1. Aggregate Demand and Aggregate Supply
Lesson 7 Chapter 33
Aggregate Demand and Aggregate Supply

2. Short-Run Economic Fluctuations
Economic activity fluctuates from year to year.
In most years production of goods and services rises.
On average since 1955, 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.
Definition of a recession is two consecutive quarters of negative growth

3. Negative Growth?

4. Short-Run Economic Fluctuations
A recession is a period of declining real incomes, rising unemployment and negative growth in the real GDP
A depression is a severe recession as witnesses after the First World War 1914 – 1918 – which finally hit the world economies in the 1920’s

5. THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS
Economic fluctuations are irregular and unpredictable (often)
Fluctuations in the economy are often called the business cycle.
Most macroeconomic variables fluctuate together.
As output falls, unemployment rises.
As output increases, unemployment falls and ?

6. THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS
Most macroeconomic variables fluctuate together.
Most macroeconomic variables that measure some type of income or production fluctuate closely together.
Although many macroeconomic variables fluctuate together, they fluctuate by different amounts.

7. 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.
Leading to Government increase in Government spending – Transfer payments AND reduced Government income. (less tax revenues)

8. EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS
How the Short Run Differs from the Long Run
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.

9. The Basic Model of Economic Fluctuations
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 overall price level measured by the CPI or the GDP deflator.

10. The Basic Model of Economic Fluctuations
The Basic 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.
Aggregate everything combined….. A mixture…
Includes general level of prices

11. Figure 1 The Circular-Flow Diagram OLD FRIEND
Firms sell
Households buy
MARKETS
FOR
GOODS AND SERVICES
Revenue
Spending
Goods
and services
sold
Goods and
services
bought
FIRMS
Produce and sell
goods and services
Hire and use factors
of production
Buy and consume
goods and services
Own and sell factors
of production
HOUSEHOLDS
Households sell
Firms buy
MARKETS
FOR
FACTORS OF PRODUCTION
Factors of
production
Labor, land,
and capital
Wages, rent,
and profit
Income
= Flow of inputs
and outputs
= Flow of dollars
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12. The Basic Model of Economic Fluctuations
The Basic 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.

13. Micro vs Macro Demand
We know that there is the substitute effect.
The aggregate demand curve allows for switching to substitutes or lower priced/QUALITY items
So for example demand for coffee goes down and demand for tea and other substitutes goes up OR demand for expensive coffee goes down and cheaper coffee is demanded.
Other e.g. maybe spending on leisure – A SECTOR may change overall

14. The Basic Model of Economic Fluctuations
The Basic Model of Aggregate Demand and Aggregate Supply
The aggregate-supply curve shows the quantity of goods and services that (all) firms choose to produce and sell at each price level.

15. Figure 2 Aggregate Demand and Aggregate Supply...
Price
Level
Aggregate
supply
Aggregate
demand
Equilibrium
output
price level
Quantity of
Output
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16. THE AGGREGATE-DEMAND CURVE
The four components of GDP (Y) contribute to the aggregate demand for goods and services.
Y = C + I + G + NX
What are these?
EXAM QUESTION/Topic

17. Figure 3 The Aggregate-Demand Curve...
Price
Level
Aggregate
demand P Y
1. A decrease
in the price
level . . . Y2 P2
Quantity of
increases the quantity of
goods and services demanded.
Output
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18. 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 more later

19. Why the Aggregate-Demand Curve Is Downward Sloping
The Price Level and Consumption: The Wealth Effect
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. And SO?

20. 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, which encourages greater spending on investment goods.
This increase in investment spending means a larger quantity of goods and services demanded.

21. Why the Aggregate-Demand Curve Is Downward Sloping
The Price Level and Net Exports: The Exchange-Rate Effect
When a fall in the U.S. price level causes U.S. interest rates to fall, the real exchange rate depreciates, which stimulates U.S. net exports.
The increase in net export spending means a larger quantity of goods and services demanded from the U.S

22. The Exchange-Rate Effect
£ 1 = $ 4
If a car costs $40,000 it will be £10,000
£1 = $2
The $40,000 car will be £ 20,000
Imports more expensive in REAL TERMS

23. The Exchange-Rate Effect continued
£1 = $ 4
An American tourist going to UK on holiday that costs £1000 will need $4000
£1 = $2
Now her £1000 holiday will cost $2000!
Result more Americans going to UK = increase in exports for UK

24. 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.

