Aggregate Demand and Aggregate Supply Notes

Aggregate Demand and Aggregate Supply

Economic Fluctuations

Economic fluctuations refer to the variations in economic activity from year to year.
In the short run, GDP fluctuates around its trend.
Most years see a rise in the production of goods and services.
Recessions occur when normal growth does not happen, leading to declining real incomes and rising unemployment.
A recession is defined as 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

The business cycle is the natural rise and fall of economic growth that occurs over time.

Facts About Economic Fluctuations

Fact 1: Economic fluctuations are irregular and unpredictable.
Fact 2: Macroeconomic quantities fluctuate together.
Investment is more volatile than consumption.
Fact 3: Unemployment rises during recessions and falls during expansions.
The theory of economic fluctuations is controversial and complex.
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.

The Basic Model of Economic Fluctuations

Two variables are used to develop a model:
- The economy’s output of goods and services (Y).
- The overall price level (P).
- The model of Aggregate Demand and Aggregate Supply.

Model of Aggregate Demand and Aggregate Supply

The model determines the equilibrium price level and equilibrium output (real GDP).
Aggregate Demand (AD).
Short-Run Aggregate Supply (SRAS).

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.

Why the AD Curve Slopes Downward

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

The Wealth Effect

(P and C):
- Suppose P rises.
- Result: C decreases.

The Interest-Rate Effect

(P and I):
- Suppose P rises.
- Result: I decreases. (I depends negatively on interest rates.)

The Exchange-Rate Effect

(P and NX):
- Suppose P rises.
- Result: NX decreases.

Slope of the AD Curve: Summary

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

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.
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.

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.
AS is vertical in the long run.

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.
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

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 & services supplied.

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.

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  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,
  - 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 $P^E$ .
$Y = Y_N + a(P – P^E)$
- Y = Output.
- $Y_N$ = Natural rate of output (long-run).
- a > 0, measures how much Y responds to unexpected changes in P.
- P = Actual price level.
- $P^E$ = Expected price level.

SRAS vs. LRAS

The imperfections in these theories are temporary.
Over time,
- sticky wages and prices become flexible
- misperceptions are corrected
In the Long run,
- $P = P^E$
- AS curve is vertical

Why the SRAS Curve Might Shift

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.
$Y = Y_N + a(P – P^E)$

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

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 curve shifts left or right.
3. Use AD-AS diagram to see how the shift changes Y and P in the short run.
4. Use AD-AS diagram to see how the economy moves from new SR eq’m to new LR eq’m.

Effects of a Shift in AD

Event: Stock market crash

Effects of a Shift in SRAS

Event: Oil prices rise

John Maynard Keynes

Argued recessions and depressions can result from inadequate demand; policymakers should shift AD.
Famous critique of classical theory:

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.