Aggregate Demand and Aggregate Supply

Economic Fluctuations and GDP

Economic activity and GDP fluctuate from year to year.
Recession:
- Economic contraction.
- Period of declining real GDP/incomes (or a negative economic growth) and rising unemployment.
Depression:
- Severe recession (a sustained or long-term economic contraction).
- Example: Great Depression 1929-1939.

Key Facts About Economic Fluctuations

Economic fluctuations are irregular and unpredictable.
- The business cycle includes contraction, trough, expansion, and peak.
Most macroeconomic quantities fluctuate together (procyclical).
- Recessions are economy-wide phenomena.
As output (real GDP) falls, unemployment rises.

Long-Run (LR) Economic Condition

Classical dichotomy: separation of variables into real and nominal variables.
Monetary neutrality:
- Changes in the money supply affect nominal variables (e.g., prices, nominal wage, nominal GDP).
- Do not affect real variables (e.g., real wage, real GDP, unemployment).

Short-Run (SR) Economic Condition

Assumption of monetary neutrality is no longer appropriate.
Real and nominal variables are highly intertwined.
Changes in the money supply can temporarily push SR real GDP away (disequilibrium) from its long-run trend (LR real GDP).

AD-AS Model: Short-Run Economic Fluctuation

Most economists use it to explain short-run fluctuations in economic activity around its long-run trend.
- Example: Long-run economic growth of Indonesia targeted at 7%/year, but each year (SR) economic growth Indonesia is around 5%.
Aggregate demand (AD) curve:
- Shows the quantity of goods and services that households, firms, the government, and customers abroad (i.e., $C + I + G + NX = GDP$ ) want to buy at each price level.
- Downward sloping.

Three Effects Explaining Downward Slope of AD Curve

Wealth effect (on Consumption).
Interest-rate effect (on Investment).
Exchange-rate effect (on Net Export).
Assumption: Government spending (G) is fixed by fiscal policy.
Wealth effect: $P \downarrow$ & $C \uparrow$
- Decrease in overall price level (deflation):
  - Increase in real value of money (or purchasing power of money).
  - Consumers become wealthier.
  - Increase in consumer spending.
  - Increase in quantity demanded of goods & services ( $QD \uparrow$ ), vice versa.
Interest rate effect: $P \downarrow$ & $I \uparrow$
- Decrease in price level:
  - Demand for money (MD) decreases.
  - Real interest rate decreases.
  - Increase in spending on investment goods.
  - Increase in quantity demanded of goods & services ( $QD \uparrow$ ), vice versa.
Exchange-rate effect: $P \downarrow$ & $NX \uparrow$
- Decrease in domestic price level:
  - Real E domestic currency depreciates (hint: $E = (e \times P) / P^*$ ).
  - Stimulates domestic country’s net exports.
  - Increase in quantity demanded of goods & services ( $QD \uparrow$ ), vice versa.

Impact of Price Level Changes on Quantity of Goods and Services Demanded

A fall in overall price level (deflation) increases quantity of goods and services demanded ( $QD$ ) because:
1. Consumers are wealthier - stimulates the demand for consumption goods.
2. Interest rates fall - stimulates the demand for investment goods.
3. Currency depreciates - stimulates the demand for net exports.
A rise in overall price level (inflation) decreases the quantity of goods and services demanded because:
1. Consumers are poorer – depress consumer spending.
2. Higher interest rates fall - depress investment spending.
3. Currency appreciates – depress net exports.
It is moving along the AD curve ( $\Delta QD$ is due to $\Delta P$ ).

Shift of AD Curve: Changes in C, I, G, and NX

Changes in C:
- Events that change how much people want to consume at a given price level.
- E.g., Changes in taxes, wealth.
- Increase in consumer spending shifts AD curve to the right.
Changes in I:
- Events that change how much firms want to invest at a given price level.
- E.g., Better technology, tax policy, money supply.
- Increase in investment shifts AD curve to the right.
Changes in G:
- Policy makers – change government spending at a given price level.
- E.g., Build new roads.
- Increase in government purchases shifts AD curve to the right.
Changes in NX:
- Events that change net exports for a given price level.
- E.g., Economic booming in other countries.
- International speculators – change in exchange rate.
- Increase in net exports shifts AD curve to the right.

Aggregate Supply (AS) Curve

Shows the quantity of goods and services (i.e., $\sum(Pi * Qi) = GDP$ ) that firms choose to produce and sell at each price level.
Long-run aggregate supply curve (LRAS):
- LRAS curve is vertical.
- Price level does not affect factors of production (i.e., GDP) in the long-run:
  - Supplies of labor, capital, and natural resources.
  - Available technology.
Short run aggregate supply curve (SRAS):
- SRAS curve is upward sloping.
- Price level affects the short-run factors of production.
- E.g., SR: $P \uparrow$ → $SR Qs \uparrow$ (hint: Law of Supply).
- LR: $w_{nominal} \uparrow$ → cost of production $\uparrow$ → $Qs \downarrow$

Natural Rate of Output

Production of goods and services that an economy achieves in the long run when unemployment is at its normal rate (i.e., natural rate of unemployment).
= Potential output (or production capacity).
= Full-employment output.
The LRAS curve might shift due to any change in natural rate of output (not Price level).
- Changes in labor.
- Changes in capital.
- Changes in natural resources.
- Changes in technological knowledge.

