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Dynamic Change, Economic Fluctuations, and the AD-AS Model

GWARTNEY – STROUP – SOBEL – MACPHERSON

To Accompany: “Economics: Private and Public Choice, 15th ed.”

James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson

Slides authored and animated by: James Gwartney & Charles Skipton

Full Length Text —

Macro Only Text —

Part: 3

Chapter: 10

First page

Anticipated and Unanticipated Changes

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Understanding Macroeconomics -- Our Game Plan

Anticipated changes are fully expected by economic participants.

Decision makers have time to adjust to them before they occur.

Unanticipated changes catch people by surprise.

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Factors That Shift Aggregate Demand

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Shifts in Aggregate Demand

The aggregate demand (AD) curve indicates the quantity of goods & services that will be demanded at alternative price levels.

An increase in aggregate demand (a shift of the AD curve to the right) indicates that decision makers will purchase a larger quantity of goods and services at each different price level.

A decrease in aggregate demand (a shift of the AD curve to the left) indicates that decision makers will purchase a smaller quantity of goods and services at each different price level.

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Factors that Shift Aggregate Demand

The following factors will cause a shift in aggregate demand outward (inward):

an increase (decrease) in real wealth

a decrease (increase) in the real interest rate

an increase in the optimism (pessimism) of businesses and consumers about future economic conditions

an increase (decline) in the expected rate of inflation

higher (lower) real incomes abroad

a reduction (increase) in the exchange rate value of the nation’s currency

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Shifts in Aggregate Demand

An increase in real wealth, such as would result from a stock market boom, would increase aggregate demand, shifting the entire curve to the right (from AD0 to AD1).

In contrast, a reduction in real wealth decreases aggregate demand, shifting AD left (from AD0 to AD2).

Goods & Services (real GDP)

Price Level

AD1

AD2

AD0

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Aggregate Demand and Consumer Optimism / Pessimism

Below is the consumer sentiment index for 1978-2012.

This measure attempts to capture consumers’ optimism and pessimism regarding the future of the economy.

Moves toward optimism tend to increase AD, while moves toward pessimism tend to decrease AD.

Note how the consumer sentiment index turns down prior to or during recessions (shaded time periods).

1980

1984

1988

1992

1996

2004

2008

100

Consumer Sentiment Index 1978-2012

2012

2000

120

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Questions for Thought:

Explain how and why each of the following factors would influence current aggregate demand in the United States:

(a) an increased fear of recession

(b) an increased fear of inflation

(d) a reduction in the real interest rate

(e) a decline in housing prices

(f) a higher price level (be careful)

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Shifts in Aggregate Supply

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Long- and Short-Run Aggregate Supply

When considering shifts in aggregate supply, it is important to distinguish between the long run and short run.

Shifts in LRAS: A long run change in aggregate supply indicates that it will be possible to achieve and sustain a larger rate of output.

A shift in the long run aggregate supply curve (LRAS) will cause the short run aggregate supply (SRAS) curve to shift in the same direction.

Shifts in LRAS are an alternative way of indicating there has been a shift in the economy’s production possibilities curve.

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Long- and Short-Run Aggregate Supply

Shifts in SRAS: Changes that temporarily alter the productive capability of an economy will shift the SRAS curve, but not the LRAS curve.

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Shifts in Aggregate Supply

Factors that increase (decrease) LRAS:

increase (decrease) in the supply of resources

improvement (deterioration) in technology and productivity

institutional changes that increase (reduce) efficiency of resource use

Factors that increase (decrease) SRAS:

a decrease (increase) in resource prices — hence, production costs

a reduction (increase) in expected inflation

favorable (unfavorable) supply shocks, such as good (bad) weather or a reduction (increase) in the world price of key imported resource

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Shifts in LRAS & SRAS

Such factors as an increase in the stock of capital or an improvement in technology will expand an economy’s potential output and shift LRAS to the right (note that when the LRAS curve shifts, so too does SRAS).

Such factors as a reduction in resource prices or favorable weather would shift SRAS to the right (note that here the LRAS curve will remain constant).

