2Aggregate Demand and Aggregate Supply 15Aggregate Demand and Aggregate Supply
3Short-Run Economic Fluctuations What causes short-run fluctuations in economic activity?What, if anything, can the government do to stop GDP from falling and unemployment from rising?And if the government can’t stop the occurrence of bad times, can it at least make them less damaging in terms of duration and severity?
4Short-Run Economic Fluctuations Economic activity fluctuates from year to year.Real GDP increases in most years.On average over the past 50 years, real GDP in the U.S. economy has grown by about 3.2 percent per year—see chapter 10Real GDP per person has grown at the rate of about 2 percent per year—see chapter 12In some years normal growth does not occur, causing a recession.
5Short-Run Economic Fluctuations A recession is a period of declining real incomes, and rising unemployment.A depression is a severe recession.An expansion is a period of increasing real incomes, and falling unemployment.
7THREE 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.
8Three Key Facts About Economic Fluctuations Fact 1: Economic fluctuations are irregular and unpredictableSource: downloaded on Nov. 29, 2011.
9Economic fluctuations are irregular and unpredictable Recessions start at the peak of a business cycle and end at the trough.The length of a business cycle may be measured by the time between one peak and the next or the time between one trough and the next.The peaks and troughs of the US business cycle are officially registered by the NBER.During , there have been 11 cycles in the US.The average recession lasted 11 months and the average expansion lasted 59 months, thereby making the average cycle roughly 70 months long.
10THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS Fact 2: Most macroeconomic variables fluctuate together.When real GDP falls in a recession, so do many other variables:personal income, corporate profits, consumption spending, investment spending, industrial production, retail sales, home sales, auto sales, etc.However, investment fluctuates a lot more than other variables.Even though investment is about one-seventh of GDP, much of the fall in GDP during recessions is due to the fall in investment spending.
11Three Key Facts About Economic Fluctuations Fact 2: Most macroeconomic variables fluctuate together -- business investment is especially volatileDownloaded from on November 29, 2011.
12THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS Fact 3: As output falls, unemployment rises.The unemployment rate never approaches zero; instead it fluctuates around its natural rate of about 5 percent.
13Three Key Facts About Economic Fluctuations Fact 3: As Output Falls, Unemployment RisesDownloaded from on November 29, 2011.
15Recap: long-run theory Chapter 7: GDP depends onnumber of workersphysical capital per workerhuman capital per workernatural resources per workertechnological knowledgelaws, government policies, and their enforcementChapter 8: saving, investment, and the real interest rate depend on the supply and demand for loanable fundsChapter 10: unemployment depends onhow well the labor market matches unemployed workers to job vacancies, andhow close the wage is to the equilibrium wageChapter 12: the price level depends on the quantity of money, and the rate of inflation depends on the growth rate of the quantity of moneyThe factors that affect the real interest rate (Ch. 8) and the inflation rate (Ch. 12) together determine the nominal interest rate
16EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS Most economists believe that the long run theory we’ve studied in previous chapters does not explain short run fluctuationsin the long run, changes in the money supply affect nominal variables but not real variables.This is monetary neutrality; see chapter 12.But monetary neutrality is not true in the short run
17Aggregate Demand and Aggregate Supply Economists use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.
18Aggregate Demand and Aggregate Supply Real GDP (Y)Ch. 5 Measuring a Nation’s IncomeThe Price Level (P)GDP DeflatorCh. 5The CPICh 6 Measuring the Cost of LivingThe theory of aggregate demand and aggregate supply is based on two theoretical links between Y and P.
19Aggregate Demand and Aggregate Supply The aggregate-demand curve shows the total quantity of “Made in USA” goods and services that everybody—households, firms, the government, and foreigners—wants to buy at each price level.The aggregate-supply curve shows the total quantity of “Made in USA” goods and services that US firms would like to produce and sell at each price level.
