Aggregate Demand and Aggregate Supply Lesson 7 Chapter 33 Aggregate Demand and Aggregate Supply

Short-Run Economic Fluctuations Economic activity fluctuates from year to year. In most years production of goods and services rises. On average since 1955, production in the U.S. economy has grown by about 3 percent per year. In some years normal growth does not occur, causing a recession. Definition of a recession is two consecutive quarters of negative growth

Negative Growth?

Short-Run Economic Fluctuations A recession is a period of declining real incomes, rising unemployment and negative growth in the real GDP A depression is a severe recession as witnesses after the First World War 1914 – 1918 – which finally hit the world economies in the 1920’s

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS Economic fluctuations are irregular and unpredictable (often) Fluctuations in the economy are often called the business cycle. Most macroeconomic variables fluctuate together. As output falls, unemployment rises. As output increases, unemployment falls and ?

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS Most macroeconomic variables fluctuate together. Most macroeconomic variables that measure some type of income or production fluctuate closely together. Although many macroeconomic variables fluctuate together, they fluctuate by different amounts.

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS As output falls, unemployment rises. Changes in real GDP are inversely related to changes in the unemployment rate. During times of recession, unemployment rises substantially. Leading to Government increase in Government spending – Transfer payments AND reduced Government income. (less tax revenues)

EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS How the Short Run Differs from the Long Run Most economists believe that classical theory describes the world in the long run but not in the short run. Changes in the money supply affect nominal variables but not real variables in the long run.

The Basic Model of Economic Fluctuations Two variables are used to develop a model to analyze the short-run fluctuations. The economy’s output of goods and services measured by real GDP. The overall price level measured by the CPI or the GDP deflator.

The Basic Model of Economic Fluctuations The Basic 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. Aggregate everything combined….. A mixture… Includes general level of prices

Figure 1 The Circular-Flow Diagram OLD FRIEND Firms sell Households buy MARKETS FOR GOODS AND SERVICES Revenue Spending Goods and services sold Goods and services bought FIRMS Produce and sell goods and services Hire and use factors of production Buy and consume goods and services Own and sell factors of production HOUSEHOLDS Households sell Firms buy MARKETS FOR FACTORS OF PRODUCTION Factors of production Labor, land, and capital Wages, rent, and profit Income = Flow of inputs and outputs = Flow of dollars Copyright © 2004 South-Western

The Basic Model of Economic Fluctuations The Basic Model of Aggregate Demand and Aggregate Supply The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level.

Micro vs Macro Demand We know that there is the substitute effect. The aggregate demand curve allows for switching to substitutes or lower priced/QUALITY items So for example demand for coffee goes down and demand for tea and other substitutes goes up OR demand for expensive coffee goes down and cheaper coffee is demanded. Other e.g. maybe spending on leisure – A SECTOR may change overall

The Basic Model of Economic Fluctuations The Basic Model of Aggregate Demand and Aggregate Supply The aggregate-supply curve shows the quantity of goods and services that (all) firms choose to produce and sell at each price level.

Figure 2 Aggregate Demand and Aggregate Supply... Price Level Aggregate supply Aggregate demand Equilibrium output price level Quantity of Output Copyright © 2004 South-Western

THE AGGREGATE-DEMAND CURVE The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX What are these? EXAM QUESTION/Topic

Figure 3 The Aggregate-Demand Curve... Price Level Aggregate demand P Y 1. A decrease in the price level . . . Y2 P2 Quantity of 2. . . . increases the quantity of goods and services demanded. Output Copyright © 2004 South-Western

Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Consumption: The Wealth Effect The Price Level and Investment: The Interest Rate Effect The Price Level and Net Exports: The Exchange-Rate Effect more later

Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Consumption: The Wealth Effect A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more. This increase in consumer spending means larger quantities of goods and services demanded. And SO?

Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Investment: The Interest Rate Effect A lower price level reduces the interest rate, which encourages greater spending on investment goods. This increase in investment spending means a larger quantity of goods and services demanded.

Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Net Exports: The Exchange-Rate Effect When a fall in the U.S. price level causes U.S. interest rates to fall, the real exchange rate depreciates, which stimulates U.S. net exports. The increase in net export spending means a larger quantity of goods and services demanded from the U.S

The Exchange-Rate Effect £ 1 = $ 4 If a car costs $40,000 it will be £10,000 £1 = $2 The $40,000 car will be £ 20,000 Imports more expensive in REAL TERMS

The Exchange-Rate Effect continued £1 = $ 4 An American tourist going to UK on holiday that costs £1000 will need $4000 £1 = $2 Now her £1000 holiday will cost $2000! Result more Americans going to UK = increase in exports for UK

Why the Aggregate-Demand Curve Might Shift The downward slope of the aggregate demand curve shows that a fall in the price level raises the overall quantity of goods and services demanded. Many other factors, however, affect the quantity of goods and services demanded at any given price level. When one of these other factors changes, the aggregate demand curve shifts.

