Why is this good?• Breaking News Alert

The New York TimesTuesday, March 13, 2012 -- 4:08 PM EDT-----

Stocks Rally Strongly, With Nasdaq Above 3,000

Stocks climbed to new heights in part on rosy retail sales data on Tuesday, pushing the broad market to levels last seen in June 2008 and the Nasdaq composite index past the 3,000 milestone for the first time since 2000.

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What causes short run changes in the business cycle?

The Model of Aggregate Demand and Aggregate Supply

• Economist use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.

Time

Economic activity

Business cycle

http://www.youtube.com/watch?v=hTWPrWmPJS0

The Model of Aggregate Demand and Aggregate Supply

• The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level.

• The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.

Sum each definition in six words or less!!!

Figure 2 Aggregate Demand and Aggregate Supply...

Quantity ofOutput

PriceLevel

0

Aggregatesupply

Aggregatedemand

Equilibriumoutput

Equilibriumprice level

How do we measure price level?

PPICPIPrice Deflator

Figure 3 The Aggregate-Demand Curve...

Quantity ofOutput

PriceLevel

0

Aggregatedemand

P

Y Y2

P2

1. A decreasein the pricelevel . . .

2. . . . increases the quantity ofgoods and services demanded.

WHY???

Why the Aggregate-Demand Curve Is Downward 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

Why the Aggregate-Demand Curve Is Downward Sloping

• The Price Level and Consumption: – The Wealth Effect• A lower price level raises the real value of money and

makes consumers wealthier, which encourages them to spend more. • This increase in consumer spending means larger

quantities of goods and services demanded.

Why the Aggregate-Demand Curve Is Downward Sloping

• The Price Level and Investment: – The Interest Rate Effect• A lower price level reduces the interest rate and makes

borrowing less expensive, which encourages greater spending on investment goods.• This increase in investment spending means a larger

quantity of goods and services demanded.

Why the Aggregate-Demand Curve Is Downward Sloping

• The Price Level and Net Exports: – The Exchange-Rate Effect• A lower price level in the U.S. causes U.S. interest rates

to fall and the real exchange rate to depreciate, which stimulates U.S. net exports.• The increase in net export spending means a larger

quantity of goods and services demanded.

Aggregate Demand can either increase or decrease dependingon which variables shift the aggregate demand curve.

An increase in aggregate demand is always a shift to the right

A decrease in aggregate demand is always a shift to the left.

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PL

Q=Real GDP=Y

Variables that influence the components-

Consumption

People’s preferences/tastes

Change in interest rates

Expectations of the future

Relative prices of products/services

Change in income

Investment

People’s preferences/tastes

Number of consumers

Change in Inventories

Expectations of the future profit

Change in Interest rates

Gross Private Domestic Business Investment

Variables that influence the components-

Change in income

Government Spending

Dum Politiciansb

Variables that influence the components-

(X - M)

Exports Imports Relative price of foreign goods/services

Relative quality of foreign goods/services

International value of the dollar

Interest rates

Variables that influence the components-

Savings

People’s preferences/tastes

Change in Interest ratesExpectations of the future

Relative prices of products/services

Variables that influence the components-

Change in income

Demand Shifts - Summary

1. Federal government increases personal income tax rates

2. Federal Reserve implements “tight” monetary policy

3. News media runs several stories showing economy in positive light

4. U.S. currency exchange rate depreciates against the Yuan (Chinese currency).

5. People increase savings rates6. Construction of new housing increases

PL

Q = Real GDP = Y

Keynesian Range

Intermediate Range

ClassicalRange

Full Employment

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http://logic.csc.cuhk.edu.hk/~b024765/keynes.jpg

http://logic.csc.cuhk.edu.hk/~b024765/say.jpg

http://logic.csc.cuhk.edu.hk/~b024765/ricardo.jpg

COVER BY JOHN HELD JR.

As

http://www.nytimes.com/learning/general/onthisday/bday/0605.html

http://www.sntc.org.sz/sdphotos/1880s.html

PL

Q = Real GDP = Y

Keynesian Range

Intermediate Range

ClassicalRange

Full Employment

As

StructuralFrictionalCyclicalUnemployment

THE AGGREGATE-SUPPLY CURVE

• In the long run, the aggregate-supply curve is vertical because the price level does not affect long run determinants of real GDP.

• In the short run, the aggregate-supply curve is upward sloping.

THE AGGREGATE-SUPPLY CURVE

• In the long run, an economy’s production of goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services.

• The price level does not affect these variables in the long run.

