1. Chapter Aggregate Demand and Aggregate Supply 20

2. Aggregate Demand & Aggregate Supply Economic activity – Fluctuates from year to year Economic fluctuation – Business cycle Recession – Economic contraction – Period of declining real incomes and rising unemployment Depression – Severe recession 2

3. 3 Key Facts About Economic Fluctuations 1.Economic fluctuations are irregular and unpredictable – i.e, fluctuations (around the trend) = business cycles (booms/recessions) 2.Most macroeconomic quantities fluctuate together – GDP (growth rate) - Investment (I) – Unemployment Rate (U) – Inflation (∏) 3.As output falls, unemployment rises 3

4. Economic “Fluctuations” 4 Irregular and Unpredictable

5. Economic “Fluctuations” 5 Irregular and Unpredictable

6. Figure A look at short-run economic fluctuations (a) 1 6 This figure shows real GDP in panel (a), investment spending in panel (b), and unemployment in panel (c) for the U.S. economy using quarterly data since 1965. Recessions are shown as the shaded areas. Notice that real GDP and investment spending decline during recessions, while unemployment rises.

7. Figure A look at short-run economic fluctuations (b) 1 7 Note that real GDP and investment spending decline during recessions. Although I accounts for only 15-20% of GDP; it accounts for 50% of the decline in GDP during a recession

8. Figure A look at short-run economic fluctuations (c) 1 8. Recessions are shown as the shaded areas. Notice that real GDP and investment spending decline during recessions, while unemployment rises.

9. Explaining Short-Run Economic Fluctuations The assumptions of Classical economists – Austrian school (Hayek, von Mises) – Monetarists (Friedman, Univ of Chicago, “Fresh Water”) Classical dichotomy – Separation of variables into Real variables Nominal variables Monetary neutrality – Changes in the money supply Affect nominal variables Does not affect real variables 9

10. Explaining Short-Run Economic Fluctuations Classical Economist Focus on the “Long-Run” – Classical theory holds Changes in money supply – Affect prices, nominal interest rates and other nominal variables – Does not affect real GDP, unemployment, real interest rates, or other real variables 10

11. The long-run aggregate-supply curve (Classical View) 4 11 Price Level Quantity of Output Classical View – Supply determines equilibrium (real Y -> thereby U) 1. A change in the price level... 2.... does not affect the quantity of goods and services supplied in the long run Long-run aggregate supply Natural rate of output P1P1 P2P2

12. Figure 11-5 Classical Theory and Increases in Aggregate Demand

13. Explaining Short-Run Economic Fluctuations The reality of short-run fluctuations Short-run – Assumption of monetary neutrality - no longer appropriate (can affect real variables in short-run due to sticky prices/wages or “surprises” – Real and nominal variables are highly intertwined – Changes in the money supply Can temporarily push real GDP away from its long-run trend 13

14. Explaining Short-Run Economic Fluctuations Model of aggregate demand & aggregate supply – Model that most economists use to explain short-run fluctuations in economic activity Around its long-run trend Aggregate-demand curve – Shows the quantity of goods and services That households, firms, the government, and customers abroad Want to buy at each price level – Downward sloping 14

15. Figure 11-7 Demand-Determined Equilibrium Real GDP at Less Than Full Employment Keynes assumed prices will not fall when aggregate demand falls

16. Figure 11-8 Real GDP and the Price Level, 1934–1940

17. Tradeoff between Inflation and Unemployment? 6 17 Annual data from 1961 to 1968 shows a negative relationship between inflation and unemployment (inflation = stimulative monetary (M1) and fiscal (G) policy)

18. Explaining Short-Run Economic Fluctuations Model of aggregate demand & aggregate supply Aggregate-supply curve – Shows the quantity of goods and services That firms choose to produce and sell At each price level – Upward sloping (very different from Classical) Similar factors that shift micro-based supply curve (input prices, technology) also shift AS curve – E.g., OPEC oil prices 18

19. Figure Aggregate demand and aggregate supply 2 19 Price Level Quantity of Output Equilibrium price level Aggregate supply Aggregate demand Equilibrium output Economists use the model of aggregate demand and aggregate supply to analyze economic fluctuations. On the vertical axis is the overall level of prices. On the horizontal axis is the economy’s total output of goods and services. Output and the price level adjust to the point at which the aggregate-supply and aggregate-demand curves intersect.

