Lec-6 & 7 - Chapter 33 - AD AS

Aggregate Demand
and Aggregate
Supply
Chapter 33
Short-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.
Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Short-Run Economic
Fluctuations
A recession
is a period of declining real

GDP, falling incomes, and rising
unemployment.
A depression is a severe recession.
Three Key Facts About

Economic Fluctuations
Economic
fluctuations are irregular and

unpredictable.
Fluctuations in the economy are often called

the business cycle.
Most
macroeconomic variables
fluctuate together.
As output falls, unemployment rises.
A Look At Short-Run Economic Fluctuations

(a) Real GDP
Recession
Billions of
s
1992 Dollars
$7,000
6,500
Real GDP
6,000
5,500
5,000
4,500
4,000
3,500
3,000
2,500
1965 1970 1975 1980 1985 1990 1995

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.

(b) Investment Spending
Billions of
1992 Dollars
$1,100
1,000
900
800
700
600
500
Recession
s
Investment spending
400
300
1965 1970 1975 1980 1985 1990 1995

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.

(c) Unemployment Rate
Percent of
Labor Force
12
Recession
s
10
Unemployment rate
8
6
4
2
0
1965
1970
1975
1980
1985
1990
1995
How the Short Run Differs

From the Long Run
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.
The assumption of monetary neutrality is
not appropriate when studying year-to-year
changes in the economy.
The Basic Model of Economic

Fluctuations
Two variables are used to develop a
model to analyze the short-run

fluctuations.
The economys output of goods and services
measured by real GDP.
The overall price level measured by the CPI
or the GDP deflator.

Fluctuations
Economist use the model of aggregate
demand and aggregate supply to explain
short-run fluctuations in economic
activity around its long-run trend.

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.

Fluctuations
The
aggregate supply curve shows the

quantity of goods and services that
firms produce and sell at each price
level.
Aggregate Demand and

Aggregate Supply...
Price
Level
Aggregate
supply
Equilibrium
price level
Aggregate
demand
0
Equilibrium
output
Quantity of
Output
The Aggregate Demand Curve

The
four components of GDP (Y)

contribute to the aggregate demand for
goods and services.
Y = C + I + G + NX
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
Why the Aggregate Demand

Curve Is Downward Sloping
The
Price Level and Consumption: The

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

The Wealth Effect
A decrease
in the price level 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.
The Price Level and Investment:

The Interest Rate Effect
A lower price
level reduces the interest

rate, which encourages greater spending
on investment goods.
This increase in investment spending
means a larger quantity of goods and
services demanded.
The Price Level and net Exports:

The Exchange-Rate Effect
When
a fall in the U.S. price level

causes U.S. interest rates to fall, the real
exchange rate depreciates, which
stimulates U.S. net exports.
The increase in net export spending
means a larger quantity of goods and
services demanded.

Curve Might Shift
The downward slope of the aggregate
demand curve shows that a fall in the price
level raises the overall quantity of goods and
services demanded.
Many other factors, however, affect the
quantity of goods and services demanded at
any given price level.
When one of these other factors changes, the
aggregate demand curve shifts.

Curve Might Shift
Shifts
arising from Consumption

Shifts arising from Investment
Shifts arising from Government
Purchases
Shifts arising from Net Exports
Shifts in the Aggregate Demand

Curve...
Price
Level
P1
D2
Aggregate
demand, D1
0
Y1
Y2
Quantity of
Output
The Aggregate Supply Curve

In
the long run, the aggregatesupply curve is vertical.

In the short run, the aggregatesupply curve is upward sloping.
The Long-Run Aggregate

Supply Curve
In the long-run, an economys production of
goods and services depends on its supplies of
labor, capital, and natural resources and on
the available technology used to turn these
factors of production into goods and services.
The price level does not affect these variables
in the long run.
The Long-Run AggregateSupply Curve...

Pric
e
Leve
l
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
The Long-Run Aggregate

Supply Curve
The
long-run aggregate supply curve

is vertical at the natural rate of
output.
This level of production is also
referred to as potential output or
full-employment output.
Why the Long-Run Aggregate

Supply Curve Might Shift
Any change in the economy that alters
the natural rate of output shifts the longrun 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

Supply Curve Might Shift
Shifts arising from Labor
Shifts arising from Capital
Shifts arising from Natural
Resources
Shifts arising from Technological
Knowledge
Long-Run Growth and Inflation...

Price
Level
4. and
ongoing
inflation.
2. and growth in the money

supply shifts aggregate-demand...
LRAS1980 LRAS1990 LRAS2000 1. In the
long-run,
technological
progress
shifts longrun
aggregate
supply...
P2000
P1990
P1980
AD2000
AD1980
Y1980
Y1990
AD1990
Y2000
3. leading to growth in output...

