Why is this good? Breaking News Alert The New York Times Tuesday, March 13, :08 PM EDT Stocks Rally Strongly, With Nasdaq Above 3,000 Stocks climbed to new heights in part on rosy retail sales data on Tuesday, pushing the broad market to levels last seen in June 2008 and the Nasdaq composite index past the 3,000 milestone for the first time since Read More:

AD/AS What causes short run changes in the business cycle?

The 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. Time Economic activity Business cycle

The 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. The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level. Sum each definition in six words or less!!!

Figure 2 Aggregate Demand and Aggregate Supply... Quantity of Output Price Level 0 Aggregate supply Aggregate demand Equilibrium output Equilibrium price level How do we measure price level? PPI CPI Price Deflator

Figure 3 The Aggregate-Demand Curve... Quantity of Output Price Level 0 Aggregate demand P Y Y2Y2 P2P2 1. A decrease in the price level increases the quantity of goods and services demanded. WHY???

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

Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Consumption: – The Wealth Effect 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 A lower price level reduces the interest rate and makes borrowing less expensive, 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 A lower price level in the U.S. causes U.S. interest rates to fall and the real exchange rate to depreciate, which stimulates U.S. net exports. The increase in net export spending means a larger quantity of goods and services demanded.

Aggregate Demand can either increase or decrease depending on which variables shift the aggregate demand curve. An increase in aggregate demand is always a shift to the right A decrease in aggregate demand is always a shift to the left. Ad Ad1 PL Q=Real GDP=Y

Variables that influence the components- C onsumption People’s preferences/tastes Change in interest rates Expectations of the future Relative prices of products/services Change in income

I nvestment People’s preferences/tastes Number of consumers Change in Inventories Expectations of the future profit Change in Interest rates Gross Private Domestic Business Investment Variables that influence the components- Change in income

G overnment Spending Dum Politiciansb Variables that influence the components-

(X - M) ExportsImports Relative price of foreign goods/services Relative quality of foreign goods/services International value of the dollar Interest rates Variables that influence the components-

S avings People’s preferences/tastes Change in Interest rates Expectations of the future Relative prices of products/services Variables that influence the components- Change in income

Demand Shifts - Summary 1.Federal government increases personal income tax rates 2.Federal Reserve implements “tight” monetary policy 3.News media runs several stories showing economy in positive light 4.U.S. currency exchange rate depreciates against the Yuan (Chinese currency). 5.People increase savings rates 6.Construction of new housing increases

PL Q = Real GDP = Y Keynesian Range Intermediate Range Classical Range Full Employment g COVER BY JOHN HELD JR. As

PL Q = Real GDP = Y Keynesian Range Intermediate Range Classical Range Full Employment As Structural Frictional Cyclical Unemployment

THE AGGREGATE-SUPPLY CURVE In the long run, the aggregate-supply curve is vertical because the price level does not affect long run determinants of real GDP. In the short run, the aggregate-supply curve is upward sloping.

THE AGGREGATE-SUPPLY 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.

Figure 4 The Long-Run Aggregate- Supply Curve Quantity of Output Natural rate of output Price Level 0 Long-run aggregate supply P2P2 1. A change in the price level does not affect the quantity of goods and services supplied in the long run. P

Why the Long-Run Aggregate-Supply Curve Might Shift Shifts might arise from changes in: – Labor – Capital – Natural Resources – Technological Knowledge

Figure 5 Long-Run Growth and Inflation Quantity of Output Y 1980 AD 1980 AD 1990 Aggregate Demand,AD 2000 Price Level 0 Long-run aggregate supply, LRAS 1980 Y 1990 LRAS 1990 Y 2000 LRAS 2000 P In the long run, technological progress shifts long-run aggregate supply and ongoing inflation leading to growth in output... P 1990 P and growth in the money supply shifts aggregate demand...

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.

Figure 6 The Short-Run Aggregate- Supply Curve Quantity of Output Price Level 0 Short-run aggregate supply 1. A decrease in the price level reduces the quantity of goods and services supplied in the short run. Y P Y2Y2 P2P2

Why the Aggregate-Supply Curve Slopes Upward in the Short Run Three Theories: – The Sticky-Wage Theory – The Sticky-Price Theory – The Misperceptions Theory

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

Why the Aggregate-Supply Curve Slopes Upward in the Short Run The Sticky-Price Theory – 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.

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.

Why the Short-Run Aggregate-Supply Curve Might Shift Shifts might arise from changes in: – Expected Price Level. – Labor. – Capital. – Natural Resources. – Technology. COSTS!!!!

Figure 7 The Long-Run Equilibrium Natural rate of output Quantity of Output Price Level 0 Short-run aggregate supply Long-run aggregate supply Aggregate demand A Equilibrium price

TWO CAUSES OF ECONOMIC FLUCTUATIONS Four steps in the process of analyzing economic fluctuations: 1.Determine whether the event affects aggregate supply or aggregate demand. 2.Decide which direction the curve shifts. 3.Use a diagram to compare the initial and the new equilibrium. 4.Keep track of the short and long run equilibrium, and the transition between them.

Figure 8 A Contraction in Aggregate Demand Quantity of Output Price Level 0 Short-run aggregate supply,AS Long-run aggregate supply Aggregate demand,AD A P Y AD 2 AS 2 1. A decrease in aggregate demand causes output to fall in the short run but over time, the short-run aggregate-supply curve shifts and output returns to its natural rate. CP3P3 B P2P2 Y2Y2

Figure 10 An Adverse Shift in Aggregate Supply Quantity of Output Price Level 0 Aggregate demand and the price level to rise causes output to fall An adverse shift in the short- run aggregate-supply curve... Short-run aggregate supply,AS Long-run aggregate supply Y A P AS 2 B Y2Y2 P2P2

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.

Figure 11 Accommodating an Adverse Shift in Aggregate Supply Quantity of Output Natural rate of output Price Level 0 Short-run aggregate supply,AS Long-run aggregate supply Aggregate demand,AD P2P2 A P AS which causes the price level to rise further but keeps output at its natural rate policymakers can accommodate the shift by expanding aggregate demand When short-run aggregate supply falls... AD 2 C P3P3