Short-Run Economic Fluctuations

Chapter 33. Aggregate Demand and Aggregate Supply ShortShort-Run Economic Fluctuations ƒ Economic activity fluctuates from year to year. – In most y...
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Chapter 33. Aggregate Demand and Aggregate Supply

ShortShort-Run Economic Fluctuations ƒ 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.

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ShortShort-Run Economic Fluctuations

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS

ƒ A recession is a period of declining real

ƒ Economic fluctuations are irregular and

incomes, and rising unemployment.

unpredictable.

– Fluctuations in the economy are often

ƒ A depression is a severe recession.

called the business cycle.

ƒ Most macroeconomic variables fluctuate together.

ƒ As output falls, unemployment rises.

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Figure 1 A Look At ShortShort-Run Economic Fluctuations

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS ƒ Most macroeconomic variables fluctuate

(a) Real GDP Billions of 1996 Dollars

together.

– Most macroeconomic variables that

$10,000 9,000

measure some type of income or production fluctuate closely together. – Although many macroeconomic variables fluctuate together, they fluctuate by different amounts.

Real GDP

8,000 7,000 6,000 5,000 4,000 3,000 2,000 1965

1970

1975

1980

1985

1990

1995

2000

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Figure 1 A Look At ShortShort-Run Economic Fluctuations

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS ƒ As output falls, unemployment rises.

(b) Investment Spending

– Changes in real GDP are inversely related

Billions of 1996 Dollars

to changes in the unemployment rate.

$1,800

– During times of recession, unemployment

1,600 1,400

rises substantially.

Investment spending

1,200 1,000 800 600 400 200 1965

1970

1975

1980

1985

1990

1995

2000

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Figure 1 A Look At ShortShort-Run Economic Fluctuations

ƒ How the Short Run Differs from the Long

(c) Unemployment Rate

Run

Percent of Labor Force

– Most economists believe that classical

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theory describes the world in the long run but not in the short run.

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• 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-toyear changes in the economy.

Unemployment rate

8 6 4 2 0 1965

EXPLAINING SHORTSHORT-RUN ECONOMIC FLUCTUATIONS

1970

1975

1980

1985

1990

1995

2000

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The Basic Model of Economic Fluctuations

The Basic Model of Economic Fluctuations

ƒ Two variables are used to develop a

ƒ The Basic Model of Aggregate Demand

model to analyze the short-run fluctuations.

and Aggregate Supply – Economist use the model of aggregate demand and aggregate supply to explain

– The economy’s output of goods and

short-run fluctuations in economic activity around its long-run trend.

services measured by real GDP.

– The overall price level measured by the

CPI or the GDP deflator.

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The Basic Model of Economic Fluctuations

The Basic Model of Economic Fluctuations

ƒ The Basic Model of Aggregate Demand

ƒ The Basic Model of Aggregate Demand

and Aggregate Supply – The aggregate-demand curve shows the

and Aggregate Supply – The aggregate-supply curve shows the

quantity of goods and services that households, firms, and the government want to buy at each price level.

quantity of goods and services that firms choose to produce and sell at each price level.

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Figure 2 Aggregate Demand and Aggregate Supply...

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THE AGGREGATEAGGREGATE-DEMAND CURVE ƒ The four components of GDP (Y)

Price Level

contribute to the aggregate demand for goods and services.

Aggregate supply

Y = C + I + G + NX

Equilibrium price level

Aggregate demand

0

Equilibrium output

Quantity of Output slide 14

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Figure 3 The AggregateAggregate-Demand Curve...

Why the AggregateAggregate-Demand Curve Is Downward Sloping

ƒ The Price Level and Consumption: The

Price Level

Wealth Effect

ƒ The Price Level and Investment: The Interest Rate Effect

P

ƒ The Price Level and Net Exports: The Exchange-Rate Effect

P2 1. A decrease in the price level . . .

Aggregate demand

Y

0

Y2

Quantity of Output

2. . . . increases the quantity of goods and services demanded.

