1. Macroeconomics Econ 2301 Dr. Frank Jacobson Coach Stuckey

2. Today Begin Chapter 12- Aggregate Demand and Supply

3. Chapter 12 Aggregate Demand and Aggregate Supply

4. During The Semester We Have Seen How The Economy Has Changed During Different Time Period Sometimes Moderately and Sometimes Severely.

5. In This Chapter We Will Look At What Causes Both Short-Run and Long-Run Fluctuations in The Economy.

6. The 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. Time Economic activity Business cycle

7. Important Note: These Business Cycle Fluctuations Are Unpredictable and Follow No Regular Pattern.

8. Fact : Most Macroeconomic Quantities Fluctuate Together. When Real GDP Falls in a Recession So Does Personal Income, Corporate Profits, Consumer Spending, Investment Spending, Production, Home Sales, Auto Sales and Other Items.

9. Investment Spending Varies Greatly Over The Business Cycle. Investment Spending Averages Only About 1/7 of The GDP, Yet, Declines In Investment Account For About 2/3 of The Declines in GDP During Recessions.

10. Restated: When Economic Conditions Deteriorate, Much of The Decline is Attributable To Reductions in Investment Spending Such As On New Factories, Housing, Equipment and Inventories.

11. Fact : As Output Falls, Unemployment Rises. When Firms Choose To Produce A Smaller Quantity of Goods and Services, They Lay Off Workers, Increasing The Unemployment.

12. Explaining Short-Run Economic Fluctuations.

13. Most Economists Believe That Classical Theory Describes The World in The Long Run But Not in The Short Run.

14. In The Short Run, Real and Nominal Variables Are Highly Intertwined, and Changes in The Money Supply Can Temporarily Push Real GDP Away From Its Long Term Trend.

15. Therefore To Explain The Short Run Fluctuations in The Economy and Their Impact; We Must Develop a New Model Based on How Real and Nominal Variables Interact.

16. The Model of Aggregate Demand and Aggregate Supply

17. Figure 2 Aggregate Demand and Aggregate Supply... Quantity of Output Price Level 0 Aggregate supply Aggregate demand Equilibrium output Equilibrium price level

18. Figure 3 The Aggregate-Demand Curve... Quantity of Output Price Level 0 Aggregate demand P Y Y2Y2 P2P2 1. A decrease in the price level... 2.... increases the quantity of goods and services demanded.

19. Our Model of Short-Run Economic Fluctuations Focuses On The Behavior of Two Variables. The First Variable is The Economy’s Output of Goods and Services as Measured By Real GDP. The Second is The Average Level of Prices, As Measured By The CPI or The GDP Deflator.

20. Notice: That Output is a Real Variable, Whereas The Price Level is a Nominal Variable.

21. Fluctuations in The Economy as a Whole Are Measured With The Model of Aggregate Demand and Aggregate Supply.

22. Model of Aggregate Demand and Aggregate Supply The Model That Most Economists Use To Explain Short-Term Fluctuations in Economic Activity Around its Long-Run Trend.

23. The Model of Aggregate Demand and Aggregate Supply

24. On The Vertical Axis is The Overall Price Level in The Economy. On The Horizontal Axis is The Overall Quantity of Goods and Services Produced in The Economy.

25. The 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.

26. According To This Model, The Price Level and The Quantity of Output Adjust To Bring Aggregate Demand and Aggregate Supply Into Balance.

27. This May Look Like The Market Supply and Demand Curves, But Because It Involves All The Goods and Services Supplied and Demanded, Factors Such As Substitutes and Complementary Items Are Not Involved.

28. The Aggregate-Demand Curve

29. The Aggregate-Demand Curve Tells Us The Quantity of All Goods and Services Demanded in The Economy At Any Given Price Level.

30. The Aggregate-Demand Curve is Downward Sloping Indicating That, All Things Being Equal, A Decrease In The Economy’s Overall Level of Prices Raises The Quantity of Goods and Services Demanded and An Increase in Prices Reduces The Quantity of Goods and Services Demanded.

