Aggregate Demand and Aggregate Supply

Aggregate Demand and Aggregate Supply
Principles of Macroeconomics: Ch. 19
Second Canadian Edition
Overview
Three
key factors about economic fluctuations. The aggregate demand and aggregate supply model. The aggregate demand curve. The aggregate supply curve. Equilibrium in the long-run.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Short-Run Economic Fluctuations

Economic
activity fluctuates from year to year. In some years, the production of goods and services rises. In other years normal growth does not occur, leading to recession. A recession is a situation of declining real GDP, falling incomes and rising unemployment for two consecutive quarters.
Three Key Facts About Economic Fluctuations

Economic Fluctuations are Irregular
and Unpredictable.
Recessions occur with unpredictable frequency and duration.
Most Macroeconomic Variables

Fluctuate Together.
Most macroeconomic variables are closely related and move together.

Three Key Facts About Economic Fluctuations

As Output Falls, Unemployment Rises.
Changes in real GDP and the unemployment rate are inversely related.
Quick Quiz!
List
and discuss three key facts about economic fluctuations.
Overview
Three
Economic Fluctuations
Although
there remains some debate about how to analyze short-run fluctuations, most economists use the model of aggregate demand and aggregate supply.
The Basic Model of Economic Fluctuations

Two
variables are used in developing a model to analyze the short-run fluctuations:

1. The economys output of goods and services, measured by real GDP 2. The overall price level, measured by the CPI or GDP Deflator
The
Model: Aggregate Demand and Aggregate Supply

The Aggregate Demand and Aggregate Supply Model

Price Level Aggregate Supply
PE
Aggregate Demand QE
Quantity of Output
Aggregate Demand and Aggregate Supply

The
Aggregate Demand Curve shows the quantity of goods and services that households, firms and the government are willing to buy at different prices. The Aggregate Supply Curve shows the quantity of goods and services that firms would be willing to produce and sell at different prices.
Overview
Three
The Aggregate Demand Curve

The
aggregate demand for goods and services may be referred to as:
Y = C + I + G + NX
Why
is the aggregate demand curve downward sloping?

1. Pigous Wealth Effect 2. Keynes Interest Rate Effect 3. Real Exchange Rate Effect
Three Reasons for the Downward Slope of the Aggregate Demand

Pigous
Wealth Effect: Consumers feel wealthier, which stimulates the demand for consumption goods.
A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded.

Keynes
Interest-Rate Effect: The lower the price level, the less money households need to hold to buy the goods and services they want.
A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded.

Real
Exchange-Rate Effect: When prices of Bangladesh goods go down, foreigners buy more of our goods and we purchase less of their goods.
When a fall in the Bangladesh price level causes the real exchange rate to depreciate, this stimulates Bangladesh net exports, thereby increasing the quantity of goods and services demanded.
Factors that might shift the Aggregate Demand Curve

Shifts
in the aggregate demand curve may arise because of:

1. Changes in spending plans by consumers or firms. 2. Changes in fiscal or monetary policy.
Anything that causes buyers to want to purchase more or less than before will cause the aggregate demand schedule to shift.
Shifts in the Aggregate Demand Curve

AD
AD
Aggregate Demand
Quantity of Output
Quick Quiz!
Explain
the three reasons why the aggregate demand curve slopes downward. Give an example of an event that would shift the aggregate demand curve. Which way would this event shift the curve?
Overview
Three
The Long-Run Aggregate Supply Curve

The
Long-Run Aggregate Supply Curve is vertical at full-employment GDP with respect to the price level. In the long-run the quantity of output supplied depends on the economys resource endowment, technology, and its governing institutions. The price level does not affect these variables in the long-run.

Price Level
Aggregate Supply

Aggregate Demand
Quantity of Output

Price Level
Aggregate Supply
Output at Full Employment
Aggregate Demand
Quantity of Output
Shifts in the Long-Run Aggregate Supply Curve

Over
time, any change in the factors that determine the long-run aggregate supply will cause the curve to shift.
An event that reduces potential output shifts the schedule to the left. Any change that increases the economys potential output will shift the curve to the right.
The Short-Run Aggregate Supply Curve

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, and a decrease in the level of prices tends to reduce the quantity of goods and services supplied.
Reasons for the Upward Slope of the Aggregate Supply Curve

There
are three alternative explanations for the upward slope of the short-run aggregate supply curve.
New Classical Misperceptions Theory The Keynesian Sticky-Wage Theory The New Keynesian Sticky-Price Theory

The
New Classical Misperceptions Theory: A higher price level signals to each firm a greater demand for their product inducing them to produce more.
Changes in the overall price level can temporarily mislead suppliers about what is happening in the markets in which they sell their output.

