Condensed AD, AS, Policy Impact, and Philips Curve

Aggregate Demand and Aggregate Supply

  • Economic activity fluctuates from year to year.
  • Key terms:
    • Recession: Period of falling incomes and rising unemployment.
    • Depression: A severe recession.
    • Variables to Study: GDP, unemployment, interest rates, exchange rates, and prices.
  • Economists use the aggregate demand and aggregate supply model to analyze short-run economic fluctuations.

Three Key Facts About Economic Fluctuations

  1. Irregular and unpredictable: Economic fluctuations (business cycles) vary in magnitude and duration.
  2. Macroeconomic quantities fluctuate: During economic changes, most key economic indicators move simultaneously.
  3. Output and employment relation: A decrease in output leads to a rise in unemployment.

Explaining Short-Run Economic Fluctuations

  • The causes of economic fluctuations can be complex and controversial.
  • Economists need different models to understand short-run fluctuations compared to classical economics.

The Model of Aggregate Demand and Aggregate Supply

  • Aggregate-Demand Curve: Shows the total quantity of goods and services demanded at each price level (AD = C + I + G + NX).
  • Aggregate-Supply Curve: Shows the total quantity of goods and services that firms produce at each price level.
  • Difference between market demand/supply and aggregate demand/supply:
    • Market demand/supply focuses on individual markets for specific goods/services (e.g., air transportation).
Aggregate-Demand Curve Properties
  • Reflects the overall economy.
  • A decrease in price level increases the quantity demanded (the downward-sloping nature of the curve).
Factors Affecting the Aggregate-Demand Curve
  • Wealth Effect: Lower price levels increase the quantity of goods and services demanded.
  • Interest Rate Effect: Lower prices reduce the cost of borrowing, increasing investment.
  • Real Exchange Rate Effect: Lower domestic prices increase net exports, shifting aggregate demand right.
Shifts in the Aggregate-Demand Curve
  • Changes leading to shifts:
    • Investment tax credits expiring decreases demand (AD shifts left).
    • A rise in the exchange rate can increase net exports (AD shifts right).

The Aggregate-Supply Curve

  • Represents the total output firms are willing to produce at different price levels.
  • In long-run equilibrium, it is vertical, indicating that output is determined by real factors (labour, capital, natural resources).

Long-Run vs. Short-Run Aggregate Supply

  • Short-Run: As prices rise, companies are willing to produce more (upward-sloping).
  • Factors causing short-run fluctuations:
    • Sticky-Wage Theory: Wages are slow to adjust; higher prices reduce real wages, leading to layoffs.
    • Sticky-Price Theory: Fixed prices cause firms to reduce output when demand falls.
    • Misperceptions Theory: Misjudgment about price changes impacts production decisions.

Economic Fluctuations and Policy Impact

  • Shifts in demand or supply can provoke significant economic changes:
    • AD shifts can lead to a fluctuation in output vs. price levels in the short run.
  • Fiscal policy (government spending and taxes) and monetary policy (money supply adjustments) can be used to stabilize the economy.
    • Expansionary Fiscal Policy: Increases AD but may lead to crowding out effects.
    • Expansionary Monetary Policy: Increases money supply, affecting interest rates, investment, and output.

The Phillips Curve

  • Demonstrates the trade-off between inflation and unemployment.
  • Short-run dynamics: Shifts in aggregate demand cause movements along the Phillips Curve.
  • In the long run, it is presumed that inflation expectations adjust, leading to a vertical Phillips Curve where changes do not affect unemployment.