Factors Shifting the LRAS Curve

Changes in labor:
- Quantity of labor – increases; AS curve shifts right.
- Natural rate of unemployment – increases; AS curve shifts left.
Changes in capital:
- Capital stock – increase; AS curve shifts left.
- Physical and human capital.
Changes in natural resources:
- New discovery of natural resource; AS curve shifts right.
- Weather (e.g., Climate change).
- Availability of natural resources (e.g., current exploitation).
Changes in technology:
- New technology, for given labor, capital, and natural resources; AS curve shifts right.
- International trade.
- Government regulation.

Long-Run Shifts in AD and LRAS

In the Long-run: both AD and LRAS curve shift
Continual shifts of LRAS curve to the right
- E.g. Technological progress
AD curve shifts to the right
- E.g. Central Bank increases money supply over time
Result:
- Continuing growth in output (economic growth)
- Continuing inflation

Short-Run Aggregate-Supply Curve

In the short-run, SRAS (upward sloping):
Increase in overall level of prices in economy
- Tends to raise the quantity of goods and services supplied
Decrease in level of prices
- Tends to reduce quantity of goods and services supplied
3 theories explain why the SRAS curve slopes upward:
- Sticky-wage theory
- Sticky-price theory
- Misperceptions theory

Theories Behind the SRAS Curve

Sticky-wage theory
- Nominal wages - slow to adjust to changing economic conditions (sticky in short run)
- E.g. Long-term contracts of workers and firms
- Nominal wages - based on expected prices
- Don’t respond immediately when actual price level – different from what was expected (actual ≠ expected prices)
- If actual price < expected price
  - Firms – incentive to produce less output (real wage actual ↑ (due to W/P↓) → hiring less labor)
- If actual price level > expected price
  - Firms – incentive to produce more output (real wage actual ↓ → hiring more labor)
Quantity of output supplied (in SR) =
- = Natural rate of output (in LR)
- + a(Actual price level – Expected price level)
- Where a - number that determines how much output responds to unexpected changes in the price level:
  - in SR – disequilibrium: Actual > Expected (or a > 0) / Actual < Expected (or a < 0), but
  - in LR – equilibrium: Actual = Expected Price
The SRAS curve might shift:
- Changes in labor, capital, natural resources, or technological knowledge
- Expected price level increases
  - SRAS curve – shifts left (due to - a)
Sticky-price theory
- Prices of some goods & services
  - Slow to adjust to changing economic conditions
- Menu costs
  - Costs to adjusting prices
Misperceptions theory
- Changes in the overall price level
  - Can temporarily mislead suppliers
- About changes in individual markets
  - Changes in relative prices
- Suppliers - respond to changes in level of prices
  - Change - quantity supplied of goods and services

Causes of Economic Fluctuation

Assumption
- Economy begins in long-run equilibrium
Long-run equilibrium:
- Intersection of AD and LRAS curves
  - Output - natural rate
  - Expected price level
- Intersection of AD and SRAS curve (= LRAS)
  - Equilibrium price: Expected price level = Actual price level

Impact of Shifts in Aggregate Demand and Supply

Shift in AD
- E.g. Wave of pessimism – AD shifts left
Short-run (at B)
- Actual price level falls at P2 (actual P2 < expected P1)
- Output falls at Y2
Long-run (an adjustment from B to C)
- Lower actual P2 → lower nominal W (otherwise W/P ↑) → hiring more labor → produce and supply more
- SRAS curve shifts right (S1 → S2)
- Output – natural rate back at Y1
- Price level – falls at P3 (cost of production – nominal wage is lower)
Shift in SRAS (i.e. Supply shock)
- Firms – increase in production costs
- SRAS – shifts left
Short-run - stagflation
- Price level rises (Cost Push inflation)
- Output falls (Actual P2 > expected P1)
Long-run, if AD is held constant
- Low output → higher unemployment → nominal wage ↓ → cost of production ↓ production and supply ↑ (back to S1)
- Output – natural rate
- Price level – falls (back to P1)
  "In the long run we are all dead” – J.M. Keynes
Shift in SRAS
- Firms – increase in production costs
- Aggregate supply curve – shifts left
Short-run
- Output falls
- Price level rises
Long-run, policymakers – shift AD to right to increase Y
- Output – natural rate
- But price level – rises to P3 (i.e. Demand pull inflation)