Copyright © 2004 South-Western Mods 17-21, 30 Macro Analysis Part I

Copyright © 2004 South-Western Short-Run Economic 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, causing a recession.

Copyright © 2004 South-Western Short-Run Economic Fluctuations A recession is a period of declining real incomes, and rising unemployment Typically, economists term a downturn a recession if there are “2 quarters (1/2 year) of negative GDP growth” A depression is a severe recession.

Copyright © 2004 South-Western THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS Economic fluctuations are irregular and unpredictable. Fluctuations are called “the business cycle” Most macroeconomic variables fluctuate together. As output falls, unemployment rises.

A Look At Short-Run Economic Fluctuations Billions of 1996 Dollars Real GDP (a) Real GDP $10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2, Copyright © 2004 South-Western

A Look At Short-Run Economic Fluctuations Billions of 1996 Dollars (b) Investment Spending $1,800 1,600 1,400 1,200 1, Investment spending Copyright © 2004 South-Western

A Look At Short-Run Economic Fluctuations Percent of Labor Force (c) Unemployment Rate Unemployment rate Copyright © 2004 South-Western

The Basic Model of Macroeconomic Short-Run Economic Fluctuations Two variables are used to develop a model to analyze the macroeconomy and its short-run or real-time fluctuations. GDP Price level A graph is used to show the overall or AGGREGATE Demand for goods and the overall or AGGREGATE Supply of goods in the Economy as a whole

Aggregate Demand and Aggregate Supply GDP=Quantity of Output Price Level 0 Aggregate supply Aggregate demand Equilibrium output Equilibrium price level Copyright © 2004 South-Western AD AS

Copyright © 2004 South-Western The 2 Axes for our Macro We use GDP to measure the OVERALL demand for goods on the X axis. We use the Inflation Rate or GDP Deflator to measure the Price level on the Y axis But…because these are Macro models, we don’t usually use actual figures—we just use the concept of these measures to illustrate the scenarios.

Copyright © 2004 South-Western The Basic Model of Economic Fluctuations The Basic Model of Aggregate Demand The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level.

The Aggregate-Demand Curve GDP--Quantity of Output Price Level 0 Aggregate demand P Y Y2Y2 P2P2 1. A decrease in the OVERALL Price level… increases the OVERALL quantity of goods and services demanded. Copyright © 2004 South-Western

Why the Aggregate-Demand Curve Is Downward Sloping Remember: The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX There are 3 ways that Price level then affects GDP growth/demand…

Copyright © 2004 South-Western Why the Aggregate-Demand Curve Is Downward Sloping 1.The Wealth Effect—affects the “C” demand 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.

Copyright © 2004 South-Western Why the Aggregate-Demand Curve Is Downward Sloping 2.The Interest Rate Effect— affects the “I” demand A lower price level allows households to save money while reducing the interest rate for borrowers, thus allowing for more money for investment, and then greater spending by businesses on investment goods. This increase in investment spending means a larger quantity of goods and services demanded.

Copyright © 2004 South-Western Why the Aggregate-Demand Curve Is Downward Sloping The Net-Export Effect— affects the “NX” demand A lower U.S. price level means prices for goods produced in the U.S. are lower compared to the price of foreign goods. In other words, it makes U.S. goods a better deal for citizens and foreigners, increasing net exports. The increase in net export spending means a larger quantity of goods and services demanded.

Copyright © 2004 South-Western 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.

Copyright © 2004 South-Western Shifts in the Aggregate Demand Curve Quantity of Output Price Level 0 Aggregate demand, D 1 P1P1 Y1Y1 D2D2 Y2Y2

Copyright © 2004 South-Western Why the Aggregate-Demand Curve Might Shift Shifts arising from Consumption Investment Government Purchases Net Exports

Copyright © 2004 South-Western Shifts of the Aggregate Demand Curve ∆C, ∆I, ∆G, ∆X - ∆M ∆Expectations ∆Wealth ∆Existing Stock of Capital ∆Fiscal Policy ∆Monetary Policy

Copyright © 2004 South-Western Why the Aggregate-Demand Curve Might Shift Aggregate Demand Shifts worksheet