20Figure 2 Aggregate Demand and Aggregate Supply PriceLevelAggregatesupplyAggregatedemandEquilibriumoutputprice levelQuantity ofOutput
22Aggregate Demand = C + I + G + NX The aggregate demand for goods and services has four components:Aggregate Demand = C + I + G + NXAggregate Supply = YIn equilibrium, supply = demandTherefore, in equilibrium Y = C + I + G + NX
23Figure 3 The Aggregate-Demand (AD) Curve is downward sloping PriceLevelAggregate Demand (AD)C + I + G + NXPY1. A decreasein the pricelevel . . .Y2P2Quantity ofincreases the quantity ofgoods and services demanded.Output
24Bonus slide: why the demand curve for ice cream can’t explain the AD curve The demand curve for an individual commodity is downward sloping because of two effects:Substitution effect: when ice cream becomes cheaper people buy more ice cream because they are switching from frozen yogurt (a substitute)Income effect: when price of ice cream falls and income is unchanged, people feel richer and, therefore, buy more ice creamReview Chapter 4 The Market Forces of Supply and DemandBut the AD curve can consider only changes in the overall price level. If all prices decrease, there can be no substitution effectIt is inconsistent to talk about changes in aggregate demand while assuming unchanged income, because aggregate income must be equal to aggregate demand. Therefore, the income effect can’t be applied to the aggregate economy.
25Why the Aggregate-Demand Curve Is Downward Sloping: three reasons The Wealth Effect: a lower price level boosts consumption spending by householdsThe Interest-Rate Effect: a lower price level boosts investment spending by businessesThe Exchange-Rate Effect: a lower price level boosts net exports
26Why the Aggregate-Demand Curve Is Downward Sloping: Wealth Effect P↓ causes the purchasing power of consumers’ monetary wealth ↑This causes consumption ↑Besides, if a price decline is perceived to be temporary it makes sense to buy what you need now, while prices are still lowC ↑ causes aggregate demand (C+I+G+NX) ↑
27Bonus slide: Wealth Effect Controversy P↓ causes the real burden of the monetary debts of debtors ↑This causes debtors’ consumption ↓Therefore, if the decrease in debtors’ consumption exceeds the increase in the consumption of others, it is possible that C ↓Therefore, P↓ could cause aggregate demand (C+I+G+NX) ↓For this reason, the economist Paul Krugman has argued that the AD curve may be upward rising!
28P↓ causes nominal interest rate ↓ Why the Aggregate-Demand Curve Is Downward Sloping: Interest Rate EffectP↓ causes nominal interest rate ↓See Ch. 16 for more on this.nominal interest rate ↓ encourages greater investment spending by businesses (I ↑)I ↑ means aggregate demand (C+I+G+NX) ↑
29Why the Aggregate-Demand Curve Is Downward Sloping: Exchange-Rate Effect P↓ causes nominal interest rate ↓See Ch. 16 for more on this.Foreigners sell the dollars they had been holding in US banksThe value of the dollar ↓As a result, US goods become cheaper relative to foreign goods.This makes U.S. net exports increase (NX ↑)NX↑ means aggregate demand (C+I+G+NX) ↑
30Shifts in the Aggregate Demand Curve We have seen why the AD curve is negatively sloped. We know why aggregate demand would increase from Y1 to Y2 when the price level decreases from P1 to P2.But what are the reasons why the AD curve might shift? In other words, what are the reasons why aggregate demand might increase to Y2 even if the price level stays put at P1?PriceLevelD2P1Y2P2Aggregatedemand, D1Y1Y2Quantity ofOutput
31Why the Aggregate-Demand Curve Might Shift P↓ causes C+I+G+NX ↑This explains the downward slope of the aggregate demand curveMany other factors can affect C+I+G+NX even when the price level stays unchanged.When these factors change, the aggregate demand curve shifts.PADC + I + G + NX
32Why the Aggregate-Demand Curve Might Shift Shifts arising fromConsumption: consumer optimism, tax rates, prices of assets (stocks, bonds, real estate)Investment: technological progress, business confidence, tax rates, money supplyGovernment PurchasesNet Exports: foreign GDP, expectations about exchange ratesPY
33The aggregate-demand curve: summary (a) Table 1The aggregate-demand curve: summary (a)Why Does the Aggregate-Demand Curve Slope Downward?1. The Wealth Effect: A lower price level increases real wealth, which stimulates spending on consumption.2. The Interest-Rate Effect: A lower price level reduces the interest rate, which stimulates spending on investment.3. The Exchange-Rate Effect: A lower price level causes the real exchange rate to depreciate, which stimulates spending on net exports
34The aggregate-demand curve: summary (b) Table 1The aggregate-demand curve: summary (b)Why Might the Aggregate-Demand Curve Shift?1. Shifts Arising from Consumption: An event that makes consumers spend more at a given price level (a tax cut, a stock-market boom) shifts the aggregate-demand curve to the right. An event that makes consumers spend less at a given price level (a tax hike, a stock-market decline) shifts the aggregate-demand curve to the left.2. Shifts Arising from Investment: An event that makes firms invest more at a given price level (optimism about the future, a fall in interest rates due to an increase in the money supply) shifts the aggregate-demand curve to the right. An event that makes firms invest less at a given price level (pessimism about the future, a rise in interest rates due to a decrease in the money supply) shifts the aggregate-demand curve to the left.3. Shifts Arising from Government Purchases: An increase in government purchases of goods and services (greater spending on defense or highway construction) shifts the aggregate-demand curve to the right. A decrease in government purchases on goods and services (a cutback in defense or highway spending) shifts the aggregate-demand curve to the left.4. Shifts Arising from Net Exports: An event that raises spending on net exports at a given price level (a boom overseas, speculation that causes an exchange-rate depreciation) shifts the aggregate-demand curve to the right. An event that reduces spending on net exports at a given price level (a recession overseas, speculation that causes an exchange-rate appreciation) shifts the aggregate-demand curve to the left.