Price Level

Goods & Services (real GDP)

LRAS1

YF1

LRAS2

YF2

Price Level

Goods & Services (real GDP)

SRAS1

SRAS2

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Questions for Thought:

1. Which of the following would be most likely to shift the long-run aggregate supply curve (LRAS) to the left?

a. unfavorable weather conditions that reduced the size of this year’s grain harvest

b. an increase in labor productivity as the result of improved computer technology and expansion in the Internet

c. an increase in the cost of security as the result of terrorist activities

2. How would an increase in the economy’s production possibilities influence the LRAS?

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Steady Economic Growth and Anticipated Changes in Long-Run Aggregate Supply

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The Impact of Steady Economic Growth

Expansions in the productive capacity of the economy, like those resulting from capital formation or improvements in technology, shifts an economy's LRAS curve to the right.

When growth of the economy is steady and predictable, it will be anticipated by decision makers.

Anticipated increases in output (LRAS) need not disrupt macroeconomic equilibrium.

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Shifts in Long Run Aggregate Supply

Consider the impact of capital formation or a technological advancement on the economy.

Both LRAS and SRAS increase (to LRAS2 and SRAS2).

Full employment output expands from YF1 to YF2.

A sustainable, higher level of real output is the result.

Goods & Services (real GDP)

Price Level

LRAS1

YF1

P100

SRAS1

YF2

LRAS2

P95

SRAS2

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Unanticipated Changes and Market Adjustments

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Unanticipated Changes in Aggregate Demand

In the short-run, output will deviate from full employment capacity as prices in the goods and services market deviate from the price level that people expected.

Unanticipated changes in aggregate demand often lead to such deviations.

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Unanticipated Increase in Aggregate Demand

Impact of unanticipated increase in AD:

Initially, the strong demand and higher price level in the goods & services market will temporarily improve profit margins.

Output will increase, the rate of unemployment will drop below the natural rate, and output will temporarily exceed the economy's long-run potential.

With time, however, contracts will be modified and resource prices will rise and return to their competitive position relative to product prices.

Once this happens, output will recede to the economy's long-run potential.

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Unanticipated Increase in AD: Short Run

In response to an unanticipated increase in AD for goods and services (shifting AD from AD1 to AD2), prices rise to P105 and output will increase to Y2, temporarily exceeding full-employment capacity.

Goods & Services (real GDP)

Price Level

LRAS

P100

AD2

AD1

Short-run effects of an unanticipated increase in AD

SRAS1

P105

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Long-run effects of an unanticipated increase in AD

Goods & Services (real GDP)

Price Level

LRAS

P100

AD2

AD1

SRAS1

P105

Unanticipated Increase in AD: Long Run

With time, resource market prices, including labor, rise due to the strong demand. Higher costs reduce SRAS1 to SRAS2.

In the long-run, a new equilibrium at a higher price level, P110 , and output consistent with long-run potential will occur.

So, the increase in demand only temporarily expands output.

LRAS

SRAS1

SRAS2

P110

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Unanticipated Decrease in Aggregate Demand

Impact of unanticipated reduction in AD:

Weak demand and lower prices in the goods & services market will reduce profit margins. Many firms will incur losses.

Firms will reduce output, the unemployment rate will rise above the natural rate, and output will temporarily fall short of the economy's long-run potential.

With time, long-term contracts will be modified.

Eventually, lower resource prices and lower real interest rates will direct the economy back to long-run equilibrium, but this may be a lengthy and painful process.

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Unanticipated Decrease in AD: Short Run

The short-run impact of an unanticipated reduction in AD (a shift from AD1 to AD2) will be a decline in output (to Y2), and a lower price level (P95).

Temporarily, profit margins decline, output falls, and unemployment rises above its natural rate.

Goods & Services (real GDP)

Price Level

LRAS

P100

AD1

SRAS1

Short-run effects of an unanticipated reduction in AD

AD2

P95

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Goods & Services (real GDP)

Price Level

LRAS

P100

AD1

SRAS1

AD2

P95

Unanticipated Decrease in AD: Long Run

In the long-run, both weak demand and excess supply in the resource market lead to lower resource prices (including labor) resulting in an expansion in SRAS (shifting it from SRAS1 to SRAS2).

A new equilibrium at a lower price level, P90, and an output consistent with long-run potential will result.

Long-run effects of an unanticipated reduction in AD

SRAS2

P90

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Unanticipated Changes in Short-Run Aggregate Supply

Unanticipated changes in short-run aggregate supply (SRAS) can catch people by surprise.

Thus, they are often referred to as supply shocks.

A supply shock is an unexpected event that temporarily increases or decreases aggregate supply.

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Impact of Unanticipated Increase in SRAS

SRAS shifts to the right – output temporarily exceeds the economy's long-run potential.

