Aggregate Demand and Supply

Aggregate Demand and Supply

Introduction

  • Real GDP grows about 3% per year on average over the long run.

  • GDP fluctuates around its trend in the short run.

  • Recessions: Periods of falling real incomes and rising unemployment.

  • Depressions: Severe recessions (very rare).

Three Facts About Economic Fluctuations

  • FACT 1: Economic fluctuations are irregular and unpredictable.

  • FACT 2: Most macroeconomic quantities fluctuate together.

  • FACT 3: As output falls, unemployment rises.

The Classical Dichotomy

  • Classical dichotomy: The theoretical separation of nominal variables and real variables.

  • Nominal variables: Measured in monetary units.

    • Nominal GDP, nominal interest rate (rate of return measured in )) , nominal wage (perhourworked).</p></li></ul></li><li><p>Realvariables:Measuredinphysicalunits.</p><ul><li><p>RealGDP,realinterestrate(measuredinoutput),realwage(measuredinoutput).</p></li></ul></li></ul><h4id="376827cf−bb36−473b−915c−ae21670e31c9"data−toc−id="376827cf−bb36−473b−915c−ae21670e31c9"collapsed="false"seolevelmigrated="true">ClassicalEconomics</h4><ul><li><p>Classicaleconomics:</p><ul><li><p>TheClassicalDichotomy,theseparationofvariablesintotwogroups:</p><ul><li><p>Real–quantities,relativeprices</p></li><li><p>Nominal–measuredintermsofmoney</p></li></ul></li><li><p>Theneutralityofmoney:Changesinthemoneysupplyaffectnominalbutnotrealvariables.</p></li></ul></li></ul><h4id="8a3f3d19−394c−4750−8b70−31e64298216c"data−toc−id="8a3f3d19−394c−4750−8b70−31e64298216c"collapsed="false"seolevelmigrated="true">ClassicalEconomics—ARecap</h4><ul><li><p>Classicaltheorydescribestheworldinthelongrun,butnottheshortrun</p></li><li><p>Intheshortrun,changesinnominalvariables(likethemoneysupplyorP)canaffectrealvariables(likeYortheu−rate).</p></li><li><p>Anewmodelisintroducedtoanalyzetheshortrun.</p></li></ul><h4id="a8c08a3e−9c3a−4f97−bd7b−6e554cf72954"data−toc−id="a8c08a3e−9c3a−4f97−bd7b−6e554cf72954"collapsed="false"seolevelmigrated="true">ModelofAggregateDemandandAggregateSupply</h4><ul><li><p>Themodeldeterminestheequilibriumpricelevelandequilibriumoutput(realGDP).</p></li><li><p>ThemodelincludesAggregateDemand(AD)andShort−RunAggregateSupply(SRAS)curves.</p></li><li><p>TheintersectionofADandSRASdeterminestheequilibriumpricelevelandequilibriumoutput.</p></li></ul><h4id="0256ed65−30e7−4004−a665−071eb064ba5e"data−toc−id="0256ed65−30e7−4004−a665−071eb064ba5e"collapsed="false"seolevelmigrated="true">TheAggregate−Demand(AD)Curve</h4><ul><li><p>TheADcurveshowsthequantityofallgoodsandservicesdemandedintheeconomyatanygivenpricelevel.</p></li><li><p>TheADcurveslopesdownward.</p></li></ul><h4id="30ffec95−c743−4c1d−9348−6b784a2afedc"data−toc−id="30ffec95−c743−4c1d−9348−6b784a2afedc"collapsed="false"seolevelmigrated="true">WhytheADCurveSlopesDownward</h4><ul><li><p>per hour worked).</p></li></ul></li><li><p>Real variables: Measured in physical units.</p><ul><li><p>Real GDP, real interest rate (measured in output), real wage (measured in output).</p></li></ul></li></ul><h4 id="376827cf-bb36-473b-915c-ae21670e31c9" data-toc-id="376827cf-bb36-473b-915c-ae21670e31c9" collapsed="false" seolevelmigrated="true">Classical Economics</h4><ul><li><p>Classical economics:</p><ul><li><p>The Classical Dichotomy, the separation of variables into two groups:</p><ul><li><p>Real – quantities, relative prices</p></li><li><p>Nominal – measured in terms of money</p></li></ul></li><li><p>The neutrality of money: Changes in the money supply affect nominal but not real variables.</p></li></ul></li></ul><h4 id="8a3f3d19-394c-4750-8b70-31e64298216c" data-toc-id="8a3f3d19-394c-4750-8b70-31e64298216c" collapsed="false" seolevelmigrated="true">Classical Economics—A Recap</h4><ul><li><p>Classical theory describes the world in the long run, but not the short run</p></li><li><p>In the short run, changes in nominal variables (like the money supply or P) can affect real variables (like Y or the u-rate).</p></li><li><p>A new model is introduced to analyze the short run.</p></li></ul><h4 id="a8c08a3e-9c3a-4f97-bd7b-6e554cf72954" data-toc-id="a8c08a3e-9c3a-4f97-bd7b-6e554cf72954" collapsed="false" seolevelmigrated="true">Model of Aggregate Demand and Aggregate Supply</h4><ul><li><p>The model determines the equilibrium price level and equilibrium output (real GDP).</p></li><li><p>The model includes Aggregate Demand (AD) and Short-Run Aggregate Supply (SRAS) curves.</p></li><li><p>The intersection of AD and SRAS determines the equilibrium price level and equilibrium output.</p></li></ul><h4 id="0256ed65-30e7-4004-a665-071eb064ba5e" data-toc-id="0256ed65-30e7-4004-a665-071eb064ba5e" collapsed="false" seolevelmigrated="true">The Aggregate-Demand (AD) Curve</h4><ul><li><p>The AD curve shows the quantity of all goods and services demanded in the economy at any given price level.</p></li><li><p>The AD curve slopes downward.</p></li></ul><h4 id="30ffec95-c743-4c1d-9348-6b784a2afedc" data-toc-id="30ffec95-c743-4c1d-9348-6b784a2afedc" collapsed="false" seolevelmigrated="true">Why the AD Curve Slopes Downward</h4><ul><li><p>Y = C + I + G + NX where G is fixed by government policy.

