Short-Run Economic Fluctuations Aggregate Demand and Aggregate Supply

Outline What causes SR fluctuations in an economy? Analysis of SR fluctuations around its LR trend Model of aggregate demand and aggregate supply

Properties of economic fluctuations Economic fluctuations are irregular and unpredictable Most macroeconomic quantities fluctuate together Unemployment rises with fall in output

Difference between SR and LR Classical economics examines the determinants of real macroeconomic variables in the LR without introducing nominal variables. Classical economics is based on two relate ideas- classical dichotomy and monetary neutrality. In the SR, both real and nominal variables are intertwined. Changes in nominal variables explain SR fluctuations around the LR trend.

Basic model of economic fluctuations Examines the relationship between real GDP and the price level. Model of aggregate demand and aggregate supply explains the SR fluctuations in economic activity around its LR trend. Aggregate demand shows the quantity of goods and services that households, firms, and the government want to buy at each price level. Aggregate supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.

Why the aggregate demand slopes downward? A fall in the price level results in the: wealth effect, which stimulates demand for consumption goods interest rate effect which stimulates the demand for investment goods Real Exchange Rate (RER) effect, which stimulates demand for Net exports (NX) Remember that Money supply is constant

Why the aggregate demand curve may shift? Aggregate demand curve shifts when the demand for quantity of goods and services changes at a given price level. Shifts may occur due to the following factors: Shifts arising from consumption Shifts arising from investment Shifts arising from government purchases Shifts arising from NX

Aggregate Supply Curve: LR and SR In the LR aggregate supply is vertical. In the SR aggregate supply is downward sloping.

Why the aggregate supply curve is vertical in the LR? LR level of production is called as the natural level output or full employment or potential output. Real GDP, in the LR, is a function of factor inputs and available technology. Nominal variables (p level) has no impact on real GDP in the LR. Supply curves for specific goods slope upwards as they depend on relative prices. Economy’s supply of output is limited by factor inputs and technology. Thus an increase in the overall price does not alter the output supplied.

Why the LR aggregate supply curve may shift? Any economic change that alters the natural level of output shifts the aggregate supply curve. Sources of shifts: Changes in labour supply Changes in capital (physical and human) stock Changes in the availability of natural resources Changes in technological knowledge

Relation between LR growth and inflation In the LR, technological changes shift the LR aggregate supply curve In the LR, growth in money supply shifts the LR aggregate demand curve The intersection in aggregate demand and aggregate supply curves shows the trend growth in output and inflation

Why the aggregate supply curve slopes upward in the SR? Specific market imperfections cause deviation in the SR quantity of output from its natural (LR) level, when the price level deviates from its expected level. Theories explaining market imperfections: The misperceptions theory The sticky-wage theory The sticky-price theory

Why the SR aggregate supply curve may shift? The misperceptions theory The sticky-wage theory The sticky-price theory People’s expectations of price level

Why the SR aggregate supply curve may shift? (conclusion) An increase in the expected price level reduces quantity of goods and services supplied and shifts the SR aggregate supply curve to the left. A decrease in the expected price level increases quantity of goods and services supplied and shifts the SR aggregate supply curve to the right. In the SR, expectations are fixed In the LR, expectations adjust and SR aggregate supply curve shifts.

Economic fluctuations: Shifts in aggregate demand In the SR, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services. In the LR, shifts in aggregate demand affect the overall price level but do not affect output. Policy makers can offset shifts in aggregate demand through changes in government exp or changes in money supply.

Economic fluctuations: Shifts in aggregate supply Shifts in aggregate supply can cause stagflation Policy makers can influence aggregate demand in order to maintain output at its natural level. But this leads to a permanent increase in prices. Policy makers may chose not to intervene and let the economy adjust itself. This approach will see a low price level but temporary rise in unemployment and fall in output.