Transcript Demand shocks - McGraw-Hill

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Expectations: The anticipations of
consumers, firms, and others about future
economic conditions.
Expectations have a large effect on economic
growth
Expectations can become unmet due to
shocks
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Shocks: Situations in which one thing is expected to
occur but in reality something different occurs.
Two types of shocks: demand shocks and supply
shocks.
Demand shocks: Sudden, unexpected changes in
demand.
Supply shocks: Sudden, unexpected changes in
aggregate supply
Economists believe that most short-run
fluctuations are the result of demand shocks
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Price
Flexible Prices
$40,000
$37,000
$35,000
DM
DH
DL
900
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Price
Fixed Prices
$37,000
DH
DL
700
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DM
Cars per week
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If the prices of goods and services could
always adjust quickly to unexpected changes
in demand, then the economy could always
produce at its optimal capacity since prices
would adjust to ensure that the quantity
demanded of each good and service would
always equal the quantity supplied.
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In reality, many prices in the economy are inflexible and do
not change rapidly when demand changes unexpectedly.
 Manufacturing firms typically attempt to deal with
unexpected changes in demand by maintaining an inventory
 Inventory : Goods that have been produced but remain
unsold.
 If demand falls for many goods and services across the entire
economy for an extended period of time, then many firms
will find inventories piling up and will be forced to cut
production resulting in recession, with GDP falling and
unemployment rising.
 If, however, demand is unexpectedly high for a prolonged
period of time, the economy will boom and unemployment
will fall.
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Inflexible prices (sticky prices): Product
prices that remain in place (at least for a
while) even though supply or demand has
changed.
Flexible prices: Product prices that react
within seconds to changes in supply and
demand.
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Item
Months
Coin-operated laundry machines
46.4
Newspapers
29.9
Haircuts
25.5
Taxi fare
19.7
Veterinary services
14.9
Magazines
11.2
Computer software
5.5
Beer
4.3
Microwaves ovens
3.0
Milk
2.4
Electricity
1.8
Airline tickets
1.0
Gasoline
0.6
Source: Mark Bils and Peter J. Klenow, “Some Evidence on the Importance of Sticky Prices”, Journal of Political Economy,
October 2004, pp 947-985, Used with permission of The University of Chicago Press.
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Companies selling final goods and services know
that consumers prefer stable, predictable prices
that do not fluctuate rapidly with changes in
demand.
 In certain situations a firm may be afraid that
cutting its price may be counterproductive because
its rivals might simply match the price cut - a
situation often referred to as a price war.
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Price stickiness moderates over time.
If unexpected changes in demand begin to look
permanent, many firms will allow their prices to
change so that price changes (in addition to
quantity changes) can help to equalize quantities
supplied with quantities demanded.
 Prices go from stuck in the extreme short run to
fully flexible in the long run.
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