    • The slope of AD is determined by how a change in P affects C, I, and NX.

    The Wealth Effect (P and C)

    • If the price level, P, declines:

      • The real value of money increases.

      • Consumers are wealthier.

      • Consumer spending, C, increases.

      • The quantity demanded of goods and services increases.

    The Interest-Rate Effect (P and I)

    • If the price level, P, declines:

      • Fewer dollars are needed to buy goods and services.

      • People buy bonds and other assets.

      • The interest rate decreases.

      • Spending on investment goods, I, increases.

      • The quantity demanded of goods and services increases.

    The Exchange-Rate Effect (P and NX)

    • If the U.S. price level, P, declines:

      • The interest rate decreases.

      • The U.S. dollar depreciates.

      • U.S. net exports, NX, are stimulated.

      • The quantity demanded of goods and services increases.

    The Slope of the AD Curve: Summary

    • An increase in P reduces the quantity of goods and services demanded because:

      • The wealth effect (C falls)

      • The interest-rate effect (I falls)

      • The exchange-rate effect (NX falls)

    Why the AD Curve Might Shift

    • Any event that changes C, I, G, or NX—except a change in P—will shift the AD curve.

    • Example: A stock market boom makes households feel wealthier, C rises, and the AD curve shifts right.

    Factors That Shift the AD Curve

    • Changes in C:

      • Stock market boom/crash

      • Preferences re: consumption/saving tradeoff

      • Tax hikes/cuts

      • Expectations, Optimism/ Pessimism

      • Interest Rates, Monetary Policy

    • Changes in I:

      • Firms buy new computers, equipment, factories

      • Expectations, optimism/pessimism

      • Interest rates

      • Monetary policy

      • Investment Tax Credit or other tax incentives

    • Changes in G:

      • Federal spending (e.g., defense)

      • State & local spending (e.g., roads, schools)

    • Changes in NX:

      • Booms/recessions in countries that buy U.S. exports

      • Appreciation/depreciation resulting from international speculation in the foreign exchange market

    Examples of Shifts in the AD Curve

    • A ten-year-old investment tax credit expires: I falls, AD curve shifts left.

    • The U.S. exchange rate falls: NX rises, AD curve shifts right.

    • A fall in prices increases the real value of consumers’ wealth: Move down along the AD curve (wealth-effect).

    • State governments replace their sales taxes with new taxes on interest, dividends, and capital gains: C rises, AD shifts right.

    The Aggregate-Supply (AS) Curves

    • The AS curve shows the total quantity of goods and services firms produce and sell at any given price level.

    • AS is upward-sloping in the short run and vertical in the long run.

