Overview
• Three key factors about
economic fluctuations.
• The aggregate demand and
aggregate supply model.
• The aggregate demand curve.
• The aggregate supply curve.
• Equilibrium in the SR & long-run.
Short-Run Economic
Fluctuations
• Economic activity fluctuates from
year to year. In some years, the
production of goods and services
rises. In other years normal growth
does not occur, leading to recession.
• A recession is a situation of
declining real GDP, falling incomes
and rising unemployment for two
consecutive quarters.
Three Key Facts About
Economic Fluctuations
Economic Fluctuations are
Irregular and Unpredictable.
•
Recessions occur with
unpredictable frequency and
duration.
Most Macroeconomic Variables
Fluctuate Together.
•
Most macroeconomic variables are
closely related and move together.
Three Key Facts About
Economic Fluctuations
As Output Falls, Unemployment
Rises.
•
•
•
Changes in real GDP and the
unemployment rate are inversely
related.
Labour demand depends on output.
Y= f(K,L) Y is GDP
Selling Cars in the US
US Housing Starts
TSX—Wealth Decline
Economic Fluctuations
• Although there remains some
debate about how to analyze
short-run fluctuations, most
economists use the model of
aggregate demand and
aggregate supply.
Fluctuations
Investment is volatile in
Y=C+I+G+NX
Unemployment rate
Model of Economic Fluctuations
• Two variables are used in developing
a model to analyze the short-run
fluctuations:
1. The economy’s output of goods and
services, measured by real GDP
2. The overall price level, measured by the
CPI or GDP deflator
• The Model: Aggregate Demand and
Aggregate Supply
The Aggregate Demand and
Aggregate Supply Model
Price
SR Aggregate
Supply
Level
PE
Aggregate
Demand
QE
Quantity of Output
Aggregate Demand and
Aggregate Supply
• The Aggregate Demand Curve shows
the quantity of goods and services
that households, firms and the
government are willing to buy at
different prices.
• The Aggregate Supply Curve shows
the quantity of goods and services
that firms would be willing to
produce and sell at different prices.
Tech boom and bust
ECONOMIC “BUBBLES”
• An economic bubble is the
commonly used term for an
economic cycle that is
characterized by a rapid
expansion followed by a
contraction, often in a dramatic
fashion.
NORTEL—NO LONGER EXISTSTECH BUBBLE
House price bubble
Business cycles
The Aggregate Demand
Curve
• The aggregate demand for
goods and services is:
Y = C + I + G + NX
• Why is the aggregate demand
curve downward sloping?
1. Pigou’s Wealth Effect
2. Keynes’ Interest Rate Effect
3. Real Exchange Rate Effect
Slope of AD
Downward Slope of AD:
1. Pigou’s Wealth Effect:
• If P declines “Consumers feel
wealthier, which stimulates the
demand for consumption goods.”
• A decrease in the price level
makes consumers feel more
wealthy, which in turn encourages
them to spend more.
• The increase in consumer
spending means a larger quantity
of goods and services demanded.
Downward Slope of AD:
2. Keynes’ Interest-Rate Effect:
• “The lower the price level, the
less money households need to
hold to buy the goods and
services they want.” MD down
•
A lower price level reduces the
interest rate, encourages greater
spending on investment goods,
and thereby increases the quantity
of goods and services demanded.
Downward Slope of AD:
3. Real Exchange-Rate Effect:
• “When prices of Canadian goods go
down, foreigners buy more of our
goods and we purchase less of their
goods.”
•
When a fall in the Canadian price level
causes the real exchange rate to
depreciate, this stimulates Canadian
net exports, thereby increasing the
quantity of goods and services
demanded.
Slope of AD
• The aggregate demand for
goods and services is:
Y = C + I + G + NX
• Why is the aggregate demand
curve downward sloping?
1. Pigou’s Wealth Effect
2. Keynes’ Interest Rate Effect
3. Real Exchange Rate Effect
Factors that might shift
Aggregate Demand
• Shifts in the aggregate demand
curve may arise because of:
1. Changes in spending plans by
consumers or firms. C, I, NX
2. Changes in fiscal or monetary
policy. G
“Anything that causes buyers to want
to purchase more or less than before
will cause the aggregate demand
schedule to shift.”