25. Why the Aggregate-Demand Curve Might Shift
Shifts arising from
Consumption – EG change in personal taxation.
Investment – Change in Interest Rates
Government Purchases – change of government
Net Exports – New trade deal

26. 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 26

27. THE AGGREGATE-SUPPLY CURVE
The Long-Run Aggregate-Supply Curve
In the long run, an economy’s production of goods and services depends on its supplies of labour, 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.

28. Figure 4 The Long-Run Aggregate-Supply Curve
Price
Level
Long-run
aggregate
supply P
1. A change
in the price
level . . . P2
does not affect
the quantity of goods
and services supplied
in the long run.
Natural rate
Quantity of
of output
Output
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29. THE AGGREGATE-SUPPLY CURVE
The Long-Run Aggregate-Supply Curve
The long-run aggregate-supply curve is vertical at the natural rate of output.
This level of production is also referred to as potential output or full-employment output.

30. 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.

31. Why the Long-Run Aggregate-Supply Curve Might Shift
Shifts arising
Labour
Capital
Natural Resources
Technological Knowledge and Innovation.

32. Figure 5 Long-Run Growth and Inflation
and growth in the
money supply shifts
aggregate demand . . .
Long-run
aggregate
supply,
LRAS
1980 Y
1990
LRAS Y
2000
LRAS
Price
Aggregate
Demand, AD
2000
Level
1. In the long run,
technological
progress shifts
long-run aggregate
supply . . . AD
1990 P
2000
and
ongoing inflation. P
1990 P
1980 AD
1980 Y
1980
leading to growth
in output . . .
Quantity of
Output
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33. A New Way to Depict Long-Run Growth and Inflation
Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends.

34. 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.
Potential supply – shut down versus exit

35. Figure 6 The Short-Run Aggregate-Supply Curve
Price
Level
Short-run
aggregate
supply Y P
1. A decrease
in the price
level . . . Y2 P2
reduces the quantity
of goods and services
supplied in the short run.
Quantity of
Output
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36. Why the Aggregate-Supply Curve Slopes Upward in the Short Run
The Misperceptions Theory
The Sticky-Wage Theory
The Sticky-Price Theory
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.) 36

37. 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. 37

38. Why the Short-Run Aggregate-Supply Curve Might Shift
Shifts arising
Labor
Capital
Natural Resources.
Technology.
Expected Price Level.

39. 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…” 39

40. Figure 7 The Long-Run Equilibrium
Price
Level
Long-run
aggregate
supply
Short-run
aggregate
supply
Aggregate
demand A
Equilibrium
price
Natural rate
of output
Quantity of
Output
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41. Figure 8 A Contraction in Aggregate Demand
causes output to fall in the short run . . .
Price
Level
Short-run aggregate
supply, AS
Long-run
aggregate
supply
Aggregate
demand, AD
AS2
AD2
but over
time, the short-run
aggregate-supply
curve shifts . . . A P Y B P2 Y2
1. A decrease in
aggregate demand . . . C P3
and output returns
to its natural rate.
Quantity of
Output
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42. 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.

43. TWO CAUSES OF ECONOMIC FLUCTUATIONS
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.

44. Figure 10 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
and
the price
level to rise.
Quantity of
causes output to fall . . .
Output
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45. Interest/Base rates and Recession

46. The Effects of a Shift in Aggregate Supply
Stagflation
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.

47. 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.

48. Figure 11 Accommodating an Adverse Shift in Aggregate Supply
1. When short-run aggregate
supply falls . . .
Price
Level
Long-run
Short-run
aggregate
supply, AS
AS2
aggregate
AD2
supply C P3
policymakers can
accommodate the shift
by expanding aggregate
demand . . .
which
causes the
price level
to rise
further . . . P2 A P
but keeps output
at its natural rate.
Aggregate demand, AD
Natural rate
Quantity of
of output
Output
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49. Summary
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.

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

51. Summary
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.

52. Summary
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.

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

54. Activity
What effect do you think that the internet has had on Aggregate Supply and Demand?
Explain your view – in economic terms…

55. Catch up two key topics
Velocity of money Costs of Inflation.

56. The Inflation Tax
When the government raises revenue by printing money, it is said to levy an inflation tax.
An inflation tax is like a tax on everyone who holds money.
The inflation ends when the government institutes fiscal reforms such as cuts in government spending.

57. The real interest rate stays the same.
The Fisher Effect
The Fisher effect refers to a one-to-one adjustment of the nominal interest rate to the inflation rate.
According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount.
The real interest rate stays the same.
The equation of the fisher effect must appear here or on a new next slide:
“Nominal interest rate = real interest rate + inflation rate”

58. Figure 5 The Nominal Interest Rate and the Inflation Rate
Percent
(per year) 15 12
Nominal interest rate 9 6
Inflation 3
1960
1965
1970
1975
1980
1985
1990
1995
2000
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59. THE COSTS OF INFLATION A Fall in Purchasing Power?
Inflation does not in itself reduce people’s real purchasing power.