    The Long-Run Aggregate-Supply Curve (LRAS)

    • The natural rate of output (Y_N)istheamountofoutputtheeconomyproduceswhenunemploymentisatitsnaturalrate.</p></li><li><p>Alsocalledpotentialoutputorfull−employmentoutput.</p></li><li><p>TheLRAScurveisverticalat) is the amount of output the economy produces when unemployment is at its natural rate.</p></li><li><p>Also called potential output or full-employment output.</p></li><li><p>The LRAS curve is vertical atY_N.</p></li></ul><h4id="47ed16c5−21f3−4bb2−8d90−095011091f7d"data−toc−id="47ed16c5−21f3−4bb2−8d90−095011091f7d"collapsed="false"seolevelmigrated="true">WhyLRASIsVertical</h4><ul><li><p>.</p></li></ul><h4 id="47ed16c5-21f3-4bb2-8d90-095011091f7d" data-toc-id="47ed16c5-21f3-4bb2-8d90-095011091f7d" collapsed="false" seolevelmigrated="true">Why LRAS Is Vertical</h4><ul><li><p>Y_Nisdeterminedbytheeconomy’sstocksoflabor,capital,andnaturalresources,andontheleveloftechnology.</p></li><li><p>AnincreaseinPdoesnotaffectanyofthese,soitdoesnotaffectis determined by the economy’s stocks of labor, capital, and natural resources, and on the level of technology.</p></li><li><p>An increase in P does not affect any of these, so it does not affectY_N(Classicaldichotomy).</p></li></ul><h4id="233fbcc3−4c5b−4c0b−8ae5−bef1893e4b60"data−toc−id="233fbcc3−4c5b−4c0b−8ae5−bef1893e4b60"collapsed="false"seolevelmigrated="true">WhytheLRASCurveMightShift</h4><ul><li><p>Anyeventthatchangesanyofthedeterminantsof(Classical dichotomy).</p></li></ul><h4 id="233fbcc3-4c5b-4c0b-8ae5-bef1893e4b60" data-toc-id="233fbcc3-4c5b-4c0b-8ae5-bef1893e4b60" collapsed="false" seolevelmigrated="true">Why the LRAS Curve Might Shift</h4><ul><li><p>Any event that changes any of the determinants ofY_NwillshiftLRAS.</p></li><li><p>Example:ImmigrationincreasesL,causingwill shift LRAS.</p></li><li><p>Example: Immigration increases L, causingY_Ntorise.</p></li></ul><h4id="175fde4f−6616−4be0−a853−20718eb7e147"data−toc−id="175fde4f−6616−4be0−a853−20718eb7e147"collapsed="false"seolevelmigrated="true">FactorsThatShifttheLRASCurve</h4><ul><li><p>ChangesinLornaturalrateofunemployment</p><ul><li><p>Immigration</p></li><li><p>Baby−boomersretire</p></li><li><p>Governmentpoliciesreducenaturalu−rate</p></li></ul></li><li><p>ChangesinKorH</p><ul><li><p>Investmentinfactories,equipment</p></li><li><p>Morepeoplegetcollegedegrees</p></li><li><p>Factoriesdestroyedbyahurricane</p></li></ul></li><li><p>Changesinnaturalresources</p><ul><li><p>Discoveryofnewmineraldeposits</p></li><li><p>Reductioninsupplyofimportedoil</p></li><li><p>Changingweatherpatternsthataffectagriculturalproduction</p></li></ul></li><li><p>Changesintechnology</p><ul><li><p>Productivityimprovementsfromtechnologicalprogress</p></li></ul></li></ul><h4id="d7450994−eae9−4576−b779−aa72ff5bfb65"data−toc−id="d7450994−eae9−4576−b779−aa72ff5bfb65"collapsed="false"seolevelmigrated="true">Long−RunGrowthandInflation</h4><ul><li><p>Overthelongrun,technologicalprogressshiftsLRAStotheright.</p></li><li><p>GrowthinthemoneysupplyshiftsADtotheright.</p></li><li><p>Result:ongoinginflationandgrowthinoutput.</p></li></ul><h4id="e22ef5ce−2a25−4fc0−8ddf−3a3289510e9b"data−toc−id="e22ef5ce−2a25−4fc0−8ddf−3a3289510e9b"collapsed="false"seolevelmigrated="true">ShortRunAggregateSupply(SRAS)</h4><ul><li><p>TheSRAScurveisupwardsloping.</p></li><li><p>Overtheperiodof1–2years,anincreaseinPcausesanincreaseinthequantityofgoodsandservicessupplied.</p></li></ul><h4id="2a04893e−7db9−468b−8c4b−e33593267396"data−toc−id="2a04893e−7db9−468b−8c4b−e33593267396"collapsed="false"seolevelmigrated="true">WhytheSlopeofSRASMatters</h4><ul><li><p>IfASisvertical,fluctuationsinADdonotcausefluctuationsinoutputoremployment.</p></li><li><p>IfASslopesup,thenshiftsinADdoaffectoutputandemployment.