MacroeconomicsMacroeconomicsEcon 2301Econ 2301

Dr. Frank JacobsonDr. Frank Jacobson

Coach StuckeyCoach Stuckey

TodayToday

• Begin Chapter 12- Aggregate Demand and Supply

Chapter 12Chapter 12

Aggregate Demand and Aggregate Demand and Aggregate SupplyAggregate Supply

During The Semester We Have During The Semester We Have Seen How The Economy Has Seen How The Economy Has

Changed During Different Changed During Different Time Period Sometimes Time Period Sometimes

Moderately and Sometimes Moderately and Sometimes Severely.Severely.

In This Chapter We Will In This Chapter We Will Look At What Causes Both Look At What Causes Both Short-Run and Long-Run Short-Run and Long-Run

Fluctuations in The Fluctuations in The Economy.Economy.

The Model of Aggregate The Model of Aggregate Demand and Aggregate SupplyDemand 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.

Time

Economic activity

Business cycle

Important Note:Important Note:

These These Business CycleBusiness Cycle Fluctuations Are Fluctuations Are

Unpredictable and Follow Unpredictable and Follow No Regular Pattern.No Regular Pattern.

Fact : Most Macroeconomic Fact : Most Macroeconomic Quantities Fluctuate Together.Quantities Fluctuate Together.

When Real GDP Falls in a Recession When Real GDP Falls in a Recession So Does Personal Income, Corporate So Does Personal Income, Corporate

Profits, Consumer Spending, Profits, Consumer Spending, Investment Spending, Production, Investment Spending, Production, Home Sales, Auto Sales and Other Home Sales, Auto Sales and Other

Items.Items.

Investment Spending Varies Investment Spending Varies Greatly Over The Business Cycle. Greatly Over The Business Cycle.

Investment Spending Averages Investment Spending Averages Only About 1/7 of The GDP, Yet, Only About 1/7 of The GDP, Yet, Declines In Investment Account Declines In Investment Account For About 2/3 of The Declines in For About 2/3 of The Declines in

GDP During Recessions.GDP During Recessions.

Restated:Restated:When Economic Conditions When Economic Conditions

Deteriorate, Much of The Decline Deteriorate, Much of The Decline is Attributable To Reductions in is Attributable To Reductions in Investment Spending Such As Investment Spending Such As

On New Factories, Housing, On New Factories, Housing, Equipment and Inventories.Equipment and Inventories.

Fact : As Output Falls, Fact : As Output Falls, Unemployment Rises.Unemployment Rises.

When Firms Choose To Produce When Firms Choose To Produce A Smaller Quantity of Goods and A Smaller Quantity of Goods and Services, They Lay Off Workers, Services, They Lay Off Workers, Increasing The Unemployment.Increasing The Unemployment.

Explaining Short-Run Explaining Short-Run Economic Fluctuations.Economic Fluctuations.

Most Economists Believe Most Economists Believe That Classical Theory That Classical Theory

Describes The World in Describes The World in The Long Run But Not in The Long Run But Not in

The Short Run.The Short Run.

In The Short Run, Real and In The Short Run, Real and Nominal Variables Are Highly Nominal Variables Are Highly Intertwined, and Changes in Intertwined, and Changes in

The Money Supply Can The Money Supply Can Temporarily Push Real GDP Temporarily Push Real GDP Away From Its Long Term Away From Its Long Term

Trend.Trend.

Therefore To Explain The Therefore To Explain The Short Run Fluctuations in The Short Run Fluctuations in The

Economy and Their Impact; Economy and Their Impact; We Must Develop a New Model We Must Develop a New Model

Based on How Real and Based on How Real and Nominal Variables Interact.Nominal Variables Interact.

The Model of Aggregate The Model of Aggregate Demand and Aggregate Demand and Aggregate

SupplySupply

Figure 2 Aggregate Demand and Aggregate Figure 2 Aggregate Demand and Aggregate Supply...Supply...

Quantity ofOutput

PriceLevel

0

Aggregatesupply

Aggregatedemand

Equilibriumoutput

Equilibriumprice level

Figure 3 The Aggregate-Demand CurveFigure 3 The Aggregate-Demand Curve......

