ELECTIVE L2: Aggregate Demand and Aggregate Supply

economic fluctuations

• all economies experience short run fluctuations around a long term growth trend, these are known as business cycles

• expansion → rising output, income, employment

• recession → falling GDP, rising unemployment

• these fluctuations are irregular and unpredictable

classic vs short run view

• classing theory (long run): money / prices (nominal variables) do not affect output and employment

• modern view (short run): prices / wages are not perfectly flexible → economic shocks affect real output

• why economists use the aggregate demand-aggregate supply (AD-AS) model

aggregate demand

• represents total spending in the economy

• consumption + investment + government spending (X-M net exports)

why AD slopes downward

• wealth effect: lower prices → money has more value → ppl spend more

• interest rate: lower prices → lower increase rates → more investments

• exchange rate effect: lower prices → weaker currenly → efforts increase

shifts in AD

• AD increase when: consumption, investment, government and net exports ↑

• AD decreases when these falls

• shift causes short run economic fluctuations

aggregate supply (AS)

• long run aggregate supply (LRAS):

  • vertical line

  • determined by: labor, capital, natural resources, technology

• short run aggregate supply (SRAS):

  • sloes upward

  • output response to price changes in the short run

why SRAS slopes upward

3 theories:

• sticky wage theory

• sticky price theory

• misperceptions theory

all imply that output changes when actual prices is different from the expected prices

• ex: if they thought prices are higher than expected, they think they’re earning more → produce more

sticky wage theory

• wages adjust slowly

• lower prices → higher real wages → firms hire less

sticky price theory

• prices don’t adjust immediately

• firms lose sales → reduce production

misperception theory

• firms misinterpret price changes

• reduce output due to confusion

causes of economic fluctuations

1. demand shocks

2. supply shocks (stagflation)

demand shocks

• ad shifts to left → recession

  • output & price decreases

• overtime:

  • expectations adjust

  • SRAS shifts right

  • economy returns to normal

supply shocks (stagflation)

• SRAS shifts to left

  • output decrease, price increase

• overtime:

  • wages / expectations adjust

  • SRAS shifts back

  • economy stabilizes