lecture 3a ad as

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Copyright 2004 South-Western

Aggregate Demand

and AggregateSupply


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Short-Run Economic Fluctuations

Economic activity fluctuates from year to year. In most years production of goods and services

rises.

In some years normal growth does not occur,causing a recession.


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Short-Run Economic Fluctuations

A recession is a period of declining real

incomes, and rising unemployment.

A depression is a severe recession.


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THREE KEY FACTS ABOUTECONOMIC 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.


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Most macroeconomic variables fluctuate

together.

Most macroeconomic variables that measure some

type of income or production fluctuate closelytogether.

Although many macroeconomic variables fluctuate

together, they fluctuate by different amounts.


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As output falls, unemployment rises.

Changes in real GDP are inversely related to

changes in the unemployment rate.

During times of recession, unemployment risessubstantially.


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The Basic Model of Economic Fluctuations

The Basic Model of Aggregate Demand and

Aggregate Supply

Economist use the model of aggregate demand and

aggregate supply to explain short-run fluctuationsin economic activity around its long-run trend.





Aggregate Supply

The aggregate-demand curve shows the quantity of

goods and services that households, firms, and thegovernment want to buy at each price level.





Aggregate Supply

The aggregate-supply curve shows the quantity of

goods and services that firms choose to produce andsell at each price level.


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Aggregate Demand and Aggregate Supply...

Quantity of

Output

Price

Level

0

Aggregate

supply

Aggregate

demand

Equilibrium

output

Equilibrium

price level




THE AGGREGATE-DEMANDCURVE

The four components of GDP (Y) contribute to

the aggregate demand for goods and services.

Y = C + I + G + NX


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Figure The Aggregate-Demand Curve...

Quantity of

Output

Price

Level

0

Aggregate

demand

P

Y Y2

P2

1. A decrease

in the price

level . . .

2. . . . increases the quantity of

goods and services demanded.




Why the Aggregate-Demand Curve IsDownward Sloping

The Price Level and Consumption: The Wealth

Effect

The Price Level and Investment: The Interest

Rate Effect

The Price Level and Net Exports: The

Exchange-Rate Effect




The Price Level and Consumption: The Wealth

Effect

A decrease in the price level makes consumers feel

more wealthy (real income increases), which in turnencourages them to spend more.

This increase in consumer spending means larger

quantities of goods and services demanded.




The Price Level and Investment: The InterestRate Effect

A lower price level reduces the interest rate

(because lower P means consumers need lesscurrency to buy things, so they keep more currency

in banks, more money in banks means they charge

less interest rate as they have large quantity with

them which they can lend) , which encouragesgreater spending on investment goods.

This increase in investment spending means a larger

quantity of goods and services demanded.




The Price Level and Net Exports: TheExchange-Rate Effect

When a fall in the India's price level causes India's

interest rates to fall, Indian rupees flow to countrywhere interest is higher (say USA) , demand for

dollars increase, the real exchange rate depreciates,

which stimulates India's net exports.

The increase in net export spending means a larger

quantity of goods and services demanded.



Why the Aggregate-Demand Curve MightShift

The downward slope of the aggregate demandcurve shows that a fall in the price level raises

the overall quantity of goods and services

demanded. Many other factors, however, affect the quantity

of goods and services demanded at any given

price level. When one of these other factors changes, the

aggregate demand curve shifts.



Why the Aggregate-Demand Curve MightShift

Shifts arising from

Consumption

Investment

Government Purchases

Net Exports



Shifts in the Aggregate DemandCurve

Quantity ofOutput

PriceLevel

0

Aggregatedemand, D1

P1

Y1

D2

Y2



THE AGGREGATE-SUPPLYCURVE

In the long run, the aggregate-supply curve isvertical.

In the short run, the aggregate-supply curve is

upward sloping.




The Long-Run Aggregate-Supply Curve

In the long run, an economys production of goods

and services depends on its supplies of labor,

capital, and natural resources and on the availabletechnology used to turn these factors of production

into goods and services.

The price level does not affect these variables in the

long run.


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Figure The Long-Run Aggregate-Supply Curve

Quantity of

Output

Natural rate

of output

Price

Level

0

Long-run

aggregate

supply

P2

1. A change

in the price

level . . .

2. . . . does not affect

the quantity of goodsand services supplied

in the long run.

P





The Long-Run Aggregate-Supply Curve

The long-run aggregate-supply curve is vertical at

the natural rate of output.

This level of production is also referred to aspotential output or full-employment output.


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Why the Long-Run Aggregate-Supply CurveMight Shift

Any change in the economy that alters thenatural rate of output shifts the long-run

aggregate-supply curve.

The shifts may be categorized according to thevarious factors in the classical model that affect

output.


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Why the Long-Run Aggregate-Supply CurveMight Shift

Shifts arising

Labor

Capital

Natural Resources

Technological Knowledge


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Figure Long-Run Growth and Inflation

Quantity of

OutputY1980

AD1980

AD1990

Aggregate

Demand,AD2000

Price

Level

0

Long-run

aggregate

supply,LRAS1980

Y1990

LRAS1990

Y2000

LRAS2000

P1980

1. In the long run,

technological

progress shiftslong-run aggregate

supply . . .4. . . . and

ongoing inflation.

3. . . . leading to growth

in output . . .

P1990

P2000

2. . . . and growth in the

money supply shifts

aggregate demand . . .



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Why the Aggregate-Supply Curve SlopesUpward in the Short Run

In the short run, an increase in the overall levelof prices in the economy tends to raise the

quantity of goods and services supplied.

A decrease in the level of prices tends to reducethe quantity of goods and services supplied.


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Figure The Short-Run Aggregate-Supply Curve

Quantity of

Output

PriceLevel

0

Short-run

aggregate

supply

1. A decrease

in the price

level . . .

2. . . . reduces the quantity

of goods and services

supplied in the short run.

Y

P

Y2

P2



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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 in the pricelevel.

A lower price level makes employment and production

less profitable.

This induces firms to reduce the quantity of goods andservices supplied.


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The Sticky-Price Theory

Prices of some goods and services adjust sluggishlyin 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 Short-Run Aggregate-Supply CurveMight Shift

Shifts arising

Labor

Capital

Natural Resources.

Technology.

Expected Price Level.


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Why the Aggregate Supply Curve Might Shift

An increase in the expected price level reducesthe quantity of goods and services supplied and

shifts the short-run aggregate supply 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 tothe right.

Fi Th L R E ilib i


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Figure The Long-Run Equilibrium

Natural rate

of output

Quantity of

Output

Price

Level

0

Short-run

aggregate

supply

Long-run

aggregate

supply

Aggregate

demand

AEquilibrium

price


Fi C t ti i A t D d


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Figure Contraction in Aggregate Demand

Quantity of

Output

PriceLevel

0

Short-run aggregate

supply,AS

Long-run

aggregate

supply

Aggregate

demand,AD

AP

Y

AD2

AS2

1. A decrease in

aggregate demand . . .

2. . . . causes output to fall in the short run . . .

3. . . . but over

time, the short-run

aggregate-supply

curve shifts . . .

4. . . . and output returns

to its natural rate.

CP3

BP2

Y2

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