Aggregate Demand and Aggregate Supply Chapter 33 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

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.

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 Recessions and Depressions u Most macroeconomic variables fluctuate together. u As output falls, unemployment rises.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Recessions (a) Real GDP Billions of 1992 Dollars ,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

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Recessions (b) Investment Spending Billions of 1992 Dollars ,000 $1,100 Investment spending A Look At Short-Run Economic Fluctuations

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Recessions (c) Unemployment Rate Unemployment rate Percent of Labor Force A Look At Short-Run Economic Fluctuations

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Basic Model of Economic Fluctuations Economists use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend. n Price level as measured by the CPI n Aggregate Output as measured by real GDP.

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

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

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...

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

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Why the Aggregate Demand Curve Might Shift u Y=C + I + G + NET EXPORTS u Shifts arising from Consumption u Shifts arising from Investment u Shifts arising from Government Purchases u Shifts arising from Net Exports u Changes in the price level cause a movement along the Aggregate Demand Curve.

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

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Aggregate Supply Curve u The aggregate supply curve shows the level of production at each price level. u In the long run, the aggregate-supply curve is vertical. u In the short run, the aggregate-supply curve is upward sloping.

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.

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…

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 u Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve.

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

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. u Workers may be fooled as well-Sticky Wage Theory. u But Supply always snaps back to the Long run.

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

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.

An Adverse Shift in Short Run 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. u Stagflation results!

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 …and the price level to rise. P2P2 2. …causes output to fall… B Y2Y2

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.

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 P3P 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