Chapter 20: Aggregate Demand and Aggregate Supply

By the end of this chapter, you should be able to answer:

What are economic fluctuations? What are their characteristics?
How does the model of aggregate demand and aggregate supply explain economic fluctuations?
Why does the Aggregate-Demand curve slope downward? What shifts the AD curve?
What is the slope of the Aggregate-Supply curve in the short run? In the long run? What shifts the AS curve(s)?

Real GDP grew by 4 percent in 2000 and shrank by 3 percent in 2009.
The inflation rate fluctuated, ranging from a:
- High of 3.3 percent in 2005
- Low of 0.9 percent in 2009
- High of 6.2 percent in 2022

Economic activity fluctuates from year to year.
Over the long run, real GDP grows about 3% per year on average (U.S. economy over the past half century).
Short-run GDP fluctuations:
- Example: Q2-2020 GDP decreased by 31.4%, subsequently increased by 33.1% in Q3-2020.

Recession: A period characterized by falling real incomes and rising unemployment, generally defined as a fall in GDP in two successive quarters.
- Example: The downturn in 2008-2009 where real GDP fell by 4.2% from the fourth quarter of 2007 to the second quarter of 2009.
Depression: A severe recession (which is very rare).

Irregular and Unpredictable: Economic fluctuations are often referred to as the business cycle, which corresponds to changes in business conditions characterized by economic expansion and recession.
Macroeconomic Variables Fluctuate Together: Quantities that measure some type of income, spending, or production (e.g., personal income, corporate profits, consumer spending) typically fluctuate in unison during economic changes.
Output and Unemployment Relationship: As economic output falls, unemployment tends to rise.

Classical Economics:
- Classical Dichotomy: Separation of variables into:
- Real variables: quantities, relative prices
- Nominal variables: measured in monetary terms
- Neutrality of Money: Changes in the money supply only affect nominal variables.

Classical theory describes the world accurately in the long run but not in the short run.
In the short run, changes in nominal variables can affect real variables.
Monetary neutrality may not hold, as variables can be closely intertwined, impacting real GDP away from its long-term trend.

This model focuses on two key variables:
- Real Variable: Output of goods and services (real GDP)
- Nominal Variable: Average level of prices (CPI or GDP deflator)

The Aggregate-Demand (AD) curve demonstrates the quantity of goods and services that households, firms, the government, and foreign consumers wish to buy at each price level.
The Aggregate-Supply (AS) curve illustrates the quantity of goods and services firms are willing to produce and sell at each price level.

The AD curve shows the total amount demanded for all goods and services in the economy at any given price level.
The downward slope of the AD curve is explained through three effects:
1. Wealth Effect (C): A decline in price level increases real value of money, making consumers feel wealthier thus increasing consumer spending,

Interest-Rate Effect (I): A decline in price level reduces the amount of money required for purchasing goods, leading to increased saving and borrowing, thus investment rises,
Exchange-Rate Effect (NX): A decline in price level lowers interest rates, prompting an increase in net exports as the dollar depreciates in value.

A decrease in price (P) increases quantity demanded for goods and services due to:
- Wealth effect (increases C)
- Interest-rate effect (increases I)
- Exchange-rate effect (increases NX)
Conversely, an increase in P decreases quantity demanded for goods and services due to:
- Wealth effect (decreases C)
- Interest-rate effect (decreases I)
- Exchange-rate effect (decreases NX)

Any event that causes changes in C, I, G, or NX (except changes in P) can shift the AD curve:
- Example: A stock market boom leads to increased consumer wealth and shifts the AD curve to the right.

Changes in consumers (C), firms (I), government (G), and net exports (NX) can all cause shifts in AD:
- Changes in C: Stock market fluctuations, shifts in consumer preferences, tax changes,
- Changes in I: Investment expectations and technologies, interest rates, monetary policies,
- Changes in G: Federal and state spending dynamics,
- Changes in NX: Global economic conditions, currency exchange rate trends.

The Aggregate-Supply (AS) curve shows total quantity of goods and services produced at any given price level, with the following characteristics:
- Upward-sloping in the short run: Higher price levels lead to increased quantity supplied,
- Vertical in the long run: Long-run Aggregate Supply (LRAS) reflects output at full employment and natural unemployment rates.

The natural rate of output (Y_N) represents the output level when the economy achieves its natural unemployment rate, also termed potential output or full-employment output.

Shifts in the LRAS curve occur with changes in the economy’s labor, capital, natural resources, or technology.
For example:
- Increase in immigration could raise L (labor force), shifting Y_N upward.
- Changes in technological advancements could increase production capacities across industries.

This chapter focused on critical aspects of short-run economic fluctuations and introduced the AD-AS model, which analyzes the movements and relationships in economic activity over short-term periods.
Follow-up chapters will delve further into the causes of these fluctuations and potential policy responses depending on economic conditions.

Scenario Analysis: Analyze changes in AD curve in various economic scenarios, such as a stock market crash or changes in government policies or international relations.
Equilibrium Analysis: Understand the transition from short-run to long-run equilibrium in response to fluctuating aggregate demands and supplies.