CH 1.1 Aggregate Demand & Aggregate Supply.ppt
- 1. Aggregate demand and Aggregate supply Assoc. Prof Dr. Ergin AKALPLER [email protected] [email protected]
- 2. THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS 1. Economic fluctuations are irregular and unpredictable. Fluctuations in the economy are often called the business cycle. These fluctuations do not follow regular or easily predictable patterns.
- 3. Figure 1 A Look At Short-Run Economic Fluctuations (a) Real GDP Billions of 2000 Dollars 1965 1970 1975 1980 1985 1990 1995 2000 2005 2,000 4,000 6,000 8,000 $10,000 3,000 5,000 7,000 9,000 Real GDP
- 4. THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS 2. Most macroeconomic variables fluctuate together. Most macroeconomic variables that measure some type of income or production fluctuate closely together. Although many macroeconomic variables fluctuate together, they fluctuate by different amounts.
- 5. Figure 1 A Look At Short-Run Economic Fluctuations (b) Investment Spending 1965 1970 1975 1980 1985 1990 1995 2000 2005 Billions of 2000 Dollars 0 500 1,000 $1,500 Investment Spending
- 6. THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS 3. As output falls, unemployment rises. Changes in real GDP are inversely related to changes in the unemployment rate. During times of recession, unemployment rises substantially.
- 7. Figure 1 A Look At Short-Run Economic Fluctuations (c) Unemployment Rate 1965 1970 1975 1980 1985 1990 1995 2000 2005 Percent of Labor Force 2 4 6 8 10 12% Unemployment Rate
- 8. EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS Most economists believe that classical theory describes the world in the long run but not in the short run.
- 9. EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS If the quantity of money in the economy were to double, prices would double (inflation) and so would incomes. Real variables would remain constant. HOWEVER: These changes will not occur instantaneously. It takes time for prices and incomes to change, and in the meantime, there can be real effects.
- 10. Resource transfer Welfare will decrease and producer gain supposed to be increased This so called resource transfers from consumers to producers.
- 11. Producer gain and consumer surplus
- 12. Welfare and producer effect
- 13. The Model of Aggregate Demand and Aggregate Supply Two variables are used to develop a model to analyze the short-run fluctuations. The economy’s output of goods and services measured by real GDP. The average level of prices measured by the CPI or the GDP deflator.
- 14. Short run production The short run, as it applies to business, states that at a certain point in the future, one or more inputs will be fixed, while others are variable. When it relates to economics, the short run speaks to the idea that an economy's behavior will vary based on how much time it has to absorb and react to stimuli. The short run's counterpart is the long run, which contains no fixed costs. Instead, costs balance out with the desired amount of costs available at the lowest possible price.
- 15. The Model of Aggregate Demand and Aggregate Supply Economist use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend. Time Economic activity Business cycle
- 16. The Model of Aggregate Demand and Aggregate Supply The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level. The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.
- 17. Figure 2 Aggregate Demand and Aggregate Supply... Quantity of Output Price Level 0 Aggregate supply Aggregate demand Equilibrium output Equilibrium price level
- 18. Let start with Aggregate Demand
- 19. Aggregate demand Aggregate demand is made up of household or consumer spending (C), business investment (I), government spending (G) and net exports (NX). It is about the spending decisions of households, firms and government
- 20. THE AGGREGATE-DEMAND CURVE The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX
- 21. Components of the GDP Y= C+G+I+NX Y= output , C=Consumption, G=gov spending NX=Export-Import The model will attempt to capture the essence or most important features of the process. The economic decisions that we will consider will involve static and inter-temporal choice
- 22. Figure 3 The Aggregate-Demand Curve... Quantity of Output Price Level 0 Aggregate demand P Y Y2 P2 1. A decrease in the price level . . . 2. . . . increases the quantity of goods and services demanded.
- 23. Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Consumption: The Wealth Effect The Price Level and Investment: The Interest Rate Effect The Price Level and Net Exports: The Exchange-Rate Effect
- 24. Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Consumption: The Wealth Effect A lower price level raises the real value of money and makes consumers wealthier, which encourages them to spend more. This increase in consumer spending means larger quantities of goods and services demanded.
- 25. Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Investment: The Interest Rate Effect A lower price level reduces the interest rate and makes borrowing less expensive, which encourages greater spending on investment goods. This increase in investment spending means a larger quantity of goods and services demanded.
- 26. Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Net Exports: The Exchange-Rate Effect A lower price level in the U.S. causes U.S. interest rates to fall and the real exchange rate to depreciate, which stimulates U.S. net exports. The increase in net export spending means a larger quantity of goods and services demanded.
- 27. Why the Aggregate-Demand Curve Might Shift The downward slope of the aggregate-demand curve shows that a fall in the price level raises the overall quantity of goods and services demanded. Many other factors, however, affect the quantity of goods and services demanded at any given price level. When one of these other factors changes, the aggregate demand curve shifts.