Why the Aggregate-Demand Curve Might Shift Shifts arising from Consumption – EG change in personal taxation. Investment – Change in Interest Rates Government Purchases – change of government Net Exports – New trade deal

Shifts in the Aggregate Demand Curve Price Level D2 P1 Y2 Remove bullet in graph – graph needs no additional title??? Aggregate demand, D1 Y1 Quantity of Output 26

THE AGGREGATE-SUPPLY CURVE The Long-Run Aggregate-Supply Curve In the long run, an economy’s production of goods and services depends on its supplies of labour, capital, and natural resources and on the available technology used to turn these factors of production into goods and services. The price level does not affect these variables in the long run.

Figure 4 The Long-Run Aggregate-Supply Curve Price Level Long-run aggregate supply P 1. A change in the price level . . . P2 2. . . . does not affect the quantity of goods and services supplied in the long run. Natural rate Quantity of of output Output Copyright © 2004 South-Western

THE AGGREGATE-SUPPLY CURVE The Long-Run Aggregate-Supply Curve The long-run aggregate-supply curve is vertical at the natural rate of output. This level of production is also referred to as potential output or full-employment output.

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.

Why the Long-Run Aggregate-Supply Curve Might Shift Shifts arising Labour Capital Natural Resources Technological Knowledge and Innovation.

Figure 5 Long-Run Growth and Inflation 2. . . . and growth in the money supply shifts aggregate demand . . . Long-run aggregate supply, LRAS 1980 Y 1990 LRAS Y 2000 LRAS Price Aggregate Demand, AD 2000 Level 1. In the long run, technological progress shifts long-run aggregate supply . . . AD 1990 P 2000 4. . . . and ongoing inflation. P 1990 P 1980 AD 1980 Y 1980 3. . . . leading to growth in output . . . Quantity of Output Copyright © 2004 South-Western

A 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.

Why the Aggregate-Supply Curve Slopes Upward in the Short Run 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. A decrease in the level of prices tends to reduce the quantity of goods and services supplied. Potential supply – shut down versus exit

Figure 6 The Short-Run Aggregate-Supply Curve Price Level Short-run aggregate supply Y P 1. A decrease in the price level . . . Y2 P2 2. . . . reduces the quantity of goods and services supplied in the short run. Quantity of Output Copyright © 2004 South-Western

Why the Aggregate-Supply Curve Slopes Upward in the Short Run The Misperceptions Theory The Sticky-Wage Theory The Sticky-Price Theory The order of discussion in Mankiw has been changed. The “misperceptions theory” must be moved to the bottom of the list. (This may affect the entire order of presentation following this slide.) 36

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. Move this slide so that it follows the next two slides. That puts the discussion in the new order of the text. 37

Why the Short-Run Aggregate-Supply Curve Might Shift Shifts arising Labor Capital Natural Resources. Technology. Expected Price Level.

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. Should title be, “Why the short-run aggregate supply…” 39

Figure 7 The Long-Run Equilibrium Price Level Long-run aggregate supply Short-run aggregate supply Aggregate demand A Equilibrium price Natural rate of output Quantity of Output Copyright © 2004 South-Western

Figure 8 A Contraction in Aggregate Demand 2. . . . causes output to fall in the short run . . . Price Level Short-run aggregate supply, AS Long-run aggregate supply Aggregate demand, AD AS2 AD2 3. . . . but over time, the short-run aggregate-supply curve shifts . . . A P Y B P2 Y2 1. A decrease in aggregate demand . . . C P3 4. . . . and output returns to its natural rate. Quantity of Output Copyright © 2004 South-Western

TWO 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.

TWO CAUSES OF ECONOMIC FLUCTUATIONS An Adverse Shift in Aggregate Supply A decrease in one of the determinants of aggregate supply shifts the curve to the left: Output falls below the natural rate of employment. Unemployment rises. The price level rises.

Figure 10 An Adverse Shift in Aggregate Supply 1. An adverse shift in the short- run aggregate-supply curve . . . Price Level Long-run Short-run aggregate supply, AS AS2 aggregate supply Aggregate demand B Y2 P2 Y A P 3. . . . and the price level to rise. Quantity of 2. . . . causes output to fall . . . Output Copyright © 2004 South-Western

Interest/Base rates and Recession

The Effects of a Shift in Aggregate Supply Stagflation 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.

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.

Figure 11 Accommodating an Adverse Shift in Aggregate Supply 1. When short-run aggregate supply falls . . . Price Level Long-run Short-run aggregate supply, AS AS2 aggregate AD2 supply C P3 2. . . . policymakers can accommodate the shift by expanding aggregate demand . . . 3. . . . which causes the price level to rise further . . . P2 A P 4. . . . but keeps output at its natural rate. Aggregate demand, AD Natural rate Quantity of of output Output Copyright © 2004 South-Western

Summary All 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.

Summary Economists 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.

Summary The 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.

Summary Events 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.

Summary A second possible cause of economic fluctuations is a shift in aggregate supply. Stagflation is a period of falling output and rising prices. STICKY????

Activity What effect do you think that the internet has had on Aggregate Supply and Demand? Explain your view – in economic terms…

Catch up two key topics Velocity of money Costs of Inflation.