Quantity ofOutput

PriceLevel

0

Aggregatedemand

P

Y Y2

P2

1. A decreasein the pricelevel . . .

2. . . . increases the quantity ofgoods and services demanded.

Our Model of Short-Run Economic Our Model of Short-Run Economic Fluctuations Focuses On The Fluctuations Focuses On The

Behavior of Behavior of Two VariablesTwo Variables. The First . The First Variable is Variable is The Economy’s Output of The Economy’s Output of Goods and ServicesGoods and Services as Measured By as Measured By

Real GDP. The Second is The Real GDP. The Second is The Average Level of PricesAverage Level of Prices, As , As

Measured By The CPI or The GDP Measured By The CPI or The GDP Deflator.Deflator.

Notice:Notice:

That Output is a Real That Output is a Real Variable, Whereas The Variable, Whereas The

Price Level is a Nominal Price Level is a Nominal Variable.Variable.

Fluctuations in The Fluctuations in The Economy as a Whole Are Economy as a Whole Are Measured WithMeasured With The Model The Model of Aggregate Demand and of Aggregate Demand and

Aggregate Supply.Aggregate Supply.

Model of Aggregate Demand Model of Aggregate Demand and Aggregate Supplyand Aggregate Supply

The Model That Most Economists The Model That Most Economists Use To Explain Short-Term Use To Explain Short-Term Fluctuations in Economic Fluctuations in Economic

Activity Around its Long-Run Activity Around its Long-Run Trend.Trend.

The Model of Aggregate The Model of Aggregate Demand and Aggregate Demand and Aggregate

SupplySupply

On The Vertical Axis is The On The Vertical Axis is The Overall Price Level in The Overall Price Level in The

Economy. On The Horizontal Economy. On The Horizontal Axis is The Overall Quantity of Axis is The Overall Quantity of Goods and Services Produced Goods and Services Produced

in The Economy.in The Economy.

The Aggregate Demand CurveThe Aggregate Demand Curve Shows The Quantity of Goods Shows The Quantity of Goods

and Services That and Services That Households, Firms, The Households, Firms, The

Government, and Customers Government, and Customers Abroad Want To Buy At Each Abroad Want To Buy At Each

Price Level.Price Level.

According To This Model, According To This Model, The Price Level and The The Price Level and The

Quantity of Output Adjust Quantity of Output Adjust To Bring Aggregate To Bring Aggregate

Demand and Aggregate Demand and Aggregate Supply Into Balance.Supply Into Balance.

This May Look Like The Market This May Look Like The Market Supply and Demand Curves, But Supply and Demand Curves, But

Because It Involves All The Because It Involves All The Goods and Services Supplied Goods and Services Supplied

and Demanded, Factors Such As and Demanded, Factors Such As Substitutes and Complementary Substitutes and Complementary

Items Are Not Involved.Items Are Not Involved.

The Aggregate-Demand The Aggregate-Demand CurveCurve

The Aggregate-Demand The Aggregate-Demand CurveCurve Tells Us The Tells Us The

Quantity of All Goods and Quantity of All Goods and Services Demanded in The Services Demanded in The

Economy At Any Given Economy At Any Given Price Level.Price Level.

The Aggregate-Demand Curve is The Aggregate-Demand Curve is Downward Sloping Indicating That, Downward Sloping Indicating That, All Things Being Equal, A Decrease All Things Being Equal, A Decrease In The Economy’s Overall Level of In The Economy’s Overall Level of

Prices Raises The Quantity of Goods Prices Raises The Quantity of Goods and Services Demanded and An and Services Demanded and An Increase in Prices Reduces The Increase in Prices Reduces The Quantity of Goods and Services Quantity of Goods and Services

Demanded.Demanded.

Why Does The Aggregate-Why Does The Aggregate-Demand Curve Slope Demand Curve Slope

Downward?Downward?

Price Level Affects The Price Level Affects The Quantity of Goods and Quantity of Goods and

Services Demanded Services Demanded Relative to The GDP--- For Relative to The GDP--- For Consumption, Investment Consumption, Investment

and Net Exports.and Net Exports.

There Are 3 Reasons The There Are 3 Reasons The Aggregate-Demand Curve Aggregate-Demand Curve

is Downward Sloping.is Downward Sloping.