Since the temporarily favorable supply conditions cannot be counted on in the future, the economy’s long-term production capacity will not be altered.

If individuals recognize that they will be unable to maintain their current high level of income, they will increase their saving. Lower interest rates, and additional capital formation may result.

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Unanticipated Increase in SRAS

Consider an unanticipated, temporary, increase in SRAS, such as may result from a bumper crop from good weather.

The increase in aggregate supply (to SRAS2) would lead to a lower price level P95 and an increase in current GDP to Y2.

As the supply conditions are temporary, LRAS persists.

Goods & Services (real GDP)

Price Level

LRAS

P100

AD1

SRAS1

SRAS2

P95

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Impact of Unanticipated Decrease in SRAS

SRAS shifts to the left – output falls short of economy's long-run potential temporarily.

If an unfavorable supply shock is expected to be temporary, long-run aggregate supply will be unaffected.

Households may reduce their current saving (dip into past savings).

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Supply Shock: Resource Market

Suppose there is an adverse supply shock, perhaps as the result of a crop failure or a sharp increase in the world price of a major resource, such as oil.

Here we show the impact in the resource market: prices rise from Pr1 to Pr2.

Quantity Employment

Real resource price

Resource

market

Pr1

Pr2

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Supply Shock: Product Market

As shown here, the higher resource prices shift SRAS to the left in the product market; in the short-run, price level rises to P110 and output falls to Y2.

What happens in the long-run depends on whether the supply shock is temporary or permanent.

Goods & Services (real GDP)

Price Level

LRAS

P100

AD1

SRAS1 (Pr1 )

P110

SRAS2 (Pr2 )

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Effects of Adverse Supply Shock

If the adverse supply shock is temporary, resource prices will eventually fall in the future, shifting SRAS2 back to SRAS1, returning equilibrium to (A).

If the adverse supply factor is permanent, the productive potential of the economy will shrink (LRAS shifts left and Y2 becomes YF2) and (B) will become the long-run equilibrium.

Goods & Services (real GDP)

Price Level

LRAS

P100

AD1

SRAS1 (Pr1 )

P110

SRAS2 (Pr2 )

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The Price Level, Inflation, and the AD-AS Model

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The basic AD-AS model focuses on how the general level of prices influences the choices of business decision makers.

If the price level in the product market changes, this indicates that this price has changed relative to other markets.

This structure implicitly assumes that the actual and expected rates of inflation are initially zero.

When inflation is present this model can be recast in a dynamic setting.

Price Level, Inflation, and the AD-AS Model

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When the actual and expected rates of inflation are equal:

Inflation will be built into long term contracts.

Prices will rise in both resource and product markets, but the relative price between the two will be unchanged.

When Actual and Expected Rates of Inflation are Equal

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An actual rate of inflation that is less than anticipated is the equivalent of a reduction in the price level. As a result, firms will incur losses and reduce output.

An actual rate of inflation that is greater than anticipated is the equivalent of an increase in the price level. Profits will be enhanced and firms will expand output.

When Actual and Expected Rates of Inflation Differ

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Unanticipated Changes, Recessions, and Booms

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The AD-AS Model and Instability

The AD-AS model indicates that unanticipated changes will disrupt macro equilibrium and result in economic instability.

Recessions occur because prices in the goods and services market are low relative to the costs of production and resource prices.

The two causes of recessions are:

unanticipated reductions in AD, and,

unfavorable supply shocks.

An unsustainable boom occurs when prices in the goods and services market are high relative to resource prices and other costs.

The two causes of booms are:

unanticipated increases in AD, and,

favorable supply shocks.

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Two Forces Directing the Economy Back to Equilibrium

The AD-AS model indicates that there are two forces that will help direct an economy back to long-run equilibrium:

Changes in real resource prices:

During a recession, real resource prices will tend to fall because the demand for resources will be weak and the rate of unemployment high.

During a boom, real resource prices will tend to rise as demand for resources will be strong and the unemployment rate low.

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The AD-AS model indicates that there are two forces that will help direct an economy back to long-run equilibrium:

Changes in real interest rates:

During a recession, real interest rates will tend to decline because of the weak demand for investment. The lower interest rates will stimulate AD and help direct the economy back to full employment.

During a boom, real interest rates will tend to rise because of the strong demand for investment. The higher rates will retard AD and help direct the economy back to full employment.

