Download Aggregate Demand and Aggregate Supply

Aggregate Demand
and Aggregate
Supply
20
Short-Run Economic Fluctuations
• Economic activity fluctuates from year to year.
• In most years production of goods and services
rises.
• On average over the past 50 years, production in the
U.S. economy has grown by about 3 percent per
year.
• These fluctuations are known as the business cycle.
Short-Run Economic Fluctuations
• Business cycle has the stages of expansion –
rising GDP, and
• recession - a period of declining real GDP, and
rising unemployment.
• depression - a severe recession (more than four
quarters).
Figure 1 A Look At Short-Run Economic
Fluctuations
(a) Real GDP
Billions of
1996 Dollars
$10,000
9,000
Real GDP
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1965
1970
1975
1980
1985
1990
1995
2000
EXPLAINING SHORT-RUN
ECONOMIC FLUCTUATIONS
• How the Short Run Differs from the Long Run
• Most economists believe that classical theory
describes the world in the long run but not in the
short run.
• Changes in the money supply affect nominal variables
but not real variables in the long run.
• The assumption of monetary neutrality is not appropriate
when studying year-to-year changes in the economy.
The Basic Model of Economic Fluctuations
• The Basic Model of Aggregate Demand and
Aggregate Supply
• Model of aggregate demand and aggregate supply
is used to explain short-run fluctuations in
economic activity around its long-run trend.
• It focuses on behavior of real GDP and inflation
Figure 2 Aggregate Demand and Aggregate
Supply...
Price
Level
Aggregate
supply
Equilibrium
price level
Aggregate
demand
0
Equilibrium
output
Quantity of
Output
THE AGGREGATE-DEMAND
CURVE
• Represents spending in the economy
• The four components of GDP (Y) from the
expenditure approach contribute to the
aggregate demand for goods and services.
Y = C + I + G + NX
Figure 3 The Aggregate-Demand Curve...
Price
Level
P
P2
1. A decrease
in the price
level . . .
0
Aggregate
demand
Y
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
Why the Aggregate-Demand Curve Is
Downward Sloping
• The Price Level and Consumption: The Wealth
Effect
• A decrease in the price level makes consumers feel
more wealthy, which in turn encourages them to
spend more.
• This increase in consumer spending means larger
quantities of goods and services demanded.
Why the Aggregate-Demand Curve Is
Downward Sloping
• The Price Level and Investment: The Interest
Rate Effect
• A lower price level reduces money demand, which
reduces the interest rate, leading to greater spending
on investment goods.
• This increase in investment spending means a larger
quantity of goods and services demanded.
Why the Aggregate-Demand Curve Might
Shift
• The downward slope of the aggregate demand
curve shows that a fall in the price level raises
the overall quantity of goods and services
demanded.
• Many other factors in the economy may affect
the quantity of goods and services demanded at
any given price level.
• When one of these other factors changes, the
aggregate demand curve shifts.
Why the Aggregate-Demand Curve Might
Shift
• Shifts arising from
•
•
•
•
Consumption
Investment
Government Purchases
Net Exports
Shifts in the Aggregate Demand
Curve
Price
Level
P1
D2
Aggregate
demand, D1
0
Y1
Y2
Quantity of
Output
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 AGGREGATE-SUPPLY
CURVE
• The Long-Run Aggregate-Supply Curve
• In the long run, an economy’s production of goods
and services depends on its supplies of labor,
capital, and natural resources and on the available
technology used to turn these factors of production
into goods and services.
• The price level does not affect these variables in the
long run.
Figure 4 The Long-Run Aggregate-Supply Curve
Price
Level
Long-run
aggregate
supply
P
P2
2. . . . does not affect
the quantity of goods
and services supplied
in the long run.
1. A change
in the price
level . . .
0
Natural rate
of output
Quantity of
Output
THE AGGREGATE-SUPPLY
CURVE
• The Long-Run Aggregate-Supply Curve
• The long-run aggregate-supply curve is vertical at
the natural rate of output.
• This level of production is also referred to as
potential GDP or full-employment output.
Why the Long-Run Aggregate-Supply Curve
Might Shift
• Shifts arising
•
•
•
•
Labor
Capital
Natural Resources
Technological Knowledge
A New Way to Depict Long-Run Growth and
Inflation
• Short-run fluctuations in output and price level
should be viewed as deviations from the
continuing long-run trends.
Figure 6 The Short-Run Aggregate-Supply Curve
Price
Level
Short-run
aggregate
supply
P
P2
2. . . . reduces the quantity
of goods and services
supplied in the short run.
1. A decrease
in the price
level . . .
0
Y2
Y
Quantity of
Output
Why the Aggregate-Supply Curve Slopes
Upward in the Short Run
• The Sticky-Wage Theory
• The Sticky-Price Theory
• The Misperceptions Theory
Why the Aggregate-Supply Curve Slopes
Upward in the Short Run
• The Sticky-Wage Theory
• Nominal wages are slow to adjust, or are “sticky” in
the short run:
• Wages do not adjust immediately to a rise in the price
level.
• A higher price level makes labor relatively cheaper.
• This allows some firms to increase the quantity of goods
and services supplied.
The Sticky-Price Theory
• Prices of some goods and services adjust sluggishly
in response to changing economic conditions:
• An unexpected rise in the price level leaves some firms
with lower-than-desired prices.
• This increases sales, which induces firms to increase the
quantity of goods and services they produce.
Why the Aggregate-Supply Curve Slopes
Upward in the Short Run
• The 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 firm only sees its own price, and mistakes
inflationary effect for greater relative price of its
product
• These misperceptions induce suppliers to increase the
quantity of goods and services supplied.
Why the Short-Run Aggregate-Supply Curve
Might Shift
• Shifts arising
•
•
•
•
•
Labor
Capital
Natural Resources.
Technology.
Expected Price Level.
Figure 7 The Long-Run Equilibrium
Price
Level
Long-run
aggregate
supply
Short-run
aggregate
supply
A
Equilibrium
price
Aggregate
demand
0
Natural rate
of output
Quantity of
Output
Figure 8 A Contraction in Aggregate Demand
2. . . . causes output to fall in the short run . . .
Price
Level
Long-run
aggregate
supply
Short-run aggregate
supply, AS
AS2
3. . . . but over
time, the short-run
aggregate-supply
curve shifts . . .
A
P
B
P2
P3
1. A decrease in
aggregate demand . . .
C
Aggregate
demand, AD
AD2
0
Y2
Y
4. . . . and output returns
to its natural rate.
Quantity of
Output
The Effects of a Shift in Aggregate Supply
• 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.
Figure 11 Accommodating an Adverse Shift in
Aggregate Supply
1. When short-run aggregate
supply falls . . .
Price
Level
Long-run
aggregate
supply
P3
C
P2
A
3. . . . which P
causes the
price level
to rise
further . . .
0
4. . . . but keeps output
at its natural rate.
Natural rate
of output
Short-run
aggregate
supply, AS
AS2
2. . . . policymakers can
accommodate the shift
by expanding aggregate
demand . . .
AD2
Aggregate demand, AD
Quantity of
Output