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This chapter introduces the model’s two key pieces—the aggregate-demand curve and the aggregatesupply curve. After getting a sense of the overall structure of the model in this chapter, we examine the pieces of the model in more detail in the next two chapters.
12 SHORT-RUN ECONOMIC FLUCTUATIONS Aggregate Demand and Aggregate Supply Copyright © 2004 South-Western 33 Short-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. Copyright © 2004 South-Western Short-Run Economic Fluctuations • A recession is a period of declining real incomes, and rising unemployment • A depression is a severe recession Copyright © 2004 South-Western THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS • Economic fluctuations are irregular and unpredictable • Fluctuations in the economy are often called the business cycle • Most macroeconomic variables fluctuate together • As output falls, unemployment rises Copyright © 2004 South-Western Figure A Look At Short-Run Economic Fluctuations (a) Real GDP Billions of 1996 Dollars $10,000 9,000 Real GDP 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1965 1970 1975 1980 1985 1990 1995 2000 Copyright © 2004 South-Western THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS • Most macroeconomic variables fluctuate together • Most macroeconomic variables that measure some type of income or production fluctuate closely together. • Although many macroeconomic variables fluctuate together, they fluctuate by different amounts Copyright © 2004 South-Western Figure A Look At Short-Run Economic Fluctuations (b) Investment Spending Billions of 1996 Dollars $1,800 1,600 1,400 Investment spending 1,200 1,000 800 600 400 200 1965 1970 1975 1980 1985 1990 1995 2000 Copyright © 2004 South-Western THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS • As output falls, unemployment rises • Changes in real GDP are inversely related to changes in the unemployment rate • During times of recession, unemployment rises substantially Copyright © 2004 South-Western Figure A Look At Short-Run Economic Fluctuations (c) Unemployment Rate Percent of Labor Force 12 10 Unemployment rate 1965 1970 1975 1980 1985 1990 1995 2000 Copyright © 2004 South-Western 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 shortrun aggregate supply curve to the left • A decrease in the expected price level raises the quantity of goods and services supplied and shifts the shortrun aggregate supply curve to the right Copyright © 2004 South-Western Figure The Long-Run Equilibrium Price Level Long-run aggregate supply Short-run aggregate supply A Equilibrium price Aggregate demand Natural rate of output Quantity of Output Copyright © 2004 South-Western Figure A Contraction in Aggregate Demand causes output to fall in the short run Price Level Long-run aggregate supply Short-run aggregate supply, AS AS2 but over time, the short-run aggregate-supply curve shifts A P B P2 P3 A decrease in aggregate demand C Aggregate demand, AD AD2 Y2 Y and output returns to its natural rate Quantity of Output Copyright â 2004 South-Western TWO CAUSES OF ECONOMIC FLUCTUATIONS ShiftsinAggregateDemand Intheshortrun,shiftsinaggregatedemandcause fluctuationsintheeconomysoutputofgoodsand services Inthelongrun,shiftsinaggregatedemandaffect theoverallpricelevelbutdonotaffectoutput Copyright â 2004 South-Western TWO CAUSES OF ECONOMIC FLUCTUATIONS • An Adverse Shift in Aggregate Supply • Adecreaseinoneofthedeterminantsofaggregate supplyshiftsthecurvetotheleft: Outputfallsbelowthenaturalrateofemployment Unemploymentrises Thepricelevelrises Copyright â 2004 South-Western Figure 10 An Adverse Shift in Aggregate Supply An adverse shift in the shortrun aggregate-supply curve Price Level Long-run aggregate supply AS2 Short-run aggregate supply, AS B P2 A P and the price level to rise Aggregate demand Y2 causes output to fall Y Quantity of Output Copyright © 2004 South-Western The Effects of a Shift in Aggregate Supply • Stagflation • Adverse shifts in aggregate supply cause stagflation aperiodofrecessionandinflation Outputfallsandpricesrise Policymakerswhocaninfluenceaggregatedemand cannotoffsetbothoftheseadverseeffects simultaneously Copyright â 2004 South-Western The Effects of a Shift in Aggregate Supply • Policy Responses to Recession • Policymakers may respond to a recession 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 Copyright © 2004 South-Western Figure 11 Accommodating an Adverse Shift in Aggregate Supply When short-run aggregate supply falls Price Level Long-run aggregate supply P3 C P2 which P causes the price level to rise further A but keeps output at its natural rate Natural rate of output Short-run aggregate supply, AS AS2 policymakers can accommodate the shift by expanding aggregate demand AD2 Aggregate demand, AD Quantity of Output Copyright â 2004 South-Western Summary Allsocietiesexperienceshortưruneconomic fluctuationsaroundlongưruntrends. Thesefluctuationsareirregularandlargely unpredictable Whenrecessionsoccur,realGDPandother measuresofincome,spending,andproduction fall,andunemploymentrises Copyright â 2004 South-Western Summary • Economists analyze shortrun 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 aggregate demand and aggregate supply Copyright â 2004 South-Western Summary Theaggregateưdemandcurveslopesdownward forthreereasons:awealtheffect,aninterest rateeffect,andanexchangerateeffect Anyeventorpolicythatchangesconsumption, investment,governmentpurchases,ornet exportsatagivenpricelevelwillshiftthe aggregateưdemandcurve Copyright â 2004 South-Western Summary In the long run, the aggregate supply curve is vertical • The shortrun, the aggregate supply curve is upward sloping. • The are three theories explaining the upward slope of shortrun aggregate supply: the misperceptions theory, the stickywage theory, and the stickyprice theory Copyright â 2004 South-Western Summary Eventsthataltertheeconomysabilityto produceoutputwillshifttheshortưrun aggregateưsupplycurve Also,thepositionoftheshortưrunaggregateư supplycurvedependsontheexpectedprice level Onepossiblecauseofeconomicfluctuationsis ashiftinaggregatedemand Copyright â 2004 South-Western Summary Asecondpossiblecauseofeconomic fluctuationsisashiftinaggregatesupply Stagflationisaperiodoffallingoutputand risingprices Copyright â 2004 South-Western ... © 2004 South-Western The Basic Model of Economic Fluctuations • The Basic Model of Aggregate Demand and Aggregate Supply • The aggregate demand curve shows the quantity of goods and services that households, firms, and the ... level Aggregate demand Equilibrium output Quantity of Output Copyright © 2004 South-Western THE AGGREGATE- DEMAND CURVE ThefourcomponentsofGDP(Y)contributeto theaggregatedemandforgoodsandservices... South-Western Figure The Aggregate- Demand Curve Price Level P P2 A decrease in the price level Aggregate demand Y Y2 Quantity of Output increases the quantity of goods and services demanded