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Chap 20: Aggregate Demand and Aggregate Supply

Terms in this set (39)

3 key facts about economic fluctuations
1. Economic fluctuations are irregular and unpredictable --> follow the business cycle, but that is unpredictable
2. Most macroeconomic quantities fluctuate together --> when one goes up, most other variables follow. Declines are mostly attributable to reductions in investments
3. As output falls, unemployment rises
real GDP
- the measure of the value of all final G/S produced in a given period of time
- also measure total income of everyone in the economy
short term economic fluctuations
- real and nominal variables are highly intertwined
- changes in money supply can temporarily push real GDP away from its long run trend
Model of Aggregate Demand and Aggregate Supply
- focuses on behavior of 2 variables
1. economy's output of goods and services
2. average level of prices as measured by the CPI or GDP deflator

- model that most economists use to explain short run fluctuations in economic activity around its long-run trend
- price level and quant of output adjust to bring aggregate S/D into balance
aggregate demand curve
- shows the quant of G/S that households, firms, gov't, and customers abroad want to buy at each price level
- shifts come about when there is a change in spending
How price level affects the quant of G/S demanded for C, I, and NX
- wealth effect
- interest rate effect
- exchange rate effect
Price Level and Consumption: The Wealth Effect
- a decrease in the price level raises the real value of money and makes consumers wealthier, which in turn make them spend more.
- this increase in spending means a larger quant of G/S demanded

- increase in price level reduces real value ->making consumers poorer --> reduces quant of G/S demanded
Price Level and Investment: Interest rate effect
- as houses try to convert some of their money into interest bearing assets --> the interest rate goes down
- lower interest rate increase the quant of G/S demanded
- a lower price level reduces the interest rate --> encouraging spending on investment goods and increases quant of G/S demanded

- higher price level raises interest rate --> discourages investment spending --> decrease quant of G/S demanded
Price Level and Net Exports: Exchange rate effect
- fall in real exchange value of the dollar leads to an increase in the quant of G/S demanded by increasing US exports and decreasing US imports through the decrease of the relative price of the dollar

- when a fall in US price level cause US interest rates to fall, the real value of the dollar declines abroad.
- This depreciation stimulates US exports, increasing the quant of G/S demanded

- when the US price level rises --> real value of dollar increases --> appreciating dollar abroad and decreasing US exports --> decreases G/S demanded
real exchange rate
- relative price of domestic and foreign goods
how price level (falling/rising) affects quant of G/S demanded
1. consumers get (wealthier/poorer), which (stimulates/reduces) demand for consumption goods
2. Interest rates (fall/rise), which (stimulates/reduces) demand for investment goods
3. The currency (depreciates/appreciates), which (stimulates/reduces) demand for net exports
agg-dem Shifts arising from changes in Consumption
- any event that changes how much ppl want to consume at a price level shifts the agg-demand curve

- reducing current consumption --> agg demand shifts left bc quant G/S demanded is lower
- increasing consumption --> agg demand shifts right bc quant G/S demanded goes up

- Eg: tax cuts/raises shifts agg-dem left/right
agg-dem Shifts Arising from Changes in Investment
- New technology leads to more investment in company --> qG/Sd at any price level is higher, thus agg-dem curve shift right
- bad balance sheet leads to less investment in company --> qG/Sd at any price level is lower, thus agg-dem curve shifts left

- tax credit increases quant of investment goods that firms demand at any given interest rate --> shifts agg-dem curve right
- repeal of investment tax credit reduces investment and shifts agg-dem curve left

- increase in money supply lowers the interest rate in the short run --> makes borrowing less costly --> stimulates investment spending and shifts agg-dem curve to the right
- decrease in money supply raises interest rate --> discourages investment spending --> shifts curve agg-dem left
agg-dem Shifts arising from changes in Gov't Purchases
- Congress decides to buy less --> lowers qG/Sd --> shifts left
- Congress builds more public works --> raises qG/Sd --> shifts agg-dem right
agg-dem Shifts arising from changes in NX
- Europe experiences a recession and buys fewer goods from US --> reduces US NX at every price level --> shifts agg-dem curve right
- Europe experiences economic growth --> buys more goods ab US --> increases US NX at every price level --> shifts agg-dem right

