lecture 2 macro ad as

8/13/2019 Lecture 2 Macro AD As

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CHAPTER 9 Introduction to Economic Fluctuations

AGGREGATE DEMAND AND

AGGREGATE SUPPLY

Ref: Mankiw

Jamshed uz Zaman


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CHAPTER 9 Introduction to Economic Fluctuations slide 1

The model ofaggregate demand and supply

the paradigm that most mainstreameconomists & policymakers use to think

about economic fluctuations and policies

to stabilize the economy

shows how the price level and aggregate

output are determined

shows how the economys behavior isdifferent in the short run and long run


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Aggregate demand

The aggregate demand curve shows therelationship between the price level and the

quantity of output demanded.

This can be understood byY = C + I + G + NX


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Why The AD Curve Slopes

Downward

The Price Level and Consumption: WealthEffect: When prices go down, consumers arewealthier, which stimulates the demand forconsumption goods.

The Price Level and Investment: InterestRate Effect: When interest rate falls, it stimulatesthe demand for investment goods

The Price Level and Net Exports: TheExchange Rate Effect: When currencydepreciates, it stimulates the demand for netexports

slide 3


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AD Curves slopes downward

We use a simple theory of aggregatedemand based on the Quantity Theoryof Money.

slide 4


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The Quantity Equation as Agg. Demand

The quantity equation isMV = PY

For given values of M and V, these

equations imply an inverse relationshipbetween P and Y:


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The downward-sloping ADcurve

An increase in theprice level causesa fall in realmoney balances

(M/P ),causing adecrease in thedemand for goods

& services.Y

P

AD


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Shifting the ADcurve

An increase inthe money

supply shiftstheADcurveto the right.

Y

P

AD1

AD2


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Aggregate Supply in the Long Run

In the long run, output is determined byfactor supplies and technology

,

( )Y F K L

is the full-employmentor naturallevel ofoutput, the level of output at which the

economys resources are fully employed.

Y

Full employment means that

unemployment equals its natural rate.


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Aggregate Supply in the Long Run

In the long run, output is determined byfactor supplies and technology

Full-employment output does not dependon the price level,

so the long run aggregate supply (LRAS)curve is vertical:

,

( )Y F K L


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The long-run aggregate supply curve

Y

P LRAS

Y

The LRAS curveis vertical at thefull-employmentlevel of output.


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Aggregate Supply in the Short Run

In the real world, many prices are sticky inthe short run.

For now, we assume that all prices are stuckat a predetermined level in the short run

and that firms are willing to sell as muchat that price level as their customers arewilling to buy.

Therefore, the short-run aggregate supply(SRAS) curve is horizontal:


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The short run aggregate supply curve

Y

P

PSRAS

The SRAS curveis horizontal:

The price levelis fixed at apredeterminedlevel, and firms

sell as much asbuyers demand.


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Short-run effects of an increase in M

Y

P

AD1

AD2

an increasein aggregatedemand

In the short runwhen prices aresticky,

causes outputto rise.

PSRAS

Y2Y1


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From the shor t run to the long run

Over time, prices gradually become unstuck.

When they do, will they rise or fall?

Y Y

Y Y

Y Y

rise

fall

remain constant

In the short-runequilibrium, if

then over time,the price level will

This adjustment of prices is what moves

the economy to its long-run equilibrium.


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The SR & LR effects of M> 0

Y

P

AD1

AD2

LRAS

Y

PSRAS

P2

Y2

A = initialequilibrium

A BC

B = new short-

run eqmafter Fedincreases M

C = long-runequilibrium


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How shocking !!!

shocks: exogenous changes in aggregatesupply or demand

Shocks temporarily push the economy awayfrom full-employment.

An example of a demand shock:exogenous decrease in velocity

If the money supply is held constant, then a

decrease in V means people will be using theirmoney in fewer transactions, causing adecrease in demand for goods and services:


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LRAS

AD2

PSRAS

The effects of a negative demand shock

Y

P

AD1

Y

P2

Y2

The shock shiftsAD left, causingoutput andemployment to fall

in the short run ABCOver time, pricesfall and the

economy movesdown its demandcurve toward full-employment.


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Supply shocks

A supply shockalters production costs,affects the prices that firms charge.(also called price shocks)

Examples of adversesupply shocks:

Bad weather reduces crop yields, pushing upfood prices.

Workers unionize, negotiate wage increases.

New environmental regulations require firms toreduce emissions. Firms charge higher prices tohelp cover the costs of compliance.

(Favorablesupply shocks lowercosts and prices.)


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Stabilization policy

def: policy actions aimed at reducing theseverity of short-run economic fluctuations.

Example: Using monetary policy to

combat the effects of adverse supplyshocks:

St bili i t t ith


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Stabilizing output withmonetary policy

1P SRAS1

Y

P

AD1

B2P SRAS2A

Y2

LRAS

Y

The adverse

supply shock

moves the

economy to

point B.

St bili i t t ith


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Stabilizing output withmonetary policy

1P

Y

P

AD1

B2P SRAS2AC

Y2

LRAS

Y

AD2

But the Fedaccommodates

the shock by

raising agg.

demand.

results:

P is permanently

higher, but Yremains at its full-

employment level.


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Chapter summary

1. Long run: prices are flexible, output andemployment are always at their natural

rates, and the classical theory applies.

Short run: prices are sticky, shocks can

push output and employment away fromtheir natural rates.

2.Aggregate demand and supply:

a framework to analyze economicfluctuations


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Chapter summary

3. The aggregate demand curve slopesdownward.

4. The long-run aggregate supply curve is

vertical, because output depends ontechnology and factor supplies, but not

prices.

5. The short-run aggregate supply curve ishorizontal, because prices are sticky at

predetermined levels.


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Chapter summary

6. Shocks to aggregate demand and supplycause fluctuations in GDP and employmentin the short run.

7. The Fed can attempt to stabilize the

economy with monetary policy.


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