Aggregate Demand and Supply, cont. On a graph, price level (just like price) is on the vertical axis, while real GDP (just like quantity is on the horizontal. The Law of Demand and the Law of Supply apply just like they do in microeconomics. – Therefore, the AD curve slopes downward and the AS curve slopes upward. AD and AS can each change for similar reasons to those in microeconomics, resulting in a new equilibrium.

Aggregate Demand and Supply, cont. An increase in AD will lead to an increase in real GDP while price levels will also increase (inflation).

Increase in Aggregate Demand AD1 AS AD2 Original equilibrium New equilibrium Price level Real GDP

Aggregate Demand and Supply, cont. A decrease in AD will lead to a decrease in real GDP while price levels will also decrease (deflation).

Decrease in Aggregate Demand AD2 AS AD1 New equilibrium Original equilibrium Price level Real GDP

Aggregate Demand and Supply, cont. An increase in AS will lead to an increased real GDP while price levels will decrease (deflation).

Increase in Aggregate Supply AD AS1 Original equilibrium AS2 New equilibrium Price level Real GDP

Aggregate Demand and Supply, cont. A decrease in AS will lead to a decreased real GDP while price levels will increase (inflation).

Decrease in Aggregate Supply D S2 New equilibrium S1 Original equilibrium Price level Real GDP

Business Cycles While GDP tends to grow in the long term (“the trend”), it may fluctuate to large degrees. Business cycle: – A period of macroeconomic expansion followed by a period of macroeconomic contraction.

Business Cycles, cont. Every business cycle has four phases: 1. Expansion: Real GDP rises, businesses are generally prosperous. 2. Peak: Real GDP stops rising, expansion has reached its greatest height. 3. Contraction: Real GDP falls, businesses produce less 4. Trough: Real GDP stops falling, contraction has reached its lowest point.

Business Cycle

Three Types of Severe Contractions 1. Recession – When GDP falls for at least two consecutive quarters (6 months) – A prolonged economic contraction 2. Depression – An especially long and severe recession 3. Stagflation – A decline in GDP combined with a rise in the price level (due to decrease in aggregate supply)

Four Factors Behind Business Cycles 1. Business investment – When the economy expands businesses invest more, creating more jobs, continuing the expansion. – When they stop, the economy soon contracts. 2. Interest Rates and Credit – Low rates on loans encourage more spending and economic expansion. – Higher rates cause consumers and businesses to cut back on spending; the economy contracts.

Four Factors Behind Business Cycles, cont. 3. Consumer Expectations – Optimism about the economy leads to more spending and economic expansion. – Fears about the economy lead to cutbacks in spending and therefore contraction. 4. External Shocks – Positive examples: discovery of natural resources, an ideal growing season, war – Negative examples: disruption to the oil supply, drought, war

Lesson of the Business Cycle Nothing lasts forever! – When things are going well, they will eventually get less well for a while. – When things are going poorly, they will eventually improve. However, the long term trend tends to be one of economic growth, so it is okay to be optimistic!