- 28. Why the Aggregate-Demand Curve Might Shift Shifts might arise from changes in: Consumption Investment Government Purchases Net Exports
- 29. Shifts in the Aggregate Demand Curve Quantity of Output Price Level 0 Aggregate demand, D1 P1 Y1 D2 Y2
- 30. Table 1 The Aggregate Demand Curve: Summary
- 31. THE AGGREGATE-SUPPLY CURVE In the long run, the aggregate-supply curve is vertical because the price level does not affect long run determinants of real GDP. In the short run, the aggregate-supply curve is upward sloping.
- 32. THE AGGREGATE-SUPPLY CURVE In the long run, an economy’s production of goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services. The price level does not affect these variables in the long run. The long-run aggregate supply represents the classical dichotomy and money neutrality.
- 33. Figure 4 The Long-Run Aggregate-Supply Curve Quantity of Output Natural rate of output Price Level 0 Long-run aggregate supply P2 1. A change in the price level . . . 2. . . . does not affect the quantity of goods and services supplied in the long run. P
- 34. THE AGGREGATE-SUPPLY CURVE The long-run aggregate-supply curve is vertical at the natural rate of output, which is the production of goods and services that an economy achieves in the long run when unemployment is at its normal rate. This level of production is also referred to as potential output or full-employment output. The natural rate of output is level of output towards which the economy gravitates in the long run.
- 35. Why the Long-Run Aggregate- Supply Curve Might Shift Any change in the economy that alters the natural rate of output shifts the long-run aggregate- supply curve. The shifts may be categorized according to the various factors in the classical model that affect output.
- 36. Why the Long-Run Aggregate- Supply Curve Might Shift Shifts might arise from changes in: Labor -L Capital -K Natural Resources –N Technological Knowledge –H goes to available techno and know how Y= A f(KLMN) ----production function
- 37. Figure 5 Long-Run Growth and Inflation Quantity of Output Y1980 AD1980 AD1990 Aggregate Demand, AD2000 Price Level 0 Long-run aggregate supply, LRAS1980 Y1990 LRAS1990 Y2000 LRAS2000 P1980 1. In the long run, TkLM or technological progress or others shifts long-run aggregate supply . . . 4. . . . and ongoing inflation. 3. . . . leading to growth in output . . . P1990 P2000 2. . . . and growth in the money supply results of cons, invest exp or gov exp shifts A ggregate demand . . .
- 38. Using Aggregate Demand and Aggregate Supply to Depict Long-Run Growth and Inflation The most important forces that govern the economy and growth in the long run are technology and monetary policy. Short-run fluctuations in output and the price level should be viewed as deviations from the continuing long-run trends of output growth and inflation.
- 39. Why the Aggregate-Supply Curve Slopes Upward in the Short Run 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. A decrease in the level of prices tends to reduce the quantity of goods and services supplied. As a result, the short-run aggregate-supply curve is upward sloping.
- 40. Figure 6 The Short-Run Aggregate-Supply Curve Quantity of Output Price Level 0 Short-run aggregate supply 1. A decrease in the price level . . . 2. . . . reduces the quantity of goods and services supplied in the short run. Y P Y2 P2
- 41. Why the Aggregate-Supply Curve Slopes Upward in the Short Run Three Theories: The Sticky-Wage Theory The Sticky-Price Theory The Misperceptions Theory
- 42. Why the Aggregate-Supply Curve Slopes Upward in the Short Run The Sticky-Wage Theory Nominal wages are slow to adjust to changing economic conditions, or are “sticky” in the short run Nominal wages do not adjust immediately to a fall in the price level. A lower price level makes employment and production less profitable. This induces firms to reduce the quantity of goods and services supplied.
- 43. Why the Aggregate-Supply Curve Slopes Upward in the Short Run The Sticky-Price Theory Prices of some goods and services adjust sluggishly in response to changing economic conditions. An unexpected fall in the price level leaves some firms with higher-than-desired prices. For a variety of reasons, they may not want to or be able to change prices immediately. This depresses sales, which induces firms to reduce the quantity of goods and services they produce.
- 44. Why the Aggregate-Supply Curve Slopes Upward in the Short Run The Misperceptions Theory Changes in the overall price level temporarily mislead suppliers about what is happening in the markets in which they sell their output. A lower price level causes misperceptions about relative prices. These misperceptions induce suppliers to decrease the quantity of goods and services supplied.
- 45. Why the Aggregate-Supply Curve Slopes Upward in the Short Run All three theories suggest that output deviates in the short run from the natural rate when the actual price level deviates from the price level that people had expected to prevail or maintan in the market. Quantity of output supplied = Natural rate of output + a Actual price level - Expected price level
- 46. Why the Short-Run Aggregate- Supply Curve Might Shift Shifts might arise from changes in: Expected Price Level. Labor. Capital. Natural Resources. Technology.
