Transcript Chapter19

Chapter 19
Aggregate Demand and Aggregate Supply
• Three key facts about economic fluctuations
• Explaining Short-Run Economic
Fluctuations
• The Aggregate-Demand Curve
• The Aggregate-Supply Curve
• Two causes of economic fluctuations
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• Economic activity fluctuates from year to year. In some
years, the production of goods and services rises. In other
years normal growth does not occur, leading to recession.
• A recession is a situation of declining real GDP, falling
incomes and rising unemployment for two consecutive
quarters.
• Depression: a severe recession
Three Key Facts About Economic Fluctuations
Economic Fluctuations are Irregular and Unpredictable.
– Recessions occur with unpredictable frequency and
duration.
– See Figure 19-1
– Recessions defined here as two or more consecutive
quarters of negative real GDP growth, are shown as the
shaded areas.
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 Most Macroeconomic Variables Fluctuate Together.
Most macroeconomic variables are closely related and
move together.
As Output Falls, Unemployment Rises.
– Changes in real GDP and the unemployment rate are
inversely related.
–
Explaining short-run economic fluctuations
• Model of Aggregate Demand and Aggregate Supply: the
model hat most economists use to explain short-run
fluctuations in economic activity around its long-run trend.
• The Aggregate Demand Curve shows the quantity of goods
and services that households, firms and the government are
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willing to buy at different prices.
• The Aggregate Supply Curve shows the quantity of goods
and services that firms would be willing to produce and sell
at different prices.
• Two variables are used in developing AD-AS model to
analyze the short-run fluctuations:
1. The economy’s output of goods and services, measured
by real GDP
2. The overall price level, measured by the CPI or GDP
Deflator
• See figure 19-2
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The Aggregate Demand Curve
• The aggregate demand for goods and services may be
referred to as:Y = C + I + G + NX
• See figure 19-3 AD curve
• Why is the aggregate demand curve downward sloping?
1. Pigou’s Wealth Effect
2. Keynes’ Interest Rate Effect
3. Real Exchange Rate Effect
•
•
•
Pigou’s Wealth Effect: “Consumers feel wealthier, which
stimulates the demand for consumption goods.”
A decrease in the price level makes consumers feel more
wealthy, which in turn encourages them to spend more.
The increase in consumer spending means a larger
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quantity of goods and services demanded.
• Keynes’ Interest-Rate Effect: “The lower the price level, the
less money households need to hold to buy the goods and
services they want.”
• A lower price level reduces the interest rate, encourages
greater spending on investment goods, and thereby
increases the quantity of goods and services demanded.
• Real Exchange-Rate Effect: “When prices of Canadian
goods go down, foreigners buy more of our goods and we
purchase less of their goods.”
• When a fall in the Canadian price level causes the real
exchange rate to depreciate, this stimulates Canadian net
exports, thereby increasing the quantity of goods and
services demanded.
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• Why the AD curve might shift
• The downward slope of the AD 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 a give price level. When one of
these other factors changes, the AD curve shift.
• Shifts in the aggregate demand curve may arise because of:
1. Changes in spending plans by consumers or firms.
2. Changes in fiscal or monetary policy.
• “Anything that causes buyers to want to purchase more or
less than before will cause the aggregate demand schedule
to shift.”
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• See Table 19-1
The Aggregate Supply Curve
Why the AS curve is vertical in the long run
• The Long-Run Aggregate Supply Curve is vertical at fullemployment GDP with respect to the price level.
• In the long-run the quantity of output supplied depends on
the economy’s resource endowment, technology, and its
governing institutions. The price level does not affect these
variables in the long-run.
• See Figure 19-4
Why the long-run AS curve might shift
• Over time, any change in the factors that determine the
long-run aggregate supply will cause the curve to shift.
• Because output in the classical model depends on labour,
capital, natural resources and technological knowledge, we
can categorize shifts in the long-run AS as changes from
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these sources.
–
–
An event that reduces potential output shifts the schedule
to the left.
Any change that increases the economy’s potential output
will shift the curve to the right.
A new way to depict long-run growth and inflation
• See Figure 19-5 Long Run growth and inflation in the
model of AD-AS
• The LRAS may shift to the right because of technological
progress.
• At the same time, as the Bank of Canada increases the
money supply, the AD curve also shifts to the right. So price
level rises and output grows.
• Thus, AD-AS model provide a new way to depict long-run
growth and inflation.
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Why the aggregate-supply curve slopes upward in the shortrun
• See Figure 19-6
• 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, and a decrease in the level of prices tends
to reduce the quantity of goods and services supplied.
