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Why is this good?• Breaking News Alert
The New York TimesTuesday, March 13, 2012 -- 4:08 PM EDT-----
Stocks Rally Strongly, With Nasdaq Above 3,000
Stocks climbed to new heights in part on rosy retail sales data on Tuesday, pushing the broad market to levels last seen in June 2008 and the Nasdaq composite index past the 3,000 milestone for the first time since 2000.
Read More:http://www.nytimes.com/?emc=na
AD/AS
What causes short run changes in the business cycle?
The 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.
Time
Economic activity
Business cycle
http://www.youtube.com/watch?v=hTWPrWmPJS0
The 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.
Sum each definition in six words or less!!!
Figure 2 Aggregate Demand and Aggregate Supply...
Quantity ofOutput
PriceLevel
0
Aggregatesupply
Aggregatedemand
Equilibriumoutput
Equilibriumprice level
How do we measure price level?
PPICPIPrice Deflator
Figure 3 The Aggregate-Demand Curve...
Quantity ofOutput
PriceLevel
0
Aggregatedemand
P
Y Y2
P2
1. A decreasein the pricelevel . . .
2. . . . increases the quantity ofgoods and services demanded.
WHY???
Why the Aggregate-Demand Curve Is Downward Sloping
• 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
Why the Aggregate-Demand Curve Is Downward Sloping
• The Price Level and Consumption: – The Wealth Effect• A lower price level raises the real value of money and
makes consumers wealthier, which encourages them to spend more. • This increase in consumer spending means larger
quantities of goods and services demanded.
Why the Aggregate-Demand Curve Is Downward Sloping
• The Price Level and Investment: – The Interest Rate Effect• A lower price level reduces the interest rate and makes
borrowing less expensive, which 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 Is Downward Sloping
• The Price Level and Net Exports: – The Exchange-Rate Effect• A lower price level in the U.S. causes U.S. interest rates
to fall and the real exchange rate to depreciate, which stimulates U.S. net exports.• The increase in net export spending means a larger
quantity of goods and services demanded.
Aggregate Demand can either increase or decrease dependingon which variables shift the aggregate demand curve.
An increase in aggregate demand is always a shift to the right
A decrease in aggregate demand is always a shift to the left.
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PL
Q=Real GDP=Y
Variables that influence the components-
Consumption
People’s preferences/tastes
Change in interest rates
Expectations of the future
Relative prices of products/services
Change in income
Investment
People’s preferences/tastes
Number of consumers
Change in Inventories
Expectations of the future profit
Change in Interest rates
Gross Private Domestic Business Investment
Variables that influence the components-
Change in income
Government Spending
Dum Politiciansb
Variables that influence the components-
(X - M)
Exports Imports Relative price of foreign goods/services
Relative quality of foreign goods/services
International value of the dollar
Interest rates
Variables that influence the components-
Savings
People’s preferences/tastes
Change in Interest ratesExpectations of the future
Relative prices of products/services
Variables that influence the components-
Change in income
Demand Shifts - Summary
1. Federal government increases personal income tax rates
2. Federal Reserve implements “tight” monetary policy
3. News media runs several stories showing economy in positive light
4. U.S. currency exchange rate depreciates against the Yuan (Chinese currency).
5. People increase savings rates6. Construction of new housing increases
PL
Q = Real GDP = Y
Keynesian Range
Intermediate Range
ClassicalRange
Full Employment
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COVER BY JOHN HELD JR.
As
http://www.nytimes.com/learning/general/onthisday/bday/0605.html
http://www.sntc.org.sz/sdphotos/1880s.html
PL
Q = Real GDP = Y
Keynesian Range
Intermediate Range
ClassicalRange
Full Employment
As
StructuralFrictionalCyclicalUnemployment
THE AGGREGATE-SUPPLY CURVE
• In the long run, the aggregate-supply curve is vertical because the price level does not affect long run determinants of real GDP.
• In the short run, the aggregate-supply curve is upward sloping.
THE 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.
• The long-run aggregate supply represents the classical dichotomy and money neutrality.
Figure 4 The Long-Run Aggregate-Supply Curve
Quantity ofOutput
Natural rateof output
PriceLevel
0
Long-runaggregate
supply
P2
1. A changein the pricelevel . . .
2. . . . does not affect the quantity of goods and services supplied
in the long run.