36THE AGGREGATE-SUPPLY CURVE In the long run, the aggregate-supply (LRAS) curve is vertical.In the short run, the aggregate-supply (SRAS) curve is upward sloping.
37THE AGGREGATE-SUPPLY CURVE: long run An economy’s long-run output of goods and servicesis also called the natural rate of output or potential output or full-employment outputSee Chapter 7Long-run output depends on:laborphysical capitalhuman capitalnatural resourcesTechnologyLaws, government policies, and their enforcementThe price level does not affect these variables in the long run.
38Figure 4 The Long-Run Aggregate-Supply Curve PriceLevelLong-runaggregatesupplyP1. A changein the pricelevel . . .P2does not affectthe quantity of goodsand services suppliedin the long run.Natural rateQuantity ofof outputOutput
39Why the Long-Run Aggregate-Supply Curve Might Shift Any change in the economy that alters the natural rate of output will shift the long-run aggregate-supply curve.Labor: population growth, immigration, natural rate of unemploymentCapital, physical or humanNatural Resources: price of imported oilTechnologyLaws, government policiesPY
40Figure 5 Long-Run Growth and Inflation and growth in themoney supply shiftsaggregate demand . . .Long-runaggregatesupply,LRAS1980Y1990LRASY2000LRASPriceAggregateDemand,AD2000Level1. In the long run,technologicalprogress shiftslong-run aggregatesupply . . .AD1990P2000andongoing inflation.P1990P1980AD1980Y1980leading to growthin output . . .Quantity ofOutput
41A 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.
42The Aggregate-Supply Curve Slopes Upward in the Short Run In the short run, an increase in the overall level of prices 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.Why?
43Figure 6 The Short-Run Aggregate-Supply Curve PriceLevelShort-runaggregatesupplyYP1. A decreasein the pricelevel . . .Y2P2reduces the quantityof goods and servicessupplied in the short run.Quantity ofOutput
44The Sticky-Wage Theory The Sticky-Price Theory Why the Aggregate-Supply Curve Slopes Upward in the Short Run: three theoriesThe Sticky-Wage TheoryThe Sticky-Price TheoryThe Misperceptions TheoryBut, they all reach the same conclusion:Quantity of output suppliedNatural rate of outputActual price levelExpected price level=+a ✕−
45The Short Run Aggregate-Supply Curve According to the SRAS formula, if the overall price level is equal to the expected price level (P = Pe), then output supplied is equal to the natural rate of output (Y = YN).PAS140Pe = 120Also, if P > Pe, then Y > YN.That is, the SRAS curve is upward rising.YNYQuantity of output suppliedNatural rate of outputActual price levelExpected price level=+a ✕−Y = YN + a ✕ (P – Pe)
46The Short Run Aggregate-Supply Curve We have just seen that if P↑ then Y↑.AS1PAS2That is, the SRAS curve is upward rising.But the SRAS equation shows that output supplied can increase (Y↑) even when P is unchanged, as long as Pe↓ or YN↑.Pe1 = 120Pe2 = 100So, if either Pe↓ or YN↑, the AS curve shifts down or to the rightYN1YN2YQuantity of output suppliedNatural rate of outputActual price levelExpected price level=+a ✕−Y = YN + a ✕ (P – Pe)
47The Short Run Aggregate-Supply Curve AS1To summarize, the SRAS equation implies thatThe SRAS curve is upward rising, andThe SRAS curve shifts right ifThe expected price falls, orThe natural rate of output increasesPAS2YQuantity of output suppliedNatural rate of outputActual price levelExpected price level=+a ✕−Y = YN + a ✕ (P – Pe)
48The Sticky-Wage Theory Suppose wages for 2010 were set in 2009These wage agreements were based on the output prices that were expected to prevail in 2010Suppose actual prices in 2010 fall short of what was expectedWages do not adjust immediately to the unexpectedly low price level.An unexpectedly low price level and an unchanged wage level makes employment and production less profitable.This induces firms to reduce the quantity of goods and services supplied.