Reasons Aggregate-Demand Reasons Aggregate-Demand Curve is Downward SlopingCurve is Downward Sloping

1. The Price Level and Consumption: The Wealth Effect.

2. The Price Level and Investment: The Interest Rate Effect.

3. The Price Level and Net Exports: The Exchange-Rate Effect.

#1 The Price Level and #1 The Price Level and Consumption:Consumption:

A Decrease In The Price Level A Decrease In The Price Level Raises The Real Value of Money and Raises The Real Value of Money and Makes Consumers Wealthier, Which Makes Consumers Wealthier, Which In Turn Encourages Them To Spend In Turn Encourages Them To Spend More and Demand More Goods and More and Demand More Goods and

Services.Services.

#2 Price Level and Investment#2 Price Level and Investment

A Lower Price Level Reduces The A Lower Price Level Reduces The Interest Rate, Encourages Interest Rate, Encourages

Greater Spending on Investment Greater Spending on Investment Goods, Thereby Increases The Goods, Thereby Increases The

Quantity of Goods and Services Quantity of Goods and Services Demanded.Demanded.

#3 Price Level and Net Exports#3 Price Level and Net Exports

A Fall in U.S. Price Level Causes A Fall in U.S. Price Level Causes U.S. Interest Rates To Fall, The U.S. Interest Rates To Fall, The

Real Value of The Dollar Declines Real Value of The Dollar Declines In Foreign Exchange Markets, In Foreign Exchange Markets,

Which Increases U.S. Net Exports Which Increases U.S. Net Exports of Goods and Services.of Goods and Services.

Therefore a Decrease in Price Level Therefore a Decrease in Price Level Increases The Demand for Goods Increases The Demand for Goods

and Services Because:and Services Because:1. Consumers Are Wealthier, Which

Stimulates the Demand For Consumption Goods.

2. Interest Rates Fall, Which Stimulates The Demand For Investment Goods.

3. The Currency Depreciates, Which Stimulates The Demand For Net Exports.

These Same Three Effects These Same Three Effects Work in Reverse to Work in Reverse to

Decrease The Quantity of Decrease The Quantity of Goods and Services When Goods and Services When

The Price Level is The Price Level is Increased.Increased.

The Overall Aggregate The Overall Aggregate Demand Curve May Demand Curve May Shift (Right or Left).Shift (Right or Left).

Causes of Aggregate-Demand Curve Causes of Aggregate-Demand Curve To ShiftTo Shift

• Shifts Arising From Changes in Consumption.

• Shifts Arising From Changes in Investment

• Shifts Arising From Changes in Government Purchase.

• Shifts Arising From Changes in Net Exports.

Causes of Aggregate-Demand Curve Causes of Aggregate-Demand Curve To ShiftTo Shift

• Shifts Arising From Changes in Expectations.

• Shifts Arising From Changes in Wealth.

• Shifts Arising From the Size of Existing Stock of Physical Capital.

• Shifts Arising From Changes in Fiscal Policy.

• Shifts Arising From Changes in Monetary Policy.

Shifts in The Aggregate Demand Shifts in The Aggregate Demand CurveCurve

Quantity ofOutput

PriceLevel

0

Aggregatedemand, D1

P1

Y1

D2

Y2

Figure 4 The Long-Run Aggregate-Figure 4 The Long-Run Aggregate-Supply CurveSupply Curve

Quantity ofOutput

Natural rateof output

PriceLevel

0

Long-runaggregate

supply

P2

1. A changein the pricelevel . . .

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

P

The Aggregate-The Aggregate-Supply CurveSupply Curve

In The Long Run, The In The Long Run, The Aggregate-Supply Curve is Aggregate-Supply Curve is

Vertical, Whereas in The Short Vertical, Whereas in The Short Run, The Aggregate-Supply Run, The Aggregate-Supply Curve is Upward Sloping.Curve is Upward Sloping.

Why The Aggregate-Supply Why The Aggregate-Supply Curve is Vertical in The Curve is Vertical in The

Long Run.Long Run.

In The Long Run, An Economy’s In The Long Run, An Economy’s Production of Goods and Production of Goods and

Services (Its Real GDP) Depends Services (Its Real GDP) Depends On Its Supplies of Labor, Capital On Its Supplies of Labor, Capital and Natural Resources and on and Natural Resources and on The Available Technology To The Available Technology To

Turn These Factors of Turn These Factors of Production Into Goods and Production Into Goods and

Services.Services.

