Not to scare you…..but…… Yf SRAS SRAS1 AD1 AD LRAS Price Level GDP, Income, Employment Aggregate Demand and Aggregate Supply Model (AD/AS)

Ch. 31: Aggregate Demand and Aggregate Supply What causes short run fluctuations? Can public policy prevent falling income and rising unemployment? Can public policy reduce severity of recessions or depressions? Key is to focus on short run fluctuations around the long run trends.

Yf SRAS SRAS1 AD1 AD LRAS Price Level GDP, Income, Employment

Understanding Short Run Fluctuations 1. Business Cycle – NOT regular or predictable

2. Macroeconomic Quantities Fluctuate Together RGDP = most commonly used to monitor short run changes….. …..but RGDP tends to move with Income, corporate profits, consumer spending, investment spending, industrial production, retail sales, home sales, auto sales……….. ……..so, there is a lot more than RGDP to look at in the short run….

3. As output falls, unemployment rises

Explaining Short Run Economic Fluctuations “Classical Dichotomy”, “Monetary Neutrality” p. 705 – skip for now Short Run model focused on … Economy’s output (RGDP) Price Level (CPI or GDP Deflator)

Yf SRAS AD Price Level GDP, Income, Employment The good news………acts much the same as Supply and Demand from Micro The bad news……this is Macro……..much more to the curves than in Micro

I.Aggregate Demand a.shows VARIOUS amounts of goods and services that the entire economy desires to purchase b.different from Micro D curve (individual choices for one good) ; – will NOT be able to apply income (normal/inferior) or substitution (substitute/compliment)effects**** c. Similar to law of Demand ….. Inverse relationship : lower P level = larger real GDP higher the P level = smaller real GDP

AD slopes downward: Wealth Effect When PL goes up = real wealth goes….. down When PL goes down = real wealth goes…. Up As PL decreases, consumers feel ….. “wealthier” and increase quantity of ….. goods and services demanded

AD slopes downward: Interest Rate Effect As PL goes down = money demanded goes… down People will usually lend more (in form of ….. savings accts, bonds, etc.) = increase in the Supply of Loanable Funds = interest rates go…… down As interest rates go down = firms will ……. borrow more to invest (consumers in new housing) So…..Interest rates down = Investment up = increase …. quantity of goods and services demanded

AD slopes downward: Exchange Rate Effect As PL goes down, interest rates go down US investors seek higher returns elsehwere..meaning? … Want to invest where interest rates are higher to get better returns on bonds As more US dollars leave, the Supply of US dollars in “Foreign Exchange Market” increases and … in turn “DEPRECIATES” the dollar relative to value of other currencies. …. *Important – DO NOT think about inflation in this context of “appreciation” or “depreciation”

Each dollar now buys fewer units of foreign currency = foreign goods become…… More expensive …..so the US Imports will …… Decrease….and US Exports will ……. Increase ……and overall US Nx will……. Increase …..and increases the …….. Quantity of goods and services demanded

Simplify: As PL goes down, Interest Rates go down, dollar depreciates, Nx go up, Qd of goods and services go up

Why does AD Shift? Very similar to D shifting in micro Remember AD = C+I+G+Nx So if any component of AD increases or decreases independently of PL, then AD shifts C : want to save more or less, stock market boom increases wealth or crash decreases wealth, increase or decrease in taxes paid I : invest in new technology, optimism or pessimism about future, increase or decrease in business taxes or tax credits

AD shifiting..cont.. G : any increase or decrease in G spending Nx : foreign nations experience a economic growth or recession…affect on AD?..... any outside force which makes the US dollar “appreciate or depreciate” ….affect on AD? …. » Remember: “At any given price level, there is now more Aggregate Demand”

Aggregate Supply A.How do we know that aggregate supply is upward sloping in the short run and vertical in the long run? B. First, recall from microeconomics that output is a function of the inputs to production i. Supplies of labor, capital, natural resources, and available technology –(these are not affected by the price level) ii. The only way to increase output in the long run is to increase the levels of capital and labor. iii. This is called increasing the capital stock--the result of investment--and increasing the labor force--the result of more people working

iv. Therefore, in the long run, the aggregate supply curve is affected only by the levels of capital and labor and not by the price level. Thus, the long run aggregate supply is vertical with respect to the price level. ***see example on bottom of pg. 712 to 713

Why LRAS will Shift Think of what would shift PPF out pg LABOR CAPITAL NATURAL RESOURCES TECHNOLOGICAL KNOWLEDGE

A New Way to Depict Long-Run Growth and Inflation Yf1 Yf2 PL 1. There are many forces that govern the economy in the long run…but most imprt. are technology and monetary policy 2. Tech progress increases production of goods/services ; shifting LRAS right 3. Fed increases money supply over time = increase spending and shifting AD right 4. Shows the Long Run trends in growth and inflation PL2 PL1

Yf1 Yf2 PL PL2 PL1 The purpose of AD/AS model is to provide a framework for short run analysis. As we develop short run analysis, we will not necessarily show the continuing growth of GDP.