Shift in AD: not caused by changes in
the price level. Wealth decline could
decrease C: Higher interest Rates
could decrease I. G declines, NX
declines [AD1 to AD3]
SHIFTS IN AD
• Y-AXIS—Price level
• X-axis—Quantity of output (real
GDP)
• Initial AD is AD1
• Shifts right to AD2
• Caused by changes in C, I, G,
NX (spending) DIAGRAM
AD and SRAS
Real
GDP
Growth
u=7.8%
US u=9%
Canada
2007 was 6.0
2009 was8.3
2007was 4.6
2009was 9.3
AD questions
What happens to the AD curve in each of the
following scenarios?
A. A ten-year-old investment tax credit
expires.
B. The Canadian exchange rate falls.
C. A fall in prices increases the real value
of consumers’ wealth.
D. Provincial governments reduce their
sales taxes.
AD answers
A.A ten-year-old investment tax credit
expires.
I falls, AD curve shifts left.
B.The Canadian exchange rate falls.
NX rises, AD curve shifts right.
C.A fall in prices increases the real value of
consumers’ wealth.
Move down along AD curve (wealth-effect).
D.Provincial governments reduce sales
taxes.
C rises, AD shifts right.
THE AGGREGATE-SUPPLY
CURVE
• In the long run, the aggregatesupply curve is vertical.
• In the short run, the aggregatesupply curve is upward sloping.
• LR reflects PPF
• Price level does not affect real
variables in the LR—neutrality.
LRAS—like PPF
LR- growth and inflationover time
The Long-Run Aggregate
Supply Curve
Price
SR Aggregate
Level
Supply
LRS-Output at
Full Employment
Aggregate
Demand
Quantity of Output
Shifts in the Long-Run
Aggregate Supply Curve
• Over time, any change in the factors
that determine the long-run
aggregate supply will cause the
curve to shift. Like PPF
• An event that reduces potential
output shifts the schedule to the
left.
• Any change that increases the
economy’s potential output will
shift the curve to the right. R,T
The Short-Run
Aggregate
Supply Curve
• In the short-run, an increase in
the overall level of prices in the
economy tends to increase the
quantity of goods and services
supplied, and a decrease in the
level of prices tends to reduce
the quantity of goods and
services supplied.
SRAS
Reasons for the Upward
Slope of the SR Aggregate
Supply Curve
• 3 alternative explanations for
the upward slope of SRAS.
•
•
•
•
New Classical Misperceptions
Theory
Keynesian Sticky-Wage Theory
New Keynesian Sticky-Price
Theory
These are adjustment issues
Slope of SRAS matters
• If AS is vertical (LR) then
changes in AD do not cause
fluctuations in Y or N
• If AS slopes up (SR) then
changes in AD do affect output
and employment
Reasons for the Upward
Slope of SRAS
• The New Classical Misperceptions
Theory: “A higher price level signals
to each firm a greater demand for
their product inducing them to
produce more.”
• Changes in the overall price level
can temporarily mislead suppliers
about what is happening in the
markets in which they sell their
output. LR costs increase too.
Reasons for the Upward Slope
of the Aggregate Supply
Curve
• Keynesian Sticky-Wage Theory:
“The higher product prices cause a
temporary decrease in real wages
stimulating employment and output.”
• Nominal wages are slow to adjust,
or are “sticky” in the short-run,
thus a higher price level makes
employment and production more
profitable, which induces firms to
increase production. R=W/P
Reasons for the Upward Slope
of the Aggregate Supply
Curve
• New Keynesian Sticky-Price Theory:
“Prices that do not increase
immediately are temporarily low
thereby stimulating spending and
output on those goods.”
• Prices of some goods and services
adjust sluggishly in response to
changing economic conditions.
• Remember Menu Costs-adjust
slower.
3 Theories of SRAS
slope ******
Each of the 3 theories implies Y
deviates from YN when P
deviates from PE.
• Y = YN +a(P-PE)
YN =Natural rate of output (long-run)
• P-actual price level
• PE-expected price level
• P>PE GDP increases
What Might Cause the
Aggregate Supply Curve
to Shift?
• Three factors may lead to a
shift in the short-run aggregate
supply curve.
•
•
•
Changes in Factor (input) Prices
Changes in Productivity
Legal-Institutional Environment
What Might Cause the
Aggregate Supply Curve
to Shift?
• Changes in factor (input) prices:
Changes in the prices of
domestic or imported resources
will change the cost of
producing final goods.
•
•
An increase in input prices will
shift the supply curve to the left.
A decrease in input prices will
shift the supply curve to the right.
What Might Cause the
Aggregate Supply Curve
to Shift?
• Changes in productivity: If
changes in the resource
markets increase factor
productivity, more goods can be
made available at a lower cost.
New technologies can increase
the output per unit of labour or
capital and hence make
available more final goods.
