Class Test 2 Thursday May 28, 5-8 pm For those who want a paper-based test 25 multiple choice questions Covers Lectures 6 – 10 –Chapters 7-16.

Class Test 2

• Thursday May 28, 5-8 pm

• For those who want a paper-based test

• 25 multiple choice questions

• Covers Lectures 6 – 10– Chapters 7-16

Lecture Purpose

• To introduce a key macroeconomic model

• To model changes in the economy due to changes economic variables

• Prepare for the concluding discussions on macroeconomic policy

Lecture 10: Aggregate Demand and Aggregate Supply

Short run fluctuations in the economy

The Short Run & the Long Run

• In the short run.– Changes in the money supply affect nominal

variables (eg prices) but not real variables in the long run (eg output).

• In the long run– Output changes due to technology, population

growth etc

Short-Run Economic Fluctuations

• Economic activity fluctuates from year to year.– In most years production of goods and services rises

but in some years normal growth does not occur, causing a recession.

• A recession is a period of declining real GDP, falling incomes, and rising unemployment.

• A depression is a severe recession.

Growth over time

Real GDP

($b)

YearsLong term average

Recession

‘Boom’

Characteristics of Economic Fluctuations

• Economic fluctuations are irregular and unpredictable.

• Most macroeconomic variables are related and fluctuate together.– As output falls, unemployment rises and vice

versa

Explaining Economic Fluctuations

• Most economists use the model of aggregate demand and aggregate supply to illustrate the effects of short-run fluctuations in economic activity.

• This is shown in relation to the long-term trend

The Basic Model of Economic Fluctuations

• Two variables are used to develop a model to analyse the short-run fluctuations.– The economy’s output of goods and services

measured by real GDP.– The overall price level measured by the CPI or

the GDP deflator.

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 any price level.

• The aggregate supply curve shows the quantity of goods and services that firms choose to produce and want to sell at any price level.

The Aggregate Demand Curve

• The four components of GDP (Y) contribute to the aggregate demand for goods and services.

Y = C + I + G + NX


Quantity ofOutput

PriceLevel

0

Aggregatedemand

P1

Y1


Quantity ofOutput

PriceLevel

0

Aggregatedemand

P1

Y1

1. A decrease in the pricelevel


Quantity ofOutput

PriceLevel

0

Aggregatedemand

P1

Y1 Y2

P21. A decrease in the pricelevel


Quantity ofOutput

PriceLevel

0

Aggregatedemand

P1

Y1 Y2

P2

1. A decrease in the pricelevel

2. increases the quantity of goods and services demanded.

Explaining the aggregate demand curve:

3 Theories

• Pigou’s wealth effect

• Keynes’ interest rate effect

• Mundell-Fleming’s exchange-rate effect

Pigou’s wealth effect

• Consumers feel wealthier, which stimulates the demand for consumption goods.– A decrease in the price level makes consumers

feel more wealthy.– This encourages them to spend more.– The increase in consumer spending means a

larger quantity of goods and services demanded.

Keynes’ interest-rate effect

• The lower the price level, the less money households need to hold to buy the goods and services they want.– A lower price level reduces the interest rate,

which encourages greater spending on investment goods.

– The increase in investment spending means a larger quantity of goods and services demanded.

Mundell-Fleming’s exchange-rate effect

• When the prices of domestic goods decreases, net exports increase.– A fall in the Australian price level causes

Australian interest rates to fall.– The real exchange rate depreciates, which

stimulates Australian net exports.– The increase in net export spending means a

larger quantity of goods and services demanded.

Shifts in the aggregate demand curve

• Shifts in the aggregate demand curve may arise because of changes in:– Private behaviour: Changes in spending plans

by consumers or firms.– Public policy: Changes in fiscal or monetary

policy.

• Anything that causes buyers to want to purchase more or less than before will cause the aggregate demand curve to shift.

Shifts in the Aggregate Demand Curve

Quantity ofOutput

PriceLevel

0

Aggregatedemand, D1

P1

Y1


Quantity ofOutput

PriceLevel

0

Aggregatedemand, D1

P1

Y1

D2


Quantity ofOutput

PriceLevel

0

Aggregatedemand, D1

P1

Y1 Y2

D2

Shifts in aggregate demand

• People will buy more of the goods and services at every price

• Same principle as for microeconomic markets

The Aggregate Supply Curve

• In the long run, the aggregate-supply curve is vertical.

• In the short run, the aggregate-supply curve is upward sloping.

The Long-Run Aggregate Supply Curve

• The long-run aggregate supply depends on the economy’s resources and level of technology.

• The price level does not affect these variables in the long run.