</p></li></ul><h4id="14dd26e9−8473−4708−9ab3−342a3d683f05"data−toc−id="14dd26e9−8473−4708−9ab3−342a3d683f05"collapsed="false"seolevelmigrated="true">ThreeTheoriesofSRAS</h4><ul><li><p>TheoriesthatexplainwhytheAScurveslopesupwardinshort−run:</p><ul><li><p>Sticky−wagetheory</p></li><li><p>Sticky−pricetheory</p></li><li><p>Misperceptionstheory</p></li></ul></li><li><p>Ineach,sometypeofmarketimperfection:Outputdeviatesfromitsnaturalratewhentheactualpriceleveldeviatesfromthepricelevelpeopleexpected.</p></li></ul><h4id="46ff1530−02b1−4ebf−a82f−4e55a4e2fd43"data−toc−id="46ff1530−02b1−4ebf−a82f−4e55a4e2fd43"collapsed="false"seolevelmigrated="true">1.TheSticky−WageTheory</h4><ul><li><p>Imperfection:Nominalwagesarestickyintheshortrun;theyadjustsluggishlyduetolaborcontracts,socialnorms.</p></li><li><p>Firmsandworkerssetthenominalwageinadvancebasedonto rise.</p></li></ul><h4 id="175fde4f-6616-4be0-a853-20718eb7e147" data-toc-id="175fde4f-6616-4be0-a853-20718eb7e147" collapsed="false" seolevelmigrated="true">Factors That Shift the LRAS Curve</h4><ul><li><p>Changes in L or natural rate of unemployment</p><ul><li><p>Immigration</p></li><li><p>Baby-boomers retire</p></li><li><p>Government policies reduce natural u-rate</p></li></ul></li><li><p>Changes in K or H</p><ul><li><p>Investment in factories, equipment</p></li><li><p>More people get college degrees</p></li><li><p>Factories destroyed by a hurricane</p></li></ul></li><li><p>Changes in natural resources</p><ul><li><p>Discovery of new mineral deposits</p></li><li><p>Reduction in supply of imported oil</p></li><li><p>Changing weather patterns that affect agricultural production</p></li></ul></li><li><p>Changes in technology</p><ul><li><p>Productivity improvements from technological progress</p></li></ul></li></ul><h4 id="d7450994-eae9-4576-b779-aa72ff5bfb65" data-toc-id="d7450994-eae9-4576-b779-aa72ff5bfb65" collapsed="false" seolevelmigrated="true">Long-Run Growth and Inflation</h4><ul><li><p>Over the long run, technological progress shifts LRAS to the right.</p></li><li><p>Growth in the money supply shifts AD to the right.</p></li><li><p>Result: ongoing inflation and growth in output.</p></li></ul><h4 id="e22ef5ce-2a25-4fc0-8ddf-3a3289510e9b" data-toc-id="e22ef5ce-2a25-4fc0-8ddf-3a3289510e9b" collapsed="false" seolevelmigrated="true">Short Run Aggregate Supply (SRAS)</h4><ul><li><p>The SRAS curve is upward sloping.</p></li><li><p>Over the period of 1–2 years, an increase in P causes an increase in the quantity of goods and services supplied.</p></li></ul><h4 id="2a04893e-7db9-468b-8c4b-e33593267396" data-toc-id="2a04893e-7db9-468b-8c4b-e33593267396" collapsed="false" seolevelmigrated="true">Why the Slope of SRAS Matters</h4><ul><li><p>If AS is vertical, fluctuations in AD do not cause fluctuations in output or employment.</p></li><li><p>If AS slopes up, then shifts in AD do affect output and employment.</p></li></ul><h4 id="14dd26e9-8473-4708-9ab3-342a3d683f05" data-toc-id="14dd26e9-8473-4708-9ab3-342a3d683f05" collapsed="false" seolevelmigrated="true">Three Theories of SRAS</h4><ul><li><p>Theories that explain why the AS curve slopes upward in short-run:</p><ul><li><p>Sticky-wage theory</p></li><li><p>Sticky-price theory</p></li><li><p>Misperceptions theory</p></li></ul></li><li><p>In each, some type of market imperfection: Output deviates from its natural rate when the actual price level deviates from the price level people expected.</p></li></ul><h4 id="46ff1530-02b1-4ebf-a82f-4e55a4e2fd43" data-toc-id="46ff1530-02b1-4ebf-a82f-4e55a4e2fd43" collapsed="false" seolevelmigrated="true">1. The Sticky-Wage Theory</h4><ul><li><p>Imperfection: Nominal wages are sticky in the short run; they adjust sluggishly due to labor contracts, social norms.</p></li><li><p>Firms and workers set the nominal wage in advance based onP^E,thepriceleveltheyexpecttoprevail.</p></li><li><p>If, the price level they expect to prevail.