Chapter 31.ppt

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Aggregate Demandand Aggregate

Supply

Chapter 31

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 32887-6777.


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Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.

Short-Run Economic

FluctuationsEconomic 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 grownby about 3 percent per year.

In some years normal growth does not occur,

causing a recession.


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Short-Run Economic

Fluctuations

A recessionis a period of declining real

GDP, falling incomes, and risingunemployment.

A depressionis a severe recession.


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Three Key Facts About

Economic Fluctuations

Economic fluctuations are irregular

and unpredictable.Fluctuations in the economy are often called

the business cycle.

Most macroeconomic variablesfluctuate together.

As output falls, unemployment rises.


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Recessions

(a) Real GDP

Billions of1992 Dollars

1965 1970 1975 1980 1985 1990 19952,500

3,000

3,500

4,0004,500

5,000

5,500

6,0006,500

$7,000

Real GDP

A Look At Short-Run Economic Fluctuations


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Economic FluctuationsMost macroeconomic variables

fluctuate together.

Most macroeconomic variables that

measure some type of income or

production fluctuate closely together.

Although many macroeconomic variablesfluctuate together, they fluctuate by

different amounts.


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Recessions

(b) Investment Spending


300

400

500

600

700

800

9001,000

$1,100

Investment spending

1965 1970 1975 1980 1985 1990 1995



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Economic FluctuationsAs output falls, unemployment rises.

Changes in real GDP are inversely related tochanges in the unemployment rate.

During times of recession, unemployment

rises substantially.


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Recessions

(c) Unemployment Rate

Unemployment rate

0

2

4

6

8

10

12

1965 1970 1975 1980 1985 1990 1995

Percent ofLabor Force




How the Short Run Differs

From the Long RunMost economists believe that classical

theory describes the world in the long

run but not in the short run.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-to-year

changes in the economy.



The Basic Model of Economic

FluctuationsTwo variables are used to develop a

model to analyze the short-run

fluctuations.

The economys output of goods and services

measured by real GDP.

The overall price level measured by the CPIor the GDP deflator.



The Basic Model of EconomicFluctuations

Economist use the model of aggregatedemandand aggregate supplyto explain

short-run fluctuations in economic

activity around its long-run trend.


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The Basic Model of Economic

Fluctuations

The aggregate supply curveshows the

quantity of goods and services thatfirms produce and sell at each price

level.



Aggregate Demand and

Aggregate Supply...

Equilibrium

output

Quantity of

Output

PriceLevel

0

Equilibriumprice level

Aggregate

supply

Aggregatedemand



The Aggregate Demand Curve

The four components of GDP (Y)

contribute to the aggregate demand for

goods and services.

Y = C + I + G + NX



The Aggregate-Demand Curve...

Quantity ofOutput

PriceLevel

0

Aggregatedemand

P1

Y1 Y2

P2

2. increases the quantity of goodsand services demanded.

1. Adecreasein the pricelevel...



Why the Aggregate Demand

Curve Is Downward Sloping

The Price Level and Consumption: The

Wealth Effect

The Price Level and Investment: The

Interest Rate Effect

The Price Level and Net Exports: TheExchange-Rate Effect



The Price Level and Consumption:

The Wealth EffectA decrease in the price level makes

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.



The Price Level and Investment:

The Interest Rate EffectA lower price level reduces the interest

rate, which encourages greater spending

on investment goods.

This increase in investment spending

means a larger quantity of goods and

services demanded.



The Price Level and net Exports:

The Exchange-Rate EffectWhen a fall in the U.S. price level

causes U.S. interest rates to fall, the real

exchange rate depreciates, whichstimulates U.S. net exports.

The increase in net export spending

means a larger quantity of goods andservices demanded.



Why the Aggregate Demand

Curve Might Shift

The downward slope of the aggregate

demand curve shows that a fall in the price

level raises the overall quantity of goods andservices demanded.

Many other factors, however, affect the

quantity of goods and services demanded atany given price level.

When one of these other factors changes,

the aggregate demand curve shifts.


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The Aggregate Supply Curve

In the long run, the aggregate-

supply curve is vertical.

In the short run, the aggregate-

supply curve is upward sloping.



The Long-Run Aggregate

Supply CurveIn the long-run, an economys 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.



The Long-Run Aggregate-

Supply Curve...

Quantity ofOutputNatural rateof output

PriceLevel

0

Long-runaggregate

supplyP1

P22. does not

affect the quantityof goods and

services supplied

in the long run.

