Chapter 20 Aggregate Demand and Aggregate Supply 1 Economic Fluctuations Economic activity fluctuates from year to year Recession o Economic contraction o Period of declining real incomes and rising unemployment Depression Key Facts o Severe recession 1 Economic fluctuations irregular and unpredictable business cycle 2 Most macroecon Quantities fluctuate together Recessions economy wide 3 As output fall unemployment Short Run Economic Fluctuations Chapter 20 Aggregate Demand and Aggregate Supply 2 real GDP and investment spending decline during recessions while unemployment rises Classical dichotomy o Separation of variables into real variables nominal variables Monetary Neutrality o Changes in money supply Affect nominal variables Do not affect real variables Classical theory o Holds in the Long Run Chapter 20 Aggregate Demand and Aggregate Supply 3 Changes in money supply Affects prices other nominal variables Do not affect real GDP unemployment or other real o Short Run variables Monetary neutrality no longer appropriate Real nominal variables highly intertwined Changes in money supply May temporarily push real GDP away from long run trend AD AS model o explains short run fluctuations in economic activity around its long run trend Aggregate demand Curve Quantity of G S that households firms govt customers abroad want to buy at each price level Downward sloping Wealth effect Price level Consumption C o Decrease in price level Inc real value of money Wealthier consumers Inc consumer spending Inc quantity demand of G S Interest rate effect Price level and Investment I o Dec in price level Dec in interest rate Inc spending on I goods Inc QD of G S Exchange rate effect Price level and Net Exports NX o Dec in U S price level Inc interest rate Chapter 20 Aggregate Demand and Aggregate Supply 4 USD depr Stimulates U S net exports Inc QD of G S Assumption Govt Spending G Fixed by policy A fall in price level Inc Q G S demanded b c 1 Consumers are wealthier stimulates D for consumption goods Interest rates fall stimulates demand for I goods 2 3 Currency deprec stimulates the demand for net exports A rise in price level o Dec Q of G S D b c 1 Consumers are poorer depress consumer spending 2 Higher interest rates fall depress investment spending 3 Currency appreciates depress net exports AD curve shifts o Changes in Consumption C Events that change how much people wat to consume at a Events that change how much firms want to invest at a agive price level Changes in taxes wealth Inc consumer spending AD curve shifts right o Changes in Investment I given price level Better tech Tax policy Money supply Inc Investment AD curve shifts right Chapter 20 Aggregate Demand and Aggregate Supply 5 Policy makers change govt spending at a given price level o Changes in Govt Purchases G Build new roads Inc govt purchases AD curve shifts right o Changes in Net Exports NX Events that change net exports for a given price level Recession in Europe International speculators change in exchange rate Inc in net exports AD curve shifts right Quantity of G S that firms choose to produce sell at each price level Aggregate Supply Curve Long Run AS Curve LRAS Vertical o Price level does not affect long run determinants of GDP Supplies of labor capital natural resources Available tech Shifts due to o Changes in Natural level of output Production of G S that economy achieves in the long run when unemployment is at its normal rate Potential out put Full employment output When Nat rate of unemp Inc AS shifts left o Changes in Labor Q of L inc AS shifts right o Changes in Capital Capital stock inc AS shifts right Physical and human capital o Changes in Natural resources New discovery of natural resource AS shifts right Weather Avail Of natural resources o Changes in Technological knowledge new tech for given labor capital natural resources AS shifts right International trade Govt reg Chapter 20 Aggregate Demand and Aggregate Supply 6 Long Run Growth and Inflation o In long run both AD LRAS curve shift Continual shifts of LRas curve to right Tech progress AD curve shifts to right Monetary policy Result Cont growth in output Continuing inflation Fed inc money supply over time Short Run Aggregate Supply Curve o Inc overall level of prices in econ Raises Q of G S supplied Chapter 20 Aggregate Demand and Aggregate Supply 7 o Dec in level of prices Tends to reduce Q of G S supplied Upward sloping o Sticky Wage Theory Nominal wages slow to adjust to changing economic conditions Long term contracts workers and firms Slowly changing social norms Notions of fairness influence wage setting Nominal wages based on expected prices Don t respond immediately when actual price level different from what was expected If price level expected Firms incentive to produce less output If price level expected Firms incentive to produce more output o Sticky Price Theory Prices of some G S Slow to adjust to changing economic conditions Menu costs o Costs to adjusting prices o Misperceptions Theory Changes in overall price level Temporarily misleads suppliers o About changes in individual markets o Changes in relative prices Suppliers respond to changes in level of prices o Change Q supplied of G S Q of Output Supplied Chapter 20 Aggregate Demand and Aggregate Supply 8 o Natural Level of Output actual price level how much output responds to unexpected changes in o Changes in Labor capital natural resources or technical expected price level the price level Short Run AS curve shifts due to knowledge o Expected price level inc AS shifts left SUMMARY Chapter 20 Aggregate Demand and Aggregate Supply 9 Causes of Economic Fluctuations Assumption o Economy begins in long run E Long Run E o Intersection of AD LRAS curves Natural level of output Actual price level o Intersection of AD Short run AS curves Expected price level actual price level Chapter 20 Aggregate Demand and Aggregate Supply 10 Shift in AD o Wave of pessimism AD shifts left o Short run Output falls Price level falls o Long run Short run aggregate supply curve shifts right Output natural level Price level falls Four Steps for Analyzing Macroeconomic Fluctuations 1 Decide whether the event shifts the AD curve or AS curve or both 2 Decide the direction in which the curve shifts 3 Use the diagram of AD AS to determine the impact on output and the price level in the short run 4 Use the diagram of AD AS to analyze how the economy moves from its new short run E to its long run E Chapter 20