49Shape of the AS Curve: The Sticky-Wage Theory AS shows the aggregate supply curve for 2010Back in 2009, workers and their bosses had reached an agreement on wages for 2010During the negotiations, they had all expected that prices in 2010 would be Pe = 120If the actual price level in 2010 (P) turns out to be 120, the bosses’ expectations are fulfilled and nobody gets fired.So, output in 2010 is the full-employment output, YN.Therefore, the green dot, which represents the expected price level and the full-employment output, must be on the AS curveIf the actual price level in 2010 (P) turns out to be 140, production is more profitable than was expectedbecause the prices are higher than expected and the wages are unchanged at the previously agreed levelSo, production increases beyond the full-employment level (blue dot)In other words, the AS curve is upward risingPAS140Pe = 120YNY
50Shape of the AS Curve: The Sticky-Price Theory Prices of some goods and services adjust sluggishly in response to changing economic conditionsAn unexpected fall in the price level leaves some firms with higher-than-desired prices.This depresses their sales, which induces these firms to reduce the quantity of goods and services they produce.For consistency, title this slide, “Why the Aggregate supply curves slopes upward in the short run” like the previous two slides. Then move “The sticky-price theory” in large print to the top bullet (like the previous two slides).
51Shape of the AS Curve: The Sticky-Price Theory AS shows the aggregate supply curve for 2010Back in 2009, businesses had expected that demand would be strong in 2010 and prices would be Pe = 140Menu costs make frequent price changes impractical. E-type (O-type) firms set prices at the beginning of even-numbered (odd-numbered) monthsIf the actual price level in 2010 (P) turns out to be 140, the bosses’ expectations are fulfilled. Nobody gets fired. So, output in 2010 is the natural rate of output, YN.Therefore, the green dot, which represents the expected price level and the full-employment output, must be on the AS curveIf demand falls sharply on Jan. 15, businesses must reduce prices to keep their customers.On Feb. 1, only E-type firms reduce their prices. They keep their customers. They do not layoff any employees.But O-type firms cannot cut their prices. They lose customers and layoff some employeesSo, production decreases below the full-employment level (blue dot)I am assuming that firms do not produce products that are perfectly substitutableIn other words, the AS curve is upward risingPASPe = 140120YNY
52Shape of the AS Curve: The Misperceptions Theory Changes in the overall price level temporarily mislead suppliers about what is happening in the markets in which they sell their outputA lower price level causes misperceptions about relative prices.These misperceptions induce suppliers to decrease the quantity of goods and services supplied.