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Why the AggregateAggregate-Demand Curve Is Downward Sloping

Why the AggregateAggregate-Demand Curve Is Downward Sloping

ƒ The Price Level and Consumption: The

ƒ The Price Level and Investment: The

Wealth Effect

Interest Rate Effect

– A decrease in the price level makes

– A lower price level reduces the interest

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.

rate, which encourages greater spending on investment goods. – This increase in investment spending means a larger quantity of goods and services demanded.

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Why the AggregateAggregate-Demand Curve Is Downward Sloping

Why the AggregateAggregate-Demand Curve Might Shift

ƒ The Price Level and Net Exports: The

ƒ The downward slope of the aggregate

Exchange-Rate Effect

demand curve shows that a fall in the price level raises the overall quantity of goods and services demanded.

– 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.

ƒ Many other factors, however, affect the

quantity of goods and services demanded at any given price level.

ƒ When one of these other factors changes, the aggregate demand curve shifts.

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Shifts in the Aggregate Demand Curve

Why the AggregateAggregate-Demand Curve Might Shift

ƒ Shifts arising from – – – –

Consumption Investment Government Purchases Net Exports

Price Level

P1

D2 Aggregate demand, D1 0 slide 22

Y1

Y2

Quantity of Outputslide 23

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THE AGGREGATEAGGREGATE-SUPPLY CURVE ƒ In the long run, the aggregate-supply curve is vertical.

THE AGGREGATEAGGREGATE-SUPPLY CURVE ƒ 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.

ƒ In the short run, the aggregate-supply curve is upward sloping.

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Figure 4 The LongLong-Run AggregateAggregate-Supply Curve

THE AGGREGATEAGGREGATE-SUPPLY CURVE ƒ The Long-Run Aggregate-Supply Curve

Price Level

– The long-run aggregate-supply curve is

Long-run aggregate supply

vertical at the natural rate of output.

– This level of production is also referred to

as potential output or full-employment output.

P

P2

2. . . . does not affect the quantity of goods and services supplied in the long run.

1. A change in the price level . . . 0

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Natural rate of output

Quantity of Output slide 26

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Why the LongLong-Run AggregateAggregate-Supply Curve Might Shift

ƒ Any change in the economy that alters

the natural rate of output shifts the longrun aggregate-supply curve.

ƒ The shifts may be categorized according to the various factors in the classical model that affect output.

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Figure 5 LongLong-Run Growth and Inflation 2. . . . and growth in the money supply shifts aggregate demand . . .

Why the LongLong-Run AggregateAggregate-Supply Curve Might Shift

ƒ Shifts arising – – – –

Labor Capital Natural Resources Technological Knowledge

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A New Way to Depict LongLong-Run Growth and Inflation

Long-run aggregate supply, LRAS1980 LRAS1990 LRAS2000

ƒ Short-run fluctuations in output and price

level should be viewed as deviations from the continuing long-run trends.

Price Level

1. In the long run, technological progress shifts long-run aggregate supply . . .

P2000 4. . . . and ongoing inflation. P1990

Aggregate Demand, AD2000 P1980

AD1990

AD1980 0

Y1980

Y1990

Quantity of Output 3. . . . leading to growth in output . . .

Y2000

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Figure 6 The ShortShort-Run AggregateAggregate-Supply Curve

Why the AggregateAggregate-Supply Curve Slopes Upward in the Short Run

ƒ In the short run, an increase in the

Price Level

overall level of prices in the economy tends to raise the quantity of goods and services supplied.

Short-run aggregate supply

ƒ A decrease in the level of prices tends to

P

reduce the quantity of goods and services supplied.

P2 2. . . . reduces the quantity of goods and services supplied in the short run.

1. A decrease in the price level . . .

0

Y2

Y

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Why the AggregateAggregate-Supply Curve Slopes Upward in the Short Run

Quantity of Output

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Why the AggregateAggregate-Supply Curve Slopes Upward in the Short Run

ƒ The Misperceptions Theory

ƒ The Misperceptions Theory – Changes in the overall price level

ƒ The Sticky-Wage Theory

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.

ƒ The Sticky-Price Theory

• These misperceptions induce suppliers to decrease the quantity of goods and services supplied.

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Why the AggregateAggregate-Supply Curve Slopes Upward in the Short Run

The StickySticky-Price Theory

ƒ The Sticky-Wage Theory

– Prices of some goods and services adjust

sluggishly in response to changing economic conditions:

– 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.

