Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 0

C H A P T E R 6 Business Cycles and the Aggregate Demand-Aggregate Supply Model Learning objectives äIdentify business cycle movements in output, the unemployment rate, and the inflation rate. äUnderstand that output and prices are determined by the interaction of aggregate supply and aggregate demand. äUnderstand that the slope of the aggregate supply curve reflects assumptions concerning the economy's price adjustment mechanism. äUnderstand that in the very short run, we assume that there is no price adjustment and that the aggregate supply curve is horizontal. PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa Copyright 2005 © McGraw-Hill Ryerson Ltd.

C H A P T E R 6 Business Cycles and the Aggregate Demand-Aggregate Supply Model Learning objectives (cont’d) äUnderstand that in the long run, we assume that prices are completely flexible and that the aggregate supply curve is vertical. äUnderstand that the aggregate demand curve slopes downward and shifts due to change in monetary or fiscal policy. äUnderstand that changes in aggregate demand change output in the short run and changes in the long run. PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa Copyright 2005 © McGraw-Hill Ryerson Ltd.

Slide 3 Business Cycles oBusiness Cycle oBusiness Cycle: The more or less regular pattern of expansion (recovery) and contraction (recession) in economic activity around full employment output. oExpansion (Recovery) oExpansion (Recovery): A sustained period of rising real income. oContraction (Recession) oContraction (Recession): That period of time in a business cycle when output is falling below full employment. oPotential GDP oPotential GDP: Output that is produced when all factors of production are fully employed. oOutput gap oOutput gap: Measures the difference between actual output and the output that could be produced at full employment, or potential output. Chapter 6: Business Cycles and the AD-AS Model

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 4 Business Cycles Figure 6-1: A Stylized GDP Business Cycle The business cycle is the movement of current GDP around its trend path. At a cyclical peak, economic activity is high; at a through, output is below trend. Output Peak Trough Recovery Recession Peak TimeTrend

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 5 Business Cycles Figure 6-2: Actual and Potential GDP, Chapter 6: Business Cycles and the AD-AS Model

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 6 Business Cycles Figure 6-3: The Cyclical Behaviour of the Unemployment Rate, Chapter 6: Business Cycles and the AD-AS Model

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 7 Business Cycles Figure 6-4: The Cyclical Behaviour of the Inflation Rate, Chapter 6: Business Cycles and the AD-AS Model

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 8 Introduction to AD and AS oAggregate Demand (AD) Curve oAggregate Demand (AD) Curve: Shows combinations of the price level and the level of output for which the demanders of goods and services are equilibrium. oAggregate Supply (AS) Curve oAggregate Supply (AS) Curve: Relationship between the amount of final goods and services produced in an economy and the price level. oKeynesian aggregate supply curve: oKeynesian aggregate supply curve: Is horizontal because firms will supply whatever amount of goods are demanded at the existing price level. oClassical aggregate supply curve: oClassical aggregate supply curve: Is vertical because firms will supply the same amount of goods no matter what the price level. Aggregate Demand and Aggregate Supply Chapter 6: Business Cycles and the AD-AS Model

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 9 Introduction to AD and AS Price Level Output, Income Figure 6-5: The Aggregate Demand (AD) Curve P The AD curve slopes downward because as the price level increases, with the nominal money stock held constant, the real money stock decreases. An increase in the nominal money stock shifts the AD curve outward. The vertical shift in the AD curve proportional to the change in the nominal money stock. For a given level of income, Y 0, the level of the real money stock is unchanged after the shift in AD. Y0Y0Y0Y0 P0P0P0P0YP’ Chapter 6: Business Cycles and the AD-AS Model AD AD’

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 10 Introduction to AD and AS Price Level Figure 6-6: The Aggregate Supply (AS) Curve (a) P The Keynesian AS curve is horizontal, indicating that any amount of output will be supplied at a given price. This is a very short run model. YASP’ Output, Income Chapter 6: Business Cycles and the AD-AS Model

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 11 Introduction to AD and AS Price Level Output, Income Figure 6-6: The Aggregate Supply (AS) Curve (b) P The Classical AS curve is vertical at the level of full employment income, Y*. This is based on the assumptions of the classical market clearing model discussed in Chapter 3. YASY* Chapter 6: Business Cycles and the AD-AS Model

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 12 AD Policy and Alternative Supply Assumptions Chapter 6: Business Cycles and the AD-AS Model Figure 6-7: Aggregate Demand Expansion: The Keynesian Case P In the very short run the aggregate supply curve is horizontal. When the AD curve shifts to the right, output increases, while the price level remains constant. YAS P0P0P0P0 Output, Income Price Level AD Y0Y0Y0Y0 AD’ Y’

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 13 AD Policy and Alternative Supply Assumptions Chapter 6: Business Cycles and the AD-AS Model Figure 6-8: Aggregate Demand Expansion: The Classical Case P Due to the assumption of full market clearing, a shift in the AD curve leads to only a price level increase in the long run. Y Output, Income Price LevelAS Y0Y0Y0Y0 AD AD’ P0P0P0P0E P1P1P1P1E’’ E’

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 14 Vertical or Horizontal: A Matter of Timing? BOXBOX 6-2

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 15 Chapter Summary The business cycle is the more or less pattern of expansion and contraction in economic activity around full employment output. Movements in output, the unemployment rate, and the inflation rate are related through the business cycle. The output gap measures deviations of current output from potential output. The aggregate demand curve shows for each price level the quantity of goods demanded. For a given AD curve, the level of nominal money stock is constant. As the price level increases for a given nominal money stock, the real money stock decreases. Therefore, the aggregate demand curve slopes downward. Chapter 6: Business Cycles and the AD-AS Model

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 16 Chapter Summary (cont’d) A change in the level of nominal money stock or change in fiscal policy will shift the aggregate demand curve. An increase in the nominal money stock will shift the aggregate demand curve upward by an amount proportional to the change in the money stock. The Keynesian aggregate supply curve is horizontal, the Classical aggregate supply curve is vertical. Supply0side economics make the claim that reducing tax rates generates very large increases in aggregate supply. Chapter 6: Business Cycles and the AD-AS Model

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 17 The End Chapter 6: Business Cycles and the AD-AS Model