Aggregate Demand and Aggregate Supply

Aggregate Demand and 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 Short-Run Economic Fluctuations u Economic activity fluctuates from year to year In most years production of goods and services rises u On average over the past 50 years, production in the U.S economy has grown by about percent per year u In some years normal growth does not occur, causing a recession u Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Three Key Facts About Economic Fluctuations u Economic fluctuations are irregular and unpredictable u u Fluctuations in the economy are often called the business cycle Recessions and Depressions Most macroeconomic variables fluctuate together u As output falls, unemployment rises u Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc A Look At Short-Run Economic Fluctuations (a) Real GDP Billions of 1992 Dollars $7,000 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 Recessions Real GDP 1965 1970 1975 1980 1985 1990 1995 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc A Look At Short-Run Economic Fluctuations (b) Investment Spending Billions of 1992 Dollars $1,100 1,000 900 800 700 600 500 Recessions Investment spending 400 3001965 1970 1975 1980 1985 1990 1995 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc A Look At Short-Run Economic Fluctuations Percent of Labor Force 12 (c) Unemployment Rate Recessions 10 Unemployment rate 1965 1970 1975 1980 1985 1990 1995 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Basic Model of Economic Fluctuations Economists use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend n Price level as measured by the CPI nAggregate Output as measured by real GDP Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Basic Model of Economic Fluctuations The aggregate demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level u The aggregate supply curve shows the quantity of goods and services that firms produce and sell at each price level u Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Aggregate Demand and Aggregate Supply Price Level Aggregate supply Equilibrium price level Aggregate demand Equilibrium output Quantity of Output Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Aggregate-Demand Curve Price Level P1 A decrease in the price level P2 Aggregate demand Y1 Y2 …increases the quantity of goods and services demanded Quantity of Output Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Why the Aggregate Demand Curve Is Downward Sloping u The Price Level and Consumption: The Wealth Effect u The Price Level and Investment: The Interest Rate Effect u The Price Level and Net Exports: The Exchange-Rate Effect Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Why the Aggregate Demand Curve Might Shift Y=C + I + G + NET EXPORTS Shifts arising from Consumption u Shifts arising from Investment u Shifts arising from Government Purchases u Shifts arising from Net Exports u Changes in the price level cause a movement along the Aggregate Demand Curve u u Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Shifts in the Aggregate Demand Curve Price Level P1 D2 Aggregate demand, D1 Y1 Y2 Quantity of Output Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Aggregate Supply Curve The aggregate supply curve shows the level of production at each price level u In the long run, the aggregate-supply curve is vertical u In the short run, the aggregate-supply curve is upward sloping u Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc How the Short Run Differs From the Long Run u Most 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 u The assumption of monetary neutrality is not appropriate when studying year-to-year changes in the economy u Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Long-Run AggregateSupply Curve Price Level Long-run aggregate supply P1 …does not affect the quantity of goods and services supplied in the long run P2 A change in the price level… Natural rate of output Quantity of Output Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Why the Long-Run Aggregate Supply Curve Might Shift u u u u u Shifts arising from Labor Shifts arising from Capital Shifts arising from Natural Resources Shifts arising from Technological Knowledge Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Short-Run Aggregate Supply Curve Price Level Short-run aggregate supply P1 A decrease in the price level P2 reduces the quantity of goods and services supplied in the short run Y2 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Y1 Quantity of Output Why the Short-Run Aggregate Supply Curve Slopes Upward in the Short Run u u u u 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 Workers may be fooled as well-Sticky Wage Theory But Supply always snaps back to the Long run Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Long-Run Equilibrium Price Level Short-run aggregate supply Long-run aggregate supply Equilibrium price A Aggregate demand Quantity of Output Natural rate of output Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc A Contraction in Aggregate Demand Price Level …causes output to fall in the short run… Long-run aggregate supply Short-run aggregate supply, AS AS2 …but over time, the short-run aggregate-supply curve shifts… A P1 B P2 P3 A decrease in aggregate demand… C AD2 Y2 Y1 Aggregate demand, AD …and output returns to its natural rate Quantity of Output An Adverse Shift in Short Run Aggregate Supply u A decrease in one of the determinants of aggregate supply shifts the curve to the left: Output falls below the natural rate of employment u Unemployment rises u The price level rises u Stagflation results! u Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc An Adverse Shift in Aggregate Supply Price Level An adverse shift in the short-run aggregate-supply curve… Long-run aggregate supply AS2 Short-run aggregate supply, AS B P2 A P1 …and the price level to rise Aggregate demand Y2 Y1 …causes output to fall… Quantity of Output Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Policy Responses to Recession u Policymakers may respond to a recession in one of the following ways: Do nothing and wait for prices and wages to adjust u Take action to increase aggregate demand by using monetary and fiscal policy u Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Accommodating an Adverse Shift in Aggregate Supply Price Level When short-run aggregate supply falls… Long-run aggregate AS supply P3 C P2 A P1 which causes the price level to rise …but keeps output at its natural rate Natural rate of output Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Short-run aggregate supply, AS1 …policymakers can accommodate the shift by expanding aggregate demand… AD2 Aggregate demand, AD Quantity of Output