60. THE COSTS OF INFLATION Shoeleather costs Menu costs
Relative price variability
Tax distortions
Confusion and inconvenience
Arbitrary redistribution of wealth

61. Shoeleather Costs
Shoeleather costs are the resources wasted when inflation encourages people to reduce their money holdings.
Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings.

62. Shoeleather Costs
Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts.
The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand.
Also, extra trips to the bank take time away from productive activities.

63. Menu Costs
Menu costs are the costs of adjusting prices.
During inflationary times, it is necessary to update price lists and other posted prices.
This is a resource-consuming process that takes away from other productive activities.

64. Relative-Price Variability and the Misallocation of Resources
Inflation distorts relative prices.
Consumer decisions are distorted, and markets are less able to allocate resources to their best use.

65. Inflation-Induced Tax Distortion
Inflation exaggerates the size of capital gains and increases the tax burden on this type of income.
With progressive taxation, capital gains are taxed more heavily.

66. Inflation-Induced Tax Distortion
The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation.
The after-tax real interest rate falls, making saving less attractive.

67. Confusion and Inconvenience
When the CB increases the money supply and creates inflation, it erodes the real value of the unit of account.
Inflation causes dollars/RMB/Pounds at different times to have different real values.
Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time.

68. A Special Cost of Unexpected Inflation: Arbitrary Redistribution of Wealth
Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need.
These redistributions occur because many loans in the economy are specified in terms of the unit of account—money.

69. Summary
The overall level of prices in an economy adjusts to bring money supply and money demand into balance.
When the central bank increases the supply of money, it causes the price level to rise.
Persistent growth in the quantity of money supplied leads to continuing inflation.

70. Summary
The principle of money neutrality asserts that changes in the quantity of money influence nominal variables but not real variables.
A government can pay for its spending simply by printing more money.
This can result in an “inflation tax” and hyperinflation.

71. Summary
According to the Fisher effect, when the inflation rate rises, the nominal interest rate rises by the same amount, and the real interest rate stays the same.
Many people think that inflation makes them poorer because it raises the cost of what they buy.
This view is a fallacy because inflation also raises nominal incomes.

72. THE CLASSICAL THEORY OF INFLATION
The Quantity Theory of Money
How the price level is determined and why it might change over time is called the quantity theory of money.
The quantity of money available in the economy determines the value of money.
The primary cause of inflation is the growth in the quantity of money.

73. The Classical Dichotomy and Monetary Neutrality
Nominal variables are variables measured in monetary units.
Real variables are variables measured in physical units.

74. The Classical Dichotomy and Monetary Neutrality
According to Hume and others, real economic variables do not change with changes in the money supply.
According to the classical dichotomy, different forces influence real and nominal variables.
Changes in the money supply affect nominal variables but not real variables.

75. The Classical Dichotomy and Monetary Neutrality
The irrelevance of monetary changes for real variables is called monetary neutrality.

76. Velocity and the Quantity Equation
The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

77. Velocity and the Quantity Equation
The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables:
the price level must rise,
the quantity of output must rise, or
the velocity of money must fall.

78. Figure 3 Nominal GDP, the Quantity of Money, and the Velocity of Money
Indexes
(1960 = 100)
2,000
Nominal GDP
1,500 M2
1,000
500
Velocity
1960
1965
1970
1975
1980
1985
1990
1995
2000
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79. Velocity and the Quantity Equation
The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money
The velocity of money is relatively stable over time.
When the Fed changes the quantity of money, it causes proportionate changes in the nominal value of output (P  Y).
Because money is neutral, money does not affect output.

80. CASE STUDY: Money and Prices during Four Hyperinflations
Hyperinflation is inflation that exceeds 50 percent per month.
Hyperinflation occurs in some countries because the government prints too much money to pay for its spending.
Align text for second bullet.

81. Figure 4 Money and Prices During Two Hyperinflations
(c) Germany
(d) Poland
Index
Index
(Jan = 100)
(Jan = 100)
100,000,000,000,000
10,000,000
Price level
1,000,000,000,000
1,000,000
Price level
10,000,000,000
Money
supply
100,000
Money
supply
100,000,000
1,000,000
10,000
10,000
1,000
100 1
100
1921
1922
1923
1924
1925
1921
1922
1923
1924
1925
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