</p></li><li><p>IfP > P^E:</p><ul><li><p>Revenueishigher,butlaborcostisnot.</p></li><li><p>Productionismoreprofitable,sofirmsincreaseoutputandemployment.</p></li><li><p>Hence,higherPcauseshigherY,sotheSRAScurveslopesupward.</p></li></ul></li></ul><h4id="74ef47d3−ada0−4adf−9560−f231f74d116b"data−toc−id="74ef47d3−ada0−4adf−9560−f231f74d116b"collapsed="false"seolevelmigrated="true">2.TheSticky−PriceTheory</h4><ul><li><p>Imperfection:Manypricesarestickyintheshortrunduetomenucosts,thecostsofadjustingprices(e.g.,costofprintingnewmenus,thetimerequiredtochangepricetags).</p></li><li><p>Firmssetstickypricesinadvancebasedon:</p><ul><li><p>Revenue is higher, but labor cost is not.</p></li><li><p>Production is more profitable, so firms increase output and employment.</p></li><li><p>Hence, higher P causes higher Y, so the SRAS curve slopes upward.</p></li></ul></li></ul><h4 id="74ef47d3-ada0-4adf-9560-f231f74d116b" data-toc-id="74ef47d3-ada0-4adf-9560-f231f74d116b" collapsed="false" seolevelmigrated="true">2. The Sticky-Price Theory</h4><ul><li><p>Imperfection: Many prices are sticky in the short run due to menu costs, the costs of adjusting prices (e.g., cost of printing new menus, the time required to change price tags).</p></li><li><p>Firms set sticky prices in advance based onP^E.</p></li><li><p>IftheFedincreasesthemoneysupplyunexpectedly:</p><ul><li><p>Inthelongrun,Pwillrise.</p></li><li><p>Intheshortrun:Firmswithoutmenucostscanraisetheirpricesimmediately.Firmswithmenucostswaittoraisepricescausinganincreaseindemandforproductsandincreaseinoutputandemployment.Hence,higherPisassociatedwithhigherY,sotheSRAScurveslopesupward.</p></li></ul></li></ul><h4id="203c805c−2291−43f8−aedf−636c03250e3a"data−toc−id="203c805c−2291−43f8−aedf−636c03250e3a"collapsed="false"seolevelmigrated="true">3.TheMisperceptionsTheory</h4><ul><li><p>Imperfection:FirmsmayconfusechangesinPwithchangesintherelativepriceoftheproductstheysell.</p></li><li><p>IfPrisesabove.</p></li><li><p>If the Fed increases the money supply unexpectedly:</p><ul><li><p>In the long run, P will rise.</p></li><li><p>In the short run: Firms without menu costs can raise their prices immediately. Firms with menu costs wait to raise prices causing an increase in demand for products and increase in output and employment. Hence, higher P is associated with higher Y, so the SRAS curve slopes upward.</p></li></ul></li></ul><h4 id="203c805c-2291-43f8-aedf-636c03250e3a" data-toc-id="203c805c-2291-43f8-aedf-636c03250e3a" collapsed="false" seolevelmigrated="true">3. The Misperceptions Theory</h4><ul><li><p>Imperfection: Firms may confuse changes in P with changes in the relative price of the products they sell.</p></li><li><p>If P rises aboveP^E:Afirmseesitspricerisebeforerealizingallpricesarerising.Thefirmmaybelieveitsrelativepriceisrisingandmayincreaseoutputandemployment.So,anincreaseinPcancauseanincreaseinY,makingtheSRAScurveupward−sloping.</p></li></ul><h4id="b84b82ae−7a4b−4025−a101−42d8f4490ec4"data−toc−id="b84b82ae−7a4b−4025−a101−42d8f4490ec4"collapsed="false"seolevelmigrated="true">CommonElementoftheThreeTheories</h4><ul><li><p>Inall3theories,Ydeviatesfrom: A firm sees its price rise before realizing all prices are rising. The firm may believe its relative price is rising and may increase output and employment. So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping.</p></li></ul><h4 id="b84b82ae-7a4b-4025-a101-42d8f4490ec4" data-toc-id="b84b82ae-7a4b-4025-a101-42d8f4490ec4" collapsed="false" seolevelmigrated="true">Common Element of the Three Theories</h4><ul><li><p>In all 3 theories, Y deviates fromY_NwhenPdeviatesfromwhen P deviates fromP^E.</p></li><li><p>.</p></li><li><p>Y = Y_N + a(P – P^E)</p><ul><li><p>Y=Output</p></li><li><p></p><ul><li><p>Y = Output</p></li><li><p>Y_N = Natural rate of output (long-run)