The Inflation Tax When the government raises revenue by printing money, it is said to levy an inflation tax. An inflation tax is like a tax on everyone who holds money. The inflation ends when the government institutes fiscal reforms such as cuts in government spending.

The real interest rate stays the same. The Fisher Effect The Fisher effect refers to a one-to-one adjustment of the nominal interest rate to the inflation rate. According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount. The real interest rate stays the same. The equation of the fisher effect must appear here or on a new next slide: “Nominal interest rate = real interest rate + inflation rate”

Figure 5 The Nominal Interest Rate and the Inflation Rate Percent (per year) 15 12 Nominal interest rate 9 6 Inflation 3 1960 1965 1970 1975 1980 1985 1990 1995 2000 Copyright © 2004 South-Western

THE COSTS OF INFLATION A Fall in Purchasing Power? Inflation does not in itself reduce people’s real purchasing power.

THE COSTS OF INFLATION Shoeleather costs Menu costs Relative price variability Tax distortions Confusion and inconvenience Arbitrary redistribution of wealth

Shoeleather Costs Shoeleather costs are the resources wasted when inflation encourages people to reduce their money holdings. Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings.

Shoeleather Costs Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts. The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand. Also, extra trips to the bank take time away from productive activities.

Menu Costs Menu costs are the costs of adjusting prices. During inflationary times, it is necessary to update price lists and other posted prices. This is a resource-consuming process that takes away from other productive activities.

Relative-Price Variability and the Misallocation of Resources Inflation distorts relative prices. Consumer decisions are distorted, and markets are less able to allocate resources to their best use.

Inflation-Induced Tax Distortion Inflation exaggerates the size of capital gains and increases the tax burden on this type of income. With progressive taxation, capital gains are taxed more heavily.

Inflation-Induced Tax Distortion The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation. The after-tax real interest rate falls, making saving less attractive.

Confusion and Inconvenience When the CB increases the money supply and creates inflation, it erodes the real value of the unit of account. Inflation causes dollars/RMB/Pounds at different times to have different real values. Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time.

A Special Cost of Unexpected Inflation: Arbitrary Redistribution of Wealth Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need. These redistributions occur because many loans in the economy are specified in terms of the unit of account—money.

Summary The overall level of prices in an economy adjusts to bring money supply and money demand into balance. When the central bank increases the supply of money, it causes the price level to rise. Persistent growth in the quantity of money supplied leads to continuing inflation.

Summary The principle of money neutrality asserts that changes in the quantity of money influence nominal variables but not real variables. A government can pay for its spending simply by printing more money. This can result in an “inflation tax” and hyperinflation.

Summary According to the Fisher effect, when the inflation rate rises, the nominal interest rate rises by the same amount, and the real interest rate stays the same. Many people think that inflation makes them poorer because it raises the cost of what they buy. This view is a fallacy because inflation also raises nominal incomes.

THE CLASSICAL THEORY OF INFLATION The Quantity Theory of Money How the price level is determined and why it might change over time is called the quantity theory of money. The quantity of money available in the economy determines the value of money. The primary cause of inflation is the growth in the quantity of money.

The Classical Dichotomy and Monetary Neutrality Nominal variables are variables measured in monetary units. Real variables are variables measured in physical units.

The Classical Dichotomy and Monetary Neutrality According to Hume and others, real economic variables do not change with changes in the money supply. According to the classical dichotomy, different forces influence real and nominal variables. Changes in the money supply affect nominal variables but not real variables.

The Classical Dichotomy and Monetary Neutrality The irrelevance of monetary changes for real variables is called monetary neutrality.

Velocity and the Quantity Equation The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

Velocity and the Quantity Equation The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables: the price level must rise, the quantity of output must rise, or the velocity of money must fall.

Figure 3 Nominal GDP, the Quantity of Money, and the Velocity of Money Indexes (1960 = 100) 2,000 Nominal GDP 1,500 M2 1,000 500 Velocity 1960 1965 1970 1975 1980 1985 1990 1995 2000 Copyright © 2004 South-Western

Velocity and the Quantity Equation The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money The velocity of money is relatively stable over time. When the Fed changes the quantity of money, it causes proportionate changes in the nominal value of output (P  Y). Because money is neutral, money does not affect output.

CASE STUDY: Money and Prices during Four Hyperinflations Hyperinflation is inflation that exceeds 50 percent per month. Hyperinflation occurs in some countries because the government prints too much money to pay for its spending. Align text for second bullet.

Figure 4 Money and Prices During Two Hyperinflations (c) Germany (d) Poland Index Index (Jan. 1921 = 100) (Jan. 1921 = 100) 100,000,000,000,000 10,000,000 Price level 1,000,000,000,000 1,000,000 Price level 10,000,000,000 Money supply 100,000 Money supply 100,000,000 1,000,000 10,000 10,000 1,000 100 1 100 1921 1922 1923 1924 1925 1921 1922 1923 1924 1925 Copyright © 2004 South-Western