# Business Fluctuations: Aggregate Demand and Supply

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1 Chapter 13 (Chapter 32) MODERN PRINCIPLES OF ECONOMICS Third Edition Business Fluctuations: Aggregate Demand and Supply

2 Outline The Aggregate Demand Curve The Long-Run Aggregate Supply Curve Real Shocks Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve Shocks to the Components of Aggregate Demand Understanding the Great Depression: Aggregate Demand Shocks and Real Shocks 2

3 Introduction Economic growth is not a smooth process. Real GDP in the United States has grown at an average rate of 3.2% per year over the past 60 years. The economy rarely grew at an average rate. Growth fluctuated from -5% to over 8%. Recessions are of special concern to policymakers and the public because unemployment typically increases. 3

4 Definition Business fluctuations: fluctuations in the growth rate of real GDP around its trend growth rate. Recession: a significant, widespread decline in real income and employment. 4

5 Introduction Bureau of Economic Analysis Quarterly Growth Rate in Real GDP,

6 Introduction Bureau of Labor Statistics; National Bureau of Economic Research U.S. Civilian Unemployment Rate,

7 Introduction To understand booms and recessions, we are going to develop a model of aggregate demand and aggregate supply (AD/AS), with 3 curves: Aggregate demand curve (AS) the long-run aggregate supply curve (LRAS or Solow) the short-run aggregate supply curve (SRAS). The AD/AS model shows how unexpected economic disturbances or shocks can temporarily increase or decrease the rate of growth. 7

8 Definition Aggregate demand curve: shows all the combinations of inflation and real growth that are consistent with a specified rate of spending growth, M+ v. 8

9 The Aggregate Demand Curve We can derive the AD curve using the quantity theory of money in dynamic form, M +ν = P + Y R Where: = growth rate of the money supply M ν = growth in velocity P Y R = growth rate of prices (inflation) = growth rate of real GDP 9

10 The Aggregate Demand Curve We can also write the equation as: M +ν = Inflation + Real Growth So if money growth = 5%, velocity = 0%, and real growth is 0%, the inflation rate must = 5%. In other words, if the money supply is growing, velocity is constant, and there are no additional goods, then prices must go up. 10

11 The Aggregate Demand Curve Another example: if money growth = 5%, velocity = 0%, and real growth is 3%, the inflation rate must = 2%. An AD curve tells us all the combinations of inflation and real growth that are consistent with a specified rate of spending growth,. M +ν In our example, any combination of inflation and real growth that adds up to 5% is on the same AD curve. 11

12 The Aggregate Demand Curve Inflation Rate (π) If spending and real growth increases, then inflation will fall down. 5% 5% + 0% = 5% 2% 2% + 3% = 5% 0% -2% 0% 3% AD (spending growth = 5%) 5% 7% Real GDP growth rate 12

13 Self-Check equals: a. Real growth. b. Inflation + nominal growth. c. Inflation + real growth. Answer: c : M +ν = Inflation + Real Growth 13

14 Shifts in Aggregate Demand Increased spending must flow into either a higher inflation rate or a higher growth rate. If spending growth increases, either because of an increase in money supply or an increase in velocity, then the AD curve shifts up and to the right. A decrease in spending growth shifts the AD curve inward. 14

15 Shifts in Aggregate Demand Inflation Rate (π) 7% 5% 7% + 0% = 7% 1. Increases in spending growth, M and/or ν shift the AD curve to the right. 2. Decreases in spending growth, M and/or ν shift the AD curve to the left. 2% 2% + 5% = 7% AD (spending growth = 7%) 0% -2% 0% 3% 5% 7% Real GDP growth rate 15

16 Long Run Aggregate Supply Every economy has a potential growth rate determined by: Increases in the stocks of labor and capital. Increases in productivity. The rate of growth, as given by these real factors of production, is called the Solow growth rate. The long-run aggregate supply curve is a vertical line at the Solow growth rate, independent of the inflation rate. 16

17 Long Run Aggregate Supply Inflation Rate (π) LRAS Potential growth does not depend on the rate of inflation. The Solow growth rate Real GDP growth rate 17

18 Definition Solow growth rate: an economy s potential growth rate, the rate of economic growth that would occur given flexible prices and the existing real factors of production. The long run aggregate supply curve (LRAS): is vertical at the Solow growth rate. 18

19 Shifts in the LRAS Curve When we put the AD and LRAS curve together, we can see how business fluctuations can be caused by real shocks. In this model, the equilibrium inflation rate and growth rate are determined by the intersection of the AD and LRAS curves. 19

20 AD and LRAS Curves Inflation Rate (π) 7% LRAS M +ν If is 10% and real growth is 3%, then the inflation rate will be 7%. AD ( M+ v = 10%) 3% Real GDP growth rate 20