20. The Aggregate-Demand Curve Why the aggregate-demand (AD) curve slopes downward Y = C + I + G + NX Three effects: – Wealth effect (C ): decrease in prices – consumable income increases – Interest-rate effect (I): need less money to buy goods -> increase loanable funds -> interest rate decreases – Exchange-rate effect (NX) -> dec in interest rate -> depreciaion of $ Assumption: government spending (G) – Fixed by policy 20

21. Figure The aggregate-demand curve 3 21 Price Level Quantity of Output P1P1 Aggregate demand Y1Y1 A fall in the price level from P 1 to P 2 increases the quantity of goods and services demanded from Y 1 to Y 2. There are three reasons for this negative relationship. As the price level falls, real wealth rises, interest rates fall, and the exchange rate depreciates. These effects stimulate spending on consumption, investment, and net exports. Increased spending on any or all of these components of output means a larger quantity of goods and services demanded. P2P2 Y2Y2 1. A decrease in the price level... 2.... increases the quantity of goods and services demanded

22. The Aggregate-Demand Curve Why the AD curve might shift Changes in consumption, C – Events - change how much people want to consume at a given price level Level of taxation (decrease in income taxes, increases spendable income -> increase C) Decrease C: increase in the savings rate (marginal propensity to save) during a recession – Increase in consumer spending Aggregate demand - shift right 22

23. The Aggregate-Demand Curve Why the AD curve might shift Changes in investment, I – Events - change how much firms want to invest at a given price level Better technology Tax policy (tax credits for I, faster depreciation) Money supply, Federal Discount Rate, Budget deficit/surplus – Increase in investment Aggregate demand - shift right 23

24. The Aggregate-Demand Curve Why the AD curve might shift Changes in government purchases, G – Policy makers – change government spending at a given price level Build new roads – Increase in government purchases Aggregate demand - shift right – Or decreases in government purchases AD curve shifts left 24

25. The Aggregate-Demand Curve Why the AD curve might shift – Decreases in government purchases Costs of government sequester low 0.1 percent growth in personal income attributed todefense furloughs, more than 650,000 workers,more than 650,000 workers – a 0.5 percent decline in government pay, reduced wages by $7.7 billion that month, – Without sequester, income growth would have been closer to 1.2 percent. 25

26. The Aggregate-Demand Curve Why the AD curve might shift – If it sequester were reversed, the non-partisan Congressional Budget Office has estimated that as many as 1.6 million jobs would be added and GDP would get a boost of as much as 1.2 percent. Even the deficit would be in better shape if the cuts were undone.1.6 million jobs would be addedthe deficit would be in better shape 26

27. The Aggregate-Demand Curve Why the AD curve might shift Changes in net exports, NX – Events - change net exports for a given price level Recession in Europe –decrease demand US goods International speculators – change in exchange rate – Increase in net exports Decrease in exchange rate; US goods cheaper Aggregate demand - shift right 27

28. The Aggregate Supply Curve Long run – Aggregate-supply curve is vertical Short run – Aggregate-supply curve is upward sloping Why the aggregate-supply curve (LRAS) is vertical in the long run – Price level does not affect the long-run determinants of GDP: Supplies of labor, capital, and natural resources Available technology 28

29. Figure The long-run aggregate-supply curve 4 29 Price Level Quantity of Output In the long run, the quantity of output supplied depends on the economy’s quantities of labor, capital, and natural resources and on the technology for turning these inputs into output. Because the quantity supplied does not depend on the overall price level, the long-run aggregate-supply curve is vertical at the natural rate of output. 1. A change in the price level... 2.... does not affect the quantity of goods and services supplied in the long run Long-run aggregate supply Natural rate of output P1P1 P2P2

30. The Aggregate Supply Curve Why the LRAS curve might shift Natural rate of output – Production of goods and services – That an economy achieves in the long run When unemployment is at its normal rate – Potential output – Full-employment output 30

31. The Aggregate Supply Curve Why the LRAS curve might shift – Any change in natural rate of output Changes in labor – Quantity of labor – increases Aggregate supply – shifts right – Natural rate of unemployment – increases Aggregate supply – shifts left 31

