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Short-Run Aggregate Fluctuations Economic activity fluctuates from year to year. In most years production of goods and services rises. On average over the past 50 years, production in the U.S. economy has grown by about 3 percent per year. In some years normal growth does not occur, indicating a recession.

Aggregate Demand and Aggregate Supply What causes short-run fluctuations in economic activity? What can public policy do to prevent periods of falling incomes and rising unemployment rate? When recessions (景氣衰退) and depressions (經濟蕭條) occur, how can policymakers reduce their length and severity?

Aggregate Demand and Aggregate Supply Our focus is on the economy’s short-run fluctuations(短期波動) around its long-run trend (長期趨勢). This chapter introduces the aggregate demand curve and the aggregate supply curve.

Short-Run Economic Fluctuations A recession is a period of slowdown in economic growth or declining real incomes, and rising unemployment rate. A depression is a severe recession.

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS Economic fluctuations are irregular and not completely predictable. Aggregate fluctuations in the economy are often called the business cycle. These fluctuations do not follow regular or easily predictable patterns. The longest period in U.S. history without a recession was the economic expansion from 1991 to 2001.

A Look At Short-Run Economic Fluctuations (a) Real GDP Billions of 2000 Dollars Real GDP $10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 196 5 197 197 5 198 198 5 199 199 5 200 2005

台灣實證GDP：1961-2008

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS Most macroeconomic variables move together. Most macroeconomic variables that measure some type of income, spending, or production fluctuate closely together. Although many macroeconomic variables fluctuate together, they fluctuate by different amounts. Aggregate fluctuations in the economy are often called the business cycle. Consumption varies smoothly over business cycles, while investment varies greatly over business cycles.

A Look At Short-Run Economic Fluctuations (b) Investment Spending Billions of 2000 Dollars Investment Spending $1,500 1,000 500 196 5 197 197 5 198 198 5 199 199 5 200 2005

台灣國內投資占GDP比率：1961-2008

台灣淨出口占GDP比率：1961-2008

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. When the recession ends and real GDP starts to expand, the unemployment rate gradually declines.

A Look At Short-Run Economic Fluctuations (c) Unemployment Rate Percent of Labor Force 12% Unemployment Rate 10 8 6 4 2 196 5 197 197 5 198 198 5 199 199 5 200 2005

台灣失業率：1978-2008

EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS The Assumptions of Classical Economics 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 assumption of monetary neutrality is not appropriate when studying year-to-year changes in the economy.

EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS Most economists believe that classical theory describes the world in the long run but not in the short run. In the short run, real and nominal variables are highly intertwinded, and changes in the money supply can temporarily push real GDP away from its long run trend. Our new model focuses on how real and nominal variables interact.

EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS If the quantity of money in the economy were to double, prices would double and so would incomes. Real variables would remain constant. However, these changes will not occur instantaneously. It takes time for prices and incomes to change, and in the meantime, there can be real effects.

The Model of Aggregate Demand and Aggregate Supply 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 average level of prices measured by the CPI or the GDP deflator.

The Model of Aggregate Demand and Aggregate Supply Economist use the model of aggregate demand (總合需求) and aggregate supply(總合供給) to explain short-run fluctuations in economic activity around its long-run trend. Time Economic activity Business cycle

The Model of Aggregate Demand and Aggregate Supply The aggregate demand curve(總合需求曲線) shows the quantity of goods and services that households, firms, and the government want to buy at each price level. The aggregate supply curve(總合供給曲線) shows the quantity of goods and services that firms choose to produce and sell at each price level.

THE AGGREGATE-DEMAND CURVE Why does a change in price level move the quantity of goods and services demanded in the opposite direction? To answer it, recall that GDP (Y) is the sum of consumption (C), Investment (I), government (G), and net exports (NX): Y = C + I + G + NX

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

Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Consumption: The Wealth Effect (財富效果) The Price Level and Investment: The Interest Rate Effect (利率效果) The Price Level and Net Exports: The Exchange Rate Effect (匯率效果)

Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Consumption: The Wealth Effect (The least important factor) A lower price level raises the real value of money and makes consumers wealthier, which encourages them to spend more. This increase in consumer spending means larger quantities of goods and services demanded.

Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Investment: The Interest Rate Effect (The most important factor) The lower the price level, the less money households need to hold to buy goods and services they want. When the price level falls, households try to reduce their holding of money either by buying interest-bearing bonds or by depositing excess money in saving accounts. In either case, they drive down interest rate. A lower interest rate encourages firms to borrow more to invest in new plant and equipment, and also encourages households to borrow more to invest in new housing. Thus, a lower interest rate increases the quantity of goods and services demanded.

Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Net Exports: The Exchange Rate Effect A lower price level in Taiwan causes the Taiwan interest rates to fall. In response to the lower Taiwan interest rate, some Taiwan investors will seek higher returns by investing abroad. This will increase the supply of N.T. dollars in the foreign currency exchange market. It will cause N.T. dollars to depreciate relative to the foreign currency, and hence stimulates Taiwan net exports. The increase in net export spending means a larger quantity of goods and services demanded.

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 might arise from changes in: Consumption Investment in economic boom and recession Government Purchases Tax policy Net Exports due to boom and recession in world markets

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

THE AGGREGATESUPPLY CURVE Classical macroeconomics predicts the quantity of goods and services produced by an economy in the long run. In the long run, the aggregate-supply curve is vertical because the price level does not affect long run determinants of real GDP. The long-run level of output is called the natural rate of output since it shows what the economy produces when unemployment is at its natural rate. In the short run, the aggregate-supply curve is upward sloping.

THE AGGREGATESUPPLY CURVE In the long run, an economy’s production of goods and services depends on its supplies of labor, 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. The long-run aggregate supply represents the classical dichotomy and money neutrality.

The Long-Run Aggregate-Supply Curve is Vertical 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

THE AGGREGATE-SUPPLY CURVE The long-run aggregate-supply curve is vertical at the natural rate of output(自然產出率), which is the production of goods and services that an economy achieves in the long run when unemployment is at its natural rate. This level of production is also referred to as potential output or full-employment output (充分就業產出水準). The natural rate of output is level of output towards which the economy gravitates in the long run.

The determination of long-run Equilibrium

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 might arise from changes in: Labor (increases in immigration, increases in minimum wage rate) Accumulation in physical and human capital Natural Resources (oil shocks) Technological Knowledge (Trade openness)

Long-Run Growth and Inflation 2. . . . and growth in the money supply shifts aggregate demand . . . Long-run aggregate supply, LRAS Y 1990 LRAS Y 2000 LRAS 1980 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

Using Aggregate Demand and Aggregate Supply to Depict Long-Run Growth and Inflation The most important forces that govern the economy in the long run are technology and monetary policy. Short-run fluctuations in output and the price level should be viewed as deviations from the continuing long-run trends of output growth and inflation.

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. As a result, the short-run aggregate-supply curve is upward sloping.

The Short-Run Aggregate-Supply Curve is Upward Sloping Price Level Short-run aggregate Supply (S-RAS) 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

Why the Aggregate-Supply Curve Slopes Upward in the Short Run Three Theories: The Sticky-Wage Theory (薪資僵固理論) The Sticky-Price Theory (價格僵固理論) The Misperceptions Theory (對價格變動錯誤解讀理論) 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.)

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. When nominal wages are based on the expected prices and do not respond immediately when the actual price level turns out to be different from what was expected. This stickiness gives firms an incentive to produce less (more) when the price level turns out lower (higher) than expected. The slow can be attributed to long-term contract between workers and firms. This induces firms to reduce the quantity of goods and services supplied.

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. This slow adjustment of prices occurs in part because there are costs to adjusting prices, called menu costs. 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.

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.

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

The Determination of Short-Run Equilibrium Price Level S-RAS AD Equilibrium output price level Quantity of Output

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

In long-run equilibrium, Short-run equilibrium co-inside with long-run equilibrium at point A. At point A, actual inflation rate equals expect inflation rate . In long-run equilibrium, the equilibrium quantity of output equals the natural rate of output.

When short-run equilibrium differs from long-run equilibrium

At the short-run equilibrium (A), price level ( ) is less than expected price level in the long-run equilibrium (B) ( ) . Hence, economic agents will adjust their expected inflation rate so that . As expect inflation rate decreases, the short-run aggregate supply will shift to right until the long-run equilibrium is restored at point C.

Why the Short-Run Aggregate-Supply Curve Might Shift Shifts might arise from changes in: Expected Price Level (nominal wages, prices and perceptions are set on the basis of the expected price level). Labor. Capital. Natural Resources. Technology.

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…”

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.

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. Policymakers who influence aggregate demand can potentially mitigate the severity of economic fluctuations.

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

TWO CAUSES OF ECONOMIC FLUCTUATIONS Shifts in Aggregate Supply Consider 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.

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

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.

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.

Accommodating an Adverse Shift in Aggregate Supply 1. When short-run aggregate supply falls . . . Price Level Long-run Short-run AS2 aggregate AD2 aggregate supply supply, AS 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

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.

Classical economic theory is based on the assumption that nominal variables do not influence real variables. Most economists believe that this is an accurate assumption in the long run, but not in the short run.

Economists analyze short-run economic fluctuations using the aggregate demand and aggregate supply model. According to this model, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply.

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.

In the long run, the aggregate supply curve is vertical. In the short-run, the aggregate supply curve is upward sloping. The are three theories explaining the upward slope of short-run aggregate supply: the sticky-wage theory, the sticky-price theory and the misperceptions theory.

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.

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