15 Aggregate Demand and Aggregate Supply
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.
A recession
is a period of declining real incomes, and rising unemployment.
A depression
is a severe recession.
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.
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.
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.
How the Short Run Differs from the Long Run
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.
The assumption of monetary
neutrality is not appropriate when studying year-to-year changes in the
economy.
The Basic Model of Economic Fluctuations
Two variables are used to develop a model to analyze the short-run
fluctuations.
The economy’s output of goods and services measured by real GDP.
The overall price level measured by the CPI or the GDP deflator.
The Basic 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.
he Basic 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 Basic Model of Aggregate Demand and Aggregate Supply
The aggregate-supply curve shows
the quantity of goods and services that firms choose to produce and sell at
each price level.
Figure 2 Aggregate Demand and Aggregate Supply...
THE AGGREGATE-DEMAND CURVE
The four components of GDP (Y) contribute to the aggregate demand for goods and services.
Y = C + I + G + NX
Figure 3 The Aggregate-Demand Curve...
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
The Price Level and Consumption:
The Wealth Effect
A decrease in the price level makes consumers feel more wealthy, which in
turn encourages them to spend more.
This increase in consumer spending means larger quantities of goods and
services demanded.
The Price Level and Investment: The Interest Rate Effect
A lower price level reduces the interest rate, which encourages greater
spending on investment goods.
This increase in investment spending means a larger quantity of goods and
services demanded.
The Price Level and Net Exports:
The Exchange-Rate Effect
When a fall in the U.S. price level causes U.S. interest rates to fall, the
real exchange rate depreciates, which stimulates U.S. net exports.
The increase in net export spending means a larger quantity of goods and
services demanded.
Why the Aggregate-Demand Curve Might Shift
The downward slope of the aggregate demand curve 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.
Shifts arising from
Consumption
Investment
Government Purchases
Net Exports
Shifts in the Aggregate Demand Curve
THE AGGREGATE-SUPPLY CURVE
In the long run, the aggregate-supply curve is vertical.
In the short run, the aggregate-supply curve is upward sloping.
The Long-Run 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.
Figure 4 The Long-Run Aggregate-Supply Curve
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 as potential output or
full-employment output.
Why the Long-Run Aggregate-Supply Curve Might Shift
Any change in the economy that alters the natural rate of output shifts the
long-run aggregate-supply curve.
The shifts may be categorized according to the various factors in the
classical model that affect output.
Shifts arising
Labor
Capital
Natural Resources
Technological Knowledge
Figure 5 Long-Run Growth and Inflation
A New Way to Depict Long-Run Growth and Inflation
Short-run fluctuations in output and price level should be viewed as
deviations from the continuing long-run trends.
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.
Figure 6 The Short-Run Aggregate-Supply Curve
The Misperceptions Theory
The Sticky-Wage Theory
The Sticky-Price Theory
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.
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 price level.
A lower price level makes
employment and production less profitable.
This induces firms to reduce the
quantity of goods and services supplied.
The Sticky-Price Theory
Prices of some goods and services adjust sluggishly in 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.
Why the Short-Run Aggregate-Supply Curve Might Shift
Shifts arising
Labor
Capital
Natural Resources.
Technology.
Expected Price Level.
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 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 to the right.
Figure 7 The Long-Run Equilibrium
Figure 8 A Contraction in Aggregate Demand
TWO CAUSES OF ECONOMIC FLUCTUATIONS
Shifts in Aggregate Demand
In the short run, shifts in aggregate demand cause fluctuations in the
economy’s output of goods and services.
In the long run, shifts in aggregate demand affect the overall price level
but do not affect output.
An Adverse Shift in Aggregate Supply
A decrease in one of the determinants of aggregate supply shifts the curve
to the left:
Output falls below the natural
rate of employment.
Unemployment rises.
The price level rises.
Figure 10 An Adverse Shift in
Aggregate Supply
The Effects of a Shift in Aggregate Supply
Stagflation
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.
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
Summary
All societies experience short-run economic fluctuations around long-run
trends.
These fluctuations are irregular and largely unpredictable.
When recessions occur, real GDP and other measures of income, spending, and
production fall, and unemployment rises.
Economists analyze short-run 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.
The aggregate-demand curve slopes downward for three reasons: a wealth effect, an interest rate effect,
and an exchange rate effect.
Any event or policy that changes consumption, investment, government
purchases, or net exports at a given price level will shift the
aggregate-demand curve.
In the long run, the aggregate supply curve is vertical.
The short-run, the aggregate supply curve is upward sloping.
The are three theories explaining the upward slope of short-run aggregate
supply: the misperceptions theory, the
sticky-wage theory, and the sticky-price theory.
Events that alter the economy’s ability to produce output will shift the
short-run aggregate-supply curve.
Also, the position of the short-run aggregate-supply curve depends on the
expected price level.
One possible cause of economic fluctuations is a shift in aggregate demand.
A second possible cause of economic fluctuations is a shift in aggregate
supply.
Stagflation is a period of falling output and rising prices.