CHAPTER 34_Principles of Economics - Aggregate Demand and Aggregate Supply

Economic Fluctuations

• Recessions: Periods of falling real incomes and rising unemployment.
• Depressions: Severe recession.
• Economists analyze short-run fluctuations using the aggregate demand and aggregate supply model.
• Key facts about economic fluctuations:
  • They are irregular and unpredictable.
  • Most macroeconomic quantities fluctuate together.
  • As output falls, unemployment rises.

Explaining Short-Run Economic Fluctuations

• Assumptions of classical economy:
  • Separation of variables into real and nominal (Classical Dichotomy).
  • Changes in the money supply affect nominal but not real variables (Neutrality of Money).
• Reality of short-run fluctuations:
  • Classical theory describes the world in the long run, but not the short run.
  • In the short run, changes in nominal variables (like the money supply or price level $P$) can affect real variables (like output $Y$ or the unemployment rate $u$). This necessitates a new model.

The Model of Aggregate Demand and Supply

• The model is used to explain the short-run fluctuations of the economy around its long-run trend.

The Aggregate-Demand Curve

• The aggregate-demand (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 aggregate demand is represented by the equation: $Y = C + I + G + NX$, where:
  • $Y$ is the quantity of output demanded,
  • $C$ is consumption,
  • $I$ is investment,
  • $G$ is government purchases (assumed fixed by policy),
  • $NX$ is net exports.
• To understand the slope of AD, it's important to examine how a change in $P$ affects $C$, $I$, and $NX$.
• The wealth effect: If $P$ rises, each unit of currency buys fewer goods and services, reducing real wealth. Conversely, a decrease in $P$ makes consumers feel wealthier, increasing spending. This results in $C$ falling when $P$ rises.
• The interest rate effect: If $P$ rises, more money is needed to buy goods and services. To obtain more money, people sell bonds or other assets, driving up the interest rate $r$. This results in $I$ falling when $P$ rises.
• The exchange rate effect: If $P$ rises, domestic interest rates rise (interest-rate effect). Foreign investors want more of the country’s bonds. This increases the demand for the country’s currency in the foreign exchange market, causing the domestic exchange rate to appreciate. Exports become more expensive for foreign consumers, and imports become cheaper for the domestic market. This results in $NX$ falling when $P$ rises.

Why the AD Curve Might Shift

• Changes in consumption: Any event that changes how much people want to consume at a given price level (e.g., stock market boom/crash, preferences regarding consumption/saving trade-off, tax hikes/cuts).
• Changes in investment: Any event that changes how much firms want to invest at a given price level (e.g., expectations, monetary policy, tax incentives).
• Changes in government purchases: The most direct way to shift the AD curve (e.g., spending on defense, regional and local spending on infrastructure).
• Changes in net exports: Any event that changes net exports for a given price level (e.g., booms/recessions in countries that buy exports, appreciation/depreciation resulting from international speculation in the foreign exchange market).

Active Learning 1: Shifts in the AD Curve

• A. A ten-year-old investment tax credit expires: Investment falls, AD curve shifts left.
• B. The domestic exchange rate falls: Net exports rise, AD curve shifts right.
• C. A fall in prices increases the real value of consumers’ wealth: Movement down along the AD curve (wealth effect).
• D. Government replaces sales taxes with new taxes on interest, dividends, and capital gains: Consumption rises, AD shifts right.

The Long-Run Aggregate-Supply Curve

• The long-run aggregate-supply (LRAS) curve shows the total quantity of goods and services firms produce and sell at any given price level in the long run.

Why The AS Curve Is Vertical In The Long Run

• The AS curve is upward-sloping in the short-run, but vertical in the long-run.
• 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 determined by the economy’s stocks of labor, capital, natural resources, and the level of technology.
• An increase in $P$ does not affect any of these, so it does not affect $Y_N$.

Why The Long-Run AS Curve Might Shift

• Changes in labor: Any change in the natural rate of unemployment (e.g., immigration, government policies to reduce the natural unemployment rate).
• Changes in capital: Any change in capital stock changes productivity and, as a result, the quantity of goods and services (e.g., investment in factories or equipment, factories destroyed by a hurricane).
• Changes in natural resources: Any event that changes the availability of natural resources (e.g., discovery of new mineral deposits, changing weather patterns that affect agricultural production).
• Changes in technological knowledge: (e.g., Invention of new technologies, opening up to international trade to allow for specialization).

