Ch 10. Analyze the impact of unanticipated changes in aggregate demand and short run aggregate supply Evaluate the economy’s self-correcting mechanism.

Dynamic Change, Economic Fluctuations in the

AS-AD ModelCh 10

Analyze the impact of unanticipated changes in aggregate demand and short run aggregate supply

Evaluate the economy’s self-correcting mechanism

Chapter 10 Objectives

Anticipated change – foreseen in time to make adjustments

Unanticipated change – not foreseen, appropriate adjustments were not made

Anticipated/Unanticipated Change

Aggregate Demand

Price Level

P2

AD

P1

Y1Y2

A change in the price level represents a movement along the curve

Output

Aggregate Demand

Price Level

AD0

Changes in things besides the price level shift the curve and (AD1) increase or (AD2) decrease aggregate demand

Output

AD1

AD2

1. Increases in real wealth shift AD right◦ a. Stock market◦ b. Housing prices

◦ Example: The 1990s “new economy”

Aggregate Demand Shifters

2. When the interest rate falls, AD shifts right because borrowing (for consumption and investment) becomes cheaper

Aggregate Demand Shifters

3. When people are optimistic about the future, AD shifts right◦ Consumer sentiment index◦ “Animal Spirits” – Keynes◦ “Irrational Exuberance” – Greenspan

Aggregate Demand Shifters

4. When expected inflation is high, AD shifts right◦ Less incentive to save, spend now

5. If other countries’ incomes are rising, AD shifts right◦ Demand for U.S. exports increases as other

countries prosper◦ The larger the trade sector, the bigger the shift

Aggregate Demand

6. When the dollar depreciates, AD shifts right◦ Imports become more expensive◦ Exports become cheaper◦ So, NX will rise

Aggregate Demand Shifters

AD Shifters SummaryIncrease in AD (shift right) Decrease in AD (shift left)

↑ in real wealth, stock mkt, housing prices

↓ in real wealth, stock mkt, housing prices

↓ in real interest rate ↑ in real interest rate

Optimism about the future Pessimism about the future

↑ in expected inflation ↓ expected inflation

↑ real incomes abroad ↓ real incomes abroad

↓ value of nation’s currency ↑ value of nation’s currency

Permanent change in production conditions◦ Shift LRAS◦ Shift SRAS

Temporary change in production conditions◦ Shift SRAS

Aggregate Supply LR and SR

Long Run Aggregate Supply Shift

Price Level

LRAS1

Output (real GDP)

An increase in the economy’s production capacity will shift LRAS right

LRAS2

Improvements in resource base◦ Physical capital investment◦ Human capital investment

Improvements in technology Institutional and government policy changes

◦ Easy to conduct business◦ Enforce contracts fairly◦ Protect private property rights

LRAS Shift Right Ch 16 Sources of Economic

Growth

LRAS Shifters SummaryIncrease in LRAS (shift right) Decrease in LRAS (shift left)

↑ in supply of resources ↓ in supply of resources

Technology and productivity improvements

Technology and productivity deteriorations

Institutional changes that improve efficiency of resource use

Institutional changes that reduce efficiency of resource use

Note: Rightward shifts are much more common in the U.S. than leftward shifts, thank goodness!

Aggregate Supply in the Short Run

Price Level

P2

SRAS

P1

Y2Y1

Increase in price level will increase quantity supplied in the short run

Output

Aggregate Supply in the Short Run

Price Level

SRAS0

Changes in things besides the price level shift the curve and (SRAS1) increase or (SRAS2) decrease short run aggregate supply

Output (real GDP)

SRAS1SRAS2

1. When resource prices fall, SRAS shifts right◦ If the change is long-term, LRAS will shift also

2. When expected inflation is low, SRAS shifts right◦ No benefit from holding onto goods to sell at a

later date

SR Aggregate Supply Shifters

3. Favorable supply shocks shift SRAS right◦ Supply shock – unexpected event that

temporarily increases or decreases aggregate supply

◦ Examples: OPEC increases output, favorable growing conditions

SR Aggregate Supply Shifters

SRAS Shifters SummaryIncrease in SRAS (shift right) Decrease in SRAS (shift left)

↓ in resource prices (production costs)

↑ in resource prices (production costs)

↓ in expected inflation ↑ in expected inflation

Favorable supply shocks like good weather or lower prices of oil

Unfavorable supply shocks like bad weather or higher prices of oil

Holding fiscal and monetary policy constant Ceteris Paribus (one change at a time)

Reminders

Do not cause equilibrium disruptions Decision makers plan for change No booms and busts

Graph long run, steady economic growth: ◦ Long run equilibrium is the same as short run

equilibrium (no disequilibrium) Higher output Lower price level

Anticipated Changes and AD-AS

Steady Economic Growth

Price Level

LRAS1 LRAS2

Output

SRAS2

AD

YF1 YF2

E1

E2

P1

P2

SRAS1

Cause equilibrium disruptions, disequilibrium◦ Increase in AD◦ Decrease in AD◦ Increase in SRAS◦ Decrease in SRAS

No economic growth is occurring◦ Booms and busts◦ LRAS will not shift

Graphing◦ What is the short run equilibrium?◦ How do we return to long run equilibrium?

