Transcript Open-Economy Macroeconomics

Short-Run Economic
Fluctuations
Aggregate Demand
and Aggregate Supply
Outline
 What causes SR fluctuations in an
economy?
 Analysis of SR fluctuations around its LR
trend
 Model of aggregate demand and
aggregate supply
Properties of economic fluctuations
 Economic fluctuations are irregular
and unpredictable
 Most macroeconomic quantities
fluctuate together
 Unemployment rises with fall in output
Difference between SR and LR
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Classical economics examines the
determinants of real macroeconomic
variables in the LR without introducing
nominal variables.
Classical economics is based on two relate
ideas- classical dichotomy and monetary
neutrality.
In the SR, both real and nominal variables
are intertwined.
Changes in nominal variables explain SR
fluctuations around the LR trend.
Basic model of economic fluctuations
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Examines the relationship between real GDP
and the price level.
Model of aggregate demand and aggregate
supply explains the SR fluctuations in economic
activity around its LR trend.
Aggregate demand shows the quantity of
goods and services that households, firms, and
the government want to buy at each price
level.
Aggregate supply curve shows the quantity of
goods and services that firms choose to
produce and sell at each price level.
Why the aggregate demand slopes
downward?
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A fall in the price level results in the:
wealth effect, which stimulates demand for
consumption goods
interest rate effect which stimulates the
demand for investment goods
Real Exchange Rate (RER) effect, which
stimulates demand for Net exports (NX)
Remember that Money supply is constant
Why the aggregate demand curve
may shift?
 Aggregate demand curve shifts when the
demand for quantity of goods and services
changes at a given price level.
 Shifts may occur due to the following
factors:
 Shifts arising from consumption
 Shifts arising from investment
 Shifts arising from government purchases
 Shifts arising from NX
Aggregate Supply Curve: LR and SR
 In the LR aggregate supply is vertical.
 In the SR aggregate supply is downward
sloping.
Why the aggregate supply curve is vertical
in the LR?
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LR level of production is called as the natural level
output or full employment or potential output.
Real GDP, in the LR, is a function of factor inputs
and available technology.
Nominal variables (p level) has no impact on real
GDP in the LR.
Supply curves for specific goods slope upwards as
they depend on relative prices.
Economy’s supply of output is limited by factor
inputs and technology. Thus an increase in the
overall price does not alter the output supplied.
Why the LR aggregate supply curve
may shift?
 Any economic change that alters the
natural level of output shifts the aggregate
supply curve.
 Sources of shifts:
 Changes
 Changes
stock
 Changes
resources
 Changes
in labour supply
in capital (physical and human)
in the availability of natural
in technological knowledge
Relation between LR growth and
inflation
 In the LR, technological changes shift the LR
aggregate supply curve
 In the LR, growth in money supply shifts the
LR aggregate demand curve
 The intersection in aggregate demand and
aggregate supply curves shows the trend
growth in output and inflation
Why the aggregate supply curve
slopes upward in the SR?
 Specific market imperfections cause
deviation in the SR quantity of output from
its natural (LR) level, when the price level
deviates from its expected level.
 Theories explaining market imperfections:
 The misperceptions theory
 The sticky-wage theory
 The sticky-price theory
Why the SR aggregate supply curve
may shift?
 The misperceptions theory
 The sticky-wage theory
 The sticky-price theory
 People’s expectations of price level
Why the SR aggregate supply curve
may shift? (conclusion)
 An increase in the expected price level
reduces quantity of goods and services
supplied and shifts the SR aggregate supply
curve to the left.
 A decrease in the expected price level
increases quantity of goods and services
supplied and shifts the SR aggregate supply
curve to the right.
 In the SR, expectations are fixed
 In the LR, expectations adjust and SR
aggregate supply curve shifts.
Economic fluctuations: Shifts in
aggregate demand
 In the SR, shifts in aggregate demand cause
fluctuations in the economy’s output of
goods and services.
 In the LR, shifts in aggregate demand affect
the overall price level but do not affect
output.
 Policy makers can offset shifts in aggregate
demand through changes in government
exp or changes in money supply.
Economic fluctuations: Shifts in
aggregate supply
 Shifts in aggregate supply can cause
stagflation
 Policy makers can influence aggregate
demand in order to maintain output at its
natural level. But this leads to a permanent
increase in prices.
 Policy makers may chose not to intervene
and let the economy adjust itself. This
approach will see a low price level but
temporary rise in unemployment and fall in
output.