31- Agg Demand and Agg Supply

Short Run Economic Fluctuations: 

Short Run Economic Fluctuations Aggregate Demand and Aggregate Supply

Short Run Economic Fluctuations: 

Short Run Economic Fluctuations Economic activity fluctuates from year to year - In most of the normal years production of goods and services increase, but not at the same rate. - Some time the production level actually fall.

Short Run Economic Fluctuations: 

Short Run Economic Fluctuations Economic fluctuations are also called Business Cycles Business Cycles comprises of the period of economic prosperity and economic recession. A recession is a period of declining real incomes, and rising unemployment. A depression is a severe recession.

Three Key Facts About Economic Fluctuations: 

Three Key Facts About Economic Fluctuations FACT 1 : Economic fluctuations are irregular and unpredictable Though economic fluctuations are called Business Cycles, unlike cycles they are difficult to predict accurately. Sometimes two cycle are very close and sometimes there is a long gap between the two.

A Look At Short-Run Economic Fluctuations: Real GDP : 

A Look At Short-Run Economic Fluctuations: Real GDP Billions of 1996 Dollars Real GDP $10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1965 1970 1975 1980 1985 1990 1995 2000 Copyright © 2004 South-Western

A Look At Short-Run Economic Fluctuations: Investment Spending: 

A Look At Short-Run Economic Fluctuations: Investment Spending Billions of 1996 Dollars $1,800 1,600 1,400 1,200 1,000 800 600 400 200 1965 1970 1975 1980 1985 1990 1995 2000 Investment spending Copyright © 2004 South-Western

Three Key Facts About Economic Fluctuations: 

Three Key Facts About Economic Fluctuations FACT 2: Most Macro economic quantities fluctuate together. When real GDP falls in recession, so do personal income, corporate profits, consumer spending, investment spending, industrial production, retail sales and so on. Although many macroeconomic variables fluctuate together, they fluctuate by different amounts.

Three Key Facts About Economic Fluctuations: 

Three Key Facts About Economic Fluctuations FACT 3: As output falls, unemployment rises. The level of output produced in an economy is strongly correlated with use of labour force in the economy. During recession, unemployment rises. When recession ends and real GDP starts to expand, the unemployment rate gradually declines. The unemployment rate never approaches zero.

A Look At Short-Run Economic Fluctuations: Unemployment Rate: 

A Look At Short-Run Economic Fluctuations: Unemployment Rate Percent of Labor Force 0 2 4 6 8 10 12 1965 1970 1975 1980 1985 1990 1995 2000 Unemployment rate Copyright © 2004 South-Western

Explaining Short-Run Economic Fluctuations: 

Explaining Short-Run Economic Fluctuations How the Short Run Differs from the Long Run Classical Dichotomy explains that changes in the money supply affect nominal variables but not real variables in the long run. The assumption of monetary neutrality is not appropriate when studying year-to-year changes in the economy Most economists believe that classical theory describes the world in the long run but not in the short run.

Basic Model of Economic Fluctuations : 

Basic Model of Economic Fluctuations Two variables are used to develop a model to analyze the short-run fluctuations. Real Variables. Nominal Variables . In short run assumption of classical dichotomy and monetary neutrality does not work Monetary changes do bring in short run shocks in the economy Relationship between these two variables highlight the breakdown of the classical dichotomy

The Basic Model of Aggregate Demand and Aggregate Supply : 

The Basic Model of Aggregate Demand and Aggregate Supply Economist use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend. The model is based on the behavior of two important variables: GDP (Real Factors) CPI ( Nominal Factors) The price level and the quantity of output adjust to bring aggregate demand and aggregate supply into balance.

The Basic Model of Aggregate Demand and Aggregate Supply : 

The Basic Model of Aggregate Demand and Aggregate Supply The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level. The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level

Aggregate Demand and Aggregate Supply...: 

Aggregate Demand and Aggregate Supply... Quantity of Output Price Level 0 Aggregate supply Aggregate demand Equilibrium output Equilibrium price level

Macro vs. Micro Model: 

Macro vs. Micro Model Micro economic model of demand and supply explains the substitution of product by consumers as well as producers. Such substitution is not possible at the macro level. Macro economic factor are interlinked.

