Aggregate Demand and Aggregate Supply

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1 Demand and Supply Chapter 31 Copyright 21 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida Short-Run Economic Fluctuations u Economic activity fluctuates from year to year. u In most years production of goods and services rises. u On average over the past 5 years, production in the U.S. economy has grown by about 3 percent per year. u In some years normal growth does not occur, causing a recession. Three Key Facts About Economic Fluctuations u Economic fluctuations are irregular and unpredictable. u Fluctuations in the economy are often called the business cycle. u Recessions and Depressions u Most macroeconomic variables fluctuate together. u As output falls, unemployment rises. 1

2 A Look At Short-Run Economic Fluctuations (a) Real GDP Billions of Recessions 1992 Dollars $7, 6,5 Real GDP 6, 5,5 5, 4,5 4, 3,5 3, 2, A Look At Short-Run Economic Fluctuations (b) Investment Spending Billions of 1992 Dollars $1,1 1, Recessions Investment spending A Look At Short-Run Economic Fluctuations Percent of Labor Force (c) Unemployment Rate Recessions Unemployment rate

3 The Basic Model of Economic Fluctuations Economists use the model of demand and to explain short-run fluctuations in economic activity around its long-run trend. n level as measured by the CPI n as measured by real GDP. The Basic Model of Economic Fluctuations u The demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level. u The curve shows the quantity of goods and services that firms produce and sell at each price level. Demand and Supply... Equilibrium price level demand Equilibrium output 3

4 The -Demand Curve A decrease in the price level... demand Y 1 Y 2 2. increases the quantity of goods and services demanded. Why the Demand Curve Is Downward Sloping u The and Consumption: The Wealth Effect u The and Investment: The Interest Rate Effect u The and Net Exports: The Exchange-Rate Effect Why the Demand Curve Might Shift u Y=C + I + G + NET EXPORTS u Shifts arising from Consumption u Shifts arising from Investment u Shifts arising from Government Purchases u Shifts arising from Net Exports u Changes in the price level cause a movement along the Demand Curve. 4

5 Shifts in the Demand Curve... D 2 demand, D 1 Y 1 Y 2 The Supply Curve u The curve shows the level of production at each price level. u In the long run, the - curve is vertical. u In the short run, the - curve is upward sloping. How the Short Run Differs From the Long Run u Most economists believe that classical theory describes the world in the long run but not in the short run. u Changes in the money affect nominal variables but not real variables in the long run. u The assumption of monetary neutrality is not appropriate when studying year-to-year changes in the economy. 5

6 The Long-Run - Supply Curve A change in the price level Natural rate of output 2. does not affect the quantity of goods and services supplied in the long run. Why the Long-Run Supply Curve Might Shift u Shifts arising from Labor u Shifts arising from Capital u Shifts arising from Natural Resources u Shifts arising from Technological Knowledge u Any change in the economy that alters the natural rate of output shifts the long-run - curve. The Short-Run Supply Curve... Short-run 1. A decrease in the price level 2. reduces the quantity of goods and services supplied in the short run. Y 2 Y 1 6

7 Why the Short-Run Supply Curve Slopes Upward in the Short Run u In the short run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied. u A decrease in the level of prices tends to reduce the quantity of goods and services supplied. u Workers may be fooled as well-sticky Wage Theory. u But Supply always snaps back to the Long run. The Long-Run Equilibrium Short-run Equilibrium price A Natural rate of output demand A Contraction in Demand... P 3 2. causes output to fall in the short run Y 2 B Y 1 A C Short-run, AS 1 AD 2 4. and output returns to its natural rate. AS 2 3. but over time, the short-run - curve shifts 1. A decrease in demand demand, AD 1 7

8 An Adverse Shift in Short Run Supply u A decrease in one of the determinants of shifts the curve to the left: u falls below the natural rate of employment. u Unemployment rises. u The price level rises. u Stagflation results! An Adverse Shift in Supply An adverse shift in the short-run - curve AS 2 Short-run, AS 1 3. and the price level to rise. B A Y 2 Y 1 2. causes output to fall demand Policy Responses to Recession u Policymakers may respond to a recession in one of the following ways: u Do nothing and wait for prices and wages to adjust. u Take action to increase demand by using monetary and fiscal policy. 8

9 Accommodating an Adverse Shift in Supply When short-run falls AS 2 Short-run, AS 1 P 3 A C 2. policymakers can accommodate the shift by expanding demand 3...which causes the price level to rise 4. but keeps output at its natural rate. Natural rate of output AD 2 demand, AD 1 9

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