Unanticipated Changes and AD-AS

Unanticipated Increase in

Aggregate Demand

Causes: unanticipated ◦ increase in real wealth ◦ fall of the interest rate ◦ optimism about the future ◦ rising incomes abroad, or ◦ depreciation of domestic currency

Unanticipated Increase in AD

Bull Market

Short run◦ Output higher than potential◦ Price level rises unexpectedly◦ Resource prices and interest rates fixed◦ Producer profits are higher than normal

Long run◦ Resource prices, interest rates rise◦ SRAS shifts left◦ Return to full employment, normal profits◦ Price level permanently higher

Unanticipated Increase in AD

Short run equilibrium

Price LevelLRAS

Output (real GDP)

AD1

YF

E1

e2

P100

P105

SRAS1

AD2

Y2

Too Fast

Long run equilibrium

Price LevelLRAS

Output (real GDP)

AD1

YF

E1

e2

P100

P105

SRAS1

AD2

Y2

SRAS2

P110 E2

Unanticipated Decrease in

Aggregate Demand

Causes: unanticipated ◦ decrease in real wealth ◦ rise of the interest rate ◦ pessimism about the future ◦ falling incomes abroad, or ◦ appreciation of domestic currency

Unanticipated Decrease in AD

Bear Market

Short run◦ Output lower than potential◦ Price level falls unexpectedly◦ Resource prices and interest rates fixed◦ Producer profits are lower than normal

Long run◦ Resource prices, interest rates fall◦ SRAS shifts right◦ Return to full employment, normal profits◦ Price level permanently lower

Unanticipated Decrease in AD

Resource prices are “downward sticky”◦ Long term contracts◦ Workers hesitant to accept lower wages◦ Unions

Can make adjustment process slow

Unanticipated Decrease in AD

Short run equilibrium

Price LevelLRAS

Output (real GDP)

AD1

YF

E1

e2

P100

P95

SRAS1

AD2

Y2

Too Slow

Long run equilibrium

Price LevelLRAS

Output (real GDP)

AD1

YF

E1

e2

P100

P95

SRAS1

AD2

Y2

E2

SRAS2

P90

Unanticipated Increase in Short Run Aggregate

Supply

Causes: unanticipated, temporary ◦ Favorable supply shock

Good weather Cheap oil

Unanticipated Increase in SRAS

Short run equilibrium

Price LevelLRAS

Output (real GDP)

AD1

YF

E1

e2

P100

P95

SRAS1

Y2

SRAS2

Best Party Ever!

Long run equilibrium

Price LevelLRAS

Output (real GDP)

AD1

YF

E1

e2

P100

P95

SRAS1

Y2

SRAS2

Well, all good things must come to an end. We had

fun!

Short run◦ Output higher than potential◦ Price level falls unexpectedly◦ Resource prices and interest rates fixed◦ Producer profits are higher than normal

Long run◦ Favorable conditions come to an end◦ SRAS shifts left and returns to original position◦ Return to full employment, normal profits◦ No changes in prices or output in the long run

Unanticipated Increase in SRAS

Unanticipated Decrease in Short Run Aggregate

Supply

Causes: unanticipated, temporary unfavorable supply shock

Unanticipated Decrease in SRAS

Short run◦ Output lower than potential◦ Price level rises unexpectedly◦ Resource prices and interest rates fixed◦ Producer profits are lower than normal

Long run◦ Unfavorable conditions come to an end◦ SRAS shifts right and returns to original position◦ Return to full employment, normal profits◦ No changes in prices or output in the long run

Unanticipated Decrease in SRAS

Short run equilibrium

Price LevelLRAS

Output (real GDP)

AD1

YF

E1

e2

P100

P105

SRAS1

Y2

SRAS2

Ugh, this sucks!

Long run equilibriumWhew! Glad

that’s over. Back to normal

Price LevelLRAS

Output (real GDP)

AD1

YF

E1

e2

P100

P105

SRAS1

Y2

SRAS2

When AD shifts unexpectedly, the long run impacts are seen only in the price level

When SRAS shifts unexpectedly, there are no long run impacts because the change was temporary

When markets are allowed to adjust, we will always return to full employment and output

Summary

Unanticipated changes in AD or SRAS can disrupt the economy

But changes in ◦ Resource prices◦ Interest rates

Return the economy to long run equilibrium

Recessions and Booms

Recession (GDP less than YF)◦ Weak demand for resources causes

unemployment◦ Resource prices then fall◦ Return to full output

Boom (GDP greater than YF)◦ Strong demand for resources causes greater than

normal profits◦ Resource price then rise◦ Return to full output

Resource Market Adjustments

Recession (GDP less than YF)◦ Weak demand for borrowing◦ Interest rates then fall◦ Return to full output

Boom (GDP more than YF)◦ Strong demand for borrowing◦ Drives up interest rates◦ Return to full output

Loanable Funds Market Adjustments

Keynesian Economists: too long! New Classical Economists: not too long at

all!

How long does adjustment take?

Expansions and Recessions, 1950-2009

Period of ExpansionLength

(in Months) Period of RecessionLength

(in Months)

Oct ‘49 to Jul ’53 44 Jul ‘53 to May ’54 10

May ‘54 to Aug ’57 39 Aug ‘57 to Apr ’58 9

Apr ‘58 to Apr ’60 24 Apr ‘60 to Feb ’61 10

Feb ‘61 to Dec ’69 105 Dec ‘69 to Nov ’70 10

Nov ‘70 to Nov ‘73 36 Nov ‘73 to Mar ’75 16

Mar ‘75 to Jan ’80 58 Jan ‘80 to Jul ’80 6

Jul ‘80 to Jul ’81 12 Jul ‘81 to Nov ’82 16

Nov ‘82 to Jul ’90 92 Jul ‘90 Mar ’91 9

Mar ‘91 to Mar ’01 120 Mar ‘01 to Nov ’01 8

Nov ‘01 to Nov ’07 73 Dec ‘07 to June ‘09 18

Analyze the impact of unanticipated changes in aggregate demand and short run aggregate supply

Evaluate the economy’s self-correcting mechanism

Chapter 10 Objectives