Chapter 34 - aggregate demand and supply

recession

Period of declining real incomes and rising unemployment

depression

Severe recession

3 key facts on economic fluctuations

Economic fluctuations are irregular and unpredictable ;; most macroeconomic quantities fluctuate together ;; as output falls, unemployment rises

Business cycle

Fluctuations in economy not regular, almost impossible to predict accurately

Because recessions are economy wide phenomena they appear in many sources of macroeconomic data

Although many macroeconomic variables fluctuate together they move by different amounts

ex) investment spending averages only one sixth of gdp but accounts for about ⅔ of the fall in gdp during recessions

When firms choose to reduce production they lay off workers expanding the pool of unemployed

When recession ends and real gdp starts to expand, unemployment rate gradually declines.

Because there are always some workers between jobs, the unemployment rate is never zero. Instead it fluctuates around natural rate of about 5 %

Assumption of classical economics

Changes in money supply affect nominal variables but not real variables.

Most economists believe that classical theory describes the world in the long run but not short run

In short run, real and nominal variables are highly intertwined and changes in money supply can temporarily push real gdp away from long run trend

Model of aggregate demand and aggregate supply

Model that most economists use to explain short run fluctuations in economic activity around its long run trend

Aggregate demand curve

Curve that shows the quantity of goods and services that households, firms, government and customers abroad want to buy at each price level

Aggregate supply curve

Shows quantity of goods and services that firms choose to produce and sell at each price level

Aggregate demand and aggregate supply model is ___ to model of market demand and supply model?

DIFFERENT! Microeconomic substitution from one market to another is impossible for economy as a whole. This model is trying to explain real gdp (total quantity, all firms and markets)

Aggregate demand curve

Depicts q of all goods and services demanded in the economy at any price level. Slopes downwards. All things being equal, dec in economy overall level of prices raises q of goods and services demanded.

Y = C + I + G + NX

Why does the aggregate demand curve slope down?

Consumers become wealthier, stimulating demand for consumption goods. Interest rates fall, stimulating demand for investment goods. The currency depreciates, stimulating the demand for net exports.

Price level and consumption - wealth effect

Decrease in the price level raises the real value of money and makes consumers wealthier, encouraging them to spend more. Increase in consumer spending means a larger q of goods and services demanded.

Price level and investment - interest rate effect

Lower price level reduces the interest rate, encourages spending on investment goods and increases q of goods and services demanded. Vice versa

Price level and net exports - exchange rate effect

When fall in us price level causes us interest rates to fall, real value of dollar declines in foreign exchange markets. Depreciation stimulates us net exports and inc quantity of goods and services demand. Vice versa

Why the aggregate demand curve might shift

Changes in consumption; investment ; government purchases ; net exports

Aggregate demand curve shift from changes in consumption

Event that causes consumers to spend more at a given price level (tax cut, stock market boom) shifts curve to right. (tax hike, stock market decline) to left

Aggregate demand curve shift from changes in investment

Event that causes firms to invest more at a given price level (optimism about future, fall in interest rates due to increase in money supply) shift curve to right. Vice versa (pessimism about future, rise in interest rates due to decrease in money supply)

Aggregate demand curve shift from changes in gov purchases

Increase in gov purchases of goods and services (greater spending on defense or highway construction) shifts aggregate demand curve to right. Decrease in gov purchases of goods and services (cutback in defense or highway spending)

Aggregate demand curve shift from changes in net exports

Event that raises spending on net exports at given price level (boom overseas, speculation that causes currency depreciation) shifts aggregate demand curve to right. An event that reduces spending on net exports at given price level (recession overseas, speculation that causes currency appreciation)

Aggregate supply curve

In long run it is vertical, short run it slopes upwards

Why the aggregate supply curve is vertical in long run

Economys prod of goods and services (real gdp) depends on its supplies of labor capital and natural resources and on the available technology used to turn these factors of production into goods and services. Implies that quantity of output (real variable) does not depend on level of prices (Nominal).

Natural level of output

Prod of goods and services that an economy achieves in long run when unemployment is at normal rate

Any changes in the economy that alters the natural level of output shifts the long run aggregate supply curve

Shifts in aggregate supply curve from changes in labor

Immigration, workers leaving to go abroad, natural rate of unemployment (ex. Unemployment insurance more generous, successful job training program)

Shifts in aggregate supply curve from changes in capital

Increase in capital stock, decrease in capital stock. Physical capital like machines and factories or human capitals like college degrees

Shifts in aggregate supply curve from changes in natural resources

Land, mineral, weather. ex) discovery of new mineral deposit shift long run aggregate supply curve to right. Also in many countries natural resources are imported. Change in availability of these resources can also shift the aggregate supply curve

Shifts in aggregate supply curve from changes in tech knowledge

Development of tech. Also opening up international trade (bc allow country to specialize in higher productivity industries, shift long run aggregate supply curve to right). If gov passes new regulations preventing firms from using some production methods, leftward shift

Why does the short run aggregate supply curve slope up

"Sticky wage theory ;; Sticky price theory; misperceptions theory

Misperceptions theory"

Sticky wage theory

at unexpectedly low price level, for given nominal wages, causes firms to hire fewer workers and produce a smaller q of goods and services

Sticky price theory

At unexpected low price level, leaves some firms with higher than desired prices depressing their sales and leading them to cut back production

Misperceptions theory

Unexpectedly low price level leads some suppliers to think their relative prices have fallen, inducing fall in production

Effects of a shift in agg demand

1- in short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services. In the long run, shifts in agg demand affect the overall price level but not affect output. Bc policymakers inf aggregate demand, they can pot. Mitigate severity of economic fluctuations

Stagflation

Period of falling output and rising prices

Wage price spiral

Phenomenon of higher prices leading to higher wages , leading to even higher prices

Policymakers may accommodate the shift in aggregate supply. An accommodative policy accepts a permanently higher level of prices to maintain higher level of output and employment

Effects of shifts in agg supply

Shifts in agg supply can cause stagnation - combo of recession (falling output) and inflation (rising prices). Policymakers who can inf agg demand can mitigate the adverse impact on output but only at cost of exacerbating problem of inflation