Aggregate Demand and Aggregate Supply

Aggregate Demand
and Aggregate
Supply
Chapter 31
Copyright © 2001 by Harcourt, Inc.
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Short-Run Economic
Fluctuations
u Economic

activity fluctuates from
year to year.
In most years production of goods and
services rises.
u On average over the past 50 years,
production in the U.S. economy has grown
by about 3 percent per year.
u In some years normal growth does not occur,
causing a recession.
u

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Three Key Facts About
Economic Fluctuations
u

Economic fluctuations are irregular and
unpredictable.
u

u

Fluctuations in the economy are often called the
business cycle.

Recessions and Depressions

Most macroeconomic variables fluctuate
together.
u As output falls, unemployment rises.
u

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1


A Look At Short-Run Economic Fluctuations
(a) Real GDP
Billions of
1992 Dollars
$7,000
6,500
6,000
5,500
5,000

4,500
4,000
3,500
3,000
2,500

Recessions

Real GDP

1965

1970

1975

1980

1985

1990

1995

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A Look At Short-Run Economic Fluctuations
(b) Investment Spending
Billions of
1992 Dollars

$1,100
1,000
900
800
700
600
500

Recessions

Investment spending

400
3001965

1970

1975

1980

1985

1990

1995

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A Look At Short-Run Economic Fluctuations

Percent of
Labor Force
12

(c) Unemployment Rate
Recessions

10
Unemployment rate

8
6
4
2
0
1965

1970

1975

1980

1985

1990

1995

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2


The Basic Model of Economic
Fluctuations
Economists use the model of aggregate
demand and aggregate supply to explain
short-run fluctuations in economic
activity around its long-run trend.
n Price level as measured by the CPI
nAggregate Output as measured by real
GDP.
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The Basic Model of Economic
Fluctuations
The aggregate demand curve shows the
quantity of goods and services that
households, firms, and the government want
to buy at each price level.
u The aggregate supply curve shows the
quantity of goods and services that firms
produce and sell at each price level.
u

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Aggregate Demand and
Aggregate Supply...

Price
Level
Aggregate
supply

Equilibrium
price level
Aggregate
demand
0

Equilibrium
output

Quantity of
Output

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3


The Aggregate-Demand Curve...
Price
Level

P1
1. A
decrease
in the price

level...

P2
Aggregate
demand
0

Y1

Y2

2. …increases the quantity of goods
and services demanded.

Quantity of
Output

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Why the Aggregate Demand
Curve Is Downward Sloping
u The

Price Level and Consumption: The
Wealth Effect
u The Price Level and Investment: The
Interest Rate Effect
u The Price Level and Net Exports: The
Exchange-Rate Effect

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Why the Aggregate Demand
Curve Might Shift
Y=C + I + G + NET EXPORTS
Shifts arising from Consumption
u Shifts arising from Investment
u Shifts arising from Government
Purchases
u Shifts arising from Net Exports
u Changes in the price level cause a
movement along the Aggregate Demand
Curve.
u
u

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4


Shifts in the Aggregate Demand
Curve...
Price
Level

P1

D2
Aggregate

demand, D1
0

Y1

Y2

Quantity of
Output

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The Aggregate Supply Curve
The aggregate supply curve shows the
level of production at each price level.
u In the long run, the aggregate-supply
curve is vertical.
u In the short run, the aggregate-supply
curve is upward sloping.
u

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How the Short Run Differs
From the Long Run
u 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 in the long
run.
u The assumption of monetary neutrality is
not appropriate when studying year-to-year
changes in the economy.
u

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5


The Long-Run AggregateSupply Curve...
Price
Level
Long-run
aggregate
supply

P1

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

P2
1. A change

in the price
level…
0

Natural rate
of output

Quantity of
Output

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Why the Long-Run Aggregate
Supply Curve Might Shift
u
u
u
u
u

Shifts arising from Labor
Shifts arising from Capital
Shifts arising from Natural Resources
Shifts arising from Technological
Knowledge
Any change in the economy that alters the
natural rate of output shifts the long-run
aggregate-supply curve.

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The Short-Run Aggregate
Supply Curve...
Price
Level
Short-run
aggregate
supply

P1
1. A decrease
in the price
level

P2

0

2. reduces the
quantity of goods and
services supplied in
the short run.

Y2

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Y1

Quantity of

Output

6


Why the Short-Run Aggregate
Supply Curve Slopes Upward in the
Short Run
u

u
u
u

In the short run, an increase in the overall level
of prices in the economy tends to raise the
quantity of goods and services supplied.
A decrease in the level of prices tends to reduce
the quantity of goods and services supplied.
Workers may be fooled as well-Sticky Wage
Theory.
But Supply always snaps back to the Long run.

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The Long-Run Equilibrium
Price
Level

Short-run

aggregate
supply

Long-run
aggregate
supply

Equilibrium
price

A

Aggregate
demand
Quantity of
Output

Natural rate
of output

0

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A Contraction in Aggregate Demand...
Price
Level

2. …causes output to
fall in the short run…
Long-run
aggregate
supply

Short-run aggregate
supply, AS 1

AS2
3. …but over time,
the short-run
aggregate-supply
curve shifts…

A

P1
B

P2
P3

1. A decrease in
aggregate demand…

C

AD2
0

Y2

Y1

Aggregate
demand, AD 1

4. …and output returns
to its natural rate.

Quantity of
Output

7


An Adverse Shift in Short Run
Aggregate Supply
u

A decrease in one of the determinants
of aggregate supply shifts the curve to
the left:
Output falls below the natural rate of
employment.
u Unemployment rises.
u The price level rises.
u Stagflation results!
u

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An Adverse Shift in Aggregate Supply...
Price
Level

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

Long-run
aggregate
supply

AS2

Short-run
aggregate
supply, AS 1

B

P2

A

P1
3. …and the
price level to

rise.

Aggregate demand

0

Y2

Y1

2. …causes output to fall…

Quantity of
Output

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Policy Responses to
Recession
u Policymakers

may respond to a recession
in one of the following ways:
Do nothing and wait for prices and wages to
adjust.
u Take action to increase aggregate demand by
using monetary and fiscal policy.
u

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8


Accommodating an Adverse Shift
in Aggregate Supply...
Price
Level

1. When short-run aggregate supply falls…
Long-run
aggregate AS
2
supply

P3

C

P2

A

P1
3....which
causes the
price level
to rise

4. …but keeps

output at its
natural rate.
0

Natural rate
of output

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Short-run
aggregate
supply, AS1

2. …policymakers can
accommodate the shift
by expanding aggregate
demand…

AD2
Aggregate demand, AD 1

Quantity of
Output

9