Yf1 PL PL2 PL1 The Short Run fluctuations in output and the price level should be viewed as deviations from the continuing long run trends

Stated another way…… 1. LRAS is vertical and represents full employment and full output (natural rate of unemployment) Real GDP is maximized. 2. Any changes in AD will affect only the price level. 3. In the long run, prices and wages are flexible. 4. This means that if products don’t sell and employees become unemployed, the market will self correct We will look at HOW the economy will self correct later…but first lets analyze the SRAS

Why AS slopes upward in short run As PL rises, Q of goods and services supplied rises (similar to Law of Supply in Micro) Three theories help explain why AS is upward sloping in short run 3 theories but 1 common theme: Q of output supplied deviates from its long run or natural level when the PL deviates from the PL that people expected. When PL is higher than expected, Output rises above its natural rate When PL is lower than expected, Output falls below its natural rate.

Misperceptions Theory Example PL falls below expectations Firms may feel the reward for production has been lowered and reduce output “Lower than expected PL causes misperceptions about relative prices and these misperceptions induce suppliers to respond by decreasing Q of goods and services supplied” If PL rises above expectations……

Stick-Wage Theory Nominal wages are sticky in the short run Think long term contract at given wage As PL falls below expectations, nominal wages are fixed, but real wages rise. Because real wages are major input cost, firms real costs rise and begin to hire less and produce less “As PL falls below expectations, nominal wages are sticky, makes real wages and costs rise, production is less profitable and firms decrease quantity of goods and services supplied” If PL rises above expectations……

Sticky Price Theory As PL falls below expectations, not all firms will react immediately and so some Prices are sticky The firms that do not lower Prices right away will have relatively higher prices which will reduce sales …… This induces firms to reduce production and employment As PL falls unexpectedly, some firms leave prices higher than desired which results in lower sales. Firms begin to decrease the quantity of goods and services supplied. If PL rises above expectations……

Shifting SRAS If it shifted LRAS, then it must also shift SRAS Labor, Capital, Natural Resources, Technology One new variable….. Expected Price Level If the Expected Price Level falls….(notice difference from the three theories) …. Firms expect wages and all input costs to fall and begin to increase the Quantity of goods and services supplied If the Expected Price Level rises……

AD/AS: Self Correcting in the Long Run The Effects of a Shift in AD The economy self corrects; P and W change but it is nominal (not real) and these changes offset eachother and purchasing power remains the same. = Classical view

…but how long do we wait for self correcting? This was the question being asked during the Great Depression and one in which the Bush and Obama administrations definitively answered. …….discuss Lets look at how this model self corrects when AD increases

Event increases (C, I, G, or Xn) = shift AD right Evaluate = P and GDP (output is beyond full employment levels)…..how do we know this is short run ? …. Long run RGDP growth is only possible when LRAS shifts right The current condition = Inflationary Gap ……why? Nominal Wages don’t respond in short run = so Real Wages …. decrease …explain? Yf

As “Long Run” nears and PL remain high, Nominal Wages begin to respond and increase….Explain? All input P have increased and now W increase = Shift Short Run AS left Result= higher P but back at Yf and increase in Nominal W are offset by increase in P level Yf

Now lets see how it self corrects when AD decreases

Event decreases (C, I, G, or Xn) = shift AD left Evaluate= P decrease, GDP decrease (below full employment levels) = Recessionary Gap ….why? As GDP and PL fall, Nominal Wages don’t respond in short run, so = Real Wages….. increase With lower Prices and output and Nominal wages “stuck” higher = decrease profits for firms As the Long Run nears, Nominal W begin to decrease All input P have decreased and now W decrease = shift Short Run AS right Result = lower P level but back at Yf, and decrease in Nominal W are offset by lower P levels Yf