Slide 1Slide 2OVERVIEW / Questions of the DayU.S. Quarterly Real GDP (base = 2009)BASIC AD AND AS MODELi. Aggregate demandAggregate Demand: DefinitionAGGREGATE DEMANDAggregate Demand: SlopeAggregate Demand: DerivationAggregate Demand: ShiftsAD: Consumption ShiftersU.S. Consumer ConfidenceAD: Investment ShiftersAD: G and NX 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?‘THE ECONOMY’WHAT IS IT AND HOW DOES IT WORK?The Economy I: Gross Domestic ProductThe Economy II: Business Cycles and UnemploymentThe Economy III: Inflation and the Cost of LivingThe Economy IV: Modeling The Economy1THE ECONOMY IV:MODELING THE ECONOMYUsing Aggregate Demand and Supply to Explain Short Term Fluctuations in the Economy“U.S. Consumer Confidence sinks to record low”: Associate Press, Jan 11, 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?3U.S. Quarterly Real GDP (base = 2009)Jan-00Jan-01Jan-02Jan-03Jan-04Jan-05Jan-06Jan-07Jan-08Jan-09Jan-10Jan-11Jan-12Jan-13Jan-14Jan-15Jan-16$11,000$13,000$15,000$17,000$19,000$21,000$23,000$15 T$15 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 MODEL5Price Level(CPI or GDP deflator)Output (Real GDP)I. AGGREGATE DEMAND6Aggregate 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 7AGGREGATE DEMAND8Price Level(CPI or GDP deflator)Output (Real GDP)ADAggregate DemandAggregate Demand: Slope Why does the AD slope downward?1. Real Balances Effect (wealth effect)As P rises, consumers As P↑, C↓ (Opposite also true)2. Interest Rate EffectAs P rises, As P↑, I↓ (Opposite also true)3. Net Exports Effect (foreign exchange effect)As P rises (domestic price level), U.S. goods become As P ↑, M↑ and X↓, meaning NX↓ (Opposite also true)9150C300AD25NX50G75I200190180CPI180Real GDP300PAD is downward sloping because its components (C, I, NX) have a negative relationship with PAggregate Demand: Derivation 10Aggregate 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 •Anything (other than changes in P) that cause C or I or G or NX to decrease will 11AD0PReal GDPAD: Consumption Shifters Shifts in Consumption Spending•Changes in •↑ in consumer wealth means households can•This leads to an•Examples – •Changes in the •↓ in tax rate means more •leads to an •Changes in consumer confidence •↑ in consumer confidence means households are •leads to an 12U.S. Consumer Confidence40506070809010011012013Source: St. Louis Federal Reserve: University of Michigan Consumer Sentiment; 1966 = 100AD: Investment ShiftersShifts in Investment Spending•Changes in •A general improvement in the general business environment leads to •A fall in •These both lead to an •Changes in business confidence •↑ in confidence about the future leads to greater borrowing and investment spending•Leads to 14AD: G and NX ShiftersShifts in •Changes in any level of Shifts in•Changes in foreign wealth •an ↑ in foreign wealth means foreign buyers will demand more U.S. goods•This leads to •Changes in •a ↓ in the value of the dollar relative to foreign currencies makes U.S. goods cheaper than before (and foreign goods more expensive•This leads to 15AD: Other ShiftersMoney Supply•Changes in the money supply affect the nominal interest rate (i) •An ↑ in MS leads to a ↓ in •Opposite also true16For each of the following scenarios determine their effect, if any, on U.S. aggregate demand1. The Asian economies experience a significant downturn2. The Fed increases the money supply3. Business confidence falls4. Due to war on terror, government buys more fighter planes17PracticePracticeII. AGGREGATE SUPPLY18AGGREGATE SUPPLY: DEFINITION Aggregate Supply – •the quantity of total output (domestic goods and services) that•Aggregate supply shows the relationship between the ability and willingness of a country to produce goods and services and the aggregate price levelQ. How does the production of output change as the general price level changes?A. 19AGGREGATE SUPPLY20Price Level(CPI or GDP deflator)Output (Real GDP)ASAggregate SupplyAGGREGATE SUPPLY: KEYNESIAN VS. CLASSICALClassical Aggregate Supply •Assumes that all market participants (economic agents) can •In practice, this means that prices in all market are•Generally is considered more true when Keynesian Aggregate Supply •Assumes that some market participants are •In practice, prices in some markets (particularly input prices) may be •Generally is considered more true when 21AGGREGATE SUPPLY: KEYNESIAN AS22PY (real GDP)Suppose the economy were operating at level Y and the potential level of output was ŶŶPotential GDP ŶAGGREGATE SUPPLY: CLASSICAL AS23Classical ASADPY (real GDP)If the economy were operating at it’s potential level of GDP (Ŷ)PŶAGGREGATE SUPPLY: THE COMPROMISE24PY (real GDP)A more general view tries to incorporate both ideasŶIf the economy were in a severe recession, it operates in the Keynesian portionAggregate Supply: Shifts•Examples:•Changes in •Change in •Change in price of labor (wage rate)•Change in productivity of labor•Changes in nation’s stock of physical capital•Affects•Advancements in technology of production•Affects labor