- speculators move wealth into US economy --> Appreciation of the dollar makes US goods more expensive compared to foreign goods --> depresses NX --> shifts agg-dem left
- speculators move wealth out of US economy --> depreciation of dollar makes US goods less expensive --> increases NX --> shifts agg-dem right
aggregate supply curve
- shows the quant of G/S that firms choose to produce and sell at each price level
- in long run, agg-supp curve is vertical
- in short run, agh-supp curve slopes upward
- any change in the economy that alters the natural level of output shifts the long-run agg-supp curve
why is agg-supp curve vertical in long run?
- economy's production of G/S depends on its supplies of labor, capital, natural resources, and available tech used to utilize these fop into G/S
- amt of money does not affect tech or supplies of fop, so the output of G/S does not change
natural level of output
- shows what the economy produces when unemployment is at its natural or normal rate
-this is the rate of production toward which the economy gravitates in the long run
agg-supp shifts arising from changes in labor
- immigration/emigration boom --> more/less workers --> qG/S supplied would increase/decrease --> shifts long run agg-supp curve right/left

- Congress raises/lowers min. wage --> natural rate of unemployment would rise/fall --> economy would produce smaller/larger amt of goods ---> agg-supp shifts left/right
agg-supp shifts arising from changes in capital
- increase/decrease in economy's capital stock increases/decreases productivity --> gG/S supplied goes up/down --> shifts agg-supp curve right/left
- same logic applies regardless of what physical capital or human capital.
agg-supp shifts arising from changes in natural resources
- discovery of new natural resources shifts agg-supp right
- change in weather that hurts farmers shifts agg-supp left
- imports of NR (think oil) can also
affect agg-supp
agg-supp shifts arising from changes in technical knowledge
- new technology that makes tasks easier shift agg-supp right
- opening up to international trade allows for specialization --> shifts agg-supp right
- if gov't prevents from using new production methods --> agg-supp shifts left
two most impt factors in shifts agg-dem/supp curves in long run
- technology
- monetary policy

- better tech shifts agg-supp right and Fed increasing money supply shifts agg-dem curve right
- result is continuing growth in output

- short-run fluctuations in output and price level should be viewed as deviations from the long-run trends of output growth/inflation
short agg-supp effects
- increase/decrease in overall level of prices in economy raises/lowers qG/S supplied
why do changes in the price level affect output in the short run?
- the quant of output supplied deviates from its long-run/natural level when actual price level in the economy deviates from the price level that people expected to prevail

Theories:
- sticky-wage theory
- sticky-price theory
- misperceptions theory
sticky wage theory
- short run agg-supp slopes upward bc nominal wages are slow to adjust to changing economic conditions bc they are based on expected prices
- slow adjustment is attributable to long-term contracts btw workers and firms that fix nominal wages
- prolonged adjustment may also be attributable to slowly changing social norms/notions of fairness that influence wage setting

- if price level is lower than expected, firm gets less than they expected for each unit of product sold, but cost of labor stays at the contract level. production now becomes less profitable so the firm hires fewer workers/reduces quant of output supplied.
- employment/production will remain below their long-run levels until contracts are re-negotiated

- if price level is higher than expected, firm gets more than expected for each unit of product sold. The firm hires more workers and increases quant of output supplied.
- employment/production will remain above their long-run levels until contract re-negotiation
sticky price theory
- the prices of some goods and services adjust sluggishly in response to changing economic conditions
- slow change bc there are costs of adjusting to new prices --> menu costs
- during the time that lagging firms are operating with outdated prices, there is a positive association btw overall price level and the quant of output