Aggregate Demand Curve: 

Aggregate Demand Curve Aggregate Demand Curve tells us the quantity of all goods and services demanded in the economy at any given price level. The four components of GDP ( Y ) contribute to the aggregate demand for goods and services. Y = C + I + G + NX

PowerPoint Presentation: 

The Aggregate-Demand Curve... Quantity of Output Price Level 0 Aggregate demand P Y Y 2 P 2 1. A decrease in the price level . . . 2. . . . increases the quantity of goods and services demanded.

Why the Aggregate Demand Curve Slopes Downward?: 

Why the Aggregate Demand Curve Slopes Downward? The Price Level and Consumption: The Wealth Effect The Price Level and Investment: The Interest Rate Effect The Price Level and Net Exports: The Exchange-Rate Effect Assuming government expenditure is constant by policy

Why the Aggregate Demand Curve Slopes Downward?: 

Why the Aggregate Demand Curve Slopes Downward? The Wealth Effect: A change in the price level affects the real value of the money. A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more. This increase in consumer spending means larger quantities of goods and services demanded

Why the Aggregate Demand Curve Slopes Downward?: 

Why the Aggregate Demand Curve Slopes Downward? The Interest Rate Effect Lower price level means the household need less money to buy goods and services. Household try to reduce their holding of money by lending some money, which will drive down the interest rate. A lower interest rate encourages greater spending on investment goods. This increase in investment spending means a larger quantity of goods and services demanded.

Why the Aggregate Demand Curve Slopes Downward?: 

Why the Aggregate Demand Curve Slopes Downward? The Exchange-Rate Effect When a fall in the Indian price level causes Indian interest rates to fall, Indian investors will seek higher return by investing abroad. The real exchange rate depreciates, because demand for foreign capital goods will increase. It stimulates Indian net exports, as imports are expensive The increase in net export spending means a larger quantity of goods and services demanded.

Why the Aggregate Demand Curve Might Shift?: 

Why the Aggregate Demand Curve Might Shift? Many other factors, other than price level , affect the quantity of goods and services demanded at any given price level. When one of these other factors changes, the aggregate demand curve shifts.

Why the Aggregate Demand Curve Might Shift?: 

Why the Aggregate Demand Curve Might Shift? Other factors causing shift in the Aggregate Demand Curve Change in Consumption pattern Preference for Savings Tax Policy Investment Investment Pattern due to changed technology or future expectations Investment Tax Policy Money supply Government Purchases Net Exports

Shifts in the Aggregate Demand Curve: 

Shifts in the Aggregate Demand Curve Quantity of Output Price Level 0 Aggregate demand, D 1 P 1 Y 1 D 2 Y 2 P

Aggregate Supply Curve : 

Aggregate Supply Curve The aggregate supply curve tells us the total quantity of goods and services that firms produce and sell at any given price level.

Aggregate Supply Curve: 

Aggregate Supply Curve Aggregate supply curve shows a relationship that depends crucially on time horizon being examined In the long run , the aggregate-supply curve is vertical . Because Price level does not affect long run determinants of GDP In the short run , the aggregate-supply curve is upward sloping

Aggregate Supply Curve: 

Aggregate Supply Curve The Long-Run Aggregate-Supply Curve In the long run, an economy’s production of goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services. The price level does not affect these variables in the long run, hence the aggregate supply curve is vertical. (classical dichotomy and monetary neutrality)

Aggregate Supply Curve: 

Aggregate Supply Curve The Long-Run Aggregate-Supply Curve The long-run aggregate-supply curve is vertical at the natural rate of output. This level of production is also referred to as potential output or full-employment output .

The Long-Run Aggregate-Supply Curve: 

The Long-Run Aggregate-Supply Curve The Long-Run Aggregate-Supply Curve Quantity of Output Natural rate of output Price Level 0 Long-run aggregate supply P 2 1. A change in the price level . . . 2. . . . does not affect the quantity of goods and services supplied in the long run. P Copyright © 2004 South-Western

Why the Long-Run Supply Curve Might Shift?: 

Why the Long-Run Supply Curve Might Shift? Economy gravitates towards the natural rate of output Any change in the economy that alters the natural rate of output shifts the supply curve. The shifts may be categorized according to the various factors in the classical model that affect output.

