Download Chapter 12

Macroeconomics
Econ 2301
Dr. Frank Jacobson
Coach Stuckey
Today
• Begin Chapter 12- Aggregate
Demand and Supply
Chapter 12
Aggregate Demand and
Aggregate Supply
During The Semester We Have
Seen How The Economy Has
Changed During Different
Time Period Sometimes
Moderately and Sometimes
Severely.
In This Chapter We Will
Look At What Causes Both
Short-Run and Long-Run
Fluctuations in The
Economy.
The Model of Aggregate
Demand and Aggregate Supply
• Economist use the model of aggregate
demand and aggregate supply to explain
short-run fluctuations in economic activity
around its long-run trend.
Economic
activity
Business
cycle
Time
Important Note:
These Business Cycle
Fluctuations Are
Unpredictable and Follow
No Regular Pattern.
Fact : Most Macroeconomic
Quantities Fluctuate Together.
When Real GDP Falls in a Recession
So Does Personal Income, Corporate
Profits, Consumer Spending,
Investment Spending, Production,
Home Sales, Auto Sales and Other
Items.
Investment Spending Varies
Greatly Over The Business Cycle.
Investment Spending Averages
Only About 1/7 of The GDP, Yet,
Declines In Investment Account
For About 2/3 of The Declines in
GDP During Recessions.
Restated:
When Economic Conditions
Deteriorate, Much of The Decline
is Attributable To Reductions in
Investment Spending Such As
On New Factories, Housing,
Equipment and Inventories.
Fact : As Output Falls,
Unemployment Rises.
When Firms Choose To Produce
A Smaller Quantity of Goods and
Services, They Lay Off Workers,
Increasing The Unemployment.
Explaining Short-Run
Economic Fluctuations.
Most Economists Believe
That Classical Theory
Describes The World in
The Long Run But Not in
The Short Run.
In The Short Run, Real and
Nominal Variables Are Highly
Intertwined, and Changes in
The Money Supply Can
Temporarily Push Real GDP
Away From Its Long Term
Trend.
Therefore To Explain The
Short Run Fluctuations in The
Economy and Their Impact;
We Must Develop a New Model
Based on How Real and
Nominal Variables Interact.
The Model of Aggregate
Demand and Aggregate
Supply
Figure 2 Aggregate Demand and Aggregate
Supply...
Price
Level
Aggregate
supply
Equilibrium
price level
Aggregate
demand
0
Equilibrium
output
Quantity of
Output
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
Our Model of Short-Run Economic
Fluctuations Focuses On The
Behavior of Two Variables. The First
Variable is The Economy’s Output of
Goods and Services as Measured By
Real GDP. The Second is The
Average Level of Prices, As
Measured By The CPI or The GDP
Deflator.
Notice:
That Output is a Real
Variable, Whereas The
Price Level is a Nominal
Variable.
Fluctuations in The
Economy as a Whole Are
Measured With The Model
of Aggregate Demand and
Aggregate Supply.
Model of Aggregate Demand
and Aggregate Supply
The Model That Most Economists
Use To Explain Short-Term
Fluctuations in Economic
Activity Around its Long-Run
Trend.
The Model of Aggregate
Demand and Aggregate
Supply
On The Vertical Axis is The
Overall Price Level in The
Economy. On The Horizontal
Axis is The Overall Quantity of
Goods and Services Produced
in The Economy.
The Aggregate Demand Curve
Shows The Quantity of Goods
and Services That
Households, Firms, The
Government, and Customers
Abroad Want To Buy At Each
Price Level.
According To This Model,
The Price Level and The
Quantity of Output Adjust
To Bring Aggregate
Demand and Aggregate
Supply Into Balance.
This May Look Like The Market
Supply and Demand Curves, But
Because It Involves All The
Goods and Services Supplied
and Demanded, Factors Such As
Substitutes and Complementary
Items Are Not Involved.
The Aggregate-Demand
Curve
The Aggregate-Demand
Curve Tells Us The
Quantity of All Goods and
Services Demanded in The
Economy At Any Given
Price Level.
