shift by expanding aggregate demand

AD2Aggregate demand, AD1

Natural rate of output

Quantity of Output