• The long-run aggregate supply curve is vertical at the natural rate of output.


Quantity ofOutput

Natural rateof output

Price Level

0

Long-runaggregate

supply

P1


Quantity ofOutput


Price Level

0

Long-runaggregate

supply

P21. A change in the price level…

P1


Quantity ofOutput


Price Level

0

Long-runaggregate

supply

P2

1. A change in the price level…

P1

2. …does not affect the quantity of goods and services supplied in the long run.

Shifts in the Long-Run Aggregate Supply Curve

• Any change in the factors that determine the long-run aggregate supply will cause the curve to shift.

• An event that reduces the economy’s potential output shifts the curve to the left.

• Any event that increases the economy’s potential output shifts the curve to the right.

The Short-Run Aggregate Supply Curve

• 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.


Quantity ofOutput

Price Level

0

Short-runaggregate

supply


Y1

P1

Quantity ofOutput

Price Level

0

Short-runaggregate

supply


Y1

P1

P21. A decrease in the price level Quantity of

Output

Price Level

0

Short-runaggregate

supply

Y2


Y1

P1

P21. A decrease in the price level Quantity of

Output

Price Level

0

Short-runaggregate

supply

Y2

2. reduces the quantity of goods and services supplied in the short run

Explaining the slope of the aggregate supply curve

• New classical misperceptions theory

• The Keynesian sticky-wage theory

• The new Keynesian sticky-price theory

The New Classical Misperceptions Theory

• Changes in the overall price level temporarily mislead suppliers about what is happening in the markets in which they sell their output.– A lower price level causes misperceptions

about relative prices.– These misperceptions induce suppliers to

decrease the quantity of goods and services supplied.

The Keynesian Sticky-Wage Theory

• Nominal wages are slow to adjust, or are ‘sticky’ in the short run.– Wages do not adjust immediately to a fall in the

price level.– A lower price level makes employment and

production less profitable.– This induces firms to reduce production.

The New Keynesian Sticky-Price Theory

• Prices of some goods and services adjust sluggishly in response to changing economic conditions.– An unexpected fall in the price level leaves

some firms with higher-than-desired prices.– This depresses sales, which induces firms to

reduce the quantity of goods and services they produce.

Shifts in the Aggregate Supply Curve

P1

Quantity ofOutput

Price Level

0

Short-run aggregate supply, S1

Y2


P1

Quantity ofOutput

Price Level

0


Y2

S2


Y1

P1

Quantity ofOutput

Price Level

0


Y2

S2

Why the aggregate supply curve might shift

• Changes in factor (input) prices

• Changes in productivity

• Legal-institutional environment

• Expectations about the price level

Changes in Resource Prices

• Changes in the prices of domestic or imported resources change firms’ cost of production.– An increase in input prices shifts the

aggregate supply curve to the left.– A decrease in input prices shifts the aggregate

supply curve to the right.

Changes in Productivity

• An improvement in factor productivity allows firms to produce more at a lower cost.– New technologies can increase the output per

unit of labour or capital.– The resulting decrease in production costs

shifts the aggregate supply curve to the right.

Legal-Institutional Environment

• Taxes and government regulations can increase production costs and discourage firms from producing.– The resulting increase in production costs shifts

the aggregate supply curve to the left.

Expectations About the Price Level

• Current wages and prices often depend on expectations of the price level.– A higher expected price level shifts the short-

run aggregate supply curve to the left.– A lower expected price level shifts the short-

run aggregate supply curve to the right.

Long-Run Equilibrium

• The intersection of the aggregate demand curve and the long-run aggregate supply curve determines the economy’s equilibrium output and price level.

• Output is at its ‘natural’ rate.

• The short-run aggregate supply curve passes through the point of intersection.

Long-Run Equilibrium


Quantity ofOutput

PriceLevel

0

Equilibriumprice

Short-runaggregate

supply

Long-runaggregate

supply

Aggregatedemand

A

Two causes of recession

• A recession in the economy may have two causes.– A decrease in aggregate demand.– A decrease in aggregate supply.

A decrease in aggregate demand

• A decrease in one of the determinants of aggregate demand shifts the curve to the left.– Output falls below the natural rate of

employment.– Unemployment rises.– The price level falls.