• There are three alternative explanations for the upward
slope of the short-run aggregate supply curve.
– New Classical Misperceptions Theory
– The Keynesian Sticky-Wage Theory
– The New Keynesian Sticky-Price Theory
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• The New Classical Misperceptions Theory: “A higher price
level signals to each firm a greater demand for their product
inducing them to produce more.”
– Changes in the overall price level can temporarily
mislead suppliers about what is happening in the markets
in which they sell their output.
• The Keynesian Sticky-Wage Theory: “The higher product
prices cause a temporary decrease in real wages stimulating
employment and output.”
– Nominal wages are slow to adjust, or are “sticky” in the
short-run, thus a lower price level makes employment
and production less profitable, which induces firms to
reduce production.
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• The New Keynesian Sticky-Price Theory: “Prices that do
not increase immediately are temporarily low thereby
stimulating spending and output on those goods.”
– Prices of some goods and services adjust sluggishly in
response to changing economic conditions.
– Remember Menu Costs.
Why the short-run AS curve might shift
• Three factors may lead to a shift in the short-run aggregate
supply curve.
– Changes in Factor (input) Prices
– Changes in Productivity
– Legal-Institutional Environment
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• Changes in factor (input) prices: Changes in the prices of
domestic or imported resources will change the cost of
producing final goods.
– An increase in input prices will shift the supply curve to
the left.
– A decrease in input prices will shift the supply curve to
the right.
• Changes in productivity: If changes in the resource markets
increase factor productivity, more goods can be made
available at a lower cost. New technologies can increase the
output per unit of labour or capital and hence make
available more final goods.
• Legal-institutional environment: Burdensome taxes and
counterproductive regulations can increase the cost of
production and discourage firms from producing.
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• See Table 19-2
Two Causes of Economic Fluctuations
The long-run equilibrium: See Figure 19-7
• Equilibrium output and price level are determined by the
intersection of the aggregate demand curve and the long-run
aggregate supply curve.
• Output is at its natural rate and the short-run aggregate
supply curve passes through the point of intersection.
• Two sources from which a recession in the economy may
occur:
– A decrease in aggregate demand
– A decrease in aggregate supply
• Shifts in the aggregate demand or the aggregate supply
curves result in fluctuations in the economy’s output of
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goods and services.
• Source of Recession: A Decrease in Aggregate Demand
• A decrease in one or more components of the total spending
function will cause the aggregate demand schedule to shift
leftward.
– Output will fall below the full employment output
– Unemployment will rise
– See Figure 19-8 Point A and Point B
• Although not shown in the figure, firms respond to lower
sales and production by reducing employment.
• Thus, the pessimism that caused the shift in AD is to some
extent, self-fulfilling: Pessimism about the future leads to
falling incomes and rising unemployment.
• Increase in G or an increase of money supply would
increase the quantity of goods and services demanded at any
price and therefore, would shift the AD curve back to the
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right.
• Even without action by policymakers, the recession will
remedy itself over a period of time. Because of the
reduction in AD, the price level falls. Eventually,
expectations catch up with this new reality, and the expected
price level falls as well. Because the fall in the expected
price level alters perceptions, wages, and prices, it shifts the
SRAS to the right from AS1 to AS2.
• This adjustment of expectations allows the economy over
time to approach point C in figure 19-8.
• In the new long run equilibrium, point C, output is back to
its natural level.
• Thus, the long-run effect of a shift in AD is a nominal
change ( the price level is lower) but not a real change
(output is the same).
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• See Figure 19-9 Big shifts in AD in Canada
• Source of Recession: A Decrease in Aggregate Supply
• A decrease in short-run aggregate supply will result in a
new equilibrium along the aggregate demand curve below
full employment.
• A fall in total output below full output
– An increase in unemployment
– See Figure 19-10 Point A to Point B
• When the economy falls due to a decrease in the aggregate
supply, the price level rises and output decreases. This is
called Stagflation.
• Alternatively, policymakers who control monetary and
fiscal policy might attempt to offset some of the effects of
the shift in the SRAS curve by shifting the AD curve. See
Figure 19-11. In this case, policymakers are said to
accommodate the shift in AS because they allow the
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increase in costs to affect the level of prices permanently.
Actions by Policy-makers During Periods of Recession
• Policy-makers, when faced by decreasing aggregate demand
or supply could:
– Do nothing, assuming that perceptions will adjust prices
and wages. Example: Figure 19-8
– Take action to increase aggregate demand (implement
monetary and fiscal policy). Example: Figure 19-11
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