Using AD and AS to Depict Long-Run Growth and Inflation

• The AD and AS model can be used to illustrate long-run growth and inflation trends.

The Short-Run Aggregate-Supply Curve

• The short-run aggregate-supply (SRAS) curve shows the relationship between the price level and the quantity of output supplied in the short run.

Why The AS Curve Slopes Upward In The Short Run

• The sticky-wage theory: Nominal wages are sticky in the short run, i.e., they are slow to adjust when the actual price level differs from expectations. Firms produce more when the price level is higher than expected (real wages drop temporarily) and less when it is lower (real wages rise temporarily).
• The sticky-price theory: Prices are sticky in the short run due to menu costs. An unexpected fall in price levels can leave some firms with higher-than-desired prices, depressing sales and causing them to cut back production.
• The misperception theory: Changes in the overall price level can mislead suppliers in the short run. For example, when the price of their product falls, they might mistakenly believe that their relative price has fallen, which induces them to reduce production.
• All three theories suggest that output deviates in the short run from its long-run level when the actual price level deviates from what people had expected.

Why The Short-Run AS Curve Might Shift

• Everything that shifts the long-run aggregate-supply curve also shifts the short-run aggregate-supply curve.
• Expectations of the prevailing price level affect the position of the short-run aggregate-supply curve, even though it has no effect on the long-run aggregate-supply curve.
• A higher expected price level will decrease the quantity of goods and services supplied and shift the short-run aggregate-supply curve to the left. A lower expected price level increases the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the right.

Two Causes of Economic Fluctuations

• Economic fluctuations are a result of shifts in aggregate demand and aggregate supply.
• 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.

A Contraction in Aggregate Demand

• A reduction in aggregate demand leads to lower output and prices in the short run.

Active Learning 2: Working with the Model

• Scenario: A boom occurs in Canada.
  1. Affects net exports, shifting the AD curve.
  2. Shifts AD to the right.
  3. Short-run equilibrium: Price level and output are higher, with lower unemployment.
  4. Long-run adjustment: Price level expectations rise, shifting the SRAS to the left until the economy returns to the natural rate of output and unemployment, but with a higher price level.

An Adverse Shift in Aggregate Supply

• A decrease in aggregate supply results in stagflation: falling output and rising prices.

Accommodating an Adverse Shift in AS

• Policy makers can accommodate the shift in AS by increasing aggregate demand, leading to a permanently higher price level but restoring output to its original level.

Summary

• Short-run fluctuations in GDP and other macroeconomic quantities are irregular and unpredictable.
• Recessions are periods of falling real GDP and rising unemployment.
• Economists analyze fluctuations using the model of aggregate demand and aggregate supply.
• The aggregate-demand curve slopes downward because a change in the price level has a wealth effect on consumption, an interest-rate effect on investment, and an exchange-rate effect on net exports.
• Anything that changes $C$, $I$, $G$, or $NX$—except a change in the price level—will shift the aggregate-demand curve.
• The long-run aggregate-supply curve is vertical because changes in the price level do not affect output in the long run.
• In the long run, output is determined by labor, capital, natural resources, and technology; changes in any of these will shift the long-run aggregate-supply curve.
• In the short run, output deviates from its natural rate when the price level is different than expected, leading to an upward-sloping short-run aggregate-supply curve.
• The three theories proposed to explain this upward slope are the sticky-wage theory, the sticky-price theory, and the misperceptions theory.
• The short-run aggregate-supply curve shifts in response to changes in the expected price level and to anything that shifts the long-run aggregate supply curve.
• Economic fluctuations are caused by shifts in aggregate demand and aggregate supply.
• When aggregate demand falls, output and the price level fall in the short run.
• Over time, a change in expectations causes wages, prices, and perceptions to adjust, and the short-run aggregate-supply curve shifts rightward.
• In the long run, the economy returns to the natural rates of output and unemployment, but with a lower price level.
• A fall in aggregate supply results in stagflation—falling output and rising prices.
• Wages, prices, and perceptions adjust over time, and the economy recovers.