CHAP 33: Aggregate Demand and Aggregate Supply

Group 3: Nguyễn Thị Thu Thảo, Vũ Ánh Tuyết, Nguyễn Thùy Nhung, Phạm Quỳnh
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Table of contents

1, Economic fluctuations+ characteristic

2, The model of aggregate demand and supply

3, The Aggregate demand curve slopes downward

4, The slope of the Aggregate supply curve in the short run, long run

I. What are economic fluctuations

 Average economic growth US 1961-2021: 3%

 Gross domestic product (GDP) = total price of all goods and services
produced in a country in a given year.
 In the figure here, you can see real GDP growth in the US over this
period every year. The scale of the economy in 2021 is 6% larger than in
2020. While in 2020, the total market value of goods and services
produced was nearly 3% lower than in 2019.
  These deviations from long-term growth are called economic
fluctuations. So in conclusion, economic fluctuations are deviations of
GDP compared to the long-term trend.

 The economy may grow faster than trend. We will call it an expansion
or boom period.
 The economy could also grow slower than trend or even shrink in size.
We will call the situation when the economic growth rate is negative a
recession or bankruptcy.

 These fluctuations in booms and busts in the economy are called

business cycles.

II. Three Facts About Economic Fluctuations

FACT 1: Economic fluctuations are irregular and unpredictable.

 Business cycles often do not follow a regular pattern and are difficult to
predict.
 GDP increases and decreases without a certain rule, emphasizing the
unevenness and unpredictability of economic fluctuations.
  And the following figure shows the real GDP of the US economy since 1965.
 Shaded areas represent recessionary periods. As the figure shows, economic
recessions do not come with regularity. Sometimes recessions occur close
together, such as the recessions of 1980 and 1982. Sometimes the economy
goes years without a recession recovery. The longest period in US history
without a recession was the 1991 to 2001 expansion.

FACT 2: Most macroeconomic quantities fluctuate together.

 Major economic variables often fluctuate together during the business cycle.
 When GDP falls, indicators such as personal income, corporate profits, and
consumer spending also fall.


 Investment spending varies greatly with the business cycle. Although average
investment is about one-seventh of GDP, investment declines account for about
two-thirds of GDP decline during recessions. In other words, when economic
conditions worsen, much of the decline is due to reduced spending on new
factories, housing, and inventory.

FACT 3: As output falls, unemployment rises.

 Changes in economic output often go hand in hand with changes in business

failure rates.
  When GDP falls, businesses often lay off employees, increasing the
unemployment rate


 Panel (c) of Figure 1 shows the unemployment rate in the U.S. economy since
1965. Again, the shaded areas in the figure represent periods of recession.
These Figures clearly show the impact of economic recession on the
unemployment rate. In every recession, the unemployment rate increases
significantly. As the recession ended and real GDP began to expand, the
unemployment rate gradually declined. Unemployment rates never approach
zero; instead, it fluctuates around its natural rate of about 5 or 6%.

III. Classical Economics—A Recap

 The previous chapters are based on the ideas of classical economics, especially:

 The Classical Dichotomy, the separation of variables into two groups:

o Real – quantities, relative prices
o Nominal – measured in terms of money

 The neutrality of money:

Changes in the money supply affect nominal but not real variables.

 Most economists believe classical theory describes the world in the long run,
but not the short run.

 In the short run, changes in nominal variables (like the money supply or P ) can
affect
real variables (like Y or the u-rate).

 To study the short run, we use a new model.

IV. The Model of Aggregate Demand and Aggregate Supply

V. Why the Aggregate-Demand Curve Slopes Downward

 The aggregate-demand curve tells us the quantity of all goods and services
demanded in the economy at any given price level. As Figure illustrates, the
aggregate-demand curve is downward sloping. This means that, other things
equal, a decrease in the economy’s overall level of prices (from, say, P1to P2)
raises the quantity of goods and services demanded (from Y1to Y2).
Conversely, an increase in the price level reduces the quantity of goods and
services demanded.