21 Self-Check An economy s potential growth rate is called: a. The Solow growth rate. b. Aggregate supply. c. Aggregate demand. Answer: a the potential growth rate is called the Solow growth rate. 21

22 Shifts in the LRAS Curve Real shocks are rapid changes in economic conditions that increase or diminish the productivity of capital and labor. Economies are continually hit by real shocks, which shift the Solow growth rate. This in turn influences GDP and employment. Possible shocks include wars, terrorist attacks, major new regulations, tax rate changes, mass strikes, and new technologies. 22

23 AD and LRAS Curves Inflation Rate (π) 11% 7% 3% Negative shock LRAS Positive shock 1. A positive shock results in a higher real growth rate and lower inflation. 2. A negative shock results in a lower real growth rate and higher inflation. AD ( M+ v = 10%) -1% 3% 7% Real GDP growth rate 23

24 Real Shocks Agricultural output depends on the quantity and quality of the inputs of capital and labor. It also depends on the weather. If farmers struggle, many other sectors of the economy suffer as well. When the weather fluctuates, so does output and therefore so does GDP, especially in agricultural economies. 24

25 Real Shocks: Weather 25

26 Real Shocks In an economy with a large manufacturing sector, a reduction in the oil supply reduces GDP. Oil and machines are complementary - they work together with labor to produce output. When the oil supply is reduced, capital and labor become less productive. The first OPEC oil shock came in late 1973, and the price of oil more than tripled in two years. 26

27 Real Shocks Since oil is an important input in many sectors, high oil prices or oil shocks hurt many American industries. In each of the last six U.S. recessions, there was a large increase in the price of oil just prior to or coincident with the onset of recession. A 10% increase in the price of oil lowers the GDP growth rate for just over two years. 27

28 Real Shocks The Price of Oil and U.S. Recessions 28

29 Real Shocks 29

30 Self-Check Higher business taxes will shift the long run aggregate supply curve: a. To the left. b. To the right. c. Higher taxes will not shift the LRAS curve. Answer: a higher taxes will decrease LRAS, shifting the curve to the left. 30

31 Introduction to the AD/AS Model Previous model (w/o the SRAS) is known as the Real Business Cycle (RBC) model Next model: AD-AS (New Keynesian) Explains the business cycle in terms of real shocks and/or aggregate demand shocks Both supply-side shocks and demand side shocks are incorporated This is a model for the economic short run, not the long run Trying to explain the business cycle Hence the need for the SRAS 31

32 John Maynard Keynes John Maynard Keynes ( ) The General Theory of Employment, Interest, and Money, Wrote in the context of the Great Depression. Explained that when prices are not perfectly flexible (sticky), deficiencies in aggregate demand could cause recessions Key to the model: when prices are sticky, the economy can grow faster or slower than the Solow growth rate. 32

33 Keynesianism Keynesian economic philosophy: The economy must be managed. The economy is unstable, tends to fall into recessions Government spending and money printing are the solutions to manage the economy (even if it means digging holes and then filling them up!) Economic corrections by themselves take too long In the Long Run, we re all dead. Can not rely on the economy to correct itself 33

34 Keynesianism Utilizes big aggregated concepts/explanations too aggregated, not enough information Became intellectual cover for big government spending, collectivism If WWII spending ended the Great Depression, why didn t the huge reduction in government spending cause another recession/depression? Regime uncertainty may be a better explanation Discredited in the early 1970 s but was resurrected big time in 2009 with the massive stimulus bill 34

35 Short Run Aggregate Supply (SRAS) The short run aggregate supply curve: shows the positive relationship between the inflation rate and real growth during the period when prices and wages are sticky. 35

36 Short Run Aggregate Supply (SRAS) 1. SRAS shows the relationship between inflation and growth when prices are sticky, or slow to adjust. 2. A positive relationship between inflation and real growth in the short run implies the SRAS curve will be upward-sloping. 3. The position of the SRAS curve is anchored by expected inflation E(π), and changes in πe will shift SRAS. Such shifts occur only in the long run. 4. Changes in actual inflation (π) cause a movement along the SRAS curve. Such movements occur only in the short run. 36

37 Short Run Aggregate Supply (SRAS) The SRAS show the pathway of the economy in the short run In the short run, an increase in AD will increase both inflation and real growth. Increase in AD is split between growth & inflation i.e. a decrease in demand will decrease both the inflation rate and the growth rate. Each SRAS curve is associated with a specific rate of expected inflation - E(π) 37

38 Why does the SRAS slope upwards? Given: M +ν = P + Y R When spending increases, the stickiness of prices means that changes in the growth rate of P can not change enough to compensate Therefore, real GDP growth rate must change to balance both sides of the equation (in the short run only) In the SR, output can change (temporarily) In the LR, prices can fully adjust (flexible) 38

