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.

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. In some years normal growth does not occur, causing a recession.

Short-Run Economic Fluctuations 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.

A Look At Short-Run Economic Fluctuations (a) Real GDP Billions of 1992 Dollars Recessions $7,000 Real GDP 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 1965 1970 1975 1980 1985 1990 1995

Three Key Facts About Economic Fluctuations Most macroeconomic variables fluctuate together. Most macroeconomic variables that measure some type of income or production fluctuate closely together. Although many macroeconomic variables fluctuate together, they fluctuate by different amounts.

(b) Investment Spending A Look At Short-Run Economic Fluctuations (b) Investment Spending Billions of Recessions 1992 Dollars $1,100 1,000 Investment spending 900 800 700 600 500 400 300 1965 1970 1975 1980 1985 1990 1995 1

Three Key Facts About Economic Fluctuations As output falls, unemployment rises. Changes in real GDP are inversely related to changes in the unemployment rate. During times of recession, unemployment rises substantially.

A Look At Short-Run Economic Fluctuations (c) Unemployment Rate Percent of Labor Force Recessions 12 10 Unemployment rate 8 6 4 2 1965 1970 1975 1980 1985 1990 1995

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 Two variables are used to develop a model to analyze the short-run fluctuations. The economy’s output of goods and services measured by real GDP. The overall price level measured by the CPI or the GDP deflator.

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.

The Basic Model of Economic Fluctuations The aggregate demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level.

The Basic Model of Economic Fluctuations The aggregate supply curve shows the quantity of goods and services that firms produce and sell at each price level.

Aggregate Demand and Aggregate Supply... Price Level Aggregate supply Equilibrium price level Aggregate demand Equilibrium output Quantity of Output

The Aggregate Demand Curve The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX

The Aggregate-Demand Curve... Price Level P1 Y1 1. A decrease in the price level... Y2 P2 Aggregate demand 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

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.

The Price Level and Investment: The Interest Rate Effect A lower price level reduces the interest rate, which encourages greater spending on investment goods. This increase in investment spending means a larger quantity of goods and services demanded.

The Price Level and net Exports: The Exchange-Rate Effect 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. The increase in net export 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, however, 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 Shifts arising from Investment Shifts arising from Government Purchases Shifts arising from Net Exports

Shifts in the Aggregate Demand Curve... Price Level D2 P1 Y2 Aggregate demand, D1 Y1 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 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.

The Long-Run Aggregate- Supply Curve... Price Level Long-run aggregate supply P1 1. A change in the price level… 2. …does not affect the quantity of goods and services supplied in the long run. P2 Natural rate of output Quantity of Output

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 output or full-employment output.

Why the Long-Run Aggregate Supply 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 Aggregate Supply Curve Might Shift Shifts arising from Labor Shifts arising from Capital Shifts arising from Natural Resources Shifts arising from Technological Knowledge

Long-Run Growth and Inflation... 2. …and growth in the money supply shifts aggregate-demand... AD2000 AD1990 Price Level LRAS1980 1. In the long-run, technological progress shifts long-run aggregate supply... LRAS2000 LRAS1990 4. …and ongoing inflation. P2000 P1990 P1980 AD1980 Y1990 Y2000 3. …leading to growth in output... Y1980 Quantity of Output

Long-Run Growth and Inflation Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends.

Why the Short-Run Aggregate Supply Curve Slopes Upward in the Short Run 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. A decrease in the level of prices tends to reduce the quantity of goods and services supplied.

The Short-Run Aggregate Supply Curve... Price Level Short-run aggregate supply Y1 P1 P2 1. A decrease in the price level Y2 2. reduces the quantity of goods and services supplied in the short run. Quantity of Output

Why the Short-Run Aggregate Supply Curve Slopes Upward in the Short Run The Misperceptions Theory The Sticky-Wage Theory The Sticky-Price Theory

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.

The Sticky-Wage Theory Nominal wages are slow to adjust, or are “sticky” in the short run: 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.

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. This depresses sales, which induces firms to reduce the quantity of goods and services they produce.

Why the Aggregate Supply Curve Might Shift Shifts arising from Labor Shifts arising from Capital Shifts arising from Natural Resources. Shifts arising from Technology. Shifts arising from the Expected Price Level.

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.

The Long-Run Equilibrium Quantity of Output Price Level Short-run aggregate supply Long-run Aggregate demand A Equilibrium price Natural rate of output

A Contraction in Aggregate Demand... Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Contraction in Aggregate Demand... 2. …causes output to fall in the short run… Price Level Long-run aggregate supply Short-run aggregate supply, AS1 AS2 C P3 3. …but over time, the short-run aggregate-supply curve shifts… 1. A decrease in aggregate demand… AD2 P1 A B P2 Y2 4. …and output returns to its natural rate. Aggregate demand, AD1 Y1 Quantity of Output

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.