What Might Cause the
Aggregate Supply Curve
to Shift?
• Legal-institutional environment:
Burdensome taxes and
counterproductive regulations
can increase the cost of
production and discourage firms
from producing.
Equilibrium in the LongRun
• Equilibrium output and price
level are determined by the
intersection of the aggregate
demand curve and the long-run
aggregate supply curve.
• Output is at its natural rate and
the short-run aggregate supply
curve passes through the point
of intersection.
Equilibrium in the LongRun
Price
SR Aggregate
Level
Supply
PE
Aggregate
Demand
QE
Quantity of Output
Sources of Recession
• Two sources from which a recession
in the economy may occur:
• A decrease in aggregate demand
• A decrease in SR aggregate supply
• Shifts in the aggregate demand or
the SR aggregate supply curves
result in fluctuations in the
economy’s output of goods and
services.
• Leftward shifts-recession
Gap terminology
• Recessionary gap: AD
intersects SRAS LEFT of
LAS.
• Inflationary gap: AD
intersects SRAS RIGHT of
LAS.
Source of Recession:
A Decrease in Aggregate
Demand
• A decrease in one or more
components of the total
spending function will cause the
aggregate demand schedule to
shift leftward.
•
•
Output will fall below the full
employment output
Unemployment will rise
A Decrease in Aggregate
Demand
Price
SR Aggregate
Level
Supply
PE
Aggregate
Demand
QE
Quantity of Output
AD shift--LR
Source of Recession
A Decrease in Aggregate
Supply
• A decrease in short-run
aggregate supply will result in a
new equilibrium along the
aggregate demand curve below
full employment.
• A fall in total output below full
output
•
An increase in unemployment
A Decrease in Aggregate
Supply
Price
SR Aggregate
Level
Supply
PE
Aggregate
Demand
QE
Quantity of Output
A Decrease in Aggregate
Supply
• When the economy falls due to
a decrease in the aggregate
supply, the price level rises and
output decreases. This is
called Stagflation.
• Example: Higher oil prices.
Accommodating AS shift
Actions by Policy-makers
During Periods of Recession
• Policy-makers, when faced by
decreasing aggregate demand or
supply could:
• Do nothing, assuming that
perceptions will adjust prices and
wages. Move back to LAS.
• Take action to increase aggregate
demand (e.g. increase government
spending). FISCAL policy
• Implement monetary policy. OMO
Economic Fluctuations
• Four steps to analyzing economic
fluctuations:
1. Determine whether the event shifts AD or AS.
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. Use AD-AS diagram to see how economy
moves from new SR eq’m to new LR eq’m.
AD and AS--question
• Draw the AD-SRAS-LRAS diagram
for the Canadian economy,
starting in a long-run equilibrium.
• A boom occurs in the U.S..
Use your diagram to determine
the SR and LR effects on Canadian
GDP, the price level, and
unemployment.
What happens?
•
•
•
•
Event: boom in U.S.
1. affects NX, AD curve
2. shifts AD right
3. SR eq’m at point B. P and Y
higher, unemp lower
• 4. Over time, PE rises, SRAS shifts
left, until LR eq’m at C.
Y and unemp back at initial levels.
AD shifts
US Recession
US recession
US recession
• House price bubble-wealth
decline
• Mortgage-backed securitiesMBS-exposure of banks.
Derivatives.
• MBS-Counterparty risk
• Auto sector collapse
SUMMARY
• Short-run fluctuations in GDP and
other macroeconomic quantities are
irregular and unpredictable.
Recessions are periods of falling real
GDP and rising unemployment.
• Economists analyze fluctuations
using the model of aggregate
demand and aggregate supply.
• The aggregate demand curve slopes
downward because a change in the
price level has a wealth effect on
consumption, an interest-rate effect
on investment, and an exchange-rate
Summary
• Anything that changes C, I, G, or NX
– except a change in the price level –
will shift the aggregate demand curve.
• The long-run aggregate supply curve is
vertical, because changes in the price
level do not affect output in the long run.
• In the long run, output is determined by
labour, capital, natural resources, and
technology; changes in any of these will
shift the long-run aggregate supply curve.
summary
• In the short run, output deviates from its
natural 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 price misperceptions theory.
• The short-run aggregate-supply curve
shifts in response to changes in input
costs and to anything that shifts the longrun aggregate supply curve.
summary
• Economic fluctuations are caused by shifts
in aggregate demand and aggregate
supply.
• 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 down. In the long run, the economy
returns to the natural rates of output and
unemployment, but with a lower price
level. See Figure 14.8