Slide 1OVERVIEW / Questions of the DayU.S. Quarterly Real GDPBASIC AD AND AS MODELi. Aggregate demandAggregate Demand: DefinitionAGGREGATE DEMANDAggregate Demand: SlopeAggregate Demand: DerivationAggregate Demand: ShiftsAD: Consumption ShiftersU.S. Consumer ConfidenceAD: Investment ShiftersAD: Other ShiftersPracticeii. Aggregate supplyAGGREGATE SUPPLY: DefinitionAGGREGATE SUPPLYAggregate Supply: Keynesian Vs. ClassicalAggregate Supply: Keynesian ASAggregate Supply: Classical AsAggregate Supply: The CompromiseAggregate Supply: ShiftsAD & AS: In Generaliii. Using as / as to explain inflationAD & AS: Demand-Pull InflationAD & AS: Cost-Push Inflationiv. Using ad / as to explain short-run fluctuationsUsing AD and AS to explain SR FluctuationsUsing AD and AS to explain SR FluctuationsPercentage Change in U.S. Real GDPU.S. Historical Inflation RateHistorical U.S. Unemployment RateSUMMARY – AD & AS SHIFTERSKEY CONCEPTS AND TERMSAre Asian Countries Headed for a Recession?TOPIC XIII: MODELING THE ECONOMYExplaining Fluctuations in the Economy using Aggregate Demand and Supply1“U.S. Consumer Confidence sinks to record low”: Associate Press, Jan 11, 2008“Odds Growing for an Economic Recession: up from 1 in 3 to 50/50” Associate Press, Jan 14, 2008“Americans Cut Back Sharply on Spending”; New York Times, Jan 14, 2008OVERVIEW / Questions of the DayWhat causes business cycles (short-term ups and downs in the economy)?What is the model of aggregate demand and aggregate supply?How can we use the model of aggregate demand and supply to help explain business cycles?2U.S. Quarterly Real GDPJan-00Jan-01Jan-02Jan-03Jan-04Jan-05Jan-06Jan-07Jan-08Jan-09Jan-10Jan-11Jan-12$10,000$10,500$11,000$11,500$12,000$12,500$13,000$13,500$14,000$13.31 T $13.35 TSource: U.S. Bureau of Economic Analysis; www.bea.gov; numbers in billionsHow do we explain this?Short-term ups and downs in the economy?BASIC AD AND AS MODEL4Price Level(CPI or GDP deflator)Output (Real GDP)Aggregate Demand Aggregate Supply Current Price levelCurrent Real GDPI. AGGREGATE DEMAND5Aggregate Demand: Definition Aggregate Demand•the quantity of total domestic output (goods and services) that all economic agents – domestic consumers, firms and government and foreign buyers – are prepared to buy (demand) at each price level•This is everyone who wants to buy American stuff 6AD=C+I+G+NXAGGREGATE DEMAND7Price Level(CPI or GDP deflator)Output (Real GDP)ADAggregate DemandThis curve represents the total amounts of goods/services made by an economy that buyers around the world wish to buy This is people BUYING American stuffAggregate Demand: Slope Why does the AD slope downward?1. Real Balances Effect (wealth effect)As P rises, consumers feel (and are) less wealthy; households spend lessAs P↑, C↓ (Opposite also true)So when prices go up, consumers spend less, so when there is inflation, consumers feel worse off, not as wealthy, so they cut their spending 2. Interest Rate EffectAs P rises, nominal interest rates also rise; firms borrow lessAs P↑, I↓ (Opposite also true) – I=investment When prices go up and interest rates go up then borrowing and investing goes down 3. Net Exports Effect (foreign exchange effect)As P rises (domestic price level), U.S. goods become more expensive relative to foreign goods; we export less and import moreAs P ↑, M↑ and X↓, meaning NX↓ (Opposite also true)If American prices go up, people in other countries are less likely to buy American products, so when we have American inflation we sell less to foreign buyers so exports goes down when there is US inflation, in addition we as Americans are more likely to buy foreign products if the US inflation rate rises so imports rises as well 8150C300AD25NX50G75I200190180CPI180Real GDP300PAD is downward sloping because its components (C, I, NX) have a negative relationship with PAggregate Demand: Derivation 9145705020285270156514050ADAggregate Demand: Shifts AD = C + I + G + NXAnything that changes C or I or G or NX (other than changes in P) will shift AD•Anything (other than changes in P) that cause C or I or G or NX to increase will shift AD right•Anything (other than changes in P) that cause C or I or G or NX to decrease will shift AD left 10AD0PReal GDPAD1AD1AD: Consumption Shifters Shifts in Consumption Spending•Changes in consumer wealth•↑ in wealth leads to an ↑ in C; opposite also true•Examples – stock market, home equity, retirement savings•Changes in the tax rate •↓ in tax rate means more money in households pockets; leads to an ↑ in C; opposite also true•Changes in consumer confidence •↑ in consumer confidence means consumers are optimistic about future economic conditions and spend more; leads to an ↑ in C; opposite also true11U.S. Consumer Confidence40506070809010011012012Source: St. Louis Federal Reserve: University of Michigan Consumer Sentiment; 1966 = 100AD: Investment ShiftersShifts in Investment Spending (I)•Changes in expected rate of return on investment •Change in the general business environment•Change in interest rate (price of borrowing for investment)•Changes in business confidence •↑ in confidence about the future leads to greater borrowing and investment spending•Meaning/leads to an ↑ in I•Opposite also true13AD: Other ShiftersShifts in Government Spending (G)•Changes in any level of government spending Shifts in Net Exports (NX)•Changes in foreign wealth •an ↑ in foreign wealth means they demand more goods, including our goods, leading to an ↑ in X, causing an ↑in NX•Opposite also true•Changes in foreign exchange rates•an ↑ in value of dollar relative to foreign currencies makes US goods more expensive, causing X to fall and M to rise•Opposite also trueMoney Supply (MS)•Changes in the money supply affect the nominal interest rate (i) •↑ in MS leads to a ↓ in i, which leads to an ↑ in C and I•Opposite also true14For each of the following scenarios determine their effect, if any, on U.S. aggregate demand1. The Asian economies experience a significant downturnAD shifts left (decrease in NX)2. The Fed increases the money supply3. Business confidence falls4. Due to war on terror, government buys more fighter planes15PracticePracticeII. AGGREGATE SUPPLY16AGGREGATE SUPPLY: DEFINITION Aggregate Supply – •the quantity of total output (domestic goods and services) that firms are willing and able to produce at each price level•This is the US