An Adverse 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. Unemployment rises. The price level rises.

An Adverse Shift in Aggregate Supply... 1. An adverse shift in the short-run aggregate-supply curve… AS2 Price Level Long-run aggregate supply Short-run aggregate supply, AS1 2. …causes output to fall… B Y2 3. …and the price level to rise. P2 A P1 Aggregate demand Y1 Quantity of Output

Stagflation Adverse shifts in aggregate supply cause stagflation—a combination of recession and inflation. Output falls and prices rise. Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

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.

Accommodating an Adverse Shift in Aggregate Supply... Price Level AS2 1. When short-run aggregate supply falls… Long-run aggregate supply Short-run aggregate supply, AS1 C 2. …policymakers can accommodate the shift by expanding aggregate demand… AD2 P2 P3 3....which causes the price level to rise A P1 4. …but keeps output at its natural rate. Aggregate demand, AD1 Natural rate of output Quantity of Output

The Effects of a Shift in Aggregate Supply Shifts in aggregate supply can cause stagflation – a combination of recession and inflation. Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

Summary All societies experience short-run economic fluctuations around long-run trends. These fluctuations are irregular and largely unpredictable. When recessions occur, real GDP and other measures of income, spending, and production fall, and unemployment rises.

Summary Economists analyze short-run economic fluctuations using the aggregate demand and aggregate supply model. 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.

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

Summary In the long run, the aggregate supply curve is vertical. The short-run, the aggregate supply curve is upward sloping. 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.

Summary Events that alter the economy’s ability to produce output will shift the short-run aggregate-supply curve. Also, the position of the short-run aggregate-supply curve depends on the expected price level. One possible cause of economic fluctuations is a shift in aggregate demand.

Summary A second possible cause of economic fluctuations is a shift in aggregate supply. Stagflation is a period of falling output and rising prices.

Graphical Review

A Look At Short-Run Economic Fluctuations Recessions (a) Real GDP Billions of 1992 Dollars 1965 1970 1975 1980 1985 1990 1995 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000 6,500 $7,000 Real GDP

(b) Investment Spending A Look At Short-Run Economic Fluctuations Recessions (b) Investment Spending Billions of 1992 Dollars 300 400 500 600 700 800 900 1,000 $1,100 Investment spending 1965 1970 1975 1980 1985 1990 1995 1

A Look At Short-Run Economic Fluctuations Recessions (c) Unemployment Rate Unemployment rate 2 4 6 8 10 12 1965 1970 1975 1980 1985 1990 1995 Percent of Labor Force

Aggregate Demand and Aggregate Supply... Equilibrium output Quantity of Output Price Level price level Aggregate supply demand

The Aggregate-Demand Curve... Quantity of Output Price Level Aggregate demand P1 Y1 Y2 P2 2. …increases the quantity of goods and services demanded. 1. A decrease in the price level...

Shifts in the Aggregate Demand Curve... Quantity of Output Price Level Aggregate demand, D1 P1 Y1 D2 Y2

The Long-Run Aggregate- Supply Curve... Quantity of Output Natural rate of output Price Level Long-run aggregate supply P1 P2 2. …does not affect the quantity of goods and services supplied in the long run. 1. A change in the price level…

Long-Run Growth and Inflation... 1. In the long-run, technological progress shifts long-run aggregate supply... LRAS2000 LRAS1990 Quantity of Output Price Level 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 of Output Price Level Short-run aggregate 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

The Long-Run Equilibrium Quantity of Output Price Level Short-run aggregate supply Long-run Aggregate demand A Equilibrium price Natural rate of output

A Contraction in Aggregate Demand... Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Contraction in Aggregate Demand... 1. A decrease in aggregate demand… AD2 Quantity of Output Price Level Short-run aggregate supply, AS1 Long-run aggregate supply Aggregate demand, AD1 A P1 Y1 B P2 Y2 2. …causes output to fall in the short run… AS2 C P3 3. …but over time, the short-run aggregate-supply curve shifts… 4. …and output returns to its natural rate.

An Adverse Shift in Aggregate Supply... 1. An adverse shift in the short-run aggregate-supply curve… AS2 Long-run aggregate supply Short-run aggregate supply, AS1 Quantity of Output Price Level Aggregate demand A Y1 P1 3. …and the price level to rise. P2 2. …causes output to fall… B Y2

Accommodating an Adverse Shift in Aggregate Supply... AS2 1. When short-run aggregate supply falls… Quantity of Output Natural rate of output Price Level Short-run aggregate supply, AS1 Aggregate demand, AD1 Long-run aggregate supply A P1 P2 P3 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… AD2