Aggregate Demand and Aggregate Supply

1. 20 Aggregate Demand andAggregate Supply

2. The Aggregate Supply Curve • Why the aggregate-supply (AS) curve slopes upward in the short-run • Basic Microeconomic Theory • Increase in overall level of prices in economy • Tends to raise the quantity of goods and services supplied • Decrease in level of prices • Tends to reduce quantity of goods and services supplied

3. 6 The short-run aggregate-supply curve Price Level Short-run aggregate supply P2 P1 1. A decrease in the price level . . . Quantity of Output Y1 Y2 2. . . . reduces the quantity of goods and services supplied in the short run In the short run, a fall in the price level from P1 to P2 reduces the quantity of output supplied from Y1 to Y2. This positive relationship could be due to sticky wages, sticky prices, or misperceptions. Over time, wages, prices, and perceptions adjust, so this positive relationship is only temporary.

4. The Aggregate Supply Curve • Why the AS curve slopes upward in short-run • Sticky-wage theory • Nominal wages - slow to adjust to changing economic conditions • Long-term contracts: workers and firms • Slowly changing social norms • Notions of fairness - influence wage setting • Nominal wages - based on expected prices • Don’t respond immediately when: • Actual price level – different from what was expected

5. The Aggregate Supply Curve • Why the AS curve slopes upward in short-run • Sticky-wage theory • If price level < expected • Firms – incentive to produce less output • If price level > expected • Firms – incentive to produce more output

6. The Aggregate Supply Curve • Why the AS curve slopes upward in short-run • Sticky-price theory • Prices of some goods & services • Slow to adjust to changing economic conditions • Menu costs • Costs to adjusting prices

7. The Aggregate Supply Curve • Why the AS curve slopes upward in short-run • Misperceptions theory • Changes in the overall price level • Can temporarily mislead suppliers • About changes in individual markets • Changes in relative prices • Suppliers - respond to changes in level of prices • Change - quantity supplied of goods and services

8. The Aggregate Supply Curve • Why the AS curve slopes upward in short-run • Quantity of output supplied = = Natural rate of output + + a(Actual price level – Expected price level) • Where a - number that determines how much output responds to unexpected changes in the price level • Rational Expectations Model • Mistakes in forecasting economic conditions can lead to SR AS • If no mistakes -> no effects

9. But in the LongRun – is there any effect? This figure shows annual data from 1972 to 1981 on the unemployment rate and on the inflation rate (as measured by the GDP deflator). In the periods 1973–1975 and 1978–1981, increases in world oil prices led to higher inflation and higher unemployment.

10. 2 The short-run aggregate-supply curve: summary (a)

11. Two Causes of Economic Fluctuations • Assumption • Economy begins in long-run equilibrium • Long-run equilibrium: • Intersection of AD and LRAS curves • Output - natural rate • Actual price level • And: Intersection of AD and short-run AS curve • Expected price level = Actual price level

12. 7 The long-run equilibrium Price Level Long-run aggregate supply Short-run aggregate supply A Equilibrium price Aggregate demand Quantity of Output Natural rate of output The long-run equilibrium of the economy is found where the aggregate-demand curve crosses the long-run aggregate-supply curve (point A). When the economy reaches this long-run equilibrium, the expected price level will have adjusted to equal the actual price level. As a result, the short-run aggregate-supply curve crosses this point as well.

13. Two Causes of Economic Fluctuations • The effects of a shift in aggregate demand • Wave of pessimism • Affects aggregate demand • Aggregate demand – shifts left • Short-run • Output falls & Price level falls • Long-run • Short-run aggregate supply curve – shifts right • Output – natural rate • Price level – falls

14. 3 Four steps for analyzing macroeconomic fluctuations Decide whether the event shifts the aggregate demand curve or the aggregate supply curve (or perhaps both). Decide in which direction the curve shifts. Use the diagram of aggregate demand and aggregate supply to determine the impact on output and the price level in the short run. Use the diagram of aggregate demand and aggregate supply to analyze how the economy moves from its new short-run equilibrium to its long-run equilibrium.

15. 8 A contraction in aggregate demand – Austrian School Long-run aggregate supply Price Level Short-run aggregate supply, AS1 AS2 C B A P3 P1 P2 3. . . . but over time, the short-run aggregate-supply curve shifts . . . 4. . . . and output returns to its natural rate. • A decrease in • aggregate demand . . . AD2 Aggregate demand, AD1 Quantity of Output Y1 Y2 A fall in aggregate demand is represented with a leftward shift in the aggregate-demand curve from AD1 to AD2. In the short run, the economy moves from point A to point B. Output falls from Y1 to Y2, and the price level falls from P1 to P2. Over time, as the expected price level adjusts, the short-run aggregate-supply curve shifts to the right from AS1 to AS2, and the economy reaches point C, where the new aggregate-demand curve crosses the long-run aggregate-supply curve. In the long run, the price level falls to P3, and output returns to its natural rate, Y1. 2. . . . causes output to fall in the short run . . .