- firm announces prices over the coming year, but economy experiences unexpected contraction --> reduces overall price level in the long run
- some firms may change prices immediately, but some, not willing to pay the menu costs, temporarily lag behind in reducing their prices.
- the lagging firms have too high prices --> sales decline --> leads to cut backs on production/employment

- when money supply/price level are higher than what firms expected, some firms immediately raise prices, but others lag behind keeping prices at lower than desired levels
- low prices attracts customers --> induces firm to increase employment/production
misperceptions theory
- changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output


- lower price level causes misperceptions about relative prices --> induce suppliers to respond to lower price level by decreasing the quant of G/S supp.
- suppose overall price level falls below expectation:
- suppliers see price of their products fall and they may wrongly believe that their prices have fallen compared to other prices in the economy
- as a result, the suppliers believe the price of their product is temporarily low and will reduce the quant of product they supply
- workers may notice fall in nominal wages before the prices of goods they buy fall --> they may infer that the reward for working is temporarily low and respond by reducing the quant of labor they supply

- if price level is above what was expected, suppliers of G/S may see the price of their output go up and mistakenly infer that it is a good time to increase production --> increasing qG/S supplied
quantity of output supplied
quant of output supplied = (natural level of output) + a(actual price level - expected price level)
- a = # that determines how much output responds to unexpected changes in the price level
What shifts the short-term agg-supp curve?
- changes in labor, capital, natural resources, tech knowledge. These affect short-run agg-supp same as long-run agg-supp
- expectations may be different from the actual price level --> quant of G/S supplied depends in the short run on sticky wages, prices, and misperceptions

- an increase in the expected price level reduces the qG/S supplied and shifts the short run agg-supp to the left
- a decrease in the expected price level raises the qG/S supplied and shifts short run agg-supp to the right

- short run agg-supp shifts left when price level is above expectation: firms lose money through increased costs --> reduce output
- short run agg-supp shifts right when price level is below expectation: firms gain money through decreased costs --> increase output
two cause of economic fluctuations
- shifts in agg-dem
- shifts in agg-supply

- when an economy is in its long-run equilibrium, the expected price level must equal the actual price level so that the intersection of the agg-dem with short-run agg-supply is the same as the intersection of agg-dem with long-run agg-supply
Four Steps for Analyzing Macro-Economic Fluctuations
1. decide whether the event shifts agg-supp or agg-dem
2. decide the direction in which the curve shifts
3. use the diagram of agg-dem and agg-supp to determine the impact on output and price level in the short run
4. use the diagram of agg-dem and agg-supp to analyze how the economy moves from its new short-run equilibrium to its long-run equilibrium
effect of pessimistic outlook on economy
- pessimism cauesd the shift in agg-dem
- pessimism about the future leads to falling incomes and rising unemployment
- price level falls to offset the reduction in agg-dem
- in the long run --> shift in agg-dem is reflected fully in the price level and not at all in the level of output
long run effect of a shift in agg-dem
- long run effect of a shift in agg-dem is a nominal change (price level is lower), but not a real change (output is the same)
shifts in agg-dem summary
- in short-run, shifts in agg-dem cause fluctuations in the economy's output of G/S
- in long run, shifts in agg-dem affect the overall price level, but not output
- bc policymakers influence agg-dem, they can potentially mitigate the severity of economic fluctuations
effect of sudden increase in cost of production on agg-supply
- shift in agg-supply to the left bc of higher production costs leading to smaller quant supplied
- leads to stagflation pushing the curve farther left until the wage-spiral slows
- low output and employment puts pressure on the workers wages because they have bargaining power --> as wages fall, producing G/S is more profitable and agg-supply curve shifts right
stagflation
- a period of falling output and rising prices
- may sometimes lead to wage-price spiral
accommodative policy
- accepts a permanently higher level of prices to maintain a higher level of output and employment
lessons about shifts in agg-supply
1. shifts in agg-supply can cause stagflation
2. policy makers who can influence agg-dem can potentially mitigate the adverse impact on output, but only at the cost of exacerbating the problem of inflation
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