The Basic Model of Economic Fluctuations
• 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 Economic Fluctuations
• 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 Economic Fluctuations
• 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.

Aggregate Demand and Aggregate Supply...
Price Level

Aggregate supply

Equilibrium price level

Aggregate demand

0

Equilibrium output

Quantity of Output

Y = C + I + G + NX .THE AGGREGATE-DEMAND CURVE • The four components of GDP (Y) contribute to the aggregate demand for goods and services.

. . . increases the quantity of goods and services demanded. A decrease in the price level .The Aggregate-Demand Curve. . 0 Y Y2 Aggregate demand Quantity of Output 2. Price Level P P2 1... . .

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 .

which in turn encourages them to spend more. . • This increase in consumer spending means larger quantities of goods and services demanded.Why the Aggregate-Demand Curve Is Downward Sloping • The Price Level and Consumption: The Wealth Effect • A decrease in the price level makes consumers feel more wealthy.

Why the Aggregate-Demand Curve Is Downward Sloping • The Price Level and Investment: The Interest Rate Effect • A lower price level reduces the interest rate. . • This increase in investment spending means a larger quantity of goods and services demanded. which encourages greater spending on investment goods.

which stimulates Indian net exports.Why the Aggregate-Demand Curve Is Downward Sloping • The Price Level and Net Exports: The Exchange-Rate Effect • When a fall in the Indian price level causes Indian interest rates to fall. the real exchange rate depreciates. . • The increase in net export spending means a larger quantity of goods and services demanded.

the aggregate demand curve shifts. however. affect the quantity of goods and services demanded at any given price level. . • When one of these other factors changes.Why the Aggregate-Demand 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.

Why the Aggregate-Demand Curve Might Shift • Shifts arising from • • • • Consumption Investment Government Purchases 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 is vertical. • In the short run. the aggregate-supply curve is upward sloping.THE AGGREGATE-SUPPLY CURVE • In the long run.

. • A decrease in the level of prices tends to reduce the quantity of goods and services supplied. an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied.Why the Aggregate-Supply Curve Slopes Upward in the Short Run • In the short run.

A decrease in the price level . 2. . . .Figure 6 The Short-Run Aggregate-Supply Curve Price Level Short-run aggregate supply P P2 1. reduces the quantity of goods and services supplied in the short run. . 0 Y2 Y Quantity of Output . .

Why the Aggregate-Supply Curve Slopes Upward in the Short Run • The Misperceptions Theory • The Sticky-Wage Theory • The Sticky-Price Theory .

.Why the Aggregate-Supply Curve Slopes Upward 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.

• This induces firms to reduce the quantity of goods and services supplied. 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.Why the Aggregate-Supply Curve Slopes Upward in the Short Run • The Sticky-Wage Theory • Nominal wages are slow to adjust.

which induces firms to reduce the quantity of goods and services they produce. .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.

Expected Price Level. Technology.Why the Short-Run Aggregate-Supply Curve Might Shift • Shifts arising • • • • • Labor Capital Natural Resources. .

THE AGGREGATE-SUPPLY CURVE • The Long-Run Aggregate-Supply Curve • In the long run. capital. . and natural resources and on the available technology used to turn these factors of production into goods and services. an economy’s production of goods and services depends on its supplies of labor. • The price level does not affect these variables in the long run.

. Quantity of Output . . . A change in the price level . . 0 Natural rate of output 2.The Long-Run Aggregate-Supply Curve Price Level Long-run aggregate supply P P2 1. does not affect the quantity of goods and services supplied in the long run. .

• This level of production is also referred to as potential output or full-employment output. .THE AGGREGATE-SUPPLY CURVE • The Long-Run Aggregate-Supply Curve • The long-run aggregate-supply curve is vertical at the natural rate of output.

.Justifying vertical LRAS in long run (step 1) • The aggregate supply curve depicts the quantity of real GDP that is supplied by the economy at different price levels. The supply curve for an individual good is drawn under the assumption that input prices remain constant. • The reasoning used to construct the aggregate supply curve differs from the reasoning used to construct the supply curves for individual goods and services.

• The aggregate supply curve. sellers' per unit costs of providing good X do not change. is defined in terms of the price level. Increases in the price level will increase the price that producers can get for their products and thus induce more output. however. .Justifying vertical LRAS in long run ( Step 2) • As the price of good X rises. the upward slope of the supply curve for good X. and so sellers are willing to supply more of good Xhence.

Justifying vertical LRAS in long run ( Step 3) • But an increase in the price will also have a second effect. it will eventually lead to increases in input prices as well. will cause producers to cut back. . which. ceteris paribus.