• An unexpected fall in the price level leaves some firms with higher-thandesired prices. • This depresses sales, which induces firms to reduce the quantity of goods and services they produce.

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Why the ShortShort-Run AggregateAggregate-Supply Curve Might Shift

ƒ Shifts arising – – – – –

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Why the Aggregate Supply Curve Might Shift

ƒ 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.

Labor Capital Natural Resources. Technology. Expected Price Level.

ƒ 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.

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Figure 7 The LongLong-Run Equilibrium

Figure 8 A Contraction in Aggregate Demand 2. . . . causes output to fall in the short run . . .

Price Level

Price Level

Long-run aggregate supply

Long-run aggregate supply

Short-run aggregate supply

AS2

A

Equilibrium price

B

P3

1. A decrease in aggregate demand . . .

C

Aggregate demand, AD

Aggregate demand

AD2

Quantity of Output

Natural rate of output

3. . . . but over time, the short-run aggregate-supply curve shifts . . .

A

P P2

0

Short-run aggregate supply, AS

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0

Y2

Y 4. . . . and output returns to its natural rate.

Quantity of Output

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TWO CAUSES OF ECONOMIC FLUCTUATIONS

TWO CAUSES OF ECONOMIC FLUCTUATIONS

ƒ Shifts in Aggregate Demand

ƒ An Adverse Shift in Aggregate Supply

– In the short run, shifts in aggregate

– A decrease in one of the determinants of

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.

aggregate supply shifts the curve to the left: • Output falls below the natural rate of employment. • Unemployment rises. • The price level rises.

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Figure 10 An Adverse Shift in Aggregate Supply

The Effects of a Shift in Aggregate Supply

1. An adverse shift in the shortrun aggregate-supply curve . . . Price Level

ƒ Stagflation – Adverse shifts in aggregate supply cause

Long-run aggregate supply

AS2

stagflation—a period of recession and

Short-run aggregate supply, AS

inflation.

• Output falls and prices rise. • Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

B P2 A P 3. . . . and the price level to rise. Aggregate demand 0

Y2

Y

2. . . . causes output to fall . . .

Quantity of Output

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Figure 11 Accommodating an Adverse Shift in Aggregate Supply

The Effects of a Shift in Aggregate Supply

1. When short-run aggregate supply falls . . .

ƒ Policy Responses to Recession – Policymakers may respond to a recession

Price Level

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.

Long-run aggregate supply

P3

A 3. . . . which P causes the price level to rise further . . . 0

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C

P2

4. . . . but keeps output at its natural rate. Natural rate of output

Short-run aggregate supply, AS

AS2

2. . . . policymakers can accommodate the shift by expanding aggregate demand . . .

AD2 Aggregate demand, AD Quantity of Output

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Summary

Summary

ƒ All societies experience short-run

ƒ Economists analyze short-run economic

ƒ These fluctuations are irregular and

ƒ According to the model of aggregate

economic fluctuations around long-run trends.

fluctuations using the aggregate demand and aggregate supply model.

largely unpredictable.

ƒ When recessions occur, real GDP and

other measures of income, spending, and production fall, and unemployment rises.

demand and aggregate supply, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply.

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Summary

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Summary

ƒ The aggregate-demand curve slopes

ƒ In the long run, the aggregate supply

downward for three reasons: a wealth effect, an interest rate effect, and an exchange rate effect.

curve is vertical.

ƒ The short-run, the aggregate supply curve is upward sloping.

ƒ Any event or policy that changes

consumption, investment, government purchases, or net exports at a given price level will shift the aggregate-demand curve.

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ƒ 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. slide 51

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Summary

Summary

ƒ Events that alter the economy’s ability to produce output will shift the short-run aggregate-supply curve.

ƒ A second possible cause of economic

fluctuations is a shift in aggregate supply.

ƒ Stagflation is a period of falling output and rising prices.

ƒ Also, the position of the short-run

aggregate-supply curve depends on the expected price level.

ƒ One possible cause of economic

fluctuations is a shift in aggregate demand. slide 52

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