1. Class Test 2 Thursday May 28, 5-8 pm For those who want a paper-based test 25 multiple choice questions Covers Lectures 6 – 10 –Chapters 7-16

2. Lecture Purpose To introduce a key macroeconomic model To model changes in the economy due to changes economic variables Prepare for the concluding discussions on macroeconomic policy

3. Lecture 10: Aggregate Demand and Aggregate Supply Short run fluctuations in the economy

4. The Short Run & the Long Run In the short run. –Changes in the money supply affect nominal variables (eg prices) but not real variables in the long run (eg output). In the long run –Output changes due to technology, population growth etc

5. Short-Run Economic Fluctuations Economic activity fluctuates from year to year. –In most years production of goods and services rises but in some years normal growth does not occur, causing a recession. A recession is a period of declining real GDP, falling incomes, and rising unemployment. A depression is a severe recession.

6. Growth over time Real GDP ($b) Years Long term average Recession ‘Boom’

7. Characteristics of Economic Fluctuations Economic fluctuations are irregular and unpredictable. Most macroeconomic variables are related and fluctuate together. –As output falls, unemployment rises and vice versa

8. Explaining Economic Fluctuations Most economists use the model of aggregate demand and aggregate supply to illustrate the effects of short-run fluctuations in economic activity. This is shown in relation to the long-term trend

9. The Basic Model of Economic Fluctuations Two variables are used to develop a model to analyse 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. 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 any price level. The aggregate supply curve shows the quantity of goods and services that firms choose to produce and want to sell at any price level.

11. The Aggregate Demand Curve The four components of GDP ( Y ) contribute to the aggregate demand for goods and services. Y = C + I + G + NX

12. The Aggregate Demand Curve Quantity of Output Price Level 0 Aggregate demand P1P1 Y1Y1

13. The Aggregate Demand Curve Quantity of Output Price Level 0 Aggregate demand P1P1 Y1Y1 1. A decrease in the price level

14. The Aggregate Demand Curve Quantity of Output Price Level 0 Aggregate demand P1P1 Y1Y1 Y2Y2 P2P2 1. A decrease in the price level

15. The Aggregate Demand Curve Quantity of Output Price Level 0 Aggregate demand P1P1 Y1Y1 Y2Y2 P2P2 1. A decrease in the price level 2. increases the quantity of goods and services demanded.

16. Explaining the aggregate demand curve: 3 Theories Pigou’s wealth effect Keynes’ interest rate effect Mundell-Fleming’s exchange-rate effect

17. Pigou’s wealth effect Consumers feel wealthier, which stimulates the demand for consumption goods. –A decrease in the price level makes consumers feel more wealthy. –This encourages them to spend more. –The increase in consumer spending means a larger quantity of goods and services demanded.

18. Keynes’ interest-rate effect The lower the price level, the less money households need to hold to buy the goods and services they want. –A lower price level reduces the interest rate, which encourages greater spending on investment goods. –The increase in investment spending means a larger quantity of goods and services demanded.

19. Mundell-Fleming’s exchange- rate effect When the prices of domestic goods decreases, net exports increase. –A fall in the Australian price level causes Australian interest rates to fall. –The real exchange rate depreciates, which stimulates Australian net exports. –The increase in net export spending means a larger quantity of goods and services demanded.

20. Shifts in the aggregate demand curve Shifts in the aggregate demand curve may arise because of changes in: –Private behaviour: Changes in spending plans by consumers or firms. –Public policy: Changes in fiscal or monetary policy. Anything that causes buyers to want to purchase more or less than before will cause the aggregate demand curve to shift.

21. Shifts in the Aggregate Demand Curve Quantity of Output Price Level 0 Aggregate demand, D 1 P1P1 Y1Y1

22. Shifts in the Aggregate Demand Curve Quantity of Output Price Level 0 Aggregate demand, D 1 P1P1 Y1Y1 D2D2

23. Shifts in the Aggregate Demand Curve Quantity of Output Price Level 0 Aggregate demand, D 1 P1P1 Y1Y1 Y2Y2 D2D2

24. Shifts in aggregate demand People will buy more of the goods and services at every price Same principle as for microeconomic markets

25. The Aggregate Supply Curve In the long run, the aggregate-supply curve is vertical. In the short run, the aggregate-supply curve is upward sloping.