P
Why the Long-Run Aggregate-Supply Curve Might Shift
• Shifts might arise from changes in: – Labor– Capital– Natural Resources– Technological Knowledge
Figure 5 Long-Run Growth and Inflation
Quantity ofOutput
Y 1980
AD 1980
AD1990
Aggregate Demand, AD2000
PriceLevel
0
Long-runaggregate
supply,LRAS 1980
Y1990
LRAS 1990
Y 2000
LRAS 2000
P1980
1. In the long run,technological progress shifts long-run aggregate supply . . .
4. . . . andongoing inflation.
3. . . . leading to growthin output . . .
P1990
P2000
2. . . . and growth in the money supply shifts aggregate demand . . .
Why the Aggregate-Supply Curve Slopes Upward in the Short Run
• 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.
• As a result, the short-run aggregate-supply curve is upward sloping.
Figure 6 The Short-Run Aggregate-Supply Curve
Quantity ofOutput
PriceLevel
0
Short-runaggregate
supply
1. A decreasein the pricelevel . . .
2. . . . reduces the quantityof goods and servicessupplied in the short run.
Y
P
Y2
P2
Why the Aggregate-Supply Curve Slopes Upward in the Short Run
• Three Theories:– The Sticky-Wage Theory– The Sticky-Price Theory– The Misperceptions Theory
Why the Aggregate-Supply Curve Slopes Upward in the Short Run
• The Sticky-Wage Theory– Nominal wages are slow to adjust to changing
economic conditions, or are “sticky” in the short run
Why the Aggregate-Supply Curve Slopes Upward in the Short Run
• The Sticky-Price Theory– An unexpected fall in the price level leaves some
firms with higher-than-desired prices. For a variety of reasons, they may not want to or be able to change prices immediately.
Why the Aggregate-Supply Curve Slopes Upward in the Short Run
• 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.
– A lower price level causes misperceptions about relative prices.
– These misperceptions induce suppliers to decrease the quantity of goods and services supplied.
Why the Short-Run Aggregate-Supply Curve Might Shift
• Shifts might arise from changes in: – Expected Price Level.– Labor.– Capital.– Natural Resources.– Technology.
COSTS!!!!
Figure 7 The Long-Run Equilibrium
Natural rateof output
Quantity ofOutput
PriceLevel
0
Short-runaggregate
supply
Long-runaggregate
supply
Aggregatedemand
AEquilibriumprice
TWO CAUSES OF ECONOMIC FLUCTUATIONS
• Four steps in the process of analyzing economic fluctuations:1. Determine whether the event affects aggregate
supply or aggregate demand.2. Decide which direction the curve shifts.3. Use a diagram to compare the initial and the
new equilibrium.4. Keep track of the short and long run equilibrium,
and the transition between them.
Figure 8 A Contraction in Aggregate Demand
Quantity ofOutput
PriceLevel
0
Short-run aggregatesupply, AS
Long-runaggregate
supply
Aggregatedemand, AD
AP
Y
AD2
AS2
1. A decrease inaggregate demand . . .
2. . . . causes output to fall in the short run . . .
3. . . . but over time, the short-runaggregate-supplycurve shifts . . .
4. . . . and output returnsto its natural rate.
CP3
BP2
Y2
Figure 10 An Adverse Shift in Aggregate Supply
Quantity ofOutput
PriceLevel
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-runaggregate
supply, AS
Long-runaggregate
supply
Y
AP
AS2
B
Y2
P2
The Effects of a Shift in Aggregate Supply
• 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.
The Effects of a Shift in Aggregate Supply
• 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.
Figure 11 Accommodating an Adverse Shift in Aggregate Supply
Quantity ofOutput
Natural rateof output
PriceLevel
0
Short-runaggregate
supply, AS
Long-runaggregate
supply
Aggregate demand, AD
P2
AP
AS2
3. . . . whichcauses theprice level to rise further . . .
4. . . . but keeps outputat its natural rate.
2. . . . policymakers canaccommodate the shiftby expanding aggregate
demand . . .
1. When short-run aggregatesupply falls . . .
AD2
CP3