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