. In order to address this issue. the short-run aggregate supply curve and the long-run aggregate supply curve. there is some uncertainty as to whether the economy will supply more real GDP as the price level rises.Justifying vertical LRAS in long run ( Step 4) • So. it has become customary to distinguish between two types of aggregate supply curves.

the increase in prices that sellers receive for their final goods is completely offset by the proportional increase in the prices that sellers pay for inputs.Justifying vertical LRAS in long run ( Step 5) • The long-run is defined as the period when input prices have completely adjusted to changes in the price level of final goods. . • In the long-run.

Justifying vertical LRAS in long run ( Step 6) • The result is that the quantity of real GDP supplied by all sellers in the economy is independent of changes in the price level. . Hence LRAS is a vertical line. reflecting the fact that long-run aggregate supply is not affected by changes in the price level.

• The natural rate of output is defined as the level of real GDP that arises when the economy is fully employing all of its available input resources. .Justifying vertical LRAS in long run ( Step 7) • Note that the LAS curve is vertical at the point labeled as the natural rate of output (natural level of real GDP).

Why the Long-Run Aggregate-Supply Curve Might Shift • Shifts arising • • • • Labour Capital Natural Resources Technological Knowledge .

. In the long run. .Long-Run Growth and Inflation 2. . Aggregate Demand. . . LRAS1980 LRAS1990 LRAS2000 P2000 4. . . Price Level Long-run aggregate supply. and growth in the money supply shifts aggregate demand . AD2000 P1980 AD1990 AD1980 0 Y1980 Y1990 Y2000 Quantity of Output 3. technological progress shifts long-run aggregate supply . and ongoing inflation. . . . P1990 1. . . . . . leading to growth in output . .

.A New Way to Depict Long-Run Growth and Inflation • Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends.

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 Long-run aggregate supply Short-run aggregate supply Equilibrium price A Aggregate demand 0 Natural rate of output Quantity of Output .

A decrease in aggregate demand . . Price Level Long-run aggregate supply Short-run aggregate supply. . P P2 P3 B A C Aggregate demand. . . AS AS2 3. . causes output to fall in the short run .A Contraction in Aggregate Demand 2. but over time. . . . and output returns to its natural rate. the short-run aggregate-supply curve shifts . . . . AD AD2 0 Y2 Y 4. Quantity of Output . . . 1. . .

TWO CAUSES OF ECONOMIC FLUCTUATIONS • Shifts in Aggregate Demand • In the short run. shifts in aggregate demand affect the overall price level but do not affect output. shifts in aggregate demand cause fluctuations in the economy’s output of goods and services. • In the long run. .

TWO CAUSES OF ECONOMIC FLUCTUATIONS • 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.

. . . AS B P2 A P 3. . causes output to fall .An Adverse Shift in Aggregate Supply 1. . and the price level to rise. Price Level Long-run aggregate supply AS2 Short-run aggregate supply. . . . Aggregate demand 0 Y2 Y Quantity of Output 2. An adverse shift in the shortrun aggregate-supply curve . . . .

• Output falls and prices rise.The Effects of a Shift in Aggregate Supply • Stagflation • Adverse shifts in aggregate supply cause stagflation—a period of recession and inflation. • Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously. .

• Take action to increase aggregate demand by using monetary and fiscal policy. .The Effects of a Shift in Aggregate 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.

but keeps output at its natural rate. . . AD Quantity of Output Copyright © 2004 South-Western . . . policymakers can accommodate the shift by expanding aggregate demand . . Natural rate of output AD2 Aggregate demand. . . . 4. . . AS P3 P2 C A 3. 0 2. When short-run aggregate supply falls . .Accommodating an Adverse Shift in Aggregate Supply 1. which P causes the price level to rise further . Price Level Long-run aggregate supply AS2 Short-run aggregate supply. . . . .

• When recessions occur. . real GDP and other measures of income. and production fall. • These fluctuations are irregular and largely unpredictable.Summary • All societies experience short-run economic fluctuations around long-run trends. and unemployment rises. spending.

. • According to the model of aggregate demand and aggregate supply.Summary • Economists analyze short-run economic fluctuations using the aggregate demand and aggregate supply model. the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply.

• Any event or policy that changes consumption. .Summary • The aggregate-demand curve slopes downward for three reasons: a wealth effect. and an exchange rate effect. an interest rate effect. government purchases. or net exports at a given price level will shift the aggregate-demand curve. investment.

the sticky-wage theory. the aggregate supply curve is upward sloping. • The are three theories explaining the upward slope of short-run aggregate supply: the misperceptions theory. .Summary • In the long run. and the sticky-price theory. the aggregate supply curve is vertical. • The short-run.

the position of the short-run aggregatesupply curve depends on the expected price level.Summary • Events that alter the economy’s ability to produce output will shift the short-run aggregate-supply curve. . • Also. • One possible cause of economic fluctuations is a shift in aggregate demand.

. • Stagflation is a period of falling output and rising prices.Summary • A second possible cause of economic fluctuations is a shift in aggregate supply.