The Aggregate-Demand Curve is
Downward Sloping Indicating That,
All Things Being Equal, A Decrease
In The Economy’s Overall Level of
Prices Raises The Quantity of Goods
and Services Demanded and An
Increase in Prices Reduces The
Quantity of Goods and Services
Demanded.
Why Does The AggregateDemand Curve Slope
Downward?
Price Level Affects The
Quantity of Goods and
Services Demanded
Relative to The GDP--- For
Consumption, Investment
and Net Exports.
There Are 3 Reasons The
Aggregate-Demand Curve
is Downward Sloping.
Reasons Aggregate-Demand
Curve is Downward Sloping
1. The Price Level and
Consumption: The Wealth Effect.
2. The Price Level and Investment:
The Interest Rate Effect.
3. The Price Level and Net Exports:
The Exchange-Rate Effect.
#1 The Price Level and
Consumption:
A Decrease In The Price Level
Raises The Real Value of Money and
Makes Consumers Wealthier, Which
In Turn Encourages Them To Spend
More and Demand More Goods and
Services.
#2 Price Level and Investment
A Lower Price Level Reduces The
Interest Rate, Encourages
Greater Spending on Investment
Goods, Thereby Increases The
Quantity of Goods and Services
Demanded.
#3 Price Level and Net Exports
A Fall in U.S. Price Level Causes
U.S. Interest Rates To Fall, The
Real Value of The Dollar Declines
In Foreign Exchange Markets,
Which Increases U.S. Net Exports
of Goods and Services.
Therefore a Decrease in Price Level
Increases The Demand for Goods
and Services Because:
1. Consumers Are Wealthier, Which
Stimulates the Demand For Consumption
Goods.
2. Interest Rates Fall, Which Stimulates The
Demand For Investment Goods.
3. The Currency Depreciates, Which
Stimulates The Demand For Net Exports.
These Same Three Effects
Work in Reverse to
Decrease The Quantity of
Goods and Services When
The Price Level is
Increased.
The Overall Aggregate
Demand Curve May
Shift (Right or Left).
Causes of Aggregate-Demand Curve
To Shift
• Shifts Arising From Changes in
Consumption.
• Shifts Arising From Changes in
Investment
• Shifts Arising From Changes in
Government Purchase.
• Shifts Arising From Changes in Net
Exports.
Causes of Aggregate-Demand Curve
To Shift
• Shifts Arising From Changes in
Expectations.
• Shifts Arising From Changes in Wealth.
• Shifts Arising From the Size of Existing
Stock of Physical Capital.
• Shifts Arising From Changes in Fiscal
Policy.
• Shifts Arising From Changes in
Monetary Policy.
Shifts in The Aggregate Demand
Curve
Price
Level
P1
D2
Aggregate
demand, D1
0
Y1
Y2
Quantity of
Output
Figure 4 The Long-Run AggregateSupply 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 AggregateSupply Curve
In The Long Run, The
Aggregate-Supply Curve is
Vertical, Whereas in The Short
Run, The Aggregate-Supply
Curve is Upward Sloping.
Why The Aggregate-Supply
Curve is Vertical in The
Long Run.
In The Long Run, An Economy’s
Production of Goods and
Services (Its Real GDP) Depends
On Its Supplies of Labor, Capital
and Natural Resources and on
The Available Technology To
Turn These Factors of
Production Into Goods and
Services.
The Aggregate-Supply Curve
• The Long-Run Aggregate-Supply Curve is
Vertical At The Natural Rate of Output,
Which is The Production of Goods and
Services That an Economy Achieves in The
Long Run When Unemployment is At Its
Normal Rate.
– This Level of Production is Also Referred To As
Potential Output or Full-Employment Output.
– The Natural Rate of Output is The Level of
Output Towards Which The Economy Gravitates
in The Long Run.
Natural Rate of Output
The Production of Goods and
Services That An Economy
Achieves in The Long Run When
Unemployment is At Its Normal
Rate.
The Natural Rate of Output
is The Level of Production
Toward Which The
Economy Gravitates in The
Long Run.
Why The Long-Run AggregateSupply Curve Might Shift
• Any Change in The Economy That
Alters The Natural Rate of Output
Shifts The Long-Run Aggregate-Supply
Curve.