The Aggregate-Supply CurveThe Aggregate-Supply Curve• The Long-Run Aggregate-Supply Curve is

Vertical At The Natural Rate of Output, Which is The Production of Goods and Services That an Economy Achieves in The Long Run When Unemployment is At Its Normal Rate.– This Level of Production is Also Referred To As

Potential Output or Full-Employment Output.– The Natural Rate of Output is The Level of

Output Towards Which The Economy Gravitates in The Long Run.

Natural Rate of OutputNatural Rate of Output

The Production of Goods and The Production of Goods and Services That An Economy Services That An Economy

Achieves in The Long Run When Achieves in The Long Run When Unemployment is At Its Normal Unemployment is At Its Normal

Rate.Rate.

The Natural Rate of Output The Natural Rate of Output is The Level of Production is The Level of Production

Toward Which The Toward Which The Economy Gravitates in The Economy Gravitates in The

Long Run.Long Run.

Why The Long-Run Aggregate-Why The Long-Run Aggregate-Supply Curve Might ShiftSupply Curve Might Shift

• Any Change in The Economy That Alters The Natural Rate of Output Shifts The Long-Run Aggregate-Supply Curve.

• The Shifts May Be Categorized According To The Various Factors in The Classical Model That Affect Output.

Why The Long-Run Aggregate-Why The Long-Run Aggregate-Supply Curve Might ShiftSupply Curve Might Shift

• Shifts Might Arise From Changes In:

–Labor

–Capital

–Natural Resources

–Technological Knowledge

Why The Aggregate-Supply Why The Aggregate-Supply Curve Might ShiftCurve Might Shift

• Shifts Might Arise From Changes In Commodity Prices.

• Shifts Might Arise From Changes In Nominal Wages.

• Shifts Might Arise From Changes In Productivity.

Figure 5 Long-Run Growth and InflationFigure 5 Long-Run Growth and Inflation

Quantity ofOutput

Y1980

AD1980

AD1990

Aggregate Demand, AD2000

PriceLevel

0

Long-runaggregate

supply,LRAS1980

Y1990

LRAS1990

Y2000

LRAS 2000

P1980

1. In the long run,technological progress shifts long-run aggregate supply . . .

4. . . . andongoing inflation.

3. . . . leading to growthin output . . .

P1990

P2000

2. . . . and growth in the money supply shifts aggregate demand . . .

Figure 6 The Short-Run Aggregate-Figure 6 The Short-Run Aggregate-Supply CurveSupply Curve

Quantity ofOutput

PriceLevel

0

Short-runaggregate

supply

1. A decreasein the pricelevel . . .

2. . . . reduces the quantityof goods and servicessupplied in the short run.

Y

P

Y2

P2

Why The Aggregate-Supply Why The Aggregate-Supply Curve Slopes Upward in The Curve Slopes Upward in The

Short RunShort Run

• Three Theories:

–The Sticky-Wage Theory

–The Sticky-Price Theory

–The Misperceptions Theory

Why The Aggregate-Supply Curve Why The Aggregate-Supply Curve Slopes Upward in The Short RunSlopes Upward in The Short Run

• The Sticky-Wage Theory– Nominal Wages Are Slow To Adjust To

Changing Economic Conditions, or Are “Sticky” in The Short Run

– Nominal 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 The Quantity of Goods and Services Supplied.

Why The Aggregate-Supply Curve Why The Aggregate-Supply Curve Slopes Upward in The Short RunSlopes Upward in The Short Run

• The 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. For a Variety of Reasons, They May Not Want To or Be Able To Change Prices Immediately.

– This Depresses Sales, Which Induces Firms To Reduce The Quantity of Goods and Services They Produce.

Why The Aggregate-Supply Curve Slopes Why The Aggregate-Supply Curve Slopes Upward in The Short RunUpward in The Short Run

• The 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.

Why The Aggregate-Supply Curve Why The Aggregate-Supply Curve Slopes Upward in The Short RunSlopes Upward in The Short Run

• All Three Theories Suggest That Output Deviates in The Short Run From The Natural Rate When The Actual Price Level Deviates From The Price Level That People Had Expected To Prevail.