53Shape of the AS Curve: The Misperceptions Theory Suppose an overall decline in demand reduces all pricesA wheat farmer, however, sees only that wheat prices have fallen and continues to believe that the prices of the things that she buys (milk, shoes, clothes, etc.) are unchanged at the level she had expectedThis makes work less attractive and the farmer reduces her production of wheat.I am assuming that the wheat farmer knows only how to produce wheatWhen this is repeated across the economy, both the overall price level and total output fall
54Shape of the AS Curve: The Misperceptions Theory AS shows the aggregate supply curve for 2010Back in 2009, businesses had expected that demand would be strong in 2010 and prices would be Pe = 140If the actual price level in 2010 (P) turns out to be 140, the bosses’ expectations are fulfilled. Nobody gets fired. So, output in 2010 is the natural rate of output, YN.Therefore, the green dot, which represents the expected price level and the full-employment output, must be on the AS curveIf the prices fall unexpectedly in 2010 to 120, a wheat farmer becomes aware of a fall in the price of the wheat she sells, but may be unaware that the prices of the stuff she buys have also fallenDisappointed, the wheat farmer chooses to work less and produce lessSo, production decreases below the full-employment level (blue dot)In other words, the AS curve is upward risingPASPe = 140120YNY
55How the AS curve shifts AS1 shows the aggregate supply curve for 2010 We saw in previous slides that the green dot, which represents the expected price level and the natural rate of output, must be on the AS curveIf either Pe↓ or YN↑, the green dot moves down or to the rightWhen the green dot shifts, so must the AS curveAS1PAS2Pe1 = 120Pe2 = 100YN1YN2YSo, if either Pe↓ or YN↑, the AS curve shifts down or to the right
56The Short-Run Aggregate-Supply Curve Shifts to the Right if: The natural rate of output increasesThis happens when there is an increase in:LaborPhysical CapitalHuman capitalNatural ResourcesTechnology.The Expected Price Level decreases.Price LevelQuantity of Output
57Table 2: The Short-Run Aggregate-Supply Curve: Summary
58Table 2: The Short-Run Aggregate-Supply Curve: Summary
59Recessions caused by decreases in aggregate demand Long-run equilibrium, short-run equilibrium following a disturbance that throws the economy off the long-run equilibrium, the readjustment to the long-run equilibriumRecessions caused by decreases in aggregate demand
60Figure 7 The Long-Run Equilibrium PriceLevelLong-runaggregatesupplyShort-runaggregatesupplyAggregatedemandAEquilibriumpriceNatural rateof outputQuantity ofOutput
61Figure 8 A Contraction in Aggregate Demand causes output to fall in the short run . . .PriceLevelShort-run aggregatesupply,ASLong-runaggregatesupplyAggregatedemand,ADAD2APYBP2Y21. A decrease inaggregate demand . . .CP3Quantity ofOutputIf the shock to AD is temporary, it will soon go back to AD1.But what if the shock to AD is permanent?
62Figure 8 A Contraction in Aggregate Demand causes output to fall in the short run . . .PriceLevelIf the shock to AD is permanent, people will realize that in the long run the economy will end up at C.Short-run aggregatesupply,ASLong-runaggregatesupplyAggregatedemand,ADAD2They will expect the price level to fall to P3.APYBP2Y21. A decrease inaggregate demand . . .CP3Quantity ofOutput
63Figure 8 A Contraction in Aggregate Demand causes output to fall in the short run . . .PriceLevelShort-run aggregatesupply,ASLong-runaggregatesupplyAggregatedemand,ADAS2AD2but overtime, the short-runaggregate-supplycurve shifts . . .APYBP2Y21. A decrease inaggregate demand . . .CP3and output returnsto its natural rate.Quantity of5. The government could also use expansionary monetary/fiscal policies to push AD back to AD1.Output
64ECONOMIC FLUCTUATIONS: AD Contraction (leftward shift) in Aggregate DemandIn the short run,output decreases,the overall price level decreases, andthe unemployment rate increasesIn the long run,the overall price level decreases,but output and the unemployment rate remain unchanged at their long-run levels
65ECONOMIC FLUCTUATIONS: AD (bonus slide) Note that the decrease in demand could be caused byA decrease in the quantity of money (M), orSome other (non-monetary) reasonEither way, the long run effect is that P↓ and Y stays unchanged. Therefore, P ✕ Y ↓.But in the long run, the quantity equation of chapter 17 is assumed to be true: M ✕ V = P ✕ Y.Therefore, M ✕ V must fall.If M is unchanged, then V must fallSo, the theory predicts that any non-monetary decrease in AD must cause V to fall in the long run
66Policy response to a fall in aggregate demand If production and employment take too long to return to their long-run levels, the government could step in to hasten the processThe government could push the aggregate demand curve back where it was by:increasing the money supply (expansionary monetary policy)Cutting taxes or increasing government spending (expansionary fiscal policy)
67Great Depression, recession of 2001, Great Recession of 2008 history
68Two big shifts in aggregate demand: Great Depression and World War II Early 1930s: large drop in real GDPThe Great DepressionLargest economic downturn in U.S. historyFrom 1929 to 1933Real GDP fell by 27%Unemployment rose from 3 to 25%Price level fell by 22%Cause: decrease in aggregate demandDecline in money supply (by 28%)Decreasing: consumer spending, investment spending
69Two big shifts in aggregate demand: Great Depression and World War II Early 1940s: large increase in real GDPEconomic boomWorld War IIMore resources to the militaryGovernment purchases increasedAggregate demand – increasedDoubled the economy’s production of goods and services20% increase in the price levelUnemployment fell from 17 to 1%
70U.S. real GDP growth since 1900 Figure 9U.S. real GDP growth since 1900Over the course of U.S. economic history, two fluctuations stand out as especially large. During the early 1930s, the economy went through the Great Depression, when the production of goods and services plummeted. During the early 1940s, the United States entered World War II, and the economy experienced rapidly rising production. Both of these events are usually explained by large shifts in aggregate demand.