1. A change

in the price

level


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The Long-Run Aggregate

Supply CurveThe long-run aggregate supply curve

is vertical at the natural rate of

output.

This level of production is also

referred to as potential outputorfull-employment output.


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Why the Long-Run Aggregate

Supply Curve Might ShiftAny change in the economy that alters

the natural rate of output shifts the long-

run aggregate-supply curve.

The shifts may be categorized according

to the various factors in the classical

model that affect output.


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Why the Long-Run Aggregate

Supply Curve Might ShiftShifts arising from Labor

Shifts arising from Capital

Shifts arising from Natural

Resources

Shifts arising from TechnologicalKnowledge


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1. In the long-run,technologicalprogress shiftslong-runaggregatesupply...

LRAS2000LRAS1990

Long-Run Growth and Inflation...

Quantity ofOutput

PriceLevel

0

P1980

Y1980

AD1980

P2000

P1990

LRAS1980

2. and growth in the money

supply shifts aggregate-demand...

AD2000

AD1990

4. and

ongoing

inflation.

Y1990 Y2000

3. leading to growth in output...


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Why the Short-Run Aggregate

Supply Curve Slopes Upward in the

Short Run

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.

A decrease in the level of prices tends to

reduce the quantity of goods and services

supplied.


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The Short-Run Aggregate

Supply Curve...

Quantity ofOutput

PriceLevel

0

Short-runaggregate

supply

Y1

P1

Y2

2. reduces thequantity of goods andservices supplied inthe short run.

P2

1. A decrease

in the pricelevel


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Why the Short-Run Aggregate

Supply Curve Slopes Upward in

the Short Run

The Misperceptions Theory

The Sticky-Wage Theory

The Sticky-Price Theory


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The Misperceptions Theory

Changes in the overall price level 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.

These misperceptions induce suppliers to

decrease the quantity of goods and services

supplied.


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The Sticky-Wage Theory

Nominal wages are slow to adjust, or are

sticky in the short run:

Wages do not adjust immediately to a fall inthe price level.

A lower price level makes employment

and production less profitable.

This induces firms to reduce the quantity of

goods and services supplied.


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The Sticky-Price Theory

Prices of some goods and services adjust

sluggishly in response to changing economic

conditions:An unexpected fall in the price level leaves

some firms with higher-than-desired prices.

This depresses sales, which induces firms to

reduce the quantity of goods and services

they produce.


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Why the Aggregate Supply

Curve Might ShiftShifts arising from Labor

Shifts arising from CapitalShifts arising from Natural Resources.

Shifts arising from Technology.

Shifts arising from the Expected PriceLevel.


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An increase in the expected price level

reduces the quantity of goods and services

supplied and shifts the short-run aggregatesupply curve to the left.

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.

Why the Aggregate Supply

Curve Might Shift


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The Long-Run Equilibrium

Quantity of

Output

PriceLevel

0

Short-runaggregatesupply

Long-runaggregate

supply

Aggregatedemand

AEquilibriumprice

Natural rate

of output



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1. A decrease in

aggregate demand

AD2

A Contraction in Aggregate Demand...

Quantity of

Output

PriceLevel

0

Short-run aggregatesupply,AS1

Long-runaggregate

supply

Aggregatedemand,AD1

AP1

Y1

BP2

Y2

2. causes output to

fall in the short run

AS

2

CP3

3. but over time,the short-runaggregate-supplycurve shifts

4. and output returnsto its natural rate.


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Shifts in Aggregate Demand

In the short run, shifts in aggregate

demand cause fluctuations in the

economys output of goods and services.

In the long run, shifts in aggregate

demand affect the overall price level but

do not affect output.


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An Adverse Shift in Aggregate

SupplyA decrease in one of the determinants

of 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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1. An adverse shift in the

short-run aggregate-supplycurve

AS2

Long-runaggregate

supplyShort-runaggregatesupply,AS1

Quantity ofOutput

PriceLevel

0

Aggregate demand

A

Y1

P1

AnAdverse Shift in Aggregate Supply...

3. and theprice level torise.

P2

2. causes output to fall

B

Y2


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Stagflation

Adverse shifts in aggregate supply

cause stagflationa combination of

recession and inflation.Output falls and prices rise.

Policymakers who can influence aggregate

demand cannot offset both of these adverseeffects simultaneously.


