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 3 percent per year. u In some years normal growth does not occur, causing a recession. u
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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
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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
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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
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A Look At Short-Run Economic Fluctuations Percent of Labor Force 12
(c) Unemployment Rate Recessions
10 Unemployment rate
8 6 4 2 0 1965
1970
1975
1980
1985
1990
1995
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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
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Aggregate Demand and Aggregate Supply... Price Level Aggregate supply
Equilibrium price level Aggregate demand 0
Equilibrium output
Quantity of Output
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The Aggregate-Demand Curve... Price Level
P1 1. A decrease in the price level...
P2 Aggregate demand 0
Y1
Y2
2. …increases the quantity of goods and services demanded.
Quantity of Output
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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
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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
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Shifts in the Aggregate Demand Curve... Price Level
P1
D2 Aggregate demand, D1 0
Y1
Y2
Quantity of Output
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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
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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
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The Long-Run AggregateSupply Curve... Price Level Long-run aggregate supply
P1
2. …does not affect the quantity of goods and services supplied in the long run.
P2 1. A change in the price level… 0
Natural rate of output
Quantity of Output
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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.
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The Short-Run Aggregate Supply Curve... Price Level Short-run aggregate supply
P1 1. A decrease in the price level
P2
0
2. reduces the quantity of goods and services supplied in the short run.
Y2
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Y1
Quantity of Output
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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.
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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
0
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A Contraction in Aggregate Demand... Price Level
2. …causes output to fall in the short run… Long-run aggregate supply
Short-run aggregate supply, AS 1
AS2 3. …but over time, the short-run aggregate-supply curve shifts…
A
P1 B
P2 P3
1. A decrease in aggregate demand…
C
AD2 0
Y2
Y1
Aggregate demand, AD 1
4. …and output returns to its natural rate.
Quantity of Output
7
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
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An Adverse Shift in Aggregate Supply... Price Level
1. An adverse shift in the short-run aggregate-supply curve…
Long-run aggregate supply
AS2
Short-run aggregate supply, AS 1
B
P2
A
P1 3. …and the price level to rise.
Aggregate demand
0
Y2
Y1
2. …causes output to fall…
Quantity of Output
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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
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Accommodating an Adverse Shift in Aggregate Supply... Price Level
1. When short-run aggregate supply falls… Long-run aggregate AS 2 supply
P3
C
P2
A
P1 3....which causes the price level to rise
4. …but keeps output at its natural rate. 0
Natural rate of output
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Short-run aggregate supply, AS1
2. …policymakers can accommodate the shift by expanding aggregate demand…
AD2 Aggregate demand, AD 1
Quantity of Output
9