The
Keynesian Sticky-Wage Theory: The higher product prices cause a temporary decrease in real wages stimulating employment and output.
Nominal wages are slow to adjust, or are sticky in the short-run, thus a lower price level makes employment and production less profitable, which induces firms to reduce production.

The
New Keynesian Sticky-Price Theory: Prices that do not increase immediately are temporarily low thereby stimulating spending and output on those goods.
Prices of some goods and services adjust sluggishly in response to changing economic conditions. Remember Menu Costs.
What Might Cause the Aggregate Supply Curve to Shift?

Three
factors may lead to a shift in the short-run aggregate supply curve.

Changes in Factor (input) Prices Changes in Productivity Legal-Institutional Environment
Shifts in the Aggregate Supply Curve

Price Level
AS
Aggregate Supply
AS
Aggregate Demand
Quantity of Output

Changes
in factor (input) prices: Changes in the prices of domestic or imported resources will change the cost of producing final goods.
An increase in input prices will shift the supply curve to the left. A decrease in input prices will shift the supply curve to the right.

Changes
in productivity: If changes in the resource markets increase factor productivity, more goods can be made available at a lower cost. New technologies can increase the output per unit of labour or capital and hence make available more final goods.

Legal-institutional
environment: Burdensome taxes and counterproductive regulations can increase the cost of production and discourage firms from producing.
Quick Quiz!
Explain
why the longrun aggregate supply curve is vertical. Explain three theories for why the short-run aggregate supply curve is upward sloping.
Overview
Three
Equilibrium in the Long-Run

Equilibrium
output and price level are determined by the intersection of the aggregate demand curve and the longrun aggregate supply curve. Output is at its natural rate and the short-run aggregate supply curve passes through the point of intersection.
Equilibrium in the Long-Run

PE
Aggregate Demand
QE
Quantity of Output
Sources of Recession
Two
sources from which a recession in the economy may occur: A decrease in aggregate demand A decrease in aggregate supply Shifts in the aggregate demand or the aggregate supply curves result in fluctuations in the economys output of goods and services.
Source of Recession
A Decrease in Aggregate Demand
A
decrease in one or more components of the total spending function will cause the aggregate demand schedule to shift leftward.
Output will fall below the full employment output Unemployment will rise

PE
Aggregate Demand
QE
Quantity of Output

PE
Aggregate Demand
QE
Quantity of Output

PE
Aggregate Demand
QE
Quantity of Output
Source of Recession A Decrease in Aggregate Supply

A
decrease in short-run aggregate supply will result in a new equilibrium along the aggregate demand curve below full employment. A fall in total output below full output
An increase in unemployment
A Decrease in Aggregate Supply

PE
Aggregate Demand
QE
Quantity of Output

PE
Aggregate Demand
QE
Quantity of Output

PE
Aggregate Demand
QE
Quantity of Output

When
the economy falls due to a decrease in the aggregate supply, the price level rises and output decreases. This is called Stagflation.
Actions by Policy-makers During Periods of Recession

Policy-makers,
when faced by decreasing aggregate demand or supply could:

Do nothing, assuming that perceptions will adjust prices and wages. Take action to increase aggregate demand (implement monetary and fiscal policy).
Quick Quiz!
Suppose
that the election of a popular prime ministerial candidate suddenly increases peoples confidence in the future. Use the model of aggregate supply and aggregate demand to analyze the effect on the economy.
Overview
Three

Aggregate Demand and Aggregate Supply

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Aggregate Demand and Aggregate Supply

Uploaded by

Copyright:

Available Formats

Aggregate Demand and Aggregate Supply

Principles of Macroeconomics: Ch. 19

Second Canadian Edition

Short-Run Economic Fluctuations

Three Key Facts About Economic Fluctuations

Recessions occur with unpredictable frequency and duration.

Most Macroeconomic Variables

Most macroeconomic variables are closely related and move together.

Principles of Macroeconomics: Ch. 19

Three Key Facts About Economic Fluctuations

Principles of Macroeconomics: Ch. 19

Second Canadian Edition

and discuss three key facts about economic fluctuations.

Principles of Macroeconomics: Ch. 19

Second Canadian Edition

Principles of Macroeconomics: Ch. 19

Second Canadian Edition

The Basic Model of Economic Fluctuations

variables are used in developing a model to analyze the short-run fluctuations:

Model: Aggregate Demand and Aggregate Supply

Principles of Macroeconomics: Ch. 19

The Aggregate Demand and Aggregate Supply Model