• The Shifts May Be Categorized
According To The Various Factors in
The Classical Model That Affect
Output.
Why The Long-Run AggregateSupply Curve Might Shift
• Shifts Might Arise From Changes
In:
–Labor
–Capital
–Natural Resources
–Technological Knowledge
Why The Aggregate-Supply
Curve Might Shift
• Shifts Might Arise From Changes In
Commodity Prices.
• Shifts Might Arise From Changes
In Nominal Wages.
• Shifts Might Arise From Changes In
Productivity.
Figure 5 Long-Run Growth and Inflation
2. . . . and growth in the
money supply shifts
aggregate demand . . .
Long-run
aggregate
supply,
LRAS1980 LRAS1990 LRAS2000
Price
Level
1. In the long run,
technological
progress shifts
long-run aggregate
supply . . .
P2000
4. . . . and
ongoing inflation.
P1990
Aggregate
Demand, AD2000
P1980
AD1990
AD1980
0
Y1980
Y1990
Quantity of
Output
3. . . . leading to growth
in output . . .
Y2000
Figure 6 The Short-Run AggregateSupply 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
• Three Theories:
–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 To
Changing Economic Conditions, or Are “Sticky”
in The Short Run
– Nominal 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 The Quantity of
Goods and Services Supplied.
Why The Aggregate-Supply Curve
Slopes Upward in The Short Run
• The 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.
For a Variety of Reasons, They May Not Want To
or Be Able To Change Prices Immediately.
– This Depresses Sales, Which Induces Firms To
Reduce 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 Lower Price Level Causes
Misperceptions About Relative Prices.
– These Misperceptions Induce Suppliers
To Decrease The Quantity of Goods and
Services Supplied.
Why The Aggregate-Supply Curve
Slopes Upward in The Short Run
• All Three Theories Suggest That Output
Deviates in The Short Run From The Natural
Rate When The Actual Price Level Deviates
From The Price Level That People Had
Expected To Prevail.
Quantity
of output
Supplied
=
Natural
Rate of
output
+
a
Actual
Price
Level
-
Expected
Price Level
Why The Short-Run AggregateSupply Curve Might Shift
• Shifts Might Arise From Changes In:
–Expected Price Level.
–Labor.
–Capital.
–Natural Resources.
–Technology.
Why The Aggregate Supply
Curve Might Shift
• An Increase in The Expected Price Level
Reduces The Quantity of Goods and
Services Supplied and Shifts The Short-Run
Aggregate Supply Curve To The Left.
• A Decrease in The Expected Price Level
Raises The Quantity of Goods and Services
Supplied and Shifts The Short-Run
Aggregate Supply Curve To The Right.
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
TWO CAUSES OF ECONOMIC
FLUCTUATIONS
• Four Steps in The Process of Analyzing
Economic Fluctuations:
• Determine Whether The Event Affects
Aggregate Supply or Aggregate Demand.
• Decide Which Direction The Curve Shifts.
• Use a Diagram To Compare The Initial and
The New Equilibrium.
• Keep Track of The Short and Long Run
Equilibrium, and The Transition Between
Them.
2 CAUSES OF ECONOMIC FLUCTUATIONS
• Shifts 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.
– Policymakers Who Influence Aggregate
Demand Can Potentially Mitigate The
Severity of Economic Fluctuations.
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
• Adverse Shifts in Aggregate Supply
Cause Stagflation—A Period of
Recession and Inflation.
• Output Falls and Prices Rise.
• Policymakers Who Can Influence
Aggregate Demand Cannot Offset Both
of These Adverse Effects
Simultaneously.
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 10 An Adverse Shift in Aggregate
Supply
1. An adverse shift in the shortrun aggregate-supply curve . . .
Price
Level
Long-run
aggregate
supply
AS2
Short-run
aggregate
supply, AS
B
P2
A
P
3. . . . and
the price
level to rise.
Aggregate demand
0
Y2
2. . . . causes output to fall . . .
Y
Quantity of
Output
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
Stagflation
A Period of Falling Output
and Rising Prices.
Questions
?