Chapter 20- Aggregate Demand & Supply

US GDP in the long run

3% increase per year on average

US GDP in the short run

fluctuates around its trend

Recessions vs depressions

Recession- period of falling real incomes and rising unemployment

Depression- severe recessions (rare)

Economic fluctuations facts

• they are irregular and unpredictable

• most macroeconomic quantities fluctuate together

• as output falls, unemployment rises

When can changes in nominal variables affect real variables?

In the short run

Aggregate demand curve

shows quantity of all goods/services demanded in the economy at each price level

What shifts the AD curve?

Consumption, investment, government purchases, and net exports

Why does the AD curve slope down?

wealth effect, interest rate effect, and exchange rate effect

Wealth effect

effect of a change in price on consumption (if consumers are wealthier, they consume more)

Interest rate effect

effect of a change in price on investment (if IR decreases, consumers increase spending on investment)

Exchange rate effect

effect of change in P on net exports (if the US dollar depreciates, goods are cheaper which causes increase in net exports)

How does a change in price affect the AD curve?

It moves along the curve (no shift)

Changes in consumption

• stock market crash/boom

• consumption/saving tradeoff

• tax increase/cuts

Changes in investment

• firms buy new equipment

• optimism/pessimism for future

• IR rates

• monetary policy (money supply)

• tax policy & incentives

Changes in government purchases

• federal spending

• state and local spending

Changes in net exports

• booms/recessions in countries that purchase US goods

• appreciation/depreciation

Appreciation causes net exports to ___

decrease (too expensive prices)

Aggregate supply curve

total quantity of goods/services that firms produce and sell at each price level

How does the AS curve change from short to long run?

Upward sloping in short run (SRAS) and vertical in long run (LRAS)

natural rate of output

amount of output the economy produces when unemployment is at its natural rate

Other names for natural rate of output

potential output, full employment output

What shifts the LRAS?

Labor, capital, natural resources, and level of technology

Does a change in price affect the LRAS?

no

Changes in labor

• immigration

• changes in u-rate (gov’t policies regarding UI, job training, etc)

Changes in capital

• investment in factories/equipment/human capital

• factories destroyed by weather

Changes in natural resources

• new mineral deposits

• reduction in oil supply

• changing weather patterns

Why does slope matter for SRAS and LRAS?

if AS is vertical, changes in AD don’t cause fluctuations in output or employment but if it slopes up then shifts in AD do affect them

Why does the SRAS slope upward?

sticky wage theory, sticky price theory, misperception theory

Sticky wage theory

• nominal wages adjust slowly in the short run due to labor contracts and social norms

• firms/workers set the nominal wage in advance based on P_E (expected price)

Sticky price theory

• many prices are slow to change in the short run due to menu costs

• firms set sticky prices in advanced based on P_E

What happens if P > P_E?

• revenue is higher but labor cost doesn’t change

• firms increase output/employment because production is more profitable

• higher P, higher Y (positive slope for SRAS)

What happens in long and short run if the Fed raises MS unexpectedly?

• P increases in long run

• in short run, firms w/o menu costs will raise prices and firms with menu costs will wait

• lower prices, more demand for those firm’s products and therefore more output

• higher P, higher Y

Misperception theory

• firms may confuse changes in P with changes in relative prices of products they sell

• If P > P_E, a firm may believe relative price is rising and will increase output and employment

• higher P, higher Y

Aggregate supply formula

Y= Y_N + a(P-P_E)

a

value more than 0, measures how much Y responds to changes in P

P_E

expected price level

What shifts SRAS?

Everything that shifts LRAS + shifts in P_E

4 steps to analyzing economic fluctuations

1. determine whether event shifts AD or AS

2. determine if curve shifts left or right

3. use AD-AS diagram to see how shift changes Y and P in short run

4. use AD-AS diagram to see how economy moves from new SR equilibrium to new LR equilibrium