Long run v.s. short run
Aggregate Demand and Aggregate
Supply
33
ƒ Long run growth: what determines long-run
output (and the related employment…)?
• Capital accumulation;
• Technological advancement.
PRINCIPLES OF
ECONOMICS
ƒ Short run fluctuations: what determines short-run
FOURTH EDITION
output (and the related employment…)?
• Aggregate demand and aggregate supply.
N. G R E G O R Y M A N K I W
PowerPoint® Slides
by Ron Cronovich
CHAPTER 33
© 2007 Thomson South-Western, all rights reserved
Introduction
In this chapter, look for the answers to
these questions:
ƒ What are economic fluctuations? What are their
ƒ Over the long run, real GDP grows about
3% per year on average.
ƒ In the short run, GDP fluctuates around its trend.
characteristics?
ƒ How does the model of aggregate demand and
• recessions:
periods of falling real incomes
and rising unemployment
aggregate supply explain economic fluctuations?
ƒ Why does the Aggregate-Demand curve slope
• depressions:
downward? What shifts the AD curve?
business cycles.
in the short run? In the long run?
What shifts the AS curve(s)?
2
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Three Facts About Economic Fluctuations
severe recessions (very rare)
ƒ Short-run economic fluctuations are often called
ƒ What is the slope of the Aggregate-Supply curve
CHAPTER 33
1
AGGREGATE DEMAND AND AGGREGATE SUPPLY
CHAPTER 33
3
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Three Facts About Economic Fluctuations
FACT
FACT 1:
1: Economic
Economic fluctuations
fluctuations are
are
irregular
irregular and
and unpredictable.
unpredictable.
FACT
FACT 2:
2: Most
Most macroeconomic
macroeconomic
quantities
quantities fluctuate
fluctuate together.
together.
$ 11,000
$ 1,800
U.S.
U.S. real
real GDP,
GDP,
billions
billions of
of 2000
2000 dollars
dollars
10,000
9,000
1,600
Investment
Investment spending,
spending,
billions
billions of
of 2000
2000 dollars
dollars
1,400
8,000
1,200
7,000
1,000
6,000
The
The shaded
shaded
bars
bars are
are
recessions
recessions
5,000
4,000
600
400
3,000
2,000
1965
800
1970
1975
1980
1985
1990
1995
2000
2005
200
1965
1970
1975
1980
1985
1990
1995
2000
2005
1
Three Facts About Economic Fluctuations
Explaining the short-run fluctuations
FACT
FACT 3:
3: As
As output
output falls,
falls,
unemployment
unemployment rises.
rises.
12
ƒ Warning! This chapter is very theoretical.
Unemployment
Unemployment rate,
rate,
percent
percent of
of labor
labor force
force
10
8
6
4
2
0
1965
1970
1975
1980
1985
1990
1995
2000
2005
CHAPTER 33
7
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Introduction, continued
Classical Economics
ƒ Explaining these fluctuations is difficult, and the
ƒ The previous chapters are based on the ideas of
theory of economic fluctuations is controversial.
classical economics, especially:
ƒ Most economists use the model of
ƒ The Classical Dichotomy, the separation of
aggregate demand and aggregate supply
to study fluctuations.
variables into two groups:
• real – quantities, relative prices
• nominal – measured in terms of money
ƒ This model differs from the classical economic
theories economists use to explain the long run.
ƒ The neutrality of money:
Changes in the money supply affect nominal but
not real variables.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
8
CHAPTER 33
The Model of Aggregate Demand and
Aggregate Supply
Classical Economics
ƒ Most economists believe classical theory
ƒ In the short run, changes in nominal variables
The model
determines the
eq’m price level
(like the money supply or P ) can affect
real variables (like Y or the u-rate).
ƒ To study the short run, we use a new model.
and the eq’m
level of output
(real GDP).
AGGREGATE DEMAND AND AGGREGATE SUPPLY
P
The price
level
describes the world in the long run,
but not the short run.
CHAPTER 33
9
AGGREGATE DEMAND AND AGGREGATE SUPPLY
10
CHAPTER 33
SRAS
“Short-Run
Aggregate
Supply”
P1
“Aggregate
Demand”
AD
Y1
Y
Real GDP, the
quantity of output
AGGREGATE DEMAND AND AGGREGATE SUPPLY
11
2
The Aggregate-Demand (AD) Curve
Why the AD Curve Slopes Downward
Y=C+I+G
P
The AD curve
shows the
quantity of
all g&s
demanded
in the economy
at any given
price level.