 A fall in the price level from P1 to P2 increases the quantity of goods

and services demanded from Y1 to Y2. There are three reasons
for this negative relationship. As the price level falls, real wealth
rises, interest rates fall, and the exchange rate depreciates.
These effects stimulate spending on consumption, investment,
and net exports. Increased spending on any or all of these
components of output means a larger quantity of goods and services demanded
that an economy’s GDP (which we denote as Y) is the sum of its consumption (C),
investment (I), government purchases (G), and net exports (NX):
Y = C + I + G + NX
Each of these four components contributes to the aggregate demand for goods and
services. For now, we assume that government spending is fixed by policy.
The other three components of spending—consumption, investment, and net exports
—depend on economic conditions and, in particular, on the price level.
1.The Wealth Effect : A decrease in the price level raises the real value of money and
makes consumers wealthier, which in turn encourages them to spend more. The
increase in consumer spending means a larger quantity of goods and services
demanded. Conversely, an increase in the price level reduces the real value of money
and makes consumers poorer, which in turn reduces consumer spending and the
quantity of goods and services demanded
2. The Interest-Rate Effect:A lower price level reduces the interest rate, encourages
greater spending on investment goods, and thereby increases the quantity of goods and
services demanded. Conversely, a higher price level raises the interest rate,
discourages investment spending, and decreases the quantity of goods and services
demanded.
3.The Exchange-Rate Effect:When a fall in the U.S. price level causes U.S. interest
rates to fall, the real value of the dollar declines in foreign exchange markets. This
depreciation stimulates U.S. net exports and thereby increases the quantity of goods
and services demanded. Conversely, when the U.S. price level rises and causes U.S.
interest rates to rise, the real value of the dollar increases, and this appreciation
reduces U.S. net exports and the quantity of goods and services

VI. Why the Aggregate-Demand Curve Might Shift

.
1. Shifts Arising from Changes in Consumption: An event that makes consumers
spend more at a given price level (a tax cut, a stock-market boom) shifts the aggregate
demand curve to the right. An event that makes consumers spend less at a given price
level (a tax hike, a stock market decline) shifts the aggregate demand curve to the left.
2. Shifts Arising from Changes in Investment: An event that makes firms invest more
at a given price level (optimism about the future, a fall in interest rates due to an
increase in the money supply) shifts the aggregate demand curve to the right. An event
that makes firms invest less at a given price level (pessimism about the future, a rise in
interest rates due to a decrease in the money supply) shifts the aggregate-demand
curve to the left.
3. Shifts Arising from Changes in Government Purchases: An increase in
government purchases of goods and services (greater spending on defense or highway
construction) shifts the aggregate-demand curve to the right. A decrease in
government purchases on goods and services (a cutback in defense or highway
spending) shifts the aggregate-demand curve to the left.
4. Shifts Arising from Changes in Net Exports: An event that raises spending on net
exports at a given price level (a boom overseas, speculation that causes an exchange-
rate depreciation) shifts the aggregate-demand curve to the right. An event that
reduces spending on net exports at a given price level (a recession overseas,
speculation that causes an exchange-rate appreciation) shifts the aggregate-demand
curve to the left.

VII. The Aggregate-Supply (AS) Curves

The AS curve shows the total quantity of G&S firms produce and sell at any given
price level.
The slope of the AS curve depends on the time horizon:
In the short run, the aggregate supply curve is upward-sloping. (“SR” = “short run”).
In the long run, the aggregate supply curve is vertical.

VII. The Long-Run Aggregate-Supply Curve (LRAS)

The natural rate of output (YN) is the amount of output the economy produces when
unemployment is at its natural rate.
YN is also called potential output or full-employment output.
VIII. Why LRAS Is Vertical

YN is determined by the economy’s stocks of labor, capital, and natural resources, and
on the level of technology.
An increase in P does not affect any of these, so it does not affect YN.

IX. Why the LRAS Curve Might Shift

Any event that changes any of the determinants of YN will shift LRAS.
Example: Immigration increases L, causing YN to rise.

 Changes in L or natural rate of unemployment

 Changes in K or H
 Changing weather patterns that affect agricultural production
 Changes in technology
It might be worth mentioning that the change in weather patterns or reduction in
imported resources would have to be reasonably long-lasting for the LRAS curve to
shift. Short-lived changes are more likely to affect SRAS than LRAS.

X. Using AD & AS to Depict LR Growth and Inflation

Over the long run, tech. progress shifts LRAS to the right and growth in the money
supply shifts AD to the right.
Result: ongoing inflation and growth in output.

XI. Short Run Aggregate Supply (SRAS)

The SRAS curve is upward sloping: Over the period of 1-2 years,an increase in P
causes an increase in the quantity of g & s supplied.