16. Two big shifts in aggregate demand: Great Depression and World War II • Early 1930s: large drop in real GDP • The Great Depression • Largest economic downturn in U.S. history • From 1929 to 1933 • Real GDP fell by 27% • Unemployment rose from 3 to 25% • Price level fell by 22% • Cause: decrease in aggregate demand • Decline in money supply (by 28%) • Decreasing: consumer spending, investment spending

17. Two big shifts in aggregate demand: Great Depression and World War II • Early 1940s: large increase in real GDP • Economic boom • World War II • More resources to the military • Government purchases increased • Aggregate demand – increased 1939 - 1944 • Doubled the economy’s production of goods and services • 20% increase in the price level • Unemployment fell from 17 to 1%

18. 9 U.S. real GDP growth since 1900 Over the course of U.S. economic history, two fluctuations stand out as especially large. During the early 1930s, the economy went through the Great Depression, when the production of goods and services plummeted. During the early 1940s, the United States entered World War II, and the economy experienced rapidly rising production. Both of these events are usually explained by large shifts in aggregate demand.

19. The recession of 2001 • 2001: Recession • Unemployment rate • December 2000: 3.9% • August 2001: 4.9% • June 2003: 6.3% • January 2005: 5.2% • Three events – decrease in aggregate demand • The end of dot-com bubble in stock market • Stock prices fell (25%) • Reduced consumer & investment spending • Aggregate-demand curve - shifted to left

20. The recession of 2001 • Three events – decrease in aggregate demand • Terrorist attacks on September 11, 2001 • Stock market fell (12%) in one week • Increased uncertainty about the future • Aggregate-demand curve – shifted further to left • Series of corporate accounting scandals • Enron and WorldCom • Stock market fell • Aggregate-demand curve – shifted further to left

21. The recession of 2001 • 2001: Recession • Policymakers - quick to respond • The Fed - expansionary monetary policy • Interest rates fell; Federal funds rate fell • Stimulated spending • Congress • Tax cut in 2001; Immediate tax rebate; Tax cut in 2003 • To stimulate consumer & investment spending • Aggregate-demand curve – shifted to right • Offset the three contractionary shocks

22. Two Causes of Economic Fluctuations • The effects of a left shift in aggregate supply • Start: long run equilibrium • Firms – increase in production costs • Aggregate supply curve – shifts left • Short-run • Output falls & Price level rises • Stagflation • Long-run, if AD is held constant • Short-run AS shifts back to right • Output – natural rate • Price level - falls

23. 10 An adverse shift in aggregate supply 3. . . . and the price level to rise Price Level Long-run aggregate supply 1. An adverse shift in the short-run aggregate-supply curve . . . AS2 2. . . . causes output to fall . . . Short-run aggregate supply, AS1 B A P1 P2 Aggregate demand Quantity of Output Y1 Y2 When some event increases firms’ costs, the short-run aggregate-supply curve shifts to the left from AS1 to AS2. The economy moves from point A to point B. The result is stagflation: Output falls from Y1 to Y2, and the price level rises from P1 to P2.

24. Two Causes of Economic Fluctuations • The effects of a shift in aggregate supply • Start: long run equilibrium • Firms – increase in production costs • Aggregate supply curve – shifts left • Short-run • Output falls and Price level rises • Long-run • Policymakers – shift AD to right • Output – natural rate • Price level – rises

25. 2. . . . policymakers can accommodate the shift by expanding aggregate demand . . . 11 3. . . . which causes the price level to rise further . . . Accommodating an adverse shift in aggregate supply 4. . . . but keeps output at its natural rate. Price Level Long-run aggregate supply 1. When short-run aggregate supply falls . . . AS2 Short-run aggregate supply, AS1 C A P2 P3 P1 Aggregate demand, AD1 AD2 Quantity of Output Y1 Faced with an adverse shift in aggregate supply from AS1 to AS2, policymakers who can influence aggregate demand might try to shift the aggregate-demand curve to the right from AD1 to AD2. The economy would move from point A to point C. This policy would prevent the supply shift from reducing output in the short run, but the price level would permanently rise from P1 to P3.

26. Oil and the economy • Economic fluctuations in the U.S. economy • Since 1970 • Some: originated in the oil fields of the Middle East • Some event - reduces the supply of crude oil flowing from Middle East • Price of oil - rises around the world • Aggregate-supply curve – shifts left • Stagflation • Mid-1970s • Late-1970s

27. Oil and the economy • Some event – increases the supply of crude oil from Middle East • Price of oil decreases • Aggregate-supply curve – shifts right • Output – rapid growth • Unemployment – falls • Inflation rate – falls

28. Oil and the economy • Recent years: World market for oil – not an important source of economic fluctuations • Conservation efforts • Changes in technology • 2008 - world oil prices – rising significantly • Increased demand from a rapidly growing China