Why the Long-Run Supply Curve Might Shift?: 

Why the Long-Run Supply Curve Might Shift? Shifts arising Labour Capital Natural Resources Technological Knowledge

Why the Long-Run Supply Curve Might Shift?: 

Why the Long-Run Supply Curve Might Shift? LABOUR: In-Immigration from abroad would cause more workers, hence increased quantity of goods and services. Any change in the natural rate of unemployment shifts the long-run aggregate-supply curve.

Why the Long-Run Supply Curve Might Shift?: 

Why the Long-Run Supply Curve Might Shift? CAPITAL An increase in the economy’s capital stock increases productivity and increase the supply, therefore the supply curve shifts rightward. The same logic applies for the physical capital as well as for the human capital

Why the Long-Run Supply Curve Might Shift?: 

Why the Long-Run Supply Curve Might Shift? NATURAL RESOURCES: An economy’s production depends on its natural resources including land, minerals and weather. A discovery of new mineral deposit shifts the long-run aggregate supply curve to the right. Change in the weather cycle affects the production.

Why the Long-Run Supply Curve Might Shift?: 

Why the Long-Run Supply Curve Might Shift? TECHNOLOGICAL KNOWLEDGE Technological invention is the most important factors causing increase in the production level Opening up of the trade has helped to transfer technology from one country to other.

Long-Run Growth and Inflation: 

Long-Run Growth and Inflation Long-Run Growth and Inflation Quantity of Output Y 1980 AD 1980 AD 1990 Aggregate Demand, AD 2000 Price Level 0 Long-run aggregate supply, LRAS 1980 Y 1990 LRAS 1990 Y 2000 LRAS 2000 P 1980 1. In the long run, technological progress shifts long-run aggregate supply . . . 4. . . . and ongoing inflation. 3. . . . leading to growth in output . . . P 1990 P 2000 2. . . . and growth in the money supply shifts aggregate demand . . . Copyright © 2004 South-Western

Long Run Growth and Inflation: 

Long Run Growth and Inflation Long run growth of the economy and inflation depend on Shifts in the aggregate demand and aggregate supply, as explained by the classical theory. Two most important factors causing long run changes are Technology and Monetary Policy .

A New Way To Depict Long Run Growth And Inflation: 

A New Way To Depict Long Run Growth And Inflation The model of aggregate demand and aggregate supply provides a frame work for short run analysis. Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends.

Why the Aggregate Supply Curve Slopes Upward in the Short Run: 

Why the Aggregate Supply Curve Slopes Upward in the Short Run In contrast to the long-run vertical aggregate supply curve, the short-run supply curve is upward rising. 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. A decrease in the level of prices tends to reduce the quantity of goods and services supplied.

Why the Aggregate Supply Curve Slopes Upward in the Short Run: 

Why the Aggregate Supply Curve Slopes Upward in the Short Run The quantity of output supplied deviates from its long-run, or ‘Natural’, level when the price level deviates from the expected price level. When the price level rises above the expected level, output rises above its natural rate. When the price level falls below the expected level, output falls below its natural rate.

PowerPoint Presentation: 

The Short-Run Aggregate-Supply Curve Quantity of Output Price Level 0 Short-run aggregate supply 1. A decrease in the price level . . . 2. . . . reduces the quantity of goods and services supplied in the short run. Y P Y 2 P 2

Why the Aggregate Supply Curve Slopes Upward in the Short Run: 

Why the Aggregate Supply Curve Slopes Upward in the Short Run There are three theories that explain the upward slope of the short run aggregate supply curve. The Sticky-Wage Theory The Misperceptions Theory The Sticky-Price Theory The theories highlight different market imperfections responsible for the supply curve to deviate from its long run trend.