Quantity of
Output
Long-Run Growth and Inflation

Short-run fluctuations in output and
price level should be viewed as
deviations from the continuing longrun trends.
Why the Short-Run Aggregate

Supply Curve Slopes Upward in the
Short Run
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.
The Short-Run Aggregate

Supply Curve...
Price
Leve
l
Short-run
aggregate
supply
P1
1. A
decrease in
the price
level
P2
2. reduces the
quantity of goods
and services
supplied in the
short run.
Y2
Y1
Quantity of
Output
Why the Short-Run Aggregate

Supply Curve Slopes Upward in
the Short Run
The
Misperceptions Theory
The Sticky-Wage Theory
The Sticky-Price Theory
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.
The Sticky-Wage Theory
Nominal wages are slow to adjust, or are

sticky in the short run:
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.
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.
This depresses sales, which induces firms to
reduce the quantity of goods and services
they produce.
Why the Aggregate Supply

Curve Might Shift
Shifts arising from Labor
Shifts arising from Capital
Shifts arising from Natural Resources.
Shifts arising from Technology.
Shifts arising from the Expected Price
Level.
Why the Aggregate Supply

Curve 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.
The Long-Run Equilibrium

Price
Level
Equilibriu
m
price
Short-run
aggregate
supply
Long-run
aggregate
supply
Natural rate
of output
Aggregate
demand
Quantity of
Output
A Contraction in Aggregate Demand...

Price
Level
2. causes output to
fall in the short run
Long-run
aggregate
supply
Short-run aggregate
supply, AS1
AS
3. but over
time,
the short-run
aggregatesupply curve
1. A decrease
shifts in
aggregate demand
2
P1
B
P2
P3
C
AD
Y2
Y1
Aggregate
demand, AD1
4. and output
returns
Quantity of
Output
Shifts in Aggregate Demand

In the short run, shifts in aggregate
demand cause fluctuations in the
economys output of goods and services.
In the long run, shifts in aggregate
demand affect the overall price level but
do not affect output.
An Adverse Shift in Aggregate

Supply
A decrease in one of the determinants

of aggregate supply shifts the curve to
the left:
Output falls below the natural rate of
employment.
Unemployment rises.
The price level rises.
An Adverse Shift in Aggregate Supply...

Price
Level
P2
1. An adverse shift in
the short-run
aggregate-supply
curve
AS2
Short-run
aggregate
supply, AS1
Long-run
aggregate
supply
B
A
P1
3. and
the price
level to
rise.
Aggregate demand
0
Y2
Y1
2. causes output to
fall
Harcourt, Inc. items and derived items copyright
2001 by Harcourt, Inc.
Quantity of
Output
Stagflation
Adverse
shifts in aggregate supply

cause stagflationa combination of
recession and inflation.
Output falls and prices rise.
Policymakers who can influence aggregate
demand cannot offset both of these adverse
effects simultaneously.
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.
Accommodating an Adverse Shift

in Aggregate Supply...
Price
Level
1. When short-run aggregate supply

falls
Long-run
aggregate AS2
supply
P3
P2
P1
3....which
causes
the price
level to
rise
0
4. but
keeps
output at its
natural rate.
Short-run
aggregate
supply, AS1
2. policymakers
can
accommodate the
shift
by expanding
aggregate
AD2
demand
Aggregate demand, AD1
Natural rate
of output
Quantity of
Output
The Effects of a Shift in

Aggregate Supply
Shifts in aggregate supply can cause
stagflation a combination of recession
and inflation.
Policymakers who can influence
aggregate demand cannot offset both of
these adverse effects simultaneously.
Summary
All societies experience short-run economic
fluctuations around long-run trends.
These fluctuations are irregular and largely
unpredictable.
When recessions occur, real GDP and other
measures of income, spending, and
production fall, and unemployment rises.
Summary
Economists analyze short-run economic
fluctuations using the aggregate demand
and aggregate supply model.
According to the model of aggregate
demand and aggregate supply, the output
of goods and services and the overall level
of prices adjust to balance aggregate
demand and aggregate supply.
Summary
The aggregate-demand curve slopes
downward for three reasons: a wealth
effect, an interest rate effect, and an
exchange rate effect.
Any event or policy that changes
consumption, investment, government
purchases, or net exports at a given price
level will shift the aggregate-demand
curve.
Summary
In the long run, the aggregate supply curve
is vertical.
The short-run, the aggregate supply curve
is upward sloping.
The are three theories explaining the
upward slope of short-run aggregate
supply: the misperceptions theory, the
sticky-wage theory, and the sticky-price
theory.
Summary
Events that alter the economys ability to
produce output will shift the short-run
aggregate-supply curve.
Also, the position of the short-run
aggregate-supply curve depends on the
expected price level.
One possible cause of economic fluctuations
is a shift in aggregate demand.
Summary
A second possible cause of economic
fluctuations is a shift in aggregate
supply.
Stagflation is a period of falling output
and rising prices.
Graphical
Review

(a) Real GDP
Recession
Billions of
s
1992 Dollars
$7,000
6,500
Real GDP
6,000
5,500
5,000
4,500
4,000
3,500
3,000
2,500
1965 1970 1975 1980 1985 1990 1995