    • a > 0, measures how much Y responds to unexpected changes in P

    • P = Actual price level

    • P^E=Expectedpricelevel</p></li></ul></li></ul><h4id="0da13270−d7bc−4060−83e0−51b25a6602c7"data−toc−id="0da13270−d7bc−4060−83e0−51b25a6602c7"collapsed="false"seolevelmigrated="true">SRASandLRAS</h4><ul><li><p>Theimperfectionsinthesetheoriesaretemporary.Overtime,stickywagesandpricesbecomeflexible,andmisperceptionsarecorrected.</p></li><li><p>IntheLR,= Expected price level</p></li></ul></li></ul><h4 id="0da13270-d7bc-4060-83e0-51b25a6602c7" data-toc-id="0da13270-d7bc-4060-83e0-51b25a6602c7" collapsed="false" seolevelmigrated="true">SRAS and LRAS</h4><ul><li><p>The imperfections in these theories are temporary. Over time, sticky wages and prices become flexible, and misperceptions are corrected.</p></li><li><p>In the LR,P^E= PandtheAScurveisvertical.</p></li></ul><h4id="5b48d97c−e927−4d27−bb3e−7cfb1f50ac30"data−toc−id="5b48d97c−e927−4d27−bb3e−7cfb1f50ac30"collapsed="false"seolevelmigrated="true">WhytheSRASCurveMightShift</h4><ul><li><p>EverythingthatshiftsLRASshiftsSRAS,too.</p></li><li><p>Also,and the AS curve is vertical.</p></li></ul><h4 id="5b48d97c-e927-4d27-bb3e-7cfb1f50ac30" data-toc-id="5b48d97c-e927-4d27-bb3e-7cfb1f50ac30" collapsed="false" seolevelmigrated="true">Why the SRAS Curve Might Shift</h4><ul><li><p>Everything that shifts LRAS shifts SRAS, too.</p></li><li><p>Also,P^EshiftsSRAS:Ifshifts SRAS: IfP^E rises, workers & firms set higher wages. At each P, production is less profitable, Y falls, SRAS shifts left.

