Institute of International Education SHORT RUN ECONOMIC FLUCTUATION Institute of International Education 4 1 Aggregate Demand and Aggregate Supply ▪ Economic fluctuations and their characteristics ▪ T[.]
SHORT-RUN ECONOMIC FLUCTUATION Institute of International Education 4.1 Aggregate Demand and Aggregate Supply ▪ Economic fluctuations and their characteristics ▪ The model of aggregate demand and aggregate supply ▪ Shifts in the AD curve and AS curve Institute of International Education Short-Run Economic Fluctuations ▪ In short run, GDP fluctuates around its trend ▪ Short-run economic fluctuations are called business cycles ▪ Recessions: periods of falling real incomes and rising unemployment ▪ Depressions: severe recessions Recovery Prosperity Depression Recession Institute of International Education Facts About Economic Fluctuations Fact 1: Economic fluctuations are irregular & unpredictable - Recessions are of different durations and not occur with any regularity Fact 2: Most macroeconomic quantities fluctuate together - Many variables fluctuate along with GDP: corporate profits, investment, consumption, stock prices… Fact 3: As output falls, unemployment rises - When firms cut back on production, they don’t need as many workers Institute of International Education The Basic Model of Economic Fluctuations ▪ Most economists use the model of aggregate demand and aggregate supply to study fluctuations ▪ The model focuses on the behavior of variables: - The economy’s quantity of output, which can be measured by real GDP - The economy’s price level, which can be measured by the CPI or the GDP deflator Institute of International Education Model of AS-AD P The price level The model determines the eq’m price level and eq’m output (real GDP) SRAS “Short-Run Aggregate Supply” P1 Y1 AD “Aggregate Demand” Y Real GDP, the quantity of output Institute of International Education The Aggregate-Demand (AD) Curve The AD curve shows the quantity of all g&s demanded in the economy at any given price level P P2 Y = C + I + G + NX Assume G fixed by govt policy P1 AD ➔ Slope of AD depend on C, I, NX Institute of International Education Y2 Y1 Y The Wealth Effect (P and C) Suppose P rises and people’s real incomes are unchanged ▪ The dollars people hold buy fewer g&s, so consumers feel less wealthy ▪ Consumer will spend less or C falls ➔This decrease in consumer spending means smaller quantities of g&s demanded Institute of International Education The Interest-Rate Effect (P and I) Suppose P rises ▪ Real value of consumers’ money holdings falls ▪ People need more money to make their purchases → Demand for money → interest rates → Firms & household will borrow less or I falls ➔ Decreases the quantity of g&s demanded Institute of International Education The Exchange-Rate Effect (P and NX) Suppose P rises ▪ Interest rates rise → Foreign investors desire more domestic investments → Higher demand for $ US → $ US appreciates ▪ Foreign goods become less expensive than domestic goods → imports become cheaper → NX falls ➔ The decrease in NX spending means a smaller quantity of g&s demanded Institute of International Education .. .4. 1 Aggregate Demand and Aggregate Supply ▪ Economic fluctuations and their characteristics ▪ The model of aggregate demand and aggregate supply ▪ Shifts in the AD curve and AS curve... level and eq’m output (real GDP) SRAS “Short-Run Aggregate Supply? ?? P1 Y1 AD ? ?Aggregate Demand? ?? Y Real GDP, the quantity of output Institute of International Education The Aggregate- Demand (AD)... Education The Basic Model of Economic Fluctuations ▪ Most economists use the model of aggregate demand and aggregate supply to study fluctuations ▪ The model focuses on the behavior of variables: -