26. The Long-Run Aggregate Supply Curve The long-run aggregate supply depends on the economy’s resources and level of technology. The price level does not affect these variables in the long run. The long-run aggregate supply curve is vertical at the natural rate of output.

27. The Long-Run Aggregate Supply Curve Quantity of Output Natural rate of output Price Level 0 Long-run aggregate supply P1P1

28. 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… P1P1

29. 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… P1P1 2. …does not affect the quantity of goods and services supplied in the long run.

30. Shifts in the Long-Run Aggregate Supply Curve Any change in the factors that determine the long-run aggregate supply will cause the curve to shift. An event that reduces the economy’s potential output shifts the curve to the left. Any event that increases the economy’s potential output shifts the curve to the right.

31. The Short-Run Aggregate Supply Curve 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.

32. The Short-Run Aggregate Supply Curve Quantity of Output Price Level 0 Short-run aggregate supply

33. The Short-Run Aggregate Supply Curve Y1Y1 P1P1 Quantity of Output Price Level 0 Short-run aggregate supply

34. The Short-Run Aggregate Supply Curve Y1Y1 P1P1 P2P2 1. A decrease in the price level Quantity of Output Price Level 0 Short-run aggregate supply Y2Y2

35. The Short-Run Aggregate Supply Curve Y1Y1 P1P1 P2P2 1. A decrease in the price level Quantity of Output Price Level 0 Short-run aggregate supply Y2Y2 2. reduces the quantity of goods and services supplied in the short run

36. Explaining the slope of the aggregate supply curve New classical misperceptions theory The Keynesian sticky-wage theory The new Keynesian sticky-price theory

37. The New Classical 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.

38. The Keynesian Sticky-Wage Theory Nominal wages are slow to adjust, or are ‘sticky’ in the short run. –Wages do not adjust immediately to a fall in the price level. –A lower price level makes employment and production less profitable. –This induces firms to reduce production.

39. The New Keynesian Sticky-Price Theory Prices of some goods and services adjust sluggishly in response to changing economic conditions. –An unexpected fall in the price level leaves some firms with higher-than-desired prices. –This depresses sales, which induces firms to reduce the quantity of goods and services they produce.

40. Shifts in the Aggregate Supply Curve P1P1 Quantity of Output Price Level 0 Short-run aggregate supply, S 1 Y2Y2

41. Shifts in the Aggregate Supply Curve P1P1 Quantity of Output Price Level 0 Short-run aggregate supply, S 1 Y2Y2 S2S2

42. Shifts in the Aggregate Supply Curve Y1Y1 P1P1 Quantity of Output Price Level 0 Short-run aggregate supply, S 1 Y2Y2 S2S2

43. Why the aggregate supply curve might shift Changes in factor (input) prices Changes in productivity Legal-institutional environment Expectations about the price level

44. Changes in Resource Prices Changes in the prices of domestic or imported resources change firms’ cost of production. –An increase in input prices shifts the aggregate supply curve to the left. –A decrease in input prices shifts the aggregate supply curve to the right.

45. Changes in Productivity An improvement in factor productivity allows firms to produce more at a lower cost. –New technologies can increase the output per unit of labour or capital. –The resulting decrease in production costs shifts the aggregate supply curve to the right.

46. Legal-Institutional Environment Taxes and government regulations can increase production costs and discourage firms from producing. –The resulting increase in production costs shifts the aggregate supply curve to the left.

47. Expectations About the Price Level Current wages and prices often depend on expectations of the price level. –A higher expected price level shifts the short- run aggregate supply curve to the left. –A lower expected price level shifts the short- run aggregate supply curve to the right.

48. Long-Run Equilibrium The intersection of the aggregate demand curve and the long-run aggregate supply curve determines the economy’s equilibrium output and price level. Output is at its ‘natural’ rate. The short-run aggregate supply curve passes through the point of intersection.

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

50. Two causes of recession A recession in the economy may have two causes. –A decrease in aggregate demand. –A decrease in aggregate supply.