The Sticky-Wage Theory : 

The Sticky-Wage Theory Nominal wages are slow to adjust, or are “sticky” in the short run: Slow adjustment in wages are attributed to Long term wage contract between the firm and the labour. Notion of ‘fairness’ Social norms. A higher price level makes employment and production more profitable. This induces firms to increase the quantity of goods and services supplied.

The Sticky-Price Theory : 

The Sticky-Price Theory Prices of some goods and services adjust sluggishly in response to changing economic conditions: (to avoid high menu cost) An unexpected rise in the price level leaves some firms with lower-than-expected prices. This increase sales, which induces firms to increase the quantity of goods and services they produce.

The Misperceptions Theory : 

The Misperceptions Theory Changes in the overall price level temporarily mislead suppliers about what is happening in the markets in which they sell their output: - As a result of these short-run misperceptions, suppliers respond to changes in the level of prices and response leads to an upward-sloping aggregate-supply curve. - For Example A lower price level causes misperception about the relative prices which induce suppliers to decrease the quantity of goods and services supplied.

Why the Short-Run Aggregate Supply Curve Might Shift: 

Why the Short-Run Aggregate Supply Curve Might Shift Short-Run aggregate-supply curve is like long-run supply curve but made upward sloping because of misperceptions. So, the factors responsible for the shift in the long-run supply curve can be considered even for the short-run supply curve that are Labor Capital Natural Resources. Technology Expected Price Level – (the new variable)

Why the Short-Run Aggregate Supply Curve Might Shift: 

Why the Short-Run Aggregate Supply Curve Might Shift An increase in the expected price level reduces the quantity of goods and services supplied and shifts the short-run aggregate supply curve to the left. (Higher Cost effect) A decrease in the expected price level raises the quantity of goods and services supplied and shifts the short-run aggregate supply curve to the right. (Lower cost Effect)

PowerPoint Presentation: 

The Long-Run Equilibrium Natural rate of output Quantity of Output Price Level 0 Short-run aggregate supply Long-run aggregate supply Aggregate demand A Equilibrium price

PowerPoint Presentation: 

A Contraction in Aggregate Demand Quantity of Output Price Level 0 Short-run aggregate supply, AS Long-run aggregate supply Aggregate demand, AD A P Y AD 2 AS 2 1. A decrease in aggregate demand . . . 2. . . . causes output to fall in the short run . . . 3. . . . but over time, the short-run aggregate-supply curve shifts . . . 4. . . . and output returns to its natural rate. C P 3 B P 2 Y 2

Effects of A Shifts in Aggregate Demand : 

Effects of A Shifts in Aggregate Demand In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services. In the long run, shifts in aggregate demand affect the overall price level but do not affect output.

Effects of A Shifts in Aggregate Supply: 

Effects of A Shifts in Aggregate Supply An Adverse Shift in Aggregate Supply A decrease in one of the determinants of aggregate supply shifts the curve to the left: Output falls below the natural rate of employment. Unemployment rises. The price level rises.

PowerPoint Presentation: 

An Adverse Shift in Aggregate Supply Quantity of Output Price Level 0 Aggregate demand 3. . . . and the price level to rise. 2. . . . causes output to fall . . . 1. An adverse shift in the short- run aggregate-supply curve . . . Short-run aggregate supply, AS Long-run aggregate supply Y A P AS 2 B Y 2 P 2 Copyright © 2004 South-Western

Stagflation: 

Stagflation Adverse shifts in aggregate supply cause stagflation —a period of recession and inflation. Output falls and prices rise. Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

Policy Responses to Recession: 

Policy Responses to Recession Policymakers may respond to a recession in one of the following ways: Do nothing and wait for prices and wages to adjust. Take action to increase aggregate demand by using monetary and fiscal policy.

PowerPoint Presentation: 

Accommodating an Adverse Shift in Aggregate Supply Quantity of Output Natural rate of output Price Level 0 Short-run aggregate supply, AS Long-run aggregate supply Aggregate demand, AD P 2 A P AS 2 3. . . . which causes the price level to rise further . . . 4. . . . but keeps output at its natural rate. 2. . . . policymakers can accommodate the shift by expanding aggregate demand . . . 1. When short-run aggregate supply falls . . . AD 2 C P 3 Copyright © 2004 South-Western