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Policy Responses to

RecessionPolicymakers may respond to a recession

in one of the following ways:

Do nothing and wait for prices and wages toadjust.

Take action to increase aggregate demand by

using monetary and fiscal policy.

Accommodating an Ad erse Shift


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AS2

1. When short-run aggregate supply falls

Accommodating an Adverse Shift

in Aggregate Supply...

Quantity of

Output

Natural rate

of output

PriceLevel

0

Short-runaggregatesupply,AS1

Aggregate demand,AD1

Long-runaggregate

supply

A

P1

P2

P3

3....whichcauses theprice levelto rise

4. but keepsoutput at itsnatural rate.

C 2. policymakers canaccommodate the shiftby expanding aggregatedemand

AD2


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The Effects of a Shift in

Aggregate Supply

Shifts in aggregate supply can cause

stagflationa combination of recession

and inflation.

Policymakers who can influence

aggregate demand cannot offset both of

these adverse effects simultaneously.


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Summary

All societies experience short-run economic

fluctuations around long-run trends.

These fluctuations are irregular and largelyunpredictable.

When recessions occur, real GDP and other

measures of income, spending, andproduction fall, and unemployment rises.


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Summary

Economists analyze short-run economic

fluctuations using the aggregate demand

and aggregate supply model.

According to the model of aggregate

demand and aggregate supply, the output

of goods and services and the overall level

of prices adjust to balance aggregatedemand and aggregate supply.


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Summary

In the long run, the aggregate supply curve

is vertical.

The short-run, the aggregate supply curve

is upward sloping.

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.


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Summary

Events that alter the economys ability to

produce output will shift the short-run

aggregate-supply curve.

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.


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Summary

A second possible cause of economic

fluctuations is a shift in aggregate

supply.Stagflation is a period of falling output

and rising prices.


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Graphical

Review


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Recessions

(a) Real GDP


1965 1970 1975 1980 1985 1990 19952,500

3,000

3,500

4,000

4,500

5,000

5,500

6,000

6,500

$7,000

Real GDP


A L k At Sh t R E i Fl t ti


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Recessions

(b) Investment Spending


300

400

500600

700

800

900

1,000

$1,100

Investment spending

1965 1970 1975 1980 1985 1990 1995


A L k At Sh t R E i Fl t ti


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Recessions

(c) Unemployment Rate

Unemployment rate

0

2

4

6

8

10

12

1965 1970 1975 1980 1985 1990 1995

Percent ofLabor Force



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The Aggregate-Demand Curve...

Quantity ofOutput

PriceLevel

0

Aggregatedemand

P1

Y1 Y2

P2

2. increases the quantity of goods

and services demanded.

1. Adecreasein the pricelevel...


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Shifts in the Aggregate Demand

Curve...

Quantity of

Output

PriceLevel

0

Aggregatedemand, D1

P1

Y1

D2

Y2


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The Long-Run Aggregate-

Supply Curve...

Quantity ofOutput

Natural rateof output

PriceLevel

0

Long-runaggregate

supplyP1

P22. does not

affect the quantity

of goods and

services supplied

in the long run.

1. A change

in the price

level


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Th Sh t R A t


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The Short-Run Aggregate

Supply Curve...

Quantity ofOutput

PriceLevel

0

Short-runaggregate

supply

Y1

P1

Y2

2. reduces thequantity of goods andservices supplied inthe short run.

P2

1. A decreasein the pricelevel


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The Long-Run Equilibrium

Quantity of

Output

PriceLevel

0

Short-runaggregatesupply

Long-runaggregate

supply

Aggregatedemand

AEquilibriumprice

Natural rate

of output



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A Contraction in Aggregate Demand...

1. A decrease in

aggregate demand

AD2

Quantity ofOutput

PriceLevel

0

Short-run aggregatesupply,AS1

Long-runaggregate

supply

Aggregatedemand,AD1

AP1

Y1

BP2

Y2

2. causes output to

fall in the short run

AS2

CP3

3. but over time,the short-runaggregate-supplycurve shifts

4. and output returns

to its natural rate.


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in Aggregate Supply...

AS2

1. When short-run aggregate supply falls

Quantity ofNatural rate

PriceLevel

0

Short-runaggregatesupply,AS1

Aggregate demand,AD1

Long-runaggregate

supply

A

P1

P2

P3

3....whichcauses theprice levelto rise

4. but keepsoutput at itsnatural rate.

C 2. policymakers canaccommodate the shiftby expanding aggregatedemand

AD2

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