Two Forces Directing the Economy Back to Equilibrium

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The Macro-Adjustment Process

If output is temporarily less than long-run potential YF …

Goods & Services (real GDP)

Price Level

LRAS

AD1

SRAS1

P100

Lower real interest rates increase AD

AD2

SRAS2

Lower resource prices increase SRAS

falling interest rates will shift AD (from AD1 to AD2) …

while lower resource prices decrease production costs and thereby increase SRAS (from SRAS1 to SRAS2) …

and so direct output toward its full-employment potential (YF).

P100

Output may exceed or fall short of the economy’s full-employment capacity (YF) in the short-run.

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Goods & Services (real GDP)

Price Level

The Macro-Adjustment Process

If output is temporarily greater than long-run potential YF …

higher interest rates will reduce AD (from AD1 to AD2) …

while higher resource prices increase production costs and thereby reduce SRAS (from SRAS1 to SRAS2) …

directing output toward its full-employment potential (YF).

P100

LRAS

SRAS1

AD1

Higher real interest rates reduce AD

AD2

SRAS2

Higher resource prices reduce SRAS

Output may exceed or fall short of the economy’s full-employment capacity (YF) in the short-run.

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Questions for Thought:

Suppose consumers and investors suddenly become more pessimistic about the future and therefore decide to reduce their consumption and investment spending. How will a market economy adjust to this increase in pessimism?

“If the general level of prices is higher than business decision makers anticipated when they entered into long-term contracts for raw materials and other resources, profit margins will be abnormally low and the economy will fall into a recession.” – Is this statement true?

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Questions for Thought:

3. Which of the following would be most likely to throw the U.S. economy into a recession?

(a) a reduction in transaction costs as the result of the growth and development of the Internet

(b) an unanticipated reduction in the world price of oil

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Expansions and Recessions: The Historical Record

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During the past six decades, economic expansions have been far more lengthy than recessions.

The depth and severity of the recession that started in December 2007 highlights the issue of economic instability and recovery from a recession.

Expansions and Recessions: the Historical Record

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Expansions and Recessions: 1950-2012

Period of Expansion	Length (in Months)	Period of Recession	Length (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	19
July ’09 to ?	?

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Using the AD-AS Model to Think about the Business Cycle and the Great Recession of 2008-2009

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What caused boom of 2003-07 and the bust of 2008-09?

Between 2002 and mid-year 2006, housing prices rose by almost 90%. Stock prices also rose rapidly. As a result, wealth expanded and AD increased, leading to an economic boom.

But the situation changed in the second half of 2006. Housing prices began to fall. Both mortgage default and housing foreclosure rates increased. This reduced AD.

Stock prices began to decline in October 2007 and they plunged during 2008. This also reduced wealth and AD.

The Great Recession of 2008-2009

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What caused boom and bust?

During 2007 and the first half of 2008, crude oil and other energy prices soared, and this generated an unanticipated reduction in SRAS.

These forces led to a sharp reduction in consumer and investor confidence, further reducing AD.

The reductions in both AD and SRAS reduced output and employment just as the AD-AS model implies.

The Great Recession of 2008-2009

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Changes in Stock and Housing Prices During Expansions

Both stock & housing prices generally rise prior to and during expansions.

This leads to increases in AD.

In contrast, stock and housing prices generally fall prior to and during recessions, and this reduces AD.

The wealth effects associated with the swings in stock and housing prices are a contributing factor to the ups and downs of the business cycle.

Note: the reduction in housing prices for the 2008-2009 recession were far greater than other recessions. Stock price reductions were also substantial.

These price reductions increased the severity of the recent downturn.

1970-72

1975-77

1980-81

1982-84

1991-93

2002-04

50%

40%

30%

20%

10%

-10%

-20%

-30%

-40%

-50%

% Change

Home Prices

Stock Prices

––– Recession –––

––– Expansion –––

2010--

1969-70

1973-75

1980

1981-82

1990-91

2001

2008-09

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Questions for Thought:

1. During the first half of 2008, the world price of oil soared while stock and housing prices plunged. Within the framework of the AD-AS model, how would these two changes influence the U.S. economy? Explain the expected impact on output & price level.

2. When actual output is less than the economy’s full employment level of output, how will real resource prices and real interest rates adjust?

3. Build the AD, SRAS, & LRAS curves for an economy experiencing:

(a) full employment equilibrium

(b) an economic boom

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End of

Chapter 10

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