XII. Why the Slope of SRAS Matters

If AS is vertical, fluctuations in AD do not cause fluctuations in output or

employment.
If AS slopes up,then shifts in AD do affect output and employment.
XIII. Three Theories of SRAS

In each, some type of market imperfection, Output deviates from its natural rate when
the actual price level deviates from the price level people expected.

1. The Sticky-Wage Theory

If P > PE, revenue is higher, but labor cost is not.
Production is more profitable, so firms increase output and employment.
Hence, higher P causes higher Y, so the SRAS curve slopes upward.

2. The Sticky-Price Theory

 Imperfection: Many prices are sticky in the short run.
 Due to menu costs, the costs of adjusting prices.
 Examples: cost of printing new menus, the time required to change price tags
 Firms set sticky prices in advance based on PE.
 Suppose the Fed increases the money supply unexpectedly. In the long run, P
will rise.
 In the short run, firms without menu costs can raise their prices immediately.
 Firms with menu costs wait to raise prices. Meantime, their prices are
relatively low, which increases demand for their products, so they increase
output and employment.
 Hence, higher P is associated with higher Y, so the SRAS curve slopes upward.

3. The Misperceptions Theory

Imperfection:
Firms may confuse changes in P with changes in the relative price of the products they
sell.
If P rises above PE, a firm sees its price rise before realizing all prices are rising.
The firm may believe its relative price is rising, and may increase output and
employment. So, an increase in P can cause an increase in Y, making the SRAS curve
upward-sloping.
In all 3 theories, Y deviates from YN when P deviates from PE.
Y = YN + a (P – PE)
Y: output
YN: Natural rate of output (long-run)
a > 0, measures how much Y responds to unexpected changes in P
P: actual price level
PE: expected price level

 In all 3 theories, Y deviates from YN when P deviates from PE

XIV. SRAS and LRAS

In the LR,
 PE = P
 AS curve is vertical
In the long run, PE = P and Y = YN.

XV. Why the SRAS Curve Might Shift

Everything that shifts LRAS shifts SRAS, too.
Also, PE shifts SRAS:
If PE rises, workers & firms set higher wages.
At each P, production is less profitable, Y falls, SRAS shifts left.

XVI. The Long-Run Equilibrium

In the long-run equilibrium, PE = P, Y = YN , and unemployment is at its natural rate.

XVII. Economic Fluctuations

Caused by events that shift the AD and/or AS curves.

Four steps to analyzing economic fluctuations:

1. Determine whether the event shifts AD or AS.
 2. Determine whether curve shifts left or right.
3. Use AD-AS diagram to see how the shift changes Y and P in the
short run.
4. Use AD-AS diagram to see how economy moves from new SR eq’m
to new LR eq’m
The Effects of a Shift in AD

Event: Stock market crash

1. Affects C, AD curve
2. C falls, so AD shifts left
3. SR eq’m at B.
P and Y lower, unemp higher
4. Over time, PE falls, SRAS shifts right,
until LR eq’m at C.
Y and unemp back at initial levels.

Two Big AD Shifts:

1. The Great Depression
From 1929-1933,
money supply fell 28% due to problems in banking system
stock prices fell 90%, reducing C and I
Y fell 27%
P fell 22%
u-rate rose
from 3% to 25%
2. The World War II Boom
From 1939-1944,govt outlays rose from $9.1 billion to $91.3 billion
Y rose 90%
P rose 20%
unemp fell from 17% to 1%

XVIII. The Effects of a Shift in SRAS

Event: Oil prices rise
1. Increases costs,
shifts SRAS
(assume LRAS constant)
2. SRAS shifts left
3. SR eq’m at point B.
P higher, Y lower, unemp higher
From A to B, stagflation, a period of
falling output and rising prices.
XIV. Accommodating an Adverse Shift in SRAS
If policymakers do nothing,
Low employment causes wages to fall, SRAS shifts right,
until LR eq’m at A.
Or, policymakers could use fiscal or monetary policy to increase AD and
accommodate the AS shift:
Y back to YN, but
P permanently higher.

CONCLUSION

This chapter has introduced the model of aggregate demand and aggregate supply,

which helps explain economic fluctuations.

Keep in mind: these fluctuations are deviations from the long-run trends explained by
the models we learned in previous chapters.

In the next chapter, we will learn how policymakers can affect aggregate demand

with fiscal and monetary policy.