31. Why Does The Aggregate- Demand Curve Slope Downward?

32. Price Level Affects The Quantity of Goods and Services Demanded Relative to The GDP--- For Consumption, Investment and Net Exports.

33. There Are 3 Reasons The Aggregate-Demand Curve is Downward Sloping.

34. Reasons Aggregate-Demand Curve is Downward Sloping 1.The Price Level and Consumption: The Wealth Effect. 2.The Price Level and Investment: The Interest Rate Effect. 3.The Price Level and Net Exports: The Exchange-Rate Effect.

35. #1 The Price Level and Consumption: A Decrease In The Price Level Raises The Real Value of Money and Makes Consumers Wealthier, Which In Turn Encourages Them To Spend More and Demand More Goods and Services.

36. #2 Price Level and Investment A Lower Price Level Reduces The Interest Rate, Encourages Greater Spending on Investment Goods, Thereby Increases The Quantity of Goods and Services Demanded.

37. #3 Price Level and Net Exports A Fall in U.S. Price Level Causes U.S. Interest Rates To Fall, The Real Value of The Dollar Declines In Foreign Exchange Markets, Which Increases U.S. Net Exports of Goods and Services.

38. Therefore a Decrease in Price Level Increases The Demand for Goods and Services Because: 1.Consumers Are Wealthier, Which Stimulates the Demand For Consumption Goods. 2.Interest Rates Fall, Which Stimulates The Demand For Investment Goods. 3.The Currency Depreciates, Which Stimulates The Demand For Net Exports.

39. These Same Three Effects Work in Reverse to Decrease The Quantity of Goods and Services When The Price Level is Increased.

40. The Overall Aggregate Demand Curve May Shift (Right or Left).

41. Causes of Aggregate-Demand Curve To Shift Shifts Arising From Changes in Consumption. Shifts Arising From Changes in Investment Shifts Arising From Changes in Government Purchase. Shifts Arising From Changes in Net Exports.

42. Causes of Aggregate-Demand Curve To Shift Shifts Arising From Changes in Expectations. Shifts Arising From Changes in Wealth. Shifts Arising From the Size of Existing Stock of Physical Capital. Shifts Arising From Changes in Fiscal Policy. Shifts Arising From Changes in Monetary Policy.

43. Shifts in The Aggregate Demand Curve Quantity of Output Price Level 0 Aggregate demand, D 1 P1P1 Y1Y1 D2D2 Y2Y2

44. Figure 4 The Long-Run Aggregate- Supply Curve Quantity of Output Natural rate of output Price Level 0 Long-run aggregate supply P2P2 1. A change in the price level... 2.... does not affect the quantity of goods and services supplied in the long run. P

45. The Aggregate- Supply Curve

46. In The Long Run, The Aggregate-Supply Curve is Vertical, Whereas in The Short Run, The Aggregate-Supply Curve is Upward Sloping.

47. Why The Aggregate-Supply Curve is Vertical in The Long Run.

48. In The Long Run, An Economy’s Production of Goods and Services (Its Real GDP) Depends On Its Supplies of Labor, Capital and Natural Resources and on The Available Technology To Turn These Factors of Production Into Goods and Services.

49. The Aggregate-Supply Curve The Long-Run Aggregate-Supply Curve is Vertical At The Natural Rate of Output, Which is The Production of Goods and Services That an Economy Achieves in The Long Run When Unemployment is At Its Normal Rate. –This Level of Production is Also Referred To As Potential Output or Full-Employment Output. –The Natural Rate of Output is The Level of Output Towards Which The Economy Gravitates in The Long Run.

50. Natural Rate of Output The Production of Goods and Services That An Economy Achieves in The Long Run When Unemployment is At Its Normal Rate.

51. The Natural Rate of Output is The Level of Production Toward Which The Economy Gravitates in The Long Run.

52. 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.

53. Why The Long-Run Aggregate- Supply Curve Might Shift Shifts Might Arise From Changes In: –Labor –Capital –Natural Resources –Technological Knowledge

54. Why The Aggregate-Supply Curve Might Shift Shifts Might Arise From Changes In Commodity Prices. Shifts Might Arise From Changes In Nominal Wages. Shifts Might Arise From Changes In Productivity.

