Lecture macroeconomics chapter 4 1 aggregate supply and aggregate demand

Institute of International Education SHORT RUN ECONOMIC FLUCTUATION Institute of International Education 4 1 Aggregate Demand and Aggregate Supply ▪ Economic fluctuations and their characteristics ▪ T[.]

SHORT-RUN ECONOMIC

FLUCTUATION

4.1 Aggregate Demand and

Aggregate Supply

▪ Economic fluctuations and their characteristics

▪ The model of aggregate demand and

aggregate supply

▪ Shifts in the AD curve and AS curve.

Short-Run Economic Fluctuations

and rising unemployment

Recession

Depression Prosperity

Recovery

and fall in production output of goods

Recovery: That's when the economy is

3 Facts About Economic Fluctuations

Fact 1: Economic fluctuations are irregular & unpredictable.

- Recessions are of different durations and do not occur

with any regularity

Fact 2: Most macroeconomic quantities fluctuate together.

Fact 3: As output falls, unemployment rises

- Many variables fluctuate along with GDP: corporate

profits, investment, consumption, stock prices…

- When firms cut back on production, they don’t need as

The Basic Model of Economic Fluctuations

▪ Most economists use the model of

aggregate demand and aggregate supply

to study fluctuations

▪ The model focuses on the behavior of 2 variables:

- The economy’s quantity of output, which can be

measured by real GDP.

- The economy’s price level, which can be measured

by the CPI or the GDP deflator

Model of AS-AD

P

Y

AD

SRAS

P1

Y1

The price level

Real GDP, the

The model

determines the

eq’m price level

and eq’m output

(real GDP).

“Aggregate Demand”

“Short-Run Aggregate Supply”

The Aggregate-Demand (AD) Curve

The AD curve shows the

quantity of all g&s

demanded in the economy

at any given price level.

P

Y

AD

P1

Y

P2

Y

Y = C + I + G + NX

Assume G fixed by

govt policy

➔ Slope of AD depend on C, I, NX

1 The Wealth Effect (P and C)

Suppose P rises and people’s real incomes are

unchanged

▪ The dollars people hold buy fewer g&s, so

consumers feel less wealthy

▪ Consumer will spend less or C falls

➔This decrease in consumer spending means smaller quantities of g&s demanded

2 The Interest-Rate Effect (P and I)

Suppose P rises

▪ Real value of consumers’ money holdings falls

▪ People need more money to make their

purchases → Demand for money  → interest rates  → Firms & household will borrow less

or I falls.

➔ Decreases the quantity of g&s demanded

3 The Exchange-Rate Effect (P and NX)

Suppose P rises

more domestic investments → Higher demand for $ US → $ US appreciates

domestic goods → imports become cheaper →

NX falls.

➔ The decrease in NX spending means a smaller

quantity of g&s demanded