    The Long-Run Equilibrium

    • In the long-run equilibrium, P^E = P,,Y = Y_N,andunemploymentisatitsnaturalrate.</p></li></ul><h4id="995704c6−6888−4fbc−a5cd−daca98599b1d"data−toc−id="995704c6−6888−4fbc−a5cd−daca98599b1d"collapsed="false"seolevelmigrated="true">AnalyzingEconomicFluctuations</h4><ul><li><p>Fourstepstoanalyzingeconomicfluctuations:</p><ol><li><p>DeterminewhethertheeventshiftsADorAS.</p></li><li><p>Determinewhetherthecurveshiftsleftorright.</p></li><li><p>UseAD–ASdiagramtoseehowtheshiftchangesYandPintheshortrun.</p></li><li><p>Determinethenewlong−runequilibrium.</p></li></ol></li></ul><h4id="b7029110−bbef−4104−835e−c06a150a1f7e"data−toc−id="b7029110−bbef−4104−835e−c06a150a1f7e"collapsed="false"seolevelmigrated="true">Example:StockMarketCrash</h4><ul><li><p>Event:Stockmarketcrash</p><ol><li><p>AffectsC,ADcurve</p></li><li><p>Cfalls,soADshiftsleft</p></li><li><p>SRequilibrium:PandYlower,unemploymenthigher</p></li><li><p>Overtime,, and unemployment is at its natural rate.</p></li></ul><h4 id="995704c6-6888-4fbc-a5cd-daca98599b1d" data-toc-id="995704c6-6888-4fbc-a5cd-daca98599b1d" collapsed="false" seolevelmigrated="true">Analyzing Economic Fluctuations</h4><ul><li><p>Four steps to analyzing economic fluctuations:</p><ol><li><p>Determine whether the event shifts AD or AS.</p></li><li><p>Determine whether the curve shifts left or right.</p></li><li><p>Use AD–AS diagram to see how the shift changes Y and P in the short run.</p></li><li><p>Determine the new long-run equilibrium.</p></li></ol></li></ul><h4 id="b7029110-bbef-4104-835e-c06a150a1f7e" data-toc-id="b7029110-bbef-4104-835e-c06a150a1f7e" collapsed="false" seolevelmigrated="true">Example: Stock Market Crash</h4><ul><li><p>Event: Stock market crash</p><ol><li><p>Affects C, AD curve</p></li><li><p>C falls, so AD shifts left</p></li><li><p>SR equilibrium: P and Y lower, unemployment higher</p></li><li><p>Over time,P^Efalls,SRASshiftsright,untilLRequilibriumatinitiallevels.</p></li></ol></li></ul><h4id="922bc5a1−dbfd−4cf0−bb4e−6474e5b7bf1a"data−toc−id="922bc5a1−dbfd−4cf0−bb4e−6474e5b7bf1a"collapsed="false"seolevelmigrated="true">TwoBigADShifts:TheGreatDepression</h4><ul><li><p>From1929–1933,moneysupplyfell28falls, SRAS shifts right, until LR equilibrium at initial levels.</p></li></ol></li></ul><h4 id="922bc5a1-dbfd-4cf0-bb4e-6474e5b7bf1a" data-toc-id="922bc5a1-dbfd-4cf0-bb4e-6474e5b7bf1a" collapsed="false" seolevelmigrated="true">Two Big AD Shifts: The Great Depression</h4><ul><li><p>From 1929–1933, money supply fell 28% due to problems in the banking system.</p></li><li><p>Stock prices fell 90%, reducing C and I.</p></li><li><p>Y fell 27%.</p></li><li><p>P fell 22%.</p></li><li><p>Unemployment rate rose from 3% to 25%.</p></li></ul><h4 id="70f22e60-1f35-43ab-868c-8ca0e45cc07d" data-toc-id="70f22e60-1f35-43ab-868c-8ca0e45cc07d" collapsed="false" seolevelmigrated="true">Two Big AD Shifts: The World War II Boom</h4><ul><li><p>From 1939–1944, government outlays rose from $9.1 billion to $91.3 billion.</p></li><li><p>Y rose 90%.</p></li><li><p>P rose 20%.</p></li><li><p>Unemployment fell from 17% to 1%.</p></li></ul><h4 id="a8489dd6-8820-4758-8ea2-5862b5731687" data-toc-id="a8489dd6-8820-4758-8ea2-5862b5731687" collapsed="false" seolevelmigrated="true">Example: Boom in Canada</h4><ul><li><p>Event: Boom in Canada</p><ul><li><p>Affects NX, AD curve</p></li><li><p>Shifts AD right</p></li><li><p>SR equilibrium: P and Y higher, unemployment lower</p></li><li><p>Over time,P^Erises,SRASshiftsleft,untilLRequilibriumatinitiallevels.</p></li></ul></li></ul><h4id="2b3ee963−623e−40f1−9829−dc8d0184b630"data−toc−id="2b3ee963−623e−40f1−9829−dc8d0184b630"collapsed="false"seolevelmigrated="true">TheGreatRecessionof2008–2009</h4><ul><li><p>LargecontractionaryshiftinAD</p></li><li><p>RealGDPfellsharply(by4.2rises, SRAS shifts left, until LR equilibrium at initial levels.</p></li></ul></li></ul><h4 id="2b3ee963-623e-40f1-9829-dc8d0184b630" data-toc-id="2b3ee963-623e-40f1-9829-dc8d0184b630" collapsed="false" seolevelmigrated="true">The Great Recession of 2008–2009</h4><ul><li><p>Large contractionary shift in AD</p></li><li><p>Real GDP fell sharply (by 4.2% between the fourth quarter of 2007 and the second quarter of 2009).</p></li><li><p>Employment fell sharply.</p></li><li><p>Unemployment rate rose from 4.4% in May 2007 to 10.0% in October 2009.</p></li><li><p>The housing market played a central role in this recession.</p></li></ul><h4 id="ac6ae3d6-2a63-4d8a-98ce-7330e4c29835" data-toc-id="ac6ae3d6-2a63-4d8a-98ce-7330e4c29835" collapsed="false" seolevelmigrated="true">Causes of the Housing Bubble</h4><ul><li><p>Rising house prices during 2002–2006 due to:</p><ul><li><p>Low interest rates</p></li><li><p>Easier credit for “sub-prime” borrowers</p></li><li><p>Government policies to increase homeownership</p></li><li><p>Securitization of mortgages</p></li></ul></li></ul><h4 id="6caf4a18-d65a-4624-bb99-5fad3e8d4373" data-toc-id="6caf4a18-d65a-4624-bb99-5fad3e8d4373" collapsed="false" seolevelmigrated="true">Securitization of Mortgages</h4><ul><li><p>Investment banks purchased mortgages from lenders, created securities backed by these mortgages, and sold the securities to banks, insurance companies, and other investors.</p></li><li><p>Mortgage-backed securities perceived as safe, since house prices “never fall.”</p></li></ul><h4 id="945e0608-dfc5-4596-8d39-e888da26d02b" data-toc-id="945e0608-dfc5-4596-8d39-e888da26d02b" collapsed="false" seolevelmigrated="true">Consequences of the Housing Market Crash</h4><ul><li><p>Millions of homeowners “underwater”—owed more than house was worth.</p></li><li><p>Millions of mortgage defaults and foreclosures.</p></li><li><p>Banks selling foreclosed houses increased surplus and downward price pressures.</p></li><li><p>Housing crash badly damaged construction industry: 2010 unemployment rate was 20.6% in construction vs. 9.6% overall.</p></li><li><p>Mortgage-backed securities became “toxic,” causing heavy losses for institutions that purchased them, leading to widespread failures of banks and other financial institutions, sharply rising unemployment, and falling GDP.</p></li></ul><h4 id="f69aeb46-b958-483d-baee-8739c1462ac8" data-toc-id="f69aeb46-b958-483d-baee-8739c1462ac8" collapsed="false" seolevelmigrated="true">Policy Response to the Great Recession</h4><ul><li><p>Federal Reserve reduced Fed Funds rate target to near zero.</p></li><li><p>Federal Reserve purchased mortgage-backed securities and other private loans.</p></li><li><p>U.S. Treasury injected capital into the banking system to increase banks’ liquidity and solvency in hopes of staving off a “credit crunch.”</p></li><li><p>Fiscal policymakers increased government spending and reduced taxes by $800 billion.</p></li></ul><h4 id="e24a4ecd-248e-4f5b-81ad-a19ccb7127e6" data-toc-id="e24a4ecd-248e-4f5b-81ad-a19ccb7127e6" collapsed="false" seolevelmigrated="true">Effects of a Shift in SRAS: Oil Prices Rise</h4><ul><li><p>Event: Oil prices rise</p><ol><li><p>Increases costs, shifts SRAS (assume LRAS constant)</p></li><li><p>SRAS shifts left</p></li><li><p>SR equilibrium: P higher, Y lower, unemployment higher</p></li><li><p>From A to B, stagflation, a period of falling output and rising prices.</p></li></ol></li></ul><h4 id="07cab027-6dc4-4712-912c-78255d739759" data-toc-id="07cab027-6dc4-4712-912c-78255d739759" collapsed="false" seolevelmigrated="true">Accommodating an Adverse Shift in SRAS</h4><ul><li><p>If policymakers do nothing, low employment causes wages to fall, and SRAS shifts right, until LR equilibrium at A.</p></li><li><p>Or, policymakers could use fiscal or monetary policy to increase AD and accommodate the AS shift, returning Y back toY_N$$, but P permanently higher.

