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ECO1000Economics
Lecture Ten, 2004
Class Test Two Reminder for Internal Students
Wednesday May 26, 5-8 pm 25 multiple choice questions Covers Lectures 6 – 10
(Chapters 7-16) Same deal as test one (online
etc)
Outline or Plan of Today’s Lecture
Material Covered: Module Seven Reading: Text Chapter 16 Topics: Aggregate Demand and
Aggregate Supply
Purpose or Objectives of Today’s Lecture
You will be able to: Work with a key macroeconomic
modelModel changes in the economy due to
changes economic variablesThink about policy implications (in
preparation for next week’s work)
Economic Fluctuations
What Are Economic Fluctuations?
Economic fluctuations are the ups and downs in economic activity from year to year. In most years production of goods and services
rises but 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.
Growth over time
Real GDP
($b)
YearsLong term average
Recession
‘Boom’
Characteristics of Economic Fluctuations
Economic fluctuations are irregular and unpredictable.
Most macroeconomic variables are related and fluctuate together.
As output falls, unemployment rises and vice versa
The Short Run and The Long Run
How Long is the Long Run?
The long run can be considered to be a period of at least several years.
The short run is a period of about one to two years.
This is a bit like asking, “How long is the present?” (i.e. When does the present become the future?)
Incidentally… the present lasts for as long as you can hold the cube (below) in focus before it transposes itself (back becomes front or vice versa)
In the Short Run & the Long Run… We have previously used two ideas:
classical dichotomy and money neutrality In the short run, it is now more or less
accepted that real and nominal variables move together
We need a new model with which to analyse short and long run economic fluctuations.
Explaining the Fluctuations Using the AD-AS Model
The Space in Which AD-AS is Mapped Two variables are used to develop a
model to analyse the short-run fluctuations.The economy’s output of goods and
services measured by real GDP.The overall price level measured by
the CPI or the GDP deflator.AD-AS are plotted in output-price level
space.
Aggregate Demand and Aggregate Supply
The aggregate demand curve shows the quantity of goods and services that households, firms, and the government want to buy at any price level.
The aggregate supply curve shows the quantity of goods and services that firms choose to produce and want to sell at any price level.
The Aggregate Demand Curve
The four components of GDP (Y) contribute to the aggregate demand for goods and services.
Y = C + I + G + NX
The Aggregate Demand Curve
Quantity ofOutput
PriceLevel
0
Aggregatedemand
P1
Y1
1. A decrease in the pricelevel
P2
2. Leads to an increase in quantity demanded
3. And an increase in output
Y2
Explaining the Negative Slope of the Aggregate Demand Curve: Three Theories
Pigou’s wealth effect Keynes’ interest rate effect Mundell-Fleming’s exchange-rate effect
Pigou’s Wealth Effect
Consumers feel wealthier, which stimulates the demand for consumption goods.A decrease in the price level makes
consumers feel more wealthy.This encourages them to spend more.The increase in consumer spending
means a larger quantity of goods and services demanded.
Keynes’ Interest-Rate Effect
The lower the price level, the less money households need to hold to buy the goods and services they want. A lower price level reduces the interest rate,
which encourages greater spending on investment goods.
The increase in investment spending means a larger quantity of goods and services demanded.
Mundell-Fleming’s Exchange-Rate Effect When the prices of domestic goods
decreases, net exports increase.A fall in the Australian price level
causes Australian interest rates to fall.The real exchange rate depreciates,
which stimulates Australian net exports.
The increase in net export spending means a larger quantity of goods and services demanded.
Shifts in the Aggregate Demand Curve Shifts in the aggregate demand curve may
arise because of changes in: Private behaviour: Changes in spending
plans by consumers or firms. Public policy: Changes in fiscal or monetary
policy. Anything that causes buyers to want to
purchase more or less than before will cause the aggregate demand curve to shift.
Shifts in the Aggregate Demand Curve
Quantity ofOutput
PriceLevel
0
Aggregatedemand, D1
P1
Y1 Y2
D2
The Aggregate Supply Curve
In the long run, the aggregate-supply curve is vertical.
In the short run, the aggregate-supply curve is upward sloping.
The Long-Run Aggregate Supply Curve
The long-run aggregate supply depends on the economy’s resources and level of technology.
The price level does not affect these variables in the long run.
The long-run aggregate supply curve is vertical at the natural rate of output.
The Long-Run Aggregate Supply Curve
Quantity ofOutput
Natural rateof output
Price Level
0
Long-runaggregate
supply
P1
P2
1. A Change in the Price Level
2. Does not change the natural rate of output in the long run
Shifts in the Long-Run Aggregate Supply Curve
Any change in the factors that determine the long-run aggregate supply will cause the curve to shift.
An event that reduces the economy’s potential output shifts the curve to the left.
Any event that increases the economy’s potential output shifts the curve to the right.
The Short-Run Aggregate Supply Curve
In the short run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied.
A decrease in the level of prices tends to reduce the quantity of goods and services supplied.
