Lecture 2 Macro AD As
Transcript of Lecture 2 Macro AD As
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CHAPTER 9 Introduction to Economic Fluctuations
AGGREGATE DEMAND AND
AGGREGATE SUPPLY
Ref: Mankiw
Jamshed uz Zaman
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CHAPTER 9 Introduction to Economic Fluctuations slide 1
The model ofaggregate demand and supply
the paradigm that most mainstreameconomists & policymakers use to think
about economic fluctuations and policies
to stabilize the economy
shows how the price level and aggregate
output are determined
shows how the economys behavior isdifferent in the short run and long run
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Aggregate demand
The aggregate demand curve shows therelationship between the price level and the
quantity of output demanded.
This can be understood byY = C + I + G + NX
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CHAPTER 9 Introduction to Economic Fluctuations
Why The AD Curve Slopes
Downward
The Price Level and Consumption: WealthEffect: When prices go down, consumers arewealthier, which stimulates the demand forconsumption goods.
The Price Level and Investment: InterestRate Effect: When interest rate falls, it stimulatesthe demand for investment goods
The Price Level and Net Exports: TheExchange Rate Effect: When currencydepreciates, it stimulates the demand for netexports
slide 3
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CHAPTER 9 Introduction to Economic Fluctuations
AD Curves slopes downward
We use a simple theory of aggregatedemand based on the Quantity Theoryof Money.
slide 4
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The Quantity Equation as Agg. Demand
The quantity equation isMV = PY
For given values of M and V, these
equations imply an inverse relationshipbetween P and Y:
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The downward-sloping ADcurve
An increase in theprice level causesa fall in realmoney balances
(M/P ),causing adecrease in thedemand for goods
& services.Y
P
AD
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Shifting the ADcurve
An increase inthe money
supply shiftstheADcurveto the right.
Y
P
AD1
AD2
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Aggregate Supply in the Long Run
In the long run, output is determined byfactor supplies and technology
,
( )Y F K L
is the full-employmentor naturallevel ofoutput, the level of output at which the
economys resources are fully employed.
Y
Full employment means that
unemployment equals its natural rate.
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Aggregate Supply in the Long Run
In the long run, output is determined byfactor supplies and technology
Full-employment output does not dependon the price level,
so the long run aggregate supply (LRAS)curve is vertical:
,
( )Y F K L
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CHAPTER 9 Introduction to Economic Fluctuations slide 10
The long-run aggregate supply curve
Y
P LRAS
Y
The LRAS curveis vertical at thefull-employmentlevel of output.
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Aggregate Supply in the Short Run
In the real world, many prices are sticky inthe short run.
For now, we assume that all prices are stuckat a predetermined level in the short run
and that firms are willing to sell as muchat that price level as their customers arewilling to buy.
Therefore, the short-run aggregate supply(SRAS) curve is horizontal:
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CHAPTER 9 Introduction to Economic Fluctuations slide 13
The short run aggregate supply curve
Y
P
PSRAS
The SRAS curveis horizontal:
The price levelis fixed at apredeterminedlevel, and firms
sell as much asbuyers demand.
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Short-run effects of an increase in M
Y
P
AD1
AD2
an increasein aggregatedemand
In the short runwhen prices aresticky,
causes outputto rise.
PSRAS
Y2Y1
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CHAPTER 9 Introduction to Economic Fluctuations slide 15
From the shor t run to the long run
Over time, prices gradually become unstuck.
When they do, will they rise or fall?
Y Y
Y Y
Y Y
rise
fall
remain constant
In the short-runequilibrium, if
then over time,the price level will
This adjustment of prices is what moves
the economy to its long-run equilibrium.
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The SR & LR effects of M> 0
Y
P
AD1
AD2
LRAS
Y
PSRAS
P2
Y2
A = initialequilibrium
A BC
B = new short-
run eqmafter Fedincreases M
C = long-runequilibrium
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How shocking !!!
shocks: exogenous changes in aggregatesupply or demand
Shocks temporarily push the economy awayfrom full-employment.
An example of a demand shock:exogenous decrease in velocity
If the money supply is held constant, then a
decrease in V means people will be using theirmoney in fewer transactions, causing adecrease in demand for goods and services:
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LRAS
AD2
PSRAS
The effects of a negative demand shock
Y
P
AD1
Y
P2
Y2
The shock shiftsAD left, causingoutput andemployment to fall
in the short run ABCOver time, pricesfall and the
economy movesdown its demandcurve toward full-employment.
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Supply shocks
A supply shockalters production costs,affects the prices that firms charge.(also called price shocks)
Examples of adversesupply shocks:
Bad weather reduces crop yields, pushing upfood prices.
Workers unionize, negotiate wage increases.
New environmental regulations require firms toreduce emissions. Firms charge higher prices tohelp cover the costs of compliance.
(Favorablesupply shocks lowercosts and prices.)
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Stabilization policy
def: policy actions aimed at reducing theseverity of short-run economic fluctuations.
Example: Using monetary policy to
combat the effects of adverse supplyshocks:
St bili i t t ith
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CHAPTER 9 Introduction to Economic Fluctuations slide 21
Stabilizing output withmonetary policy
1P SRAS1
Y
P
AD1
B2P SRAS2A
Y2
LRAS
Y
The adverse
supply shock
moves the
economy to
point B.
St bili i t t ith
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Stabilizing output withmonetary policy
1P
Y
P
AD1
B2P SRAS2AC
Y2
LRAS
Y
AD2
But the Fedaccommodates
the shock by
raising agg.
demand.
results:
P is permanently
higher, but Yremains at its full-
employment level.
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Chapter summary
1. Long run: prices are flexible, output andemployment are always at their natural
rates, and the classical theory applies.
Short run: prices are sticky, shocks can
push output and employment away fromtheir natural rates.
2.Aggregate demand and supply:
a framework to analyze economicfluctuations
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Chapter summary
3. The aggregate demand curve slopesdownward.
4. The long-run aggregate supply curve is
vertical, because output depends ontechnology and factor supplies, but not
prices.
5. The short-run aggregate supply curve ishorizontal, because prices are sticky at
predetermined levels.
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CHAPTER 9 Introduction to Economic Fluctuations slide 25
Chapter summary
6. Shocks to aggregate demand and supplycause fluctuations in GDP and employmentin the short run.
7. The Fed can attempt to stabilize the
economy with monetary policy.
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