71The Recession of 2001 2001: Recession Unemployment rateDecember 2000: 3.9%August 2001: 4.9%June 2003: 6.3%January 2005: 5.2%Three events – decrease in aggregate demandThe end of dot-com bubble in stock marketStock prices fell (25%)Reduced consumer & investment spendingAggregate-demand curve - shifted to left
72The recession of 2001 Three events – decrease in aggregate demand Terrorist attacks on September 11, 2001Stock market fell (12%) in one weekIncreased uncertainty about the futureAggregate-demand curve – shifted further to leftSeries of corporate accounting scandalsEnron and WorldComStock market fell
73The recession of 2001 2001: Recession Policymakers - quick to respond The Fed - expansionary monetary policyInterest rates fell; Federal funds rate fellStimulated spendingCongressTax cut in 2001; Immediate tax rebate; Tax cut in 2003To stimulate consumer & investment spendingAggregate-demand curve – shifted to rightOffset the three contractionary shocks
75Roots of the Crisis of 2008The crisis of 2008 may have been caused by the Fed’s overreaction to the recession of 2001The Fed cut interest rates sharply kept them low for too long
76Roots of the Crisis of 2008Those low interest rates may have fueled a ‘bubble’ in home prices
77The Recession of 2008–2009 Developments in the mortgage market Easier for subprime borrowers to get loansBorrowers with a higher risk of default (income and credit history)SecuritizationProcess by which a financial institution (mortgage originator) makes loanThen (investment bank) bundles them together mortgage-backed securities
78The Recession of 2008–2009 Developments in the mortgage market Mortgage-backed securitiesSold to other institutions, which may not have fully appreciated the risks in these securitiesOther issuesInadequate regulation for these high-risk loansMisguided government policyEncouraged this high-risk lending
79The Recession of 2008–2009Increase in housing demandIncrease in housing pricesMore than doubled, housing prices fell 30%Substantial rise in mortgage defaults and home foreclosuresFinancial institutions that owned mortgage-backed securitiesHuge losses, stopped making loans
80The Recession of 2008–2009 Large contractionary shift in AD Real GDP fell sharplyBy 4% between the forth quarter of 2007 and the second quarter of 2009Employment fell sharplyUnemployment rate rose from 4.4% in May 2007 to 10.1% in October 2009
81The Recession of 2008–2009Three policy actions - aimed in part at returning AD to its previous levelThe FedCut its target for the federal funds rateFrom 5.25% in September 2007 to about zero in December 2008Started buying mortgage-backed securities and other private loansIn open-market operationsProvided banks with additional funds
82The Recession of 2008–2009 Three policy actions October 2008, Wall Street bailout $700 billionFor the Treasury to use to rescue the financial systemTo stem the financial crisis on Wall StreetTo make loans easier to obtainEquity injections into banksU.S. government – temporarily became a part owner of these banks
83The Recession of 2008–2009 Three policy actions Economy January 2009, President Barack Obama$787 billion stimulus bill, February 17, 2009To be spent over two yearsEconomyStarting to recover from the economic downturnReal GDP - growing againUnemployment – 9.5% in June 2010
84Crisis of 2008: housing bubble pops! This is where it all beganDownloaded from on November 29, 2011.
85Crisis of 2008: the stock market tanked This reduced people’s wealth … which reduced consumption … which reduced aggregate demandDownloaded from on November 29, 2011.
86Crisis of 2008: consumption spending tanked This was a major blow to aggregate demandDownloaded from on November 29, 2011.
87Crisis of 2008: consumption spending began tanking early We got hit by the collapse of the housing prices bubble … and by the collapse in share prices
88Crisis of 2008: business investment tanked This was a major blow to aggregate demandBusinesses got scared way back in 2006!Downloaded from on November 29, 2011.
89Crisis of 2008: business investment tanked Businesses got scared way back in 2006!
