Chapter 33. Aggregate Demand and Aggregate Supply
ShortShort-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.
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ShortShort-Run Economic Fluctuations
THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS
A recession is a period of declining real
Economic fluctuations are irregular and
incomes, and rising unemployment.
unpredictable.
– Fluctuations in the economy are often
A depression is a severe recession.
called the business cycle.
Most macroeconomic variables fluctuate together.
As output falls, unemployment rises.
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Figure 1 A Look At ShortShort-Run Economic Fluctuations
THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS 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 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
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
Two variables are used to develop a
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
The Basic Model of Aggregate Demand
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 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
The Price Level and Consumption: The
Price Level
Wealth Effect
The Price Level and Investment: The Interest Rate Effect
P
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
The Price Level and Consumption: The
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
The Price Level and Net Exports: The
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.
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.
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Shifts in the Aggregate Demand Curve
Why the AggregateAggregate-Demand Curve Might Shift
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 In the long run, the aggregate-supply curve is vertical.
THE AGGREGATEAGGREGATE-SUPPLY CURVE 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.
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 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
Any change in the economy that alters
the natural rate of output shifts the longrun aggregate-supply curve.
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
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
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
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
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
The Misperceptions Theory
The Misperceptions Theory – Changes in the overall price level
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.
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
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
Shifts arising – – – – –
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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.
Labor Capital Natural Resources. Technology. Expected Price Level.
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
Shifts in Aggregate Demand
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
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 . . .
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
All societies experience short-run
Economists analyze short-run economic
These fluctuations are irregular and
According to the model of aggregate
economic fluctuations around long-run trends.
fluctuations using the aggregate demand and aggregate supply model.
largely unpredictable.
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
The aggregate-demand curve slopes
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.
The short-run, the aggregate supply curve is upward sloping.
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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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
Events that alter the economy’s ability to produce output will shift the short-run aggregate-supply curve.
A second possible cause of economic
fluctuations is a shift in aggregate supply.
Stagflation is a period of falling output and rising prices.
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. slide 52
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