- 47. Why the Aggregate Supply Curve Might Shift An increase in the expected price level reduces the quantity of goods and services supplied and shifts the short-run aggregate supply curve to the left. A decrease in the expected price level raises the quantity of goods and services supplied and shifts the short-run aggregate supply curve to the right.
- 48. Table 2 The Short-Run Aggregate Supply Curve: Summary
- 49. Figure 7 The Long-Run Equilibrium Natural rate of output Quantity of Output Price Level 0 Short-run aggregate supply Long-run aggregate supply Aggregate demand A Equilibrium price
- 50. TWO CAUSES OF ECONOMIC FLUCTUATIONS Four steps in the process of analyzing economic fluctuations: Determine whether the event affects aggregate supply or aggregate demand. Decide which direction the curve shifts. Use a diagram to compare the initial and the new equilibrium. Keep track of the short and long run equilibrium, and the transition between them.
- 51. TWO CAUSES OF ECONOMIC FLUCTUATIONS Shifts in Aggregate Demand In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services. In the long run, shifts in aggregate demand affect the overall price level but do not affect output. Policymakers who influence aggregate demand can potentially mitigate or reduce the severity of economic fluctuations.
- 52. Figure 8 A Contraction in Aggregate Demand Quantity of Output Price Level 0 Short-run aggregate supply, AS Long-run aggregate supply Aggregate demand, AD A P Y AD2 AS2 1. A decrease in aggregate demand . . . 2. . . . causes output to fall in the short run . . . 3. . . . but over time, the short-run aggregate-supply curve shifts . . . 4. . . . and output returns to its natural rate. C P3 B P2 Y2
- 53. TWO CAUSES OF ECONOMIC FLUCTUATIONS Shifts in Aggregate Supply Consider an adverse shift in aggregate supply: A decrease in one of the determinants of aggregate supply shifts the curve to the left. Output falls below the natural rate of employment. Unemployment rises. The price level rises.
- 54. Figure 10 An Adverse Shift in Aggregate Supply Quantity of Output Price Level 0 Aggregate demand 3. . . . and the price level to rise. 2. . . . causes output to fall . . . 1. An adverse shift in the short- run aggregate-supply curve . . . Short-run aggregate supply, AS Long-run aggregate supply Y A P AS2 B Y2 P2
- 55. The Effects of a Shift in Aggregate Supply Adverse shifts in aggregate supply cause stagflation -unemployment and price both increase in phillips it is opposite price increase reduce unemployment—a period of recession and inflation. Output falls and prices rise. Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.
- 56. The Effects of a Shift in Aggregate Supply Policy Responses to Recession Policymakers may respond to a recession in one of the following ways: Do nothing and wait for prices and wages to adjust. Take action to increase aggregate demand by using monetary and fiscal policy. (Such as OMO : Expansionary money policy Buying bonds or reduce tax to increase income)
- 57. Figure 11 Accommodating an Adverse Shift in Aggregate Supply Quantity of Output Natural rate of output Price Level 0 Short-run aggregate supply, AS Long-run aggregate supply Aggregate demand, AD P2 A P AS2 3. . . . which causes the price level to rise further . . . 4. . . . but keeps output at its natural rate. 2. . . . policymakers can accommodate the shift by expanding aggregate demand . . . 1. When short-run aggregate supply falls . . . AD2 C P3
- 58. Summary © 2007 Thomson South-Western • All societies experience short-run economic fluctuations around long-run trends. • These fluctuations are irregular and largely unpredictable. • When recessions occur, real GDP and other measures of income, spending, and production fall, and unemployment rises.
- 59. Summary © 2007 Thomson South-Western • Classical economic theory is based on the assumption that nominal variables do not influence real variables. Most economists believe that this is an accurate assumption in the long run, but not in the short run.
- 60. Summary © 2007 Thomson South-Western • Economists analyze short-run economic fluctuations using the aggregate demand and aggregate supply model. According to this model, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply.
- 61. Summary © 2007 Thomson South-Western • The aggregate-demand curve slopes downward for three reasons: a wealth effect, an interest rate effect, and an exchange rate effect. • Any event or policy that changes consumption, investment, government purchases, or net exports at a given price level will shift the aggregate-demand curve.
- 62. Summary © 2007 Thomson South-Western • In the long run, the aggregate supply curve is vertical. • In the short-run, the aggregate supply curve is upward sloping. • The are three theories explaining the upward slope of short-run aggregate supply: the sticky-wage theory, the sticky-price theory and the misperceptions theory.
- 63. Summary © 2007 Thomson South-Western • Events that alter the economy’s ability to produce output will shift the short-run aggregate-supply curve. • Also, the position of the short-run aggregate- supply curve depends on the expected price level. • One possible cause of economic fluctuations is a shift in aggregate demand.
- 64. Summary © 2007 Thomson South-Western • A second possible cause of economic fluctuations is a shift in aggregate supply. • Stagflation is a period of falling output and rising prices.