1. Aggregate Demand and Aggregate Supply Chapter 31 Copyright © 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777.

2. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Short-Run Economic Fluctuations u Economic activity fluctuates from year to year. u In most years production of goods and services rises. u On average over the past 50 years, production in the U.S. economy has grown by about 3 percent per year. u In some years normal growth does not occur, causing a recession.

3. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Short-Run Economic Fluctuations u A recession is a period of declining real GDP, falling incomes, and rising unemployment. u A depression is a severe recession.

4. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Three Key Facts About Economic Fluctuations u Economic fluctuations are irregular and unpredictable. u Fluctuations in the economy are often called the business cycle. u Most macroeconomic variables fluctuate together. u As output falls, unemployment rises.

5. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Recessions (a) Real GDP Billions of 1992 Dollars 1965197019751980198519901995 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000 6,500 $7,000 Real GDP A Look At Short-Run Economic Fluctuations

6. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Three Key Facts About Economic Fluctuations u Most macroeconomic variables fluctuate together. u Most macroeconomic variables that measure some type of income or production fluctuate closely together. u Although many macroeconomic variables fluctuate together, they fluctuate by different amounts.

7. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Recessions (b) Investment Spending Billions of 1992 Dollars 300 400 500 600 700 800 900 1,000 $1,100 Investment spending 1965197019751980198519901995 A Look At Short-Run Economic Fluctuations

8. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Three Key Facts About Economic Fluctuations u As output falls, unemployment rises. u Changes in real GDP are inversely related to changes in the unemployment rate. u During times of recession, unemployment rises substantially.

9. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Recessions (c) Unemployment Rate Unemployment rate 0 2 4 6 8 10 12 1965197019751980198519901995 Percent of Labor Force A Look At Short-Run Economic Fluctuations

10. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. How the Short Run Differs From the Long Run u Most economists believe that classical theory describes the world in the long run but not in the short run. u Changes in the money supply affect nominal variables but not real variables in the long run. u The assumption of monetary neutrality is not appropriate when studying year-to-year changes in the economy.

11. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Basic Model of Economic Fluctuations u Two variables are used to develop a model to analyze the short-run fluctuations. u The economy’s output of goods and services measured by real GDP. u The overall price level measured by the CPI or the GDP deflator.

12. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Basic Model of Economic Fluctuations Economist use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.

13. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Basic Model of Economic Fluctuations u The aggregate demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level.

14. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Basic Model of Economic Fluctuations u The aggregate supply curve shows the quantity of goods and services that firms produce and sell at each price level.

15. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Aggregate Demand and Aggregate Supply... Equilibrium output Quantity of Output Price Level 0 Equilibrium price level Aggregate supply Aggregate demand

16. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Aggregate Demand Curve u The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX

17. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Aggregate-Demand Curve... Quantity of Output Price Level 0 Aggregate demand P1P1 Y1Y1 Y2Y2 P2P2 2. …increases the quantity of goods and services demanded. 1. A decrease in the price level...

18. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Why the Aggregate Demand Curve Is Downward Sloping u The Price Level and Consumption: The Wealth Effect u The Price Level and Investment: The Interest Rate Effect u The Price Level and Net Exports: The Exchange-Rate Effect

19. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Price Level and Consumption: The Wealth Effect u A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more. u This increase in consumer spending means larger quantities of goods and services demanded.

20. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Price Level and Investment: The Interest Rate Effect u A lower price level reduces the interest rate, which encourages greater spending on investment goods. u This increase in investment spending means a larger quantity of goods and services demanded.

21. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Price Level and net Exports: The Exchange-Rate Effect u When a fall in the U.S. price level causes U.S. interest rates to fall, the real exchange rate depreciates, which stimulates U.S. net exports. u The increase in net export spending means a larger quantity of goods and services demanded.

22. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Why the Aggregate Demand Curve Might Shift u 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. u Many other factors, however, affect the quantity of goods and services demanded at any given price level. u When one of these other factors changes, the aggregate demand curve shifts.

23. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Why the Aggregate Demand Curve Might Shift u Shifts arising from Consumption u Shifts arising from Investment u Shifts arising from Government Purchases u Shifts arising from Net Exports

24. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Shifts in the Aggregate Demand Curve... Quantity of Output Price Level 0 Aggregate demand, D 1 P1P1 Y1Y1 D2D2 Y2Y2

25. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Aggregate Supply Curve u In the long run, the aggregate- supply curve is vertical. u In the short run, the aggregate- supply curve is upward sloping.

26. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Long-Run Aggregate Supply Curve u 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. u The price level does not affect these variables in the long run.

27. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Long-Run Aggregate- Supply Curve... Quantity of Output Natural rate of output Price Level 0 Long-run aggregate supply P1P1 P2P2 2. …does not affect the quantity of goods and services supplied in the long run. 1. A change in the price level…

28. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Long-Run Aggregate Supply Curve u The long-run aggregate supply curve is vertical at the natural rate of output. u This level of production is also referred to as potential output or full-employment output.

29. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Why the Long-Run Aggregate Supply Curve Might Shift u Any change in the economy that alters the natural rate of output shifts the long- run aggregate-supply curve. u The shifts may be categorized according to the various factors in the classical model that affect output.

30. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Why the Long-Run Aggregate Supply Curve Might Shift u Shifts arising from Labor u Shifts arising from Capital u Shifts arising from Natural Resources u Shifts arising from Technological Knowledge

31. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 1. In the long- run, technological progress shifts long-run aggregate supply... LRAS 2000 LRAS 1990 Long-Run Growth and Inflation... Quantity of Output Price Level 0 P 1980 Y 1980 AD 1980 P 2000 P 1990 LRAS 1980 2. …and growth in the money supply shifts aggregate-demand... AD 2000 AD 1990 4. …and ongoing inflation. Y 1990 Y 2000 3. …leading to growth in output...

32. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Long-Run Growth and Inflation Short-run fluctuations in output and price level should be viewed as deviations from the continuing long- run trends.

33. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Why the Short-Run Aggregate Supply Curve Slopes Upward in the Short Run u 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. u A decrease in the level of prices tends to reduce the quantity of goods and services supplied.

34. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Short-Run Aggregate Supply Curve... Quantity of Output Price Level 0 Short-run aggregate supply Y1Y1 P1P1 Y2Y2 2. reduces the quantity of goods and services supplied in the short run. P2P2 1. A decrease in the price level

35. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Why the Short-Run Aggregate Supply Curve Slopes Upward in the Short Run u The Misperceptions Theory u The Sticky-Wage Theory u The Sticky-Price Theory

36. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Misperceptions Theory u Changes in the overall price level temporarily mislead suppliers about what is happening in the markets in which they sell their output: u A lower price level causes misperceptions about relative prices. u These misperceptions induce suppliers to decrease the quantity of goods and services supplied.

37. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Sticky-Wage Theory u Nominal wages are slow to adjust, or are “sticky” in the short run: u Wages do not adjust immediately to a fall in the price level. u A lower price level makes employment and production less profitable. u This induces firms to reduce the quantity of goods and services supplied.

38. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Sticky-Price Theory u Prices of some goods and services adjust sluggishly in response to changing economic conditions: u An unexpected fall in the price level leaves some firms with higher-than-desired prices. u This depresses sales, which induces firms to reduce the quantity of goods and services they produce.

39. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Why the Aggregate Supply Curve Might Shift u Shifts arising from Labor u Shifts arising from Capital u Shifts arising from Natural Resources. u Shifts arising from Technology. u Shifts arising from the Expected Price Level.

40. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. u 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. u 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. Why the Aggregate Supply Curve Might Shift

41. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Long-Run Equilibrium Quantity of Output Price Level 0 Short-run aggregate supply Long-run aggregate supply Aggregate demand A Equilibrium price Natural rate of output

42. 1. A decrease in aggregate demand… AD 2 A Contraction in Aggregate Demand... Quantity of Output Price Level 0 Short-run aggregate supply, AS 1 Long-run aggregate supply Aggregate demand, AD 1 A P1P1 Y1Y1 B P2P2 Y2Y2 2. …causes output to fall in the short run… AS 2 C P3P3 3. …but over time, the short-run aggregate-supply curve shifts… 4. …and output returns to its natural rate. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

43. Shifts in Aggregate Demand u In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services. u In the long run, shifts in aggregate demand affect the overall price level but do not affect output.

44. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. An Adverse Shift in Aggregate Supply u A decrease in one of the determinants of aggregate supply shifts the curve to the left: u Output falls below the natural rate of employment. u Unemployment rises. u The price level rises.

45. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 1. An adverse shift in the short-run aggregate-supply curve… AS 2 Long-run aggregate supply Short-run aggregate supply, AS 1 Quantity of Output Price Level 0 Aggregate demand A Y1Y1 P1P1 An Adverse Shift in Aggregate Supply... 3. …and the price level to rise. P2P2 2. …causes output to fall… B Y2Y2

46. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Stagflation u Adverse shifts in aggregate supply cause stagflation—a combination of recession and inflation. u Output falls and prices rise. u Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

47. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Policy Responses to Recession u Policymakers may respond to a recession in one of the following ways: u Do nothing and wait for prices and wages to adjust. u Take action to increase aggregate demand by using monetary and fiscal policy.

48. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. AS 2 1. When short-run aggregate supply falls… Accommodating an Adverse Shift in Aggregate Supply... Quantity of Output Natural rate of output Price Level 0 Short-run aggregate supply, AS 1 Aggregate demand, AD 1 Long-run aggregate supply A P1P1 P2P2 P3P3 3....which causes the price level to rise 4. …but keeps output at its natural rate. C 2. …policymakers can accommodate the shift by expanding aggregate demand… AD 2

49. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Effects of a Shift in Aggregate Supply u Shifts in aggregate supply can cause stagflation – a combination of recession and inflation. u Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

50. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u All societies experience short-run economic fluctuations around long-run trends. u These fluctuations are irregular and largely unpredictable. u When recessions occur, real GDP and other measures of income, spending, and production fall, and unemployment rises.

51. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u Economists analyze short-run economic fluctuations using the aggregate demand and aggregate supply model. u According to the model of aggregate demand and aggregate supply, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply.

52. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u The aggregate-demand curve slopes downward for three reasons: a wealth effect, an interest rate effect, and an exchange rate effect. u Any event or policy that changes consumption, investment, government purchases, or net exports at a given price level will shift the aggregate-demand curve.

53. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u In the long run, the aggregate supply curve is vertical. u The short-run, the aggregate supply curve is upward sloping. u The are three theories explaining the upward slope of short-run aggregate supply: the misperceptions theory, the sticky-wage theory, and the sticky-price theory.

54. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u Events that alter the economy’s ability to produce output will shift the short-run aggregate-supply curve. u Also, the position of the short-run aggregate-supply curve depends on the expected price level. u One possible cause of economic fluctuations is a shift in aggregate demand.

55. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u A second possible cause of economic fluctuations is a shift in aggregate supply. u Stagflation is a period of falling output and rising prices.

56. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Graphical Review

57. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Recessions (a) Real GDP Billions of 1992 Dollars 1965197019751980198519901995 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000 6,500 $7,000 Real GDP A Look At Short-Run Economic Fluctuations

58. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Recessions (b) Investment Spending Billions of 1992 Dollars 300 400 500 600 700 800 900 1,000 $1,100 Investment spending 1965197019751980198519901995 A Look At Short-Run Economic Fluctuations

59. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Recessions (c) Unemployment Rate Unemployment rate 0 2 4 6 8 10 12 1965197019751980198519901995 Percent of Labor Force A Look At Short-Run Economic Fluctuations

60. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Aggregate Demand and Aggregate Supply... Equilibrium output Quantity of Output Price Level 0 Equilibrium price level Aggregate supply Aggregate demand

61. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Aggregate-Demand Curve... Quantity of Output Price Level 0 Aggregate demand P1P1 Y1Y1 Y2Y2 P2P2 2. …increases the quantity of goods and services demanded. 1. A decrease in the price level...

62. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Shifts in the Aggregate Demand Curve... Quantity of Output Price Level 0 Aggregate demand, D 1 P1P1 Y1Y1 D2D2 Y2Y2

63. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Long-Run Aggregate- Supply Curve... Quantity of Output Natural rate of output Price Level 0 Long-run aggregate supply P1P1 P2P2 2. …does not affect the quantity of goods and services supplied in the long run. 1. A change in the price level…

64. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Long-Run Growth and Inflation... 1. In the long- run, technological progress shifts long-run aggregate supply... LRAS 2000 LRAS 1990 Quantity of Output Price Level 0 P 1980 Y 1980 AD 1980 P 2000 P 1990 LRAS 1980 2. …and growth in the money supply shifts aggregate-demand... AD 2000 AD 1990 4. …and ongoing inflation. Y 1990 Y 2000 3. …leading to growth in output...

65. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Short-Run Aggregate Supply Curve... Quantity of Output Price Level 0 Short-run aggregate supply Y1Y1 P1P1 Y2Y2 2. reduces the quantity of goods and services supplied in the short run. P2P2 1. A decrease in the price level

66. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Long-Run Equilibrium Quantity of Output Price Level 0 Short-run aggregate supply Long-run aggregate supply Aggregate demand A Equilibrium price Natural rate of output

67. A Contraction in Aggregate Demand... 1. A decrease in aggregate demand… AD 2 Quantity of Output Price Level 0 Short-run aggregate supply, AS 1 Long-run aggregate supply Aggregate demand, AD 1 A P1P1 Y1Y1 B P2P2 Y2Y2 2. …causes output to fall in the short run… AS 2 C P3P3 3. …but over time, the short-run aggregate-supply curve shifts… 4. …and output returns to its natural rate. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

68. An Adverse Shift in Aggregate Supply... 1. An adverse shift in the short-run aggregate-supply curve… AS 2 Long-run aggregate supply Short-run aggregate supply, AS 1 Quantity of Output Price Level 0 Aggregate demand A Y1Y1 P1P1 3. …and the price level to rise. P2P2 2. …causes output to fall… B Y2Y2

69. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Accommodating an Adverse Shift in Aggregate Supply... AS 2 1. When short-run aggregate supply falls… Quantity of Output Natural rate of output Price Level 0 Short-run aggregate supply, AS 1 Aggregate demand, AD 1 Long-run aggregate supply A P1P1 P2P2 P3P3 3....which causes the price level to rise 4. …but keeps output at its natural rate. C 2. …policymakers can accommodate the shift by expanding aggregate demand… AD 2