• The long-run aggregate supply represents the classical dichotomy and money neutrality.

Figure 4 The Long-Run Aggregate-Supply Curve

Quantity ofOutput

Natural rateof output

PriceLevel

0

Long-runaggregate

supply

P2

1. A changein the pricelevel . . .

2. . . . does not affect the quantity of goods and services supplied

in the long run.

P

Why the Long-Run Aggregate-Supply Curve Might Shift

• Shifts might arise from changes in: – Labor– Capital– Natural Resources– Technological Knowledge

Figure 5 Long-Run Growth and Inflation

Quantity ofOutput

Y 1980

AD 1980

AD1990

Aggregate Demand, AD2000

PriceLevel

0

Long-runaggregate

supply,LRAS 1980

Y1990

LRAS 1990

Y 2000

LRAS 2000

P1980

1. In the long run,technological progress shifts long-run aggregate supply . . .

4. . . . andongoing inflation.

3. . . . leading to growthin output . . .

P1990

P2000

2. . . . and growth in the money supply shifts aggregate demand . . .

Why the Aggregate-Supply Curve Slopes Upward in the Short Run

• 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.

• As a result, the short-run aggregate-supply curve is upward sloping.

Figure 6 The Short-Run Aggregate-Supply Curve

Quantity ofOutput

PriceLevel

0

Short-runaggregate

supply

1. A decreasein the pricelevel . . .

2. . . . reduces the quantityof goods and servicessupplied in the short run.

Y

P

Y2

P2

Why the Aggregate-Supply Curve Slopes Upward in the Short Run

• Three Theories:– The Sticky-Wage Theory– The Sticky-Price Theory– The Misperceptions Theory

Why the Aggregate-Supply Curve Slopes Upward in the Short Run

• The Sticky-Wage Theory– Nominal wages are slow to adjust to changing

economic conditions, or are “sticky” in the short run

Why the Aggregate-Supply Curve Slopes Upward in the Short Run

• The Sticky-Price Theory– An unexpected fall in the price level leaves some

firms with higher-than-desired prices. For a variety of reasons, they may not want to or be able to change prices immediately.

Why the Aggregate-Supply Curve Slopes Upward in the Short Run

• 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.

Why the Short-Run Aggregate-Supply Curve Might Shift

• Shifts might arise from changes in: – Expected Price Level.– Labor.– Capital.– Natural Resources.– Technology.

COSTS!!!!

Figure 7 The Long-Run Equilibrium

Natural rateof output

Quantity ofOutput

PriceLevel

0

Short-runaggregate

supply

Long-runaggregate

supply

Aggregatedemand

AEquilibriumprice

TWO CAUSES OF ECONOMIC FLUCTUATIONS

• Four steps in the process of analyzing economic fluctuations:1. Determine whether the event affects aggregate

supply or aggregate demand.2. Decide which direction the curve shifts.3. Use a diagram to compare the initial and the

new equilibrium.4. Keep track of the short and long run equilibrium,

and the transition between them.

Figure 8 A Contraction in Aggregate Demand

Quantity ofOutput

PriceLevel

0

Short-run aggregatesupply, AS

Long-runaggregate

supply

Aggregatedemand, AD

AP

Y

AD2

AS2

1. A decrease inaggregate demand . . .

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

3. . . . but over time, the short-runaggregate-supplycurve shifts . . .

4. . . . and output returnsto its natural rate.

CP3

BP2

Y2

Figure 10 An Adverse Shift in Aggregate Supply

Quantity ofOutput

PriceLevel

0

Aggregate demand

3. . . . and the price level to rise.

2. . . . causes output to fall . . .

1. An adverse shift in the short-run aggregate-supply curve . . .

Short-runaggregate

supply, AS

Long-runaggregate

supply

Y

AP

AS2

B

Y2

P2

The Effects of a Shift in Aggregate Supply

• Adverse shifts in aggregate supply cause stagflation—a period of recession and inflation.

• Output falls and prices rise.• Policymakers who can influence aggregate

demand cannot offset both of these adverse effects simultaneously.

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.

Figure 11 Accommodating an Adverse Shift in Aggregate Supply

Quantity ofOutput

Natural rateof output

PriceLevel

0

Short-runaggregate

supply, AS

Long-runaggregate

supply

Aggregate demand, AD

P2

AP

AS2

3. . . . whichcauses theprice level to rise further . . .

4. . . . but keeps outputat its natural rate.

2. . . . policymakers canaccommodate the shiftby expanding aggregate

demand . . .

1. When short-run aggregatesupply falls . . .

AD2

CP3