(b) Investment Spending
Billions of
1992 Dollars
$1,100
1,000
900
800
700
600
500
Recession
s
Investment spending
400
300
1965 1970 1975 1980 1985 1990 1995

(c) Unemployment Rate
Percent of
Labor Force
12
Recession
s
10
Unemployment rate
8
6
4
2
0
1965
1970
1975
1980
1985
1990
1995
Aggregate Demand and

Aggregate Supply...
Price
Level
Aggregate
supply
Equilibrium
price level
Aggregate
demand
0
Equilibrium
output
Quantity of
Output
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
Shifts in the Aggregate Demand

Curve...
Price
Level
P1
D2
Aggregate
demand, D1
0
Y1
Y2
Quantity of
Output
The Long-Run AggregateSupply Curve...

Pric
e
Leve
l
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
Long-Run Growth and Inflation...

Price
Level
4. and
ongoing
inflation.
2. and growth in the money

supply shifts aggregate-demand...
LRAS1980 LRAS1990 LRAS2000 1. In the
long-run,
technological
progress
shifts longrun
aggregate
supply...
P2000
P1990
P1980
AD2000
AD1980
Y1980
Y1990
AD1990
Y2000
3. leading to growth in output...

Quantity of
Output
The Short-Run Aggregate

Supply Curve...
Price
Leve
l
Short-run
aggregate
supply
P1
1. A
decrease in
the price
level
P2
2. reduces the
quantity of goods
and services
supplied in the
short run.
Y2
Y1
Quantity of
Output
The Long-Run Equilibrium

Price
Level
Equilibriu
m
price
Short-run
aggregate
supply
Long-run
aggregate
supply
Natural rate
of output
Aggregate
demand
Quantity of
Output
A Contraction in Aggregate Demand...

Price
Level
2. causes output to
fall in the short run
Long-run
aggregate
supply
Short-run aggregate
supply, AS1
AS
3. but over
time,
the short-run
aggregatesupply curve
1. A decrease
shifts in
aggregate demand
2
P1
B
P2
P3
C
AD
Y2
Y1
Aggregate
demand, AD1
4. and output
returns
Quantity of
Output
An Adverse Shift in Aggregate Supply...

Price
Level
P2
1. An adverse shift in
the short-run
aggregate-supply
curve
AS2
Short-run
aggregate
supply, AS1
Long-run
aggregate
supply
B
A
P1
3. and
the price
level to
rise.
Aggregate demand
0
Y2
Y1
2. causes output to
fall
Harcourt, Inc. items and derived items copyright
2001 by Harcourt, Inc.
Quantity of
Output
Accommodating an Adverse Shift

in Aggregate Supply...
Price
Level
1. When short-run aggregate supply

falls
Long-run
aggregate AS2
supply
P3
P2
P1
3....which
causes
the price
level to
rise
0
4. but
keeps
output at its
natural rate.
Short-run
aggregate
supply, AS1
2. policymakers
can
accommodate the
shift
by expanding
aggregate
AD2
demand
Aggregate demand, AD1
Natural rate
of output
Quantity of
Output

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Aggregate Demand

activity fluctuates from

is a period of declining real

Three Key Facts About

fluctuations are irregular and

Fluctuations in the economy are often called

A Look At Short-Run Economic Fluctuations

Three Key Facts About

A Look At Short-Run Economic Fluctuations

Three Key Facts About

output falls, unemployment rises.

Changes in real GDP are inversely related to

A Look At Short-Run Economic Fluctuations

How the Short Run Differs

economists believe that classical

The Basic Model of Economic

model to analyze the short-run

The Basic Model of Economic

The Basic Model of Economic

aggregate demand curve shows

The Basic Model of Economic

aggregate supply curve shows the

Aggregate Demand and

The Aggregate Demand Curve

four components of GDP (Y)

The Aggregate-Demand Curve...

2. increases the quantity of goods

Why the Aggregate Demand

Price Level and Consumption: The

The Price Level and Consumption:

in the price level makes

The Price Level and Investment:

level reduces the interest

The Price Level and net Exports:

a fall in the U.S. price level

Why the Aggregate Demand

Why the Aggregate Demand

arising from Consumption

Shifts in the Aggregate Demand

The Aggregate Supply Curve

the long run, the aggregatesupply curve is vertical.

The Long-Run Aggregate

The Long-Run AggregateSupply Curve...

The Long-Run Aggregate

long-run aggregate supply curve

Why the Long-Run Aggregate

Why the Long-Run Aggregate

Long-Run Growth and Inflation...

2. and growth in the money

3. leading to growth in output...

Long-Run Growth and Inflation

Why the Short-Run Aggregate

The Short-Run Aggregate

Why the Short-Run Aggregate

The Misperceptions Theory

Changes in the overall price level temporarily

These misperceptions induce suppliers to

The Sticky-Wage Theory

Nominal wages are slow to adjust, or are

The Sticky-Price Theory

Prices of some goods and services adjust

Why the Aggregate Supply

Why the Aggregate Supply