39 Sticky Prices Prices can be sticky (not fully flexible) due to uncertainty, menu costs, and other factors There may be confusion as to whether price changes are real or nominal. Firms may not respond immediately to changes in AD/inflation Menu costs represent the costs of changing prices Changing prices may create mistrust among the firm s customers The profit story illustrates sticky prices 39

40 Self-Check The costs associated with changing the prices of goods and services are called: a. Inflation costs. b. Inflationary expectations. c. Menu costs. Answer: c menu costs. 40

41 Sticky Wages Another form of sticky prices Wages are the major expense for many firms Wages can be slow to adjust due to labor contracts, uncertainty, human factors, etc When inflation falls, wages may remain high, making labor expensive Firms may choose to do layoffs rather than wage cuts Workers often become upset when there are reductions to their nominal wages, morale drops Wages will change more slowly than actual inflation in the short run 41

42 Definition Nominal wage confusion: occurs when workers respond to their nominal wage instead of to their real wage, that is, when workers respond to the wage number on their paychecks rather than to what their wage can buy in goods and services (the wage after correcting for inflation). 42

43 The Profit Story 43

44 Short Run Aggregate Supply (SRAS) The SRAS is drawn with a steeper slope to the right of the LRAS reflects capacity limitations in the economy Since wages are sticky downwards, a slowdown in nominal spending growth results in more unemployment than if wages/prices were perfectly flexible (RBC model) With a negative AD shock, the ultimate effect of sticky wages results in more unemployment This is reflected in the shape of the SRAS curve 44

45 Check It If π > π e : a) firms' profits will increase. b) money growth will cause the short-run aggregate supply curve to shift. c) firms' profits will decrease. d) there will be no change in real GDP growth because it is determined by real factors.

46 SRAS Shifts What shifts the SRAS curve? 1. Whenever the LRAS moves left or right, the SRAS moves with it, staying with the anchor point 2. Changes in expected inflation rate When exp infl increases, SRAS shifts left When exp infl decreases, SRAs shifts right Whenever exp infl does not equal actual inflation, the SRAS shifts in the appropriate direction 46

47 Short-Run Aggregate Supply Inflation Rate (π) LRAS SRAS (E(π) = 2%) 2% AD ( M + v = 5%) 3% Real GDP growth rate 47

48 Inflation Rate (π) 6% 4% 2% Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve Solow growth curve c a d (SRAS 2 ) (E(π) = 4%) (SRAS 1 ) (E(π) = 2%) b If π = 2% and E(π) = 2%, economy stays at point a. If π = 4% and E(π) = 2%, economy moves to b. and real growth to 7% If π = 4% and E(π) = 4%, SRAS shifts up and economy stays at point c. If π = 4% and E(π) = 6%, economy moves to d. and real growth to 7% 3% 7% Real GDP growth rate

49 Equilibrium in SR/LR Equilibrium: Long Run - When all three curves intersect at the same point (the anchor point) Expected inflation always equal actual inflation Short Run Wherever the SRAS and AD curve intersect Determines actual inflation rate and economic growth rate Does not necessarily have to be in LR equilibrium 49

50 Aggregate Demand Shocks Aggregate demand shock: a rapid and unexpected shift in the AD curve (spending). 50

51 Aggregate Demand Shocks A positive shock to spending must either increase inflation or the real growth rate. In the short run, an increase in spending will be split between increases in inflation and increases in real growth. In the long run, the real growth rate is equal to the Solow rate, which is not influenced by inflation. ( money is neutral ) In the long run, therefore, an increase in spending will increase only the inflation rate. 51

52 An Increase in Aggregate Demand Inflation Rate (π) LRAS M If there is an unexpected in, both inflation and the growth rate increase in the short run (a b). 4% 2% a 3% b AD 6% SRAS (E(π) = 2%) AD ( M + v = 10% ) ( M + v = 5%) Real GDP growth rate 52

53 An Increase in Aggregate Demand Workers initially mistake the nominal wage increase for a real increase. Prices also don t move instantly because it is costly to change prices ( menu costs ). Firms may also hold off on price changes because they are not sure whether the change in market conditions is temporary or permanent. As prices increase throughout the economy, workers demand even higher wages to catch up to the higher inflation rate. 53

54 An Increase in Aggregate Demand Inflation Rate (π) 7% 4% 2% LRAS c a 3% Eventually, inflation expectations adjust, wages are unstuck and the growth rate returns to the Solow rate (b c). SRAS (E(π) = 7%) b AD 6% SRAS (E(π) = 2%) AD ( M + v = 10% ) ( M + v = 5%) Real GDP growth rate 54