C, I, G are
the components
of agg. Demand for
a closed economy.
P2
Assume G fixed
by govt policy.
P1
CHAPTER 33
Y
Y1
12
AGGREGATE DEMAND AND AGGREGATE SUPPLY
P2
P1
To understand
the slope of AD,
must determine
how a change in P
affects C, I, and NX.
AD
Y2
P
The Wealth Effect (P and C )
CHAPTER 33
AD
Y2
Y
Y1
13
AGGREGATE DEMAND AND AGGREGATE SUPPLY
The Interest-Rate Effect (P and I )
ƒ Suppose P rises.
ƒ Suppose P rises.
ƒ The dollars people hold buy fewer g&s,
ƒ Buying g&s requires more dollars.
ƒ To get these dollars, people sell some of their bonds
so real wealth is lower.
ƒ People feel poorer, so they spend less.
ƒ Thus, an increase in P causes a fall in C
or other assets, which drives up interest rates.
…which increases the cost of borrowing to fund
investment projects.
…which means a smaller quantity of g&s
demanded.
ƒ Thus, an increase in P causes a decrease in I
…which means a smaller quantity of g&s demanded.
CHAPTER 33
14
AGGREGATE DEMAND AND AGGREGATE SUPPLY
The Slope of the AD Curve: Summary
An increase in P
reduces the quantity
of g&s demanded
because:
• the interest-rate
P2
AD
Y2
Y1
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
16
15
Why the AD Curve Might Shift
Example:
A stock market boom
makes households feel
wealthier, consume
more,
and the AD curve shifts
right.
P1
effect (I falls)
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Any event that changes
C, I, G – except a change
in P – will shift the AD
curve.
P
• the wealth effect
(C falls)
CHAPTER 33
CHAPTER 33
P
P1
AD2
AD1
Y1
Y2
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
17
3
AD Shifts arising from things affecting C:
AD Shifts Arising from things affecting I
ƒ The world becomes more uncertain, people
ƒ Firms decide to upgrade their computers:
decide to save more:
C falls, AD shifts left
I rises, AD shifts right
ƒ Firms become pessimistic about future demand:
ƒ The stock market crashes, the consumer
I falls, AD shifts left
confidence drops:
C falls, AD shifts left
ƒ Central bank uses monetary policy to reduce
interest rates:
I rises, AD shifts right
ƒ tax cut:
C falls, AD shifts right
ƒ Investment Tax Credit or other tax incentive:
I rises, AD shifts right
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
18
AD Shifts Arising from Changes in G
CHAPTER 33
ACTIVE LEARNING
Exercise
ƒ Congress increases spending on homeland
19
AGGREGATE DEMAND AND AGGREGATE SUPPLY
1:
Try this without looking at your notes.
security:
G rises, AD shifts right
What happens to the AD curve in each of the
following scenarios?
ƒ State govts cut spending on road construction:
A. A ten-year-old investment tax credit expires.
G falls, AD shifts left
B. A fall in prices increases the real value of
consumers’ wealth.
C. State governments eliminates sales taxes.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
ACTIVE LEARNING
Answers
20
1:
21
The Aggregate-Supply (AS) Curves
The AS curve shows
the total quantity of
g&s firms produce
and sell at any given
price level.
A. A ten-year-old investment tax credit
expires.
I falls, AD curve shifts left.
B. A fall in prices increases the real value of
P
LRAS
SRAS
In the short run,
AS is
upward-sloping.
consumers’ wealth.
Move down along AD curve (wealtheffect).
In the long run,
AS is vertical.
C. State governments eliminates sales
Y
taxes. C rises, AD shifts right.
22
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
23
4
Why LRAS Is Vertical
The Long-Run Aggregate-Supply Curve (LRAS)
The natural rate of
output (YN) is the
amount of output
the economy produces
when unemployment
is at its natural rate.
P
YN is also called
potential output
or
full-employment
output.
CHAPTER 33
YN depends on the
economy’s stocks of
labor, capital, and
natural resources,
and on the level of
technology.