Quantity ofOutput

PriceLevel

0

Short-run aggregatesupply, AS1

Long-runaggregate

supply

AP1

Y1

Aggregatedemand, AD1


Quantity ofOutput

PriceLevel

0


Long-runaggregate

supply


AP1

Y1

1. A decrease inaggregate demand…


Quantity ofOutput

PriceLevel

0


Long-runaggregate

supply


AP1

Y1

AD2



Quantity ofOutput

PriceLevel

0


Long-runaggregate

supply


A

B

P1

P2

Y1Y2

AD2



Quantity ofOutput

PriceLevel

0


Long-runaggregate

supply


A

B

P1

P2

Y1Y2

AD2


2. …causes output to fall in the short run…


Quantity ofOutput

PriceLevel

0


Long-runaggregate

supply


A

B

P1

P2

Y1Y2

AD2


3. …but over time,the short-run aggregate-supply curve shifts…



Quantity ofOutput

PriceLevel

0


Long-runaggregate

supply


A

B

P1

P2

Y1Y2

AD2

AS2





Quantity ofOutput

PriceLevel

0


Long-runaggregate

supply


A

B

C

P1

P2

P3

Y1Y2

AD2

AS2





Quantity ofOutput

PriceLevel

0


Long-runaggregate

supply


A

B

C

P1

P2

P3

Y1Y2

AD2

AS2




4. …and output returnsto its natural rate.

A Decrease 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.

A decrease in aggregate supply

Long-runaggregate

supply

Short-run aggregate

supply, AS1

Quantity ofOutput

PriceLevel

0

Aggregate demand

A

Y1

P1


Long-runaggregate

supply

1. An adverse shift in the short-run aggregate-supply curve…

Short-run aggregate

supply, AS1

Quantity ofOutput

PriceLevel

0

Aggregate demand

A

Y1

P1


Long-runaggregate

supply


Short-run aggregate

supply, AS1

Quantity ofOutput

PriceLevel

0

Aggregate demand

A

Y1

P1


Long-runaggregate

supply


Short-run aggregate

supply, AS1

Quantity ofOutput

PriceLevel

0

Aggregate demand

A

B

Y1Y2

P2

P1


2. …causes output to fall…

Long-runaggregate

supply


Short-run aggregate

supply, AS1

Quantity ofOutput

PriceLevel

0

Aggregate demand

A

B

Y1Y2

P2

P1


2. …causes output to fall…

Long-runaggregate

supply


Short-run aggregate

supply, AS1

Quantity ofOutput

PriceLevel

0

Aggregate demand

A

B

Y1Y2

3. …and the price level to rise.

P2

P1

Stagflation

• Adverse shifts in aggregate supply cause stagflation—a combination 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

• 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.

Policy response to recession

Quantity ofOutput


PriceLevel

0

Short-run aggregate supply, AS1

Aggregate demand, AD1

Long-run aggregate

supply

AP1


Quantity ofOutput


PriceLevel

0



Long-run aggregate

supply

AP1

1. When short-run aggregate supply falls…


Quantity ofOutput


PriceLevel

0



Long-run aggregate

supply

AP1

AS2



Quantity ofOutput


PriceLevel

0



Long-run aggregate

supply

AP2

P1

AS2



Quantity ofOutput


PriceLevel

0



Long-run aggregate

supply

AP2

P1

AS2


2. …policymakers canaccommodate the shiftby expanding aggregatedemand…


Quantity ofOutput


PriceLevel

0



Long-run aggregate

supply

AP2

P1

AS2



AD2


Quantity ofOutput


PriceLevel

0



Long-run aggregate

supply

A

C

P2

P3

P1

AS2



AD2


Quantity ofOutput


PriceLevel

0



Long-run aggregate

supply

A

C

P2

P3

P1

AS2

3....which causes the price level to rise



AD2


Quantity ofOutput


PriceLevel

0



Long-run aggregate

supply

A

C

P2

P3

P1

AS2

3....which causes the price level to rise



AD24. …but keeps output at its natural rate.

Self-Test (Hakes & Parry): Chapter 16

• Match all Terms & Definitions• Answer questions 1, 2, 3 & 4 of the Practice

Problems• Answer Short Answer questions 1, 2, 5, 6, 7, 9 &

11• Do all True/False Questions• Answer Multiple Choice Questions 1, 2, 4, 5, 6, 8,

9, 10, 11, 13, 14, 15, 16, 17, 18, 19 & 20• Make notes on the Advanced Critical Thinking

questions • Check answers in guide and revise accordingly

Reading

• This week: Text and Study Guide Chapter 16

• For next lecture: Chapter 17 & 18

Class Test 2 Thursday May 28, 5-8 pm For those who want a paper-based test 25 multiple choice questions Covers Lectures 6 – 10 –Chapters 7-16.

Documents

model of aggregate demand

aggregate demand curvethe

aggregate supplyshort

aggregate supply curve

investment goods

larger quantity of goods

consumption goods

lower price level