Aggregate Demand and Aggregate Supply Notes

Aggregate Demand and Aggregate Supply

I. Short-Run Economic Fluctuations

Economic Activity Fluctuations

Economic activity fluctuates from year to year.
In the short run, GDP fluctuates around its trend.
In most years, the production of goods and services rises.
Recessions occur when normal growth does not occur.
- A recession is a period of declining real incomes and rising unemployment.
- A depression is a severe recession (very rare).
Short-run economic fluctuations are often called business cycles.
The Business Cycle is the natural rise and fall of economic growth that occurs over time.

1. Three Facts About Economic Fluctuations

FACT 1

FACT 2

FACT 3

It is difficult, and the theory of economic fluctuations is controversial.
Most economists use the model of aggregate demand and aggregate supply to study fluctuations.
This model differs from the classical economic theories economists use to explain the long run.

2. Explaining Short Run Economic Fluctuation

The Basic Model of Economic Fluctuations

Two variables are used to develop a model:
- The economy’s output of goods and services measured by Y.
- The overall price level measured by P.
The Model of Aggregate Demand and Aggregate Supply determines the equilibrium price level and equilibrium output (real GDP).

II - The Aggregate-Demand (AD) Curve

The AD curve shows the quantity of all goods and services demanded in the economy at any given price level.

1. Why the AD Curve Slopes Downward

The four components of GDP (Y) contribute to the aggregate demand for goods and services.
$AD = C + I + G + NX$
Assume G is fixed by government policy (exogenous).
To understand the slope of AD, must determine how a change in P affects C, I, and NX.

The Wealth Effect (P and C)

Suppose P rises.
Result: C falls.

The Interest-Rate Effect (P and I)

Suppose P rises.
Result: I falls (I depends negatively on interest rates).

The Exchange-Rate Effect (P and NX)

Suppose P rises.
Result: NX falls.

The Slope of the AD Curve: Summary

An increase in P reduces the quantity of goods and services demanded because:
- The wealth effect.
- The interest-rate effect.
- The exchange-rate effect.

2. 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.
Examples:
- Changes in C
  - Stock market boom/crash
  - Preferences: consumption/saving tradeoff
  - Tax hikes/cuts ( $Y_d=Y-T=C+S$ ) => fiscal
- 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
  - Central spending, e.g., defense
  - Local spending, e.g., roads, schools
- Changes in NX
  - Booms/recessions in countries that buy our exports.
  - Appreciation/depreciation resulting from international speculation in the foreign exchange market.

III-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.

1. The Long-Run Aggregate-Supply Curve (LRAS)

The natural rate of output ( $Y_N$ ) is the amount of output the economy produces when unemployment is at its natural rate.
$Y_N$ is also called potential output or full-employment output.
Why LRAS Is Vertical
- $Y_N$ is determined by the economy’s stocks of labor, capital, and natural resources, and on the level of technology.
- An increase in P does not affect any of these, so it does not affect $Y_N$ (Classical dichotomy).

Why the LRAS Curve Might Shift

Any event that changes any of the determinants of $Y_N$ will shift LRAS.
Examples:
- Changes in L or natural rate of unemployment
  - Immigration
  - Baby-boomers retire
  - Govt policies reduce natural unemployment rate
- Changes in K or H
  - Investment in factories, equipment
  - More people get college degrees
  - Factories destroyed by a hurricane
- Changes in natural resources
  - Discovery of new mineral deposits
- Changes in technology
  - Productivity improvements from technological progress

2. Short Run Aggregate Supply (SRAS)

The SRAS curve is upward sloping:
- Over the period of 1-2 years, an increase in P causes an increase in the quantity of goods and services supplied.

Three Theories of SRAS

In each theory:
- Some type of market imperfection
- Result: Output deviates from its natural rate when the actual price level deviates from the price level people expected.

Why the SRAS Curve Slopes Upward: The Sticky-Wage Theory

Imperfection: Nominal wages are sticky in the short run; they adjust sluggishly (due to labor contracts, social norms).
Firms and workers set the nominal wage in advance based on $P^E$ , the price level they expect to prevail.
If P > $P^E$ , revenue is higher, but labor cost is not. Production is more profitable, so firms increase output and employment.
Hence, higher P causes higher Y, so the SRAS curve slopes upward.

The Sticky-Price Theory

Imperfection: Many prices are sticky in the short run.
- Due to menu costs, the costs of adjusting prices.
- Examples: cost of printing new menus, the time required to change price tags.
Firms set sticky prices in advance based on $P^E$ .
Suppose the central bank increases the money supply unexpectedly. In the long run, P will rise.
In the short run:
- Firms without menu costs can raise their prices immediately.
- Firms with menu costs wait to raise prices. Meantime, their prices are relatively low, increases demand for their products, so they increase output and employment.
Hence, higher P is associated with higher Y, so the SRAS curve slopes upward.

The Misperceptions Theory

Imperfection: Firms may confuse changes in P with changes in the relative price of the products they sell.
If P rises above $P^E$ , 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.

What the 3 Theories Have in Common:

In all 3 theories, Y deviates from $Y_N$ when P deviates from $P^E$ .
$Y = Y_N + a(P – P^E)$
a > 0, measures how much Y responds to unexpected changes in P
$
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SRAS vs. LRAS

The imperfections in these theories are temporary.
- Over time, sticky wages and prices become flexible, and misperceptions are corrected.
In the Long run, P = $P^E$ , AS curve is vertical.
Everything that shifts LRAS shifts SRAS, too.
$P^E$ shifts SRAS: If $P^E$ rises, workers & firms set higher wages. At each P, production is less profitable, Y falls, and SRAS shifts left.
$Y = Y_N + a(P – P^E)$
$
ewline$

3. Equilibrium

In the long-run equilibrium, P = $P^E$ , Y = $Y_N$ , and unemployment is at its natural rate.
In the short-run, equilibrium = SRAS x AD

IV - Analyze Economic Fluctuations

Caused by events that shift the AD and/or AS curves.
Four steps to analyzing economic fluctuations:
1. Determine whether the event shifts AD or AS.
2. Determine whether the curve shifts left or right.
3. Use the AD-AS diagram to see how the shift changes Y and P in the short run.
4. Use the AD-AS diagram to see how the economy moves from the new SR equilibrium to the new LR equilibrium.

1. The Effects of a Shift in AD

Event: Stock market crash

2. The Effects of a Shift in SRAS

Event: Oil prices rise

CONCLUSION

This chapter has introduced the model of aggregate demand and aggregate supply, which helps explain economic fluctuations.
Keep in mind: these fluctuations are deviations from the long-run trends
In the next chapter, we will learn how policymakers can affect aggregate demand with fiscal and monetary policy.