LRAS
24
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Why the LRAS Curve Might Shift
Any event that
changes any of the
determinants of YN
will shift LRAS.
P
P1
YN
Y
AGGREGATE DEMAND AND AGGREGATE SUPPLY
25
LRAS Shifts Arising from Changes in L
ƒ The Baby Boom generation retires:
LRAS1 LRAS2
L falls, LRAS shifts left
ƒ New govt policies reduce the natural rate of
unemployment:
the % of the labor force normally employed
rises, LRAS shifts right
Example:
Immigration
increases L,
causing YN to rise.
YN
CHAPTER 33
CHAPTER 33
LRAS
P2
An increase in P
does not affect
any of these,
so it does not
affect YN.
(Classical dichotomy)
Y
YN
P
Y’
N
Y
AGGREGATE DEMAND AND AGGREGATE SUPPLY
26
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
LRAS Shifts Arising from Changes in
LRAS Shifts Arising from Changes in
Physical or Human Capital
Natural Resources
ƒ Investment in factories or equipment:
27
ƒ A change in weather patterns makes farming
K rises, LRAS shifts right
more difficult:
LRAS shifts left
ƒ More people get college degrees:
ƒ Discovery of new mineral deposits:
Human capital rises, LRAS shifts right
LRAS shifts right
ƒ Earthquakes or hurricanes destroy factories:
ƒ Reduction in supply of imported oil or other
K falls, LRAS shifts left
resources:
LRAS shifts right
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
28
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
29
5
LRAS Shifts Arising from Changes in
In short:
Technology
ƒ Technological advances allow more output to be
produced from a given bundle of inputs:
LRAS shifts right.
CHAPTER 33
ƒ Anything that affects growth shifts LRAS!
30
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Using AD & AS to Depict LR Growth and
Inflation
Over the long run,
tech. progress shifts
LRAS to the right
and growth in the
aggregate demand
shifts AD to the
right.
Result:
ongoing inflation
and growth in
output.
CHAPTER 33
P
P1990
AD2000
AD1990
AD1980
Y
Y1990 Y2000
Over the period
of 1-2 years,
an increase in P
causes an
increase in the
quantity of g & s
supplied.
CHAPTER 33
Why the Slope of SRAS Matters
If AS slopes up,
then shifts in AD
do affect output
and employment.
CHAPTER 33
P1
Y2
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
33
Three Theories of SRAS
In each,
LRAS
P
SRAS
P2
Y1
32
AGGREGATE DEMAND AND AGGREGATE SUPPLY
If AS is vertical,
fluctuations in AD
do not cause
fluctuations in output
or employment.
P
The SRAS curve
is upward sloping:
P2000
Y1980
31
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Short Run Aggregate Supply (SRAS)
LRAS2000
LRAS1990
LRAS1980
P1980
CHAPTER 33
Phi
• some type of market imperfection
• result:
SRAS
Phi
Output deviates from its natural rate
when the actual price level deviates
from the price level people expected.
ADhi
Plo
AD1
Plo
ADlo
Ylo
Y1
Yhi
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
34
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
35
6
Three Theories of SRAS
The Sticky-Wage Theory
ƒ Imperfection:
P
When P > PE
the expected
price level
Nominal wages are sticky in the short run,
they adjust sluggishly.
• Due to labor contracts, social norms.
SRAS
ƒ Firms and workers set the nominal wage in
PE
advance based on PE, the price level they
expect to prevail.
When P < PE
Y
YN
Y < YN
CHAPTER 33
Y > YN
AGGREGATE DEMAND AND AGGREGATE SUPPLY
36
CHAPTER 33
The Sticky-Wage Theory
The Sticky-Wage Theory
ƒ The labor contract sets nominal wages
The sticky wage theory implies Y deviates from YN
when P deviates from PE.
according to expected prices.
ƒ If P > PE,
Y = YN + a (P – PE)
revenue is higher, but labor cost is not.
Production is more profitable,
so firms increase output and employment.