    The 1970s Oil Shocks and Their Effects

    • 1973–75: Real oil prices increased by 138%, the number of unemployed persons increased by +1.4 million, Real GDP increased by +2.9%, and CPI by +26%.

    • 1978–80: Real oil prices increased by +99%, the number of unemployed persons increased by +3.5 million, Real GDP decreased by – 0.7%, and CPI by +21%.

    Supply Side Economics

    • It is not a valid economic concept.

    • The rationale in the 1980s was that cutting taxes for the wealthy and reducing regulations could cause AS to rise since businesses and the wealthy would reinvest and grow the economy with the extra money.

    • However, this did not occur. Wealthy individuals tend to keep the money and do not reinvest it. Businesses with reduced regulations often prioritize paying off shareholders and executives.

    • This also exacerbates economic inequality, which can lead to societal unrest.

    • The economy does not grow as a result of this policy.

    • However, the national debt grows since the government receives less in tax revenue.

    John Maynard Keynes

    • Authored The General Theory of Employment, Interest, and Money (1936).

    • Argued recessions and depressions can result from inadequate demand; policymakers should shift AD.

    • Criticized classical theory, stating that the long run is a misleading guide to current affairs, stating, "In the long run, we are all dead."

    Conclusion

    • This chapter introduced the model of aggregate demand and aggregate supply, which helps explain economic fluctuations.

    • These fluctuations are deviations from the long-run trends explained by the models learned in previous chapters.

    • The next chapter will discuss how policymakers can affect aggregate demand with fiscal and monetary policy.