The Short-Run Aggregate Supply Curve
Quantity ofOutput
Price Level
0
Short-runaggregate
supply
Y1 Y0
2. Causes the level of output supplied to fall in the short run
1. A decrease in the price level
P0
P1
Explaining the Positive Slope of the Short-Run Aggregate Supply Curve
New classical misperceptions theory The Keynesian sticky-wage theory The new Keynesian sticky-price theory
The New Classical Misperceptions Theory Changes in the overall price level
temporarily mislead suppliers about what is happening in the markets in which they sell their output.A lower price level causes
misperceptions about relative prices.These misperceptions induce
suppliers to decrease the quantity of goods and services supplied.
The Keynesian Sticky-Wage Theory
Nominal wages are slow to adjust, or are ‘sticky’ in the short run.Wages do not adjust immediately to a
fall in the price level.A lower price level makes employment
and production less profitable.This induces firms to reduce
production.
The New Keynesian Sticky-Price Theory
Prices of some goods and services adjust sluggishly in response to changing economic conditions.An unexpected fall in the price level
leaves some firms with higher-than-desired prices.
This depresses sales, which induces firms to reduce the quantity of goods and services they produce.
Why the Aggregate Supply Curve Might Shift
Changes in factor (input) prices Changes in productivity Legal-institutional environment Expectations about the price level
Shifts in the Aggregate Supply Curve
P1
Quantity ofOutput
Price Level
0
Short-run aggregate supply, S1
Y0
S2
Y1Y2
S3
Changes in Resource Prices
Changes in the prices of domestic or imported resources change firms’ cost of production.An increase in input prices shifts the
aggregate supply curve to the left.A decrease in input prices shifts the
aggregate supply curve to the right.
Changes in Productivity
An improvement in factor productivity allows firms to produce more at a lower cost.New technologies can increase the
output per unit of labour or capital.The resulting decrease in production
costs shifts the aggregate supply curve to the right.
Legal-Institutional Environment
Taxes and government regulations can increase production costs and discourage firms from producing.The resulting increase in production
costs shifts the aggregate supply curve to the left.
Expectations About the Price Level
Current wages and prices often depend on expectations of the price level.A higher expected price level shifts
the short-run aggregate supply curve to the left.
A lower expected price level shifts the short-run aggregate supply curve to the right.
AD-AS and Long Run Equilibrium
Long-Run Equilibrium
The intersection of the aggregate demand curve and the long-run aggregate supply curve determines the economy’s equilibrium output and price level.
Output is at its ‘natural’ rate. The short-run aggregate supply curve
passes through the point of intersection.
Long-Run Equilibrium
Natural rateof output
Quantity ofOutput
PriceLevel
0
Equilibriumprice
Short-runaggregate
supply
Long-runaggregate
supply
Aggregatedemand
A
AD-AS and Economic Fluctuations
Recession
Recession
A recession in the economy may have two causes.A decrease in aggregate demand.A decrease in aggregate supply.
A Decrease in Aggregate Demand
A decrease in one of the determinants of aggregate demand shifts the curve to the left.Output falls below the natural rate of
employment.Unemployment rises.The price level falls.
A Decrease in Aggregate Demand
Quantity ofOutput
PriceLevel
0
Short-run aggregatesupply, AS1
Long-runaggregate
supply
AP1
Y1
Aggregatedemand, AD1
Y2
AS2
B
C
P2
P3
1. A decrease in aggregate demand…
2. Causes output to decline
3. But over time the SRAS curve shifts and output returns to its normal rate
A Decrease 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.Unemployment rises.The price level rises.
A decrease in aggregate supply
Long-runaggregate
supply
Short-run aggregate
supply, AS1
Quantity ofOutput
PriceLevel
0
Aggregate demand
A
Y1
P1
AS2
B
Y2
P2
Possible Responses to Recession
Stagflation
Adverse shifts in aggregate supply cause stagflation—a combination of recession and inflation.Output falls and prices rise.Policymakers who can influence
aggregate demand cannot offset both of these adverse effects simultaneously.
Policy Response
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.
Accommodate the Negative AS Shift
Long-runaggregate
supply
Short-run aggregate
supply, AS1
Quantity ofOutput
PriceLevel
0
Aggregate demand
A
Y1
P1
AS2
B
Y2
P2
P3
C
AD2
Concluding Remarks
The AD-AS model is a popular model used to explain and analyse economic fluctuations.
The effects of shocks to the economic system can be modelled.
We can also (next week) use the ADAS model to show the impact that government policies have on the system.
In Light of the Objectives of Today’s Lecture…
We now know about:Economic fluctuationsShort run and long run fluctuationsHow to build the AD-AS modelHow to use the AD-AS model to show
the effects of various changes
Next Week
Material Covered: Module Eight, Parts One and Two
Reading: Chapters 17, 18 and 19 Topics: Monetary and Fiscal Policy
and the Associated Debates This will be the last lecture of content. Lecture Twelve will be REVISION
THE END