Quantity of output Supplied

=Natural Rate of output

+ aActual Price Level

-Expected Price Level

Why The Short-Run Aggregate-Why The Short-Run Aggregate-Supply Curve Might ShiftSupply Curve Might Shift

• Shifts Might Arise From Changes In:

–Expected Price Level.

–Labor.

–Capital.

–Natural Resources.

–Technology.

Why The Aggregate Supply Why The Aggregate Supply Curve Might ShiftCurve Might Shift

• An Increase in The Expected Price Level Reduces The Quantity of Goods and Services Supplied and Shifts The Short-Run Aggregate Supply Curve To The Left.

• A Decrease in The Expected Price Level Raises The Quantity of Goods and Services Supplied and Shifts The Short-Run Aggregate Supply Curve To The Right.

Figure 7 The Long-Run EquilibriumFigure 7 The Long-Run Equilibrium

Natural rateof output

Quantity ofOutput

PriceLevel

0

Short-runaggregate

supply

Long-runaggregate

supply

Aggregatedemand

AEquilibriumprice

TWO CAUSES OF ECONOMIC TWO CAUSES OF ECONOMIC FLUCTUATIONSFLUCTUATIONS

• Four Steps in The Process of Analyzing Economic Fluctuations:

• Determine Whether The Event Affects Aggregate Supply or Aggregate Demand.

• Decide Which Direction The Curve Shifts.• Use a Diagram To Compare The Initial and

The New Equilibrium.• Keep Track of The Short and Long Run

Equilibrium, and The Transition Between Them.

2 CAUSES OF ECONOMIC FLUCTUATIONS2 CAUSES OF ECONOMIC FLUCTUATIONS

• Shifts in Aggregate Demand

– In The Short Run, Shifts in Aggregate Demand Cause Fluctuations in The Economy’s Output of Goods and Services.

– In The Long Run, Shifts in Aggregate Demand Affect The Overall Price Level But Do Not Affect Output.

– Policymakers Who Influence Aggregate Demand Can Potentially Mitigate The Severity of Economic Fluctuations.

Figure 8 A Contraction in Aggregate DemandFigure 8 A Contraction in Aggregate Demand

Quantity ofOutput

PriceLevel

0

Short-run aggregatesupply, AS

Long-runaggregate

supply

Aggregatedemand, AD

AP

Y

AD2

AS2

1. A decrease inaggregate demand . . .

2. . . . causes output to fall in the short run . . .

3. . . . but over time, the short-runaggregate-supplycurve shifts . . .

4. . . . and output returnsto its natural rate.

CP3

BP2

Y2

The Effects of A Shift in The Effects of A Shift in Aggregate SupplyAggregate Supply

• Adverse Shifts in Aggregate Supply Cause Stagflation—A Period of Recession and Inflation.

• Output Falls and Prices Rise.

• Policymakers Who Can Influence Aggregate Demand Cannot Offset Both of These Adverse Effects Simultaneously.

The Effects of A Shift in The Effects of A Shift in Aggregate SupplyAggregate Supply

• 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.

Figure 10 An Adverse Shift in Aggregate Figure 10 An Adverse Shift in Aggregate SupplySupply

Quantity ofOutput

PriceLevel

0

Aggregate demand

3. . . . and the price level to rise.

2. . . . causes output to fall . . .

1. An adverse shift in the short-run aggregate-supply curve . . .

Short-runaggregate

supply, AS

Long-runaggregate

supply

Y

AP

AS2

B

Y2

P2

Figure 11 Accommodating An Adverse Shift Figure 11 Accommodating An Adverse Shift in Aggregate Supplyin Aggregate Supply

Quantity ofOutput

Natural rateof output

PriceLevel

0

Short-runaggregate

supply, AS

Long-runaggregate

supply

Aggregate demand, AD

P2

AP

AS2

3. . . . whichcauses theprice level to rise further . . .

4. . . . but keeps outputat its natural rate.

2. . . . policymakers canaccommodate the shiftby expanding aggregatedemand . . .

1. When short-run aggregatesupply falls . . .

AD2

CP3

StagflationStagflation

A Period of Falling Output A Period of Falling Output and Rising Prices.and Rising Prices.

QuestionsQuestions??