32. The Aggregate Supply Curve Why the LRAS curve might shift Changes in capital – Capital stock – increase Aggregate supply – shifts left – Physical capital – Human capital 32

33. The Aggregate Supply Curve Why the LRAS might shift Changes in natural resources – New discovery of natural resource Aggregate supply – shifts right – Weather – Availability of natural resources 33

34. The Aggregate Supply Curve Why the LRAS curve might shift Changes in technology – New technology, for given labor, capital and natural resources Aggregate supply – shifts right – International trade – Government regulation 34

35. The Aggregate Supply Curve Using AD and LRAS to depict long-run growth and inflation In long run: both AD and LRAS curve shift Continual shifts of LRAS curve to right – Technological progress AD curve shifts to right – Monetary policy – The Fed increases money supply over time Result: – Continuing growth in output – Continuing inflation 35

36. Figure Long-run growth and inflation in the model of aggregate demand and aggregate supply 5 36 Price Level Quantity of Output As the economy becomes better able to produce goods and services over time, primarily because of technological progress, the long-run aggregate-supply curve shifts to the right. At the same time, as the Fed increases the money supply, the aggregate-demand curve also shifts to the right. In this figure, output grows from Y 1980 to Y 1990 and then to Y 2000, and the price level rises from P 1980 to P 1990 and then to P 2000. Thus, the model of aggregate demand and aggregate supply offers a new way to describe the classical analysis of growth and inflation Long-run aggregate supply, LRAS 1980 Y 1980 AD 1980 P 1980 LRAS 1990 Y 1990 AD 1990 LRAS 2000 Y 2000 P 1990 AD 2000 P 2000 1. In the long run, technological progress shifts long-run aggregate supply… 2.... and growth in the money supply shifts aggregate demand... 3.... leading to growth in output... 4.... and ongoing inflation

37. The Aggregate Supply Curve Why the aggregate-supply (AS) curve slopes upward in the short-run – Basic Microeconomic Theory – Increase in overall level of prices in economy Tends to raise the quantity of goods and services supplied – Decrease in level of prices Tends to reduce quantity of goods and services supplied 37

38. Figure The short-run aggregate-supply curve 6 38 Price Level Quantity of Output P2P2 Short-run aggregate supply Y1Y1 In the short run, a fall in the price level from P 1 to P 2 reduces the quantity of output supplied from Y 1 to Y 2. This positive relationship could be due to sticky wages, sticky prices, or misperceptions. Over time, wages, prices, and perceptions adjust, so this positive relationship is only temporary. P1P1 Y2Y2 1. A decrease in the price level... 2.... reduces the quantity of goods and services supplied in the short run

39. The Aggregate Supply Curve Why the AS curve slopes upward in short-run Sticky-wage theory – Nominal wages - slow to adjust to changing economic conditions Long-term contracts: workers and firms Slowly changing social norms Notions of fairness - influence wage setting – Nominal wages - based on expected prices Don’t respond immediately when: – Actual price level – different from what was expected 39

40. The Aggregate Supply Curve Why the AS curve slopes upward in short-run Sticky-wage theory – If price level < expected Firms – incentive to produce less output – If price level > expected Firms – incentive to produce more output 40

41. The Aggregate Supply Curve Why the AS curve slopes upward in short-run Sticky-price theory – Prices of some goods & services Slow to adjust to changing economic conditions Menu costs – Costs to adjusting prices 41

42. The Aggregate Supply Curve Why the AS curve slopes upward in short-run Misperceptions theory – Changes in the overall price level Can temporarily mislead suppliers – About changes in individual markets – Changes in relative prices Suppliers - respond to changes in level of prices – Change - quantity supplied of goods and services 42

43. The Aggregate Supply Curve Why the AS curve slopes upward in short-run Quantity of output supplied = = Natural rate of output + + a(Actual price level – Expected price level) Where a - number that determines how much output responds to unexpected changes in the price level 43

44. The Aggregate Supply Curve Why the short-run AS curve might shift Changes in labor, capital, natural resources, or technological knowledge – Shift the short-run AS curve Expected price level increases – Aggregate-supply curve – shifts left 44

45. Table The short-run aggregate-supply curve: summary (a) 2 45 Why Does the Short-Run Aggregate-Supply Curve Slope Upward? 1. The Sticky-Wage Theory: An unexpectedly low price level raises the real wage, which causes firms to hire fewer workers and produce a smaller quantity of goods and services. 2. The Sticky-Price Theory: An unexpectedly low price level leaves some firms with higher-than desired prices, which depresses their sales and leads them to cut back production. 3. The Misperceptions Theory: An unexpectedly low price level leads some suppliers to think their relative prices have fallen, which induces a fall in production.