55 A Decrease in Aggregate Demand When AD falls due to a fall in the money supply: The economy shifts to a new short run equilibrium point. The inflation rate decreases a little. Real growth is reduced a lot (recession). Prices and wages are especially sticky in the downward direction. It can take the economy a long time to move out of a recession. 55

56 A Decrease in Aggregate Demand Inflation Rate (π) LRAS (SRAS) (E(π)= 7%) 7% 5% b a A decrease in AD can induce a lengthy recession. AD 1 ( M + v = 10%) AD 2 ( M + v = 5%) -1% 3% Real Growth 56

57 A Decrease in Aggregate Demand Inflation Rate (π) LRAS (SRAS) (E(π)= 7%) 7% 5% a b 3% c -1% 3% AD 2 In the long run, wages become unstuck and the economy moves to a new equilibrium at c. AD 1 ( M + v = ( M + v = 10%) 5%) Real Growth 57

58 A Decrease in Aggregate Demand In the previous graph, a negative AD shock results in moving from A to B to C i.e. the economy will eventually recover to its long run Solow growth rate Keynesian say that this process takes too long, resulting in various social problems Rather than wait for this process (3 years?), the government should actively manage the economy via policies that increase aggregate demand To be covered in Fiscal Policy chapter 58

59 Shocks to Components of AD ν Changes in are the same as changes in the spending rate, holding M constant. If ν increases, the growth rate of C, I, G, or NX must increase. ν Changes in tend to be temporary. The shares of GDP devoted to C, I, G, and NX have been quite stable over time. 59

60 A Shock to the Growth Rate of Spending Inflation Rate (π) 7% LRAS (SRAS) (E(π) = 7%) a Consumers fears temporary decrease in AD Short-run Wages are sticky Real growth Long-run AD returns Real growth 6% b AD 1 ( M + v = 10%) AD 2 ( M + v = 5%) -1% 3% Real Growth 60

61 Factors That Shift AD 61

63 The Great Depression The Great Depression was due primarily to a large fall in aggregate demand. In 1929, the U.S. stock market crashed. Common belief - Capitalism is inherently unstable and goes through regular panics and recessions. World finances were a mess as a result of WWI. The US economy boomed during the Roaring 20s fueled by easy money from the recently created Federal Reserve. 63

64 The Great Depression The boom was largely due to too much credit and when the brakes were put on in the late 1920 s, the stock market crashed (just like ). Few supporters of the common belief recognize or mention the sharp depression experienced in GDP fell by over 10% though the economy recovered quickly within 18 months How did the US get out of the depression? 64

65 The Great Depression The government largely did nothing. Many people believe that monetary flows from Europe energized spending and economic growth in the US. In 1922, the Roaring 20s began. High flying tech stocks like RCA (radio) led the frenzied creation of a stock market bubble. Until the crash of October where 25% of the market value was lost over two days. Many stocks down 90% Loss of confidence in the system In the October 1989 crash, market down 25% in one day 65

66 The Great Depression People felt poorer and decreased spending, reducing aggregate demand. In 1930, depositors lost confidence in the banks. From 1930 to 1932, there were four waves of banking panics. By 1933, more than 40% of all American banks had failed. The fear and uncertainty also reduced investment spending. The U.S. capital stock was lower in 1940 than it had been in

67 The Great Depression In 1931, instead of increasing the money supply to boost the economy, the Federal Reserve allowed the money supply to contract even further. There was an additional monetary contraction during This was the infamous Depression within a depression. Much of the previous economic gains were gone. At the time of Pearl Harbor, the unemployment rate was still 14% 67

68 The Great Depression Inflation Rate (π) LRAS SRAS 0% M I C -10% AD ( M + v = 4% ) AD( M + v = - 23%) -13% 4% Real GDP growth rate 68

69 The Great Depression Real shocks also played a role in the Great Depression. Bank failures not only reduced the money supply and spending (AD), but they also reduced the efficiency of financial intermediation. Economic policy mistakes also impeded recovery; government agencies tried to increase prices by reducing supply. The Smoot Hawley Tariff of 1930 raised tariffs on imports; other countries retaliated. 69

70 The Great Depression A severe drought and decades of ecologically unsustainable farming practices turned millions of acres of farmland into a dust bowl. The shocks compounded one another and made a desperate situation even worse. NOAA GEORGE E. MARSH ALBUM 70

71 Takeaway The aggregate demand and supply model can be used to analyze fluctuations in the growth rate of real GDP. Real shocks are analyzed through shifts in the LRAS curve, while aggregate demand shocks are analyzed using shifts in the AD curve. Nominal wage and price confusion, sticky wages and prices, menu costs, and uncertainty create an upward-sloped short run aggregate supply curve. 71

72 Takeaway The Great Depression resulted from an unfortunate, concentrated, and interrelated series of aggregate demand and real shocks. It can be illustrated using the AD/AS model. 72

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