Output
Natural rate
of output
(long-run)
ƒ Hence, higher P causes higher Y,
so the SRAS curve slopes upward.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
38
SRAS and LRAS
CHAPTER 33
Expected
price level
a > 0,
measures
how much Y
responds to
unexpected
changes in P
Actual
price level
SRAS
temporary. Over time,
• sticky wages and prices become flexible
• misperceptions are corrected
Y = YN + a(P – PE)
P
LRAS
In the long run,
PE = P
ƒ In the LR,
• PE = P
• AS curve is vertical
and
Y = YN.
SRAS
PE
YN
AGGREGATE DEMAND AND AGGREGATE SUPPLY
39
AGGREGATE DEMAND AND AGGREGATE SUPPLY
and LRAS
ƒ The imperfections in these theories are
CHAPTER 33
37
AGGREGATE DEMAND AND AGGREGATE SUPPLY
40
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
41
7
The Long-Run Equilibrium
Why the SRAS Curve Might Shift
P
LRAS
Also, PE shifts SRAS:
Y = YN ,
and unemployment
is at its natural rate.
PE
YN
42
AGGREGATE DEMAND AND AGGREGATE SUPPLY
CHAPTER 33
The Effects of a Shift in AD
ƒ Four steps to analyzing economic fluctuations:
3. SR eq’m at B.
P and Y lower,
unemp higher
2. Determine whether curve shifts left or right.
3. Use AD-AS diagram to see how the shift
changes Y and P in the short run.
4. Over time, PE falls,
SRAS shifts right,
until LR eq’m at C.
Y and unemp back
at initial levels.
4. Use AD-AS diagram to see how economy
moves from new SR eq’m to new LR eq’m.
44
AGGREGATE DEMAND AND AGGREGATE SUPPLY
CHAPTER 33
CHAPTER 33
650
600
AGGREGATE DEMAND AND AGGREGATE SUPPLY
P2
SRAS2
B
P3
AD1
C
AD2
Y2
Y
YN
45
U.S. Real GDP,
billions of 2000 dollars
govt outlays rose
from $9.1 billion
to $91.3 billion
2,000
Y rose 90%
1,400
P rose 20%
1,200
unemp fell
from 17% to 1%
1,000
1,800
1,600
800
1939
1934
1933
550
1932
unemp rose
from 3% to 25%
•
•
•
700
1931
P fell 22%
•
800
1930
Y fell 27%
A
AGGREGATE DEMAND AND AGGREGATE SUPPLY
From 1939-1944,
850
1929
•
•
•
750
P1
Two Big AD Shifts:
2. The World War II Boom
U.S. Real GDP,
billions of 2000 dollars
stock prices fell 90%,
reducing C and I
SRAS1
46
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
1944
Two Big AD Shifts:
1. The Great Depression
900
LRAS
2. C falls, so AD shifts left
1. Determine whether the event shifts AD or AS.
•
P
1. affects C, AD curve
money supply fell
28% due to problems
in banking system
43
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Event: stock market crash
AS curves.
From 1929-1933,
Y
YN
Y
ƒ Caused by events that shift the AD and/or
•
PE
AD
Economic Fluctuations
CHAPTER 33
SRAS
PE = P,
1943
CHAPTER 33
PE
LRAS
1942
At each P,
production is less
profitable, Y falls,
SRAS shifts left.
SRAS
SRAS
P
1941
If PE rises,
workers & firms set
higher wages.
In the long-run
equilibrium,
1940
Everything that shifts
LRAS shifts SRAS, too.
47
8
ACTIVE LEARNING
Exercise
2:
ACTIVE LEARNING
Answers
ƒ Draw the AD-SRAS-LRAS diagram
2:
Event: a tax cut
for the U.S. economy,
starting in a long-run equilibrium.
P
1. affects C, AD curve
LRAS
SRAS2
2. shifts AD right
ƒ A boom occurs in Canada.
3. SR eq’m at point B.
P and Y higher,
unemp lower
Use your diagram to determine
the SR and LR effects on U.S. GDP,
the price level, and unemployment.
4. Over time, PE rises,
SRAS shifts left,
until LR eq’m at C.
Y and unemp back
at initial levels.
C
P3
SRAS1
B
P2
A
P1
AD2
AD1
YN
Y
Y2
48
The Effects of a Shift in SRAS
Event: oil prices rise
1. increases costs,
P
shifts SRAS
(assume LRAS constant)
2. SRAS shifts left
3. SR eq’m at point B.
P2
P higher, Y lower,
P1
unemp higher
From A to B,
stagflation,
a period of
falling output
and rising prices.
