Aggregate Demand and Aggregate Supply

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Aggregate Demand and Aggregate Supply

Chapter 31

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Short-Run Economic

Fluctuations

year to year.

u 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.

Three Key Facts About

Economic Fluctuations

u Economic fluctuations are irregular and

unpredictable.

u Fluctuations in the economy are often called the

business cycle

u Recessions and Depressions

u Most macroeconomic variables fluctuate

together.

u As output falls, unemployment rises.

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Recessions

(a) Real GDP

Billions of

1992 Dollars

1965 1970 1975 1980 1985 1990 1995

2,500

3,000

3,500

4,000

4,500

5,000

5,500

6,000

6,500

$7,000

Real GDP

A Look At Short-Run Economic Fluctuations

Recessions

(b) Investment Spending

Billions of

1992 Dollars

300

400

500

600

700

800

900

1,000

$1,100

Investment spending

1965 1970 1975 1980 1985 1990 1995

Recessions (c) Unemployment Rate

Unemployment rate

0

2

4

6

8

10

12

1965 1970 1975 1980 1985 1990 1995

Percent of

Labor Force

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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

n Aggregate Output as measured by real

GDP.

The Basic Model of Economic

Fluctuations

u 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.

Aggregate Demand and

Aggregate Supply

Equilibrium output Quantity of Output

Price

Level

0

Equilibrium

price level

Aggregate supply

Aggregate demand

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The Aggregate-Demand Curve

Quantity of Output

Price

Level

0

P1

P2

2 …increases the quantity of goods

and services demanded.

1 A

decrease

in the price

level

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

Why the Aggregate Demand

Curve Might Shift

u Y=C + I + G + NET EXPORTS

u 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.

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Shifts in the Aggregate Demand

Curve

Price

Level

0

Aggregate demand, D1

P1

Y1

D2

Y2

The Aggregate Supply Curve

u 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

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.

u 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.

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The Long-Run

Aggregate-Supply Curve

Quantity of Output Natural rate

of output

Price

Level

0

Long-run aggregate supply

P1

affect the quantity

of goods and services supplied

in the long run.

1 A change

in the price

level…

Why the Long-Run Aggregate

Supply Curve Might Shift

u Shifts arising from Labor

u Shifts arising from Capital

u Shifts arising from Natural Resources

u Shifts arising from Technological

Knowledge

u Any change in the economy that alters the

natural rate of output shifts the long-run

aggregate-supply curve.

The Short-Run Aggregate

Supply Curve

Price

Level

0

Short-run aggregate supply

Y1

P1

Y2

2 reduces the quantity of goods and services supplied in the short run.

P2

1 A decrease

in the price

level

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Why the Short-Run Aggregate

Supply Curve Slopes Upward in the

Short Run

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.

u A decrease in the level of prices tends to reduce

the quantity of goods and services supplied.

u Workers may be fooled as well-Sticky Wage

Theory.

u But Supply always snaps back to the Long run.

The Long-Run Equilibrium

Price

Level

0

Short-run aggregate supply

A Equilibrium

price

Natural rate

of output

1 A decrease in aggregate demand…

AD2

A Contraction in Aggregate Demand

Price

Level

0

Short-run aggregate supply, AS1 Long-run

aggregate

supply

Aggregate demand, AD1

A

P1

Y1

B

P2

Y2

2 …causes output to

AS2

C

P3

3 …but over time, the short-run aggregate-supply curve shifts…

4 …and output returns

to its natural rate.

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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:

u Output falls below the natural rate of

employment.

u Unemployment rises.

u The price level rises.

u Stagflation results!

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

AS2

Short-run aggregate supply, AS1

Price

Level

0

Aggregate demand A

Y1

P1

An Adverse Shift in Aggregate Supply

3 …and the

price level to

rise.

P2

2 …causes output to fall…

B

Y2

Policy Responses to

Recession

u Policymakers may respond to a recession

in one of the following ways:

u Do nothing and wait for prices and wages to

adjust.

u Take action to increase aggregate demand by

using monetary and fiscal policy.

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AS2

1 When short-run aggregate supply falls…

Accommodating an Adverse Shift

in Aggregate Supply

Quantity of Output Natural rate

of output

Price

Level

0

Short-run aggregate supply, AS1

Aggregate demand, AD1

A

P1

P2

P3

3 which

causes the

price level

to rise

4 …but keeps

output at its

natural rate.

C 2 …policymakers can

accommodate the shift

by expanding aggregate demand…

AD2

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