CHAPTER 23

AGGREGATE DEMAND AND AGGREGATE SUPPLY

Introduction
 real GDP over the long-run grows about 3% yearly in the USA
 GDP in the short run fluctuates around its trends
 recessions: periods of falling real incomes and rising unemployment
 depressions: severe recessions (rare)
Three facts about economic fluctuations:
 they are irregular and unpredictable
 most macroeconomic quantities fluctuate together
 as output falls, unemployment rises
The Assumptions of Classical Economics
 classical dichtonomy: real and nominal
 Neutrality of money: changes in money supply affect nominal but not real variables
Reality of Short-Run Fluctuations
 classical theory: describes the world in the long run, but not the short run
 in the short run changes in nominal variables (M or P) can affect real variables (Y)

New model: Aggregate S&D

 two indicators: price level (P) and quantity of output (Y)
Why AD curve shapes downward:
 Wealth Effect (P and C): suppose that price level declines:
o increase in value of money
o consumers are wealthier
o increase in consumer spending
o increase in quantity demanded of G&S
 Interest-Rate Effect (P and I): suppose that price level declines:
o buying G&S require less dollars  people buy bonds and other assets
o decrease in the interest rate
o increase spending on I
o increase in quantity demanded of G&S
 Exchange-Rate Effect (P and NX): suppose that U.S. price level declines:
o decrease in interest rate
o U.S. dollar depreciates
o stimulates U.S. net exports (NX)
o increase in quantity demanded of G&S
 Why AD curve slopes downward
o C falls
o I falls
 o NX falls

Why the AD Curve Might Shift:

 changes in C:
o stock market crash
o tax hikes/cuts
 changes in I:
o firms buy assets
o interest rates
o monetary policy
 changes in G:
o federal spending
o state and local spending
 changes in NX:
o booms/recessions in countries that buy our exports
o app’n/dep’n resulting from international speculation

Aggregate-Supply (AS) Curves

 show the quantity of G&S firms produce and sell at any given price level
 upward-sloping in short run
 vertical in long run

Long run Aggregate-Supply Curve (LRAS)

 the natural rate of output (Yn): the amount of output the economy produces when
unemployment is at its natural rate (a.k.a. potential or full-employment output)
Why LRAS is vertical
 Yn determined by the economy’s stocks of labor, capital, and natural resources, and
ont he level of technology
o increase in P does not affect it

Why LRAS curve might shift

 changes in labor or natural rate of unemployment
o immigration
o baby-boomers
 changes in capital or human capital
o investments
o more college degrees
 changes in natural resource availability
o new mineral deposits
o changing agricultural production
 changes in technology
o productivity improvements
SRAS curve (period of 1-2 years)
 if AS is vertical, AD does not affect output
 if AS slopes up, AD affects output
Sticky-Wage Theory
 imperfection: nominal wages are sticky in the short run (they adjust sluggishly)
o because of labor contracts, social norms
 takes time for the increasing cost-of-living (inflation) to be incorporated into wages
 if prices are HIGHER than expected: P>Pe
o higher P  higher Y  SRAS slopes up
 imperfection: many prices are sticky in the short run (menu costs)
 suppose that the Fed increases money supply
o in the long run P will rise
o in the short run firms without menu costs can raise prices, firms without it can
wait
o higher P  higher Y

Misperceptions Theory
 imperfection: firms may confuse changes in P with changes in the relative price of the
products they sell
 if P>Pe: a firm sees its price rise before realizing all prices are rising
 increase in P  increase in Y  SRAS slopes upward

Common things in the Theories:

 Y = Yn + a(P-Pe)
 imperfections in these theories are temporary

Why the SRAS curve might shift

 everything that shifts LRAS shifts SRAS
 Pe shifts SRAS
o Pe rises  SRAS shifts left

Long run Equilibrium

 Pe=P
 Y=Yn
Analyzing Economic Fluctuations
 four steps:
1. Does the event shift AD or AS?
2. Does the curve shift left or right?
3. Use AD-AS diagram to see how the shift changes Y and P in short run
4. Use the diagram to see how economy moves from new SR eq. to LR eq.