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N. Gregory Mankiw

Macroeconomics

Brief Principles of

Sixth Edition

Aggregate Demand and Aggregate Supply

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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2012 UPDATE

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This is perhaps the most important of the macro chapters. It develops the model of aggregate demand and aggregate supply, a paradigm that is widely used by many economists, policymakers, journalists, and business people. Mastering this chapter will give students much insight into how the world works, and will make the following two chapters easier to learn.

Most students find this to be one of the most challenging chapters in the textbook. However, much of the material here should be familiar from previous chapters—e.g., the Classical Dichotomy, the relationship between investment and interest rates, the relationship between net exports and the exchange rate. This chapter brings together much of this familiar material in a new context, which allows us to address new and important questions, such as: what causes recessions, and what can policymakers do to alleviate recessions?

This is one of the