90Crisis of 2008: Real GDP fell sharply This was the worst recession since the Great DepressionDownloaded from on November 2011.
91Crisis of 2008: Real GDP fell sharply Growth of real GDP turned negativeDownloaded from on November 2011.
92Crisis of 2008: unemployment spiked Demand had collapsed … so jobs disappearedDownloaded from on November 29, 2011.
93Crisis of 2008: prices actually fell … for a whileDownloaded from and on November 29, 2011.
94Crisis of 2008: no inflation We had deflation, for a while
95Crisis of 2008: our net exports improved This was a consequence of our falling incomesBut this did not help aggregate demand all that muchDownloaded from and on November 29, 2011.
96Crisis of 2008: government spending rose This helped aggregate demandDownloaded from on November 29, 2011.
97Crisis of 2008: government spending rose sharply as a percentage of GDP But it wasn’t enough
98Crisis of 2008: government receipts tanked Incomes fell … so tax payments fell too … automatic stabilizers in action!
100Crisis of 2008: fiscal policy stimulus The government went on a borrowing binge to stimulate the economyDownloaded from on November 29, 2011.
101Crisis of 2008: fiscal policy stimulus The government went on a borrowing binge to stimulate the economy
102Crisis of 2008: monetary stimulus Real money supply kept rising at a slightly faster than usual pace
103Crisis of 2008: monetary stimulus The Federal Reserve did all it couldBut the Federal Funds Rate could not be reduced below zero!Downloaded from on November 29, 2011.
104Recessions caused by decreases in aggregate supply
105ECONOMIC FLUCTUATIONS: AS A leftward shift in Short-Run Aggregate SupplyOutput falls below the natural rate of employmentUnemployment risesThe price level risesIf the government does nothing, the SRAS will shift back to where it was.The price level, total production and unemployment will be unaffected in the long run.Stagflation!
106Figure 10 An Adverse Shift in Aggregate Supply 1. An adverse shift in the short-run aggregate-supply curve . . .PriceLevelLong-runShort-runaggregatesupply,ASAS2aggregatesupplyAggregate demandBY2P2YAPandthe pricelevel to rise.Quantity ofcauses output to fall . . .Output
107StagflationAdverse 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.
108The Effects of a Shift in Aggregate Supply Policy Responses to RecessionPolicymakers 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 (expansionary) monetary and fiscal policy.
109Figure 11 Accommodating an Adverse Shift in Aggregate Supply 1. When short-run aggregatesupply falls . . .PriceLevelLong-runShort-runaggregatesupply,ASAS2aggregateAD2supplyCP3policymakers canaccommodate the shiftby expanding aggregatedemand . . .whichcauses theprice levelto risefurther . . .P2APbut keeps outputat its natural rate.Aggregate demand,ADNatural rateQuantity ofof outputOutput
110Economic fluctuations in the U.S. economy Oil and the economyEconomic fluctuations in the U.S. economySince 1970Some: originated in the oil fields of the Middle EastSome event - reduces the supply of crude oil flowing from Middle EastPrice of oil - rises around the worldAggregate-supply curve – shifts leftStagflationMid-1970sLate-1970s
111Some event – increases the supply of crude oil from Middle East Oil and the economySome event – increases the supply of crude oil from Middle EastPrice of oil decreasesAggregate-supply curve – shifts rightOutput – rapid growthUnemployment – fallsInflation rate – falls
1122008 - world oil prices – rising significantly Oil and the economyRecent years: World market for oil – not an important source of economic fluctuationsConservation effortsChanges in technologyworld oil prices – rising significantlyIncreased demand from a rapidly growing China
113John Maynard Keynes (1883-1946) Our understanding of the short-run behavior of the economy grew out of economists’ attempts to understand why the Great Depression happenedPublished in 1936, Keynes’s The General Theory of Employment, Interest and Money laid the foundationsTIME Cover, December 31, 1965
114John Maynard Keynes (1883-1946) “The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us when the storm is long past, the ocean will be flat.”A Tract on Monetary Reform (1923)
115SummaryAll 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.
116SummaryEconomists 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.
117SummaryThe 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.
118Summary 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.Bullet three, move the misperceptions theory to the end.
119SummaryEvents 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.
120SummaryA second possible cause of economic fluctuations is a shift in aggregate supply.Stagflation is a period of falling output and rising prices.