51. A decrease in aggregate demand A decrease in one of the determinants of aggregate demand shifts the curve to the left. –Output falls below the natural rate of employment. –Unemployment rises. –The price level falls.

52. A decrease in aggregate demand Quantity of Output Price Level 0 Short-run aggregate supply, AS 1 Long-run aggregate supply A P1P1 Y1Y1 Aggregate demand, AD 1

53. A decrease in aggregate demand Quantity of Output Price Level 0 Short-run aggregate supply, AS 1 Long-run aggregate supply Aggregate demand, AD 1 A P1P1 Y1Y1 1. A decrease in aggregate demand…

54. A decrease in aggregate demand Quantity of Output Price Level 0 Short-run aggregate supply, AS 1 Long-run aggregate supply Aggregate demand, AD 1 A P1P1 Y1Y1 AD 2 1. A decrease in aggregate demand…

55. A decrease in aggregate demand Quantity of Output Price Level 0 Short-run aggregate supply, AS 1 Long-run aggregate supply Aggregate demand, AD 1 A B P1P1 P2P2 Y1Y1 Y2Y2 AD 2 1. A decrease in aggregate demand…

56. A decrease in aggregate demand Quantity of Output Price Level 0 Short-run aggregate supply, AS 1 Long-run aggregate supply Aggregate demand, AD 1 A B P1P1 P2P2 Y1Y1 Y2Y2 AD 2 1. A decrease in aggregate demand… 2. …causes output to fall in the short run…

57. A decrease in aggregate demand Quantity of Output Price Level 0 Short-run aggregate supply, AS 1 Long-run aggregate supply Aggregate demand, AD 1 A B P1P1 P2P2 Y1Y1 Y2Y2 AD 2 1. A decrease in aggregate demand… 3. …but over time, the short-run aggregate-supply curve shifts… 2. …causes output to fall in the short run…

58. A decrease in aggregate demand Quantity of Output Price Level 0 Short-run aggregate supply, AS 1 Long-run aggregate supply Aggregate demand, AD 1 A B P1P1 P2P2 Y1Y1 Y2Y2 AD 2 AS 2 1. A decrease in aggregate demand… 3. …but over time, the short-run aggregate-supply curve shifts… 2. …causes output to fall in the short run…

59. A decrease in aggregate demand Quantity of Output Price Level 0 Short-run aggregate supply, AS 1 Long-run aggregate supply Aggregate demand, AD 1 A B C P1P1 P2P2 P3P3 Y1Y1 Y2Y2 AD 2 AS 2 1. A decrease in aggregate demand… 3. …but over time, the short-run aggregate-supply curve shifts… 2. …causes output to fall in the short run…

60. A decrease in aggregate demand Quantity of Output Price Level 0 Short-run aggregate supply, AS 1 Long-run aggregate supply Aggregate demand, AD 1 A B C P1P1 P2P2 P3P3 Y1Y1 Y2Y2 AD 2 AS 2 1. A decrease in aggregate demand… 3. …but over time, the short-run aggregate-supply curve shifts… 2. …causes output to fall in the short run… 4. …and output returns to its natural rate.

61. A Decrease 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.

62. A decrease in aggregate supply Long-run aggregate supply Short-run aggregate supply, AS 1 Quantity of Output Price Level 0 Aggregate demand A Y1Y1 P1P1

63. A decrease in aggregate supply Long-run aggregate supply 1. An adverse shift in the short-run aggregate- supply curve… Short-run aggregate supply, AS 1 Quantity of Output Price Level 0 Aggregate demand A Y1Y1 P1P1

64. A decrease in aggregate supply Long-run aggregate supply 1. An adverse shift in the short-run aggregate- supply curve… Short-run aggregate supply, AS 1 Quantity of Output Price Level 0 Aggregate demand A Y1Y1 P1P1

65. A decrease in aggregate supply Long-run aggregate supply 1. An adverse shift in the short-run aggregate- supply curve… Short-run aggregate supply, AS 1 Quantity of Output Price Level 0 Aggregate demand A B Y1Y1 Y2Y2 P2P2 P1P1

