Aggregate Demand and Aggregate SupplyShort-Run Economic FluctuationsTHREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONSFigure 1 A Look At Short-Run Economic FluctuationsSlide 5Slide 6Slide 7Slide 8EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONSThe Basic Model of Economic FluctuationsSlide 11Figure 2 Aggregate Demand and Aggregate Supply...THE AGGREGATE-DEMAND CURVEFigure 3 The Aggregate-Demand Curve...Why the Aggregate-Demand Curve Is Downward SlopingSlide 16Slide 17Slide 18Shifts in the Aggregate-Demand CurveShifts in the Aggregate Demand CurveTHE AGGREGATE-SUPPLY CURVEFigure 4 The Long-Run Aggregate-Supply CurveSlide 23Why the Long-Run Aggregate-Supply Curve Might ShiftFigure 5 Long-Run Growth and InflationA New Way to Depict Long-Run Growth and InflationWhy the Aggregate-Supply Curve Slopes Upward in the Short RunFigure 6 The Short-Run Aggregate-Supply CurveSlide 29Slide 30Slide 31The Sticky-Wage TheoryThe Sticky-Price TheoryWhy the Short-Run Aggregate-Supply Curve Might ShiftFigure 7 The Long-Run EquilibriumFigure 8 A Contraction in Aggregate DemandTWO CAUSES OF ECONOMIC FLUCTUATIONSFigure 10 An Adverse Shift in Aggregate SupplyThe Effects of a Shift in Aggregate SupplyFigure 11 Accommodating an Adverse Shift in Aggregate SupplyShort-run vs. Long-run AdjustmentSlide 42Adjustment to Shifts in AD and ASSummarySlide 45Slide 46Slide 47Slide 48Slide 49Aggregate Demand and Aggregate SupplyShort-Run Economic Fluctuations•Economic activity fluctuates from year to year.–In most years production of goods and services rises.–On average over the past 50 years, 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. •A recession is a period of declining real incomes, and rising unemployment. Since 1965, the U.S. economy has suffered six recessions. •A depression is a severe recession. The Great Depression occurred in 1929-1941 when output fell by about 30 percent and unemployment rose to 25 percent.THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS•Economic fluctuations are irregular and unpredictable.–Fluctuations in the economy are often called the business cycle. Stylized model of the business cycle.•Most macroeconomic variables fluctuate together.•As output falls, unemployment rises.Figure 1 A Look At Short-Run Economic FluctuationsBillions of1996 DollarsReal GDP(a) Real GDP$10,0009,0008,0007,0006,0005,0004,0003,0002,0001965 1970 1975 1980 1985 1990 1995 2000Copyright © 2004 South-WesternTHREE 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.Figure 1 A Look At Short-Run Economic FluctuationsBillions of1996 Dollars(b) Investment Spending$1,8001,6001,4001,2001,0008006004002001965 1970 1975 1980 1985 1990 1995 2000Investment spendingCopyright © 2004 South-WesternTHREE 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.Figure 1 A Look At Short-Run Economic FluctuationsPercent ofLabor Force(c) Unemployment Rate0246810121965 1970 1975 1980 1985 1990 1995 2000Unemployment rateCopyright © 2004 South-WesternEXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS•Short-run versus the long-run: Price Flexibility–LR: 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 = Monetary is neutral.•The aggregate supply curve is vertical and prices adjust fully.–SR: Most economists believe that prices do not adjust fully in the short-run and therefore output will change.•Changes in the money supply can affect real variables in the short-run = Money is not neutral.•Aggregate supply is upward sloping.•Therefore, aggregate demand as well as aggregate supply are important in determining output and prices in the short-run.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.•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.•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.•The Basic Model of Aggregate Demand and Aggregate Supply–The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.Figure 2 Aggregate Demand and Aggregate Supply...Quantity ofOutputPriceLevel0AggregatesupplyAggregatedemandEquilibriumoutputEquilibriumprice levelCopyright © 2004 South-WesternTHE AGGREGATE-DEMAND CURVE•The four components of GDP (Y) contribute to the aggregate demand for goods and services.Y = C + I + G + NXFigure 3 The Aggregate-Demand Curve...Quantity ofOutputPriceLevel0AggregatedemandPY Y2P21. A decreasein the pricelevel . . .2. . . . increases the quantity ofgoods and services demanded.Copyright © 2004 South-WesternWhy the Aggregate-Demand Curve Is Downward Sloping•The AD is not downward sloping for the reasons a demand curve in microeconomics is downward sloping (substitution and income effects) •Remember our analysis of the Wealth Portfolio – If P falls the value of money increases, people are then holding excess cash balances so they either spend it or lend it:–Spend it : The Price Level and Consumption: The Wealth Effect–Lend it: The Price Level and Investment: The Interest Rate Effect–The result of lend it: The Price Level and Net Exports: The Exchange-Rate Effect•The Price Level and Consumption: The Wealth Effect–A decrease in the price level increases the value of money in one’s portfolio and 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.–P↓ → VofM↑ →