55. Figure 5 Long-Run Growth and Inflation Quantity of Output Y 1980 AD 1980 AD 1990 Aggregate Demand,AD 2000 Price Level 0 Long-run aggregate supply, LRAS 1980 Y 1990 LRAS 1990 Y 2000 LRAS 2000 P 1980 1. In the long run, technological progress shifts long-run aggregate supply... 4.... and ongoing inflation. 3.... leading to growth in output... P 1990 P 2000 2.... and growth in the money supply shifts aggregate demand...

56. Figure 6 The Short-Run Aggregate- Supply Curve Quantity of Output Price Level 0 Short-run aggregate supply 1. A decrease in the price level... 2.... reduces the quantity of goods and services supplied in the short run. Y P Y2Y2 P2P2

57. Why The Aggregate-Supply Curve Slopes Upward in The Short Run Three Theories: –The Sticky-Wage Theory –The Sticky-Price Theory –The Misperceptions Theory

58. Why The Aggregate-Supply Curve Slopes Upward in The Short Run The Sticky-Wage Theory –Nominal Wages Are Slow To Adjust To Changing Economic Conditions, or Are “Sticky” in The Short Run –Nominal 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.

59. Why The Aggregate-Supply Curve Slopes Upward in The Short Run 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. For a Variety of Reasons, They May Not Want To or Be Able To Change Prices Immediately. –This Depresses Sales, Which Induces Firms To Reduce The Quantity of Goods and Services They Produce.

60. Why The Aggregate-Supply Curve Slopes Upward in The Short Run 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.

61. Why The Aggregate-Supply Curve Slopes Upward in The Short Run All Three Theories Suggest That Output Deviates in The Short Run From The Natural Rate When The Actual Price Level Deviates From The Price Level That People Had Expected To Prevail. Quantity of output Supplied = Natural Rate of output + a Actual Price Level - Expected Price Level

62. Why The Short-Run Aggregate- Supply Curve Might Shift Shifts Might Arise From Changes In: –Expected Price Level. –Labor. –Capital. –Natural Resources. –Technology.

63. 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.

64. Figure 7 The Long-Run Equilibrium Natural rate of output Quantity of Output Price Level 0 Short-run aggregate supply Long-run aggregate supply Aggregate demand A Equilibrium price

65. TWO CAUSES OF ECONOMIC FLUCTUATIONS Four Steps in The Process of Analyzing Economic Fluctuations: Determine Whether The Event Affects Aggregate Supply or Aggregate Demand. Decide Which Direction The Curve Shifts. Use a Diagram To Compare The Initial and The New Equilibrium. Keep Track of The Short and Long Run Equilibrium, and The Transition Between Them.

66. 2 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. –Policymakers Who Influence Aggregate Demand Can Potentially Mitigate The Severity of Economic Fluctuations.

67. Figure 8 A Contraction in Aggregate Demand Quantity of Output Price Level 0 Short-run aggregate supply,AS Long-run aggregate supply Aggregate demand,AD A P Y AD 2 AS 2 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. CP3P3 B P2P2 Y2Y2

68. The Effects of A Shift in Aggregate Supply 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.

69. The Effects of A Shift in Aggregate Supply 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.

70. Figure 10 An Adverse Shift in Aggregate Supply Quantity of Output Price Level 0 Aggregate demand 3.... and the price level to rise. 2.... causes output to fall... 1. An adverse shift in the short- run aggregate-supply curve... Short-run aggregate supply,AS Long-run aggregate supply Y A P AS 2 B Y2Y2 P2P2

71. Figure 11 Accommodating An Adverse Shift in Aggregate Supply Quantity of Output Natural rate of output Price Level 0 Short-run aggregate supply,AS Long-run aggregate supply Aggregate demand,AD P2P2 A P AS 2 3.... which causes the price level to rise further... 4.... but keeps output at its natural rate. 2.... policymakers can accommodate the shift by expanding aggregate demand... 1. When short-run aggregate supply falls... AD 2 C P3P3

72. Stagflation A Period of Falling Output and Rising Prices.

73. Questions ?