66. A decrease in aggregate supply 2. …causes output to fall… Long-run aggregate supply 1. An adverse shift in the short-run aggregate- supply curve… Short-run aggregate supply, AS 1 Quantity of Output Price Level 0 Aggregate demand A B Y1Y1 Y2Y2 P2P2 P1P1

67. A decrease in aggregate supply 2. …causes output to fall… Long-run aggregate supply 1. An adverse shift in the short-run aggregate- supply curve… Short-run aggregate supply, AS 1 Quantity of Output Price Level 0 Aggregate demand A B Y1Y1 Y2Y2 3. …and the price level to rise. P2P2 P1P1

68. Stagflation Adverse shifts in aggregate supply cause stagflation—a combination of recession and inflation. –Output falls and prices rise. –Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

69. 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.

70. Policy response to recession Quantity of Output Natural rate of output Price Level 0 Short-run aggregate supply, AS 1 Aggregate demand, AD 1 Long-run aggregate supply A P1P1

71. Policy response to recession Quantity of Output Natural rate of output Price Level 0 Short-run aggregate supply, AS 1 Aggregate demand, AD 1 Long-run aggregate supply A P1P1 1. When short-run aggregate supply falls…

72. Policy response to recession Quantity of Output Natural rate of output Price Level 0 Short-run aggregate supply, AS 1 Aggregate demand, AD 1 Long-run aggregate supply A P1P1 AS 2 1. When short-run aggregate supply falls…

73. Policy response to recession Quantity of Output Natural rate of output Price Level 0 Short-run aggregate supply, AS 1 Aggregate demand, AD 1 Long-run aggregate supply A P2P2 P1P1 AS 2 1. When short-run aggregate supply falls…

74. Policy response to recession Quantity of Output Natural rate of output Price Level 0 Short-run aggregate supply, AS 1 Aggregate demand, AD 1 Long-run aggregate supply A P2P2 P1P1 AS 2 1. When short-run aggregate supply falls… 2. …policymakers can accommodate the shift by expanding aggregate demand…

75. Policy response to recession Quantity of Output Natural rate of output Price Level 0 Short-run aggregate supply, AS 1 Aggregate demand, AD 1 Long-run aggregate supply A P2P2 P1P1 AS 2 1. When short-run aggregate supply falls… 2. …policymakers can accommodate the shift by expanding aggregate demand… AD 2

76. Policy response to recession Quantity of Output Natural rate of output Price Level 0 Short-run aggregate supply, AS 1 Aggregate demand, AD 1 Long-run aggregate supply A C P2P2 P3P3 P1P1 AS 2 1. When short-run aggregate supply falls… 2. …policymakers can accommodate the shift by expanding aggregate demand… AD 2

77. Policy response to recession Quantity of Output Natural rate of output Price Level 0 Short-run aggregate supply, AS 1 Aggregate demand, AD 1 Long-run aggregate supply A C P2P2 P3P3 P1P1 AS 2 3....which causes the price level to rise 1. When short-run aggregate supply falls… 2. …policymakers can accommodate the shift by expanding aggregate demand… AD 2

78. Policy response to recession Quantity of Output Natural rate of output Price Level 0 Short-run aggregate supply, AS 1 Aggregate demand, AD 1 Long-run aggregate supply A C P2P2 P3P3 P1P1 AS 2 3....which causes the price level to rise 1. When short-run aggregate supply falls… 2. …policymakers can accommodate the shift by expanding aggregate demand… AD 2 4. …but keeps output at its natural rate.

79. Self-Test (Hakes & Parry): Chapter 16 Match all Terms & Definitions Answer questions 1, 2, 3 & 4 of the Practice Problems Answer Short Answer questions 1, 2, 5, 6, 7, 9 & 11 Do all True/False Questions Answer Multiple Choice Questions 1, 2, 4, 5, 6, 8, 9, 10, 11, 13, 14, 15, 16, 17, 18, 19 & 20 Make notes on the Advanced Critical Thinking questions Check answers in guide and revise accordingly

80. Reading This week: Text and Study Guide Chapter 16 For next lecture: Chapter 17 & 18