CHAPTER 33
49
Accommodating an Adverse Shift in SRAS
If policymakers do nothing,
LRAS
SRAS2
SRAS1
B
Or, policymakers could
use fiscal or monetary
policy to increase AD
and accommodate the
AS shift:
Y back to YN, but
P permanently higher.
A
AD1
Y2 YN
AGGREGATE DEMAND AND AGGREGATE SUPPLY
4. Low employment
causes wages to fall,
SRAS shifts right,
until LR eq’m at A.
Y
50
CHAPTER 33
1978-80
Real oil prices
+ 138%
+ 99%
CPI
+ 21%
+ 26%
Real GDP
– 0.7%
+ 2.9%
# of unemployed
persons
+ 3.5
million
+ 1.4
million
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
52
LRAS
SRAS2
P3
P2
P1
C
B
SRAS1
A
AD2
AD1
Y2 YN
Y
AGGREGATE DEMAND AND AGGREGATE SUPPLY
51
John Maynard Keynes, 1883-1946
The 1970s Oil Shocks and Their Effects
1973-75
P
•
The General Theory of Employment,
Interest, and Money, 1936
•
Argued recessions and depressions
can result from inadequate demand;
policymakers should shift AD.
•
Famous critique of classical theory:
The long run is a misleading guide
to current affairs. In the long run,
we are all dead. Economists set themselves
too easy, too useless a task if in tempestuous seasons
they can only tell us when the storm is long past,
the ocean will be flat.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
53
9
CONCLUSION
CHAPTER SUMMARY
ƒ Short-run fluctuations in GDP and other
ƒ This chapter has introduced the model of
aggregate demand and aggregate supply,
which helps explain economic fluctuations.
macroeconomic quantities are irregular and
unpredictable. Recessions are periods of falling
real GDP and rising unemployment.
ƒ Keep in mind: these fluctuations are deviations
from the long-run trends explained by the
models we learned in previous chapters.
ƒ Economists analyze fluctuations using the model
of aggregate demand and aggregate supply.
ƒ In the next chapter, we will learn how
ƒ The aggregate demand curve slopes downward
policymakers can affect aggregate demand
with fiscal and monetary policy.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
because a change in the price level has a wealth
effect on consumption, an interest-rate effect on
investment, and an exchange-rate effect on net
exports.
54
CHAPTER SUMMARY
ƒ Anything that changes C, I, G, or NX
because changes in the price level do not affect
output in the long run.
ƒ In the long run, output is determined by labor,
ƒ The short-run aggregate-supply curve shifts in
capital, natural resources, and technology;
changes in any of these will shift the
long-run aggregate supply curve.
response to changes in the expected price level
and to anything that shifts the long-run aggregate
supply curve.
56
CHAPTER SUMMARY
ƒ Economic fluctuations are caused by shifts in
AGGREGATE DEMAND AND AGGREGATE SUPPLY
57
falling output and rising prices.
Wages, prices, and perceptions adjust over time,
and the economy recovers.
ƒ When aggregate demand falls, output and the
price level fall in the short run. Over time, a
change in expectations causes wages, prices, and
perceptions to adjust, and the short-run aggregate
supply curve shifts rightward. In the long run, the
economy returns to the natural rates of output and
unemployment, but with a lower price level.
AGGREGATE DEMAND AND AGGREGATE SUPPLY
CHAPTER 33
CHAPTER SUMMARY
ƒ A fall in aggregate supply results in stagflation –
aggregate demand and aggregate supply.
CHAPTER 33
55
rate when the price level is different than
expected, leading to an upward-sloping short-run
aggregate supply curve. The three theories
proposed to explain this upward slope are the
sticky wage theory, the sticky price theory, and the
misperceptions theory.
ƒ The long-run aggregate supply curve is vertical,
AGGREGATE DEMAND AND AGGREGATE SUPPLY
AGGREGATE DEMAND AND AGGREGATE SUPPLY
CHAPTER SUMMARY
ƒ In the short run, output deviates from its natural
– except a change in the price level –
will shift the aggregate demand curve.
CHAPTER 33
CHAPTER 33
58
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
59
10