46. Table The short-run aggregate-supply curve: summary (b) 2 46 Why Might the Short-Run Aggregate-Supply Curve Shift? 1. Shifts Arising from Labor: An increase in the quantity of labor available (perhaps due to a fall in the natural rate of unemployment) shifts the aggregate-supply curve to the right. A decrease in the quantity of labor available (perhaps due to a rise in the natural rate of unemployment) shifts the aggregate-supply curve to the left. 2. Shifts Arising from Capital: An increase in physical or human capital shifts the aggregate-supply curve to the right. A decrease in physical or human capital shifts the aggregate-supply curve to the left. 3. Shifts Arising from Natural Resources: An increase in the availability of natural resources shifts the aggregate-supply curve to the right. A decrease in the availability of natural resources shifts the aggregate-supply curve to the left. 4. Shifts Arising from Technology: An advance in technological knowledge shifts the aggregate-supply curve to the right. A decrease in the available technology (perhaps due to government regulation) shifts the aggregate-supply curve to the left. 5. Shifts Arising from the Expected Price Level: A decrease in the expected price level shifts the short- run aggregate-supply curve to the right. An increase in the expected price level shifts the short-run aggregate-supply curve to the left.

47. Two Causes of Economic Fluctuations Assumption – Economy begins in long-run equilibrium Long-run equilibrium: – Intersection of AD and LRAS curves Output - natural rate Actual price level – And: Intersection of AD and short-run AS curve Expected price level = Actual price level 47

48. Figure The long-run equilibrium 7 48 Price Level Quantity of Output The long-run equilibrium of the economy is found where the aggregate-demand curve crosses the long-run aggregate-supply curve (point A). When the economy reaches this long-run equilibrium, the expected price level will have adjusted to equal the actual price level. As a result, the short-run aggregate-supply curve crosses this point as well. Long-run aggregate supply Natural rate of output Short-run aggregate supply Aggregate demand Equilibrium price A

49. Two Causes of Economic Fluctuations The effects of a shift in aggregate demand Wave of pessimism – Affects aggregate demand Aggregate demand – shifts left – Short-run Output falls & Price level falls – Long-run Short-run aggregate supply curve – shifts right Output – natural rate Price level – falls 49

50. Table Four steps for analyzing macroeconomic fluctuations 3 50 1. Decide whether the event shifts the aggregate demand curve or the aggregate supply curve (or perhaps both). 2.Decide in which direction the curve shifts. 3.Use the diagram of aggregate demand and aggregate supply to determine the impact on output and the price level in the short run. 4.Use the diagram of aggregate demand and aggregate supply to analyze how the economy moves from its new short-run equilibrium to its long-run equilibrium.

51. Figure A contraction in aggregate demand 8 51 Price Level Quantity of Output A fall in aggregate demand is represented with a leftward shift in the aggregate-demand curve from AD 1 to AD 2. In the short run, the economy moves from point A to point B. Output falls from Y 1 to Y 2, and the price level falls from P 1 to P 2. Over time, as the expected price level adjusts, the short-run aggregate-supply curve shifts to the right from AS 1 to AS 2, and the economy reaches point C, where the new aggregate-demand curve crosses the long-run aggregate- supply curve. In the long run, the price level falls to P 3, and output returns to its natural rate, Y 1. Long-run aggregate supply Y1Y1 Short-run aggregate supply, AS 1 Aggregate demand, AD 1 P1P1 A AD 2 P2P2 B Y2Y2 AS 2 P3P3 C 1.A decrease in aggregate demand... 2.... causes output to fall in the short run... 3.... but over time, the short-run aggregate-supply curve shifts... 4.... and output returns to its natural rate.

52. Early 1930s: large drop in real GDP – The Great Depression – Largest economic downturn in U.S. history – From 1929 to 1933 Real GDP fell by 27% Unemployment rose from 3 to 25% Price level fell by 22% – Cause: decrease in aggregate demand Decline in money supply (by 28%) Decreasing: consumer spending, investment spending Two big shifts in aggregate demand: Great Depression and World War II 52

53. Early 1940s: large increase in real GDP – Economic boom – World War II More resources to the military Government purchases increased Aggregate demand – increased 1939 - 1944 Doubled the economy’s production of goods and services 20% increase in the price level Unemployment fell from 17 to 1% Two big shifts in aggregate demand: Great Depression and World War II 53

54. Figure U.S. real GDP growth since 1900 9 54 Over 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.

55. 2001: Recession – Unemployment rate December 2000: 3.9% August 2001: 4.9% June 2003: 6.3% January 2005: 5.2% Three events – decrease in aggregate demand 1.The end of dot-com bubble in stock market Stock prices fell (25%) Reduced consumer & investment spending Aggregate-demand curve - shifted to left The recession of 2001 55

56. Three events – decrease in aggregate demand 2.Terrorist attacks on September 11, 2001 Stock market fell (12%) in one week Increased uncertainty about the future Aggregate-demand curve – shifted further to left 3.Series of corporate accounting scandals Enron and WorldCom Stock market fell Aggregate-demand curve – shifted further to left The recession of 2001 56

57. 2001: Recession – Policymakers - quick to respond – The Fed - expansionary monetary policy Interest rates fell; Federal funds rate fell Stimulated spending – Congress Tax cut in 2001; Immediate tax rebate; Tax cut in 2003 To stimulate consumer & investment spending – Aggregate-demand curve – shifted to right Offset the three contractionary shocks The recession of 2001 57

58. Two Causes of Economic Fluctuations The effects of a shift in aggregate supply Start: long run equilibrium – Firms – increase in production costs Aggregate supply curve – shifts left Short-run – Output falls & Price level rises – Stagflation Long-run, if AD is held constant – Short-run AS shifts back to right – Output – natural rate – Price level - falls 58

59. Figure An adverse shift in aggregate supply 10 59 Price Level Quantity of Output When some event increases firms’ costs, the short-run aggregate-supply curve shifts to the left from AS 1 to AS 2. The economy moves from point A to point B. The result is stagflation: Output falls from Y 1 to Y 2, and the price level rises from P 1 to P 2. Long-run aggregate supply Y1Y1 Short-run aggregate supply, AS 1 Aggregate demand P1P1 A AS 2 P2P2 B Y2Y2 1. An adverse shift in the short-run aggregate-supply curve... 2.... causes output to fall... 3.... and the price level to rise

60. Two Causes of Economic Fluctuations The effects of a shift in aggregate supply Start: long run equilibrium – Firms – increase in production costs Aggregate supply curve – shifts left Short-run – Output falls and Price level rises Long-run – Policymakers – shift AD to right – Output – natural rate – Price level – rises 60

61. Figure Accommodating an adverse shift in aggregate supply 11 61 Price Level Quantity of Output Faced with an adverse shift in aggregate supply from AS 1 to AS 2, policymakers who can influence aggregate demand might try to shift the aggregate-demand curve to the right from AD 1 to AD 2. The economy would move from point A to point C. This policy would prevent the supply shift from reducing output in the short run, but the price level would permanently rise from P 1 to P 3. Long-run aggregate supply Y1Y1 Short-run aggregate supply, AS 1 Aggregate demand, AD 1 P1P1 A AS 2 P2P2 1. When short-run aggregate supply falls... 2.... policymakers can accommodate the shift by expanding aggregate demand... 3.... which causes the price level to rise further... AD 2 P3P3 C 4.... but keeps output at its natural rate.

62. Economic fluctuations in the U.S. economy – Since 1970 – Some: originated in the oil fields of the Middle East Some event - reduces the supply of crude oil flowing from Middle East – Price of oil - rises around the world – Aggregate-supply curve – shifts left – Stagflation Mid-1970s Late-1970s Oil and the economy 62

63. Some event – increases the supply of crude oil from Middle East – Price of oil decreases – Aggregate-supply curve – shifts right Output – rapid growth Unemployment – falls Inflation rate – falls Oil and the economy 63

64. Recent years: World market for oil – not an important source of economic fluctuations – Conservation efforts – Changes in technology 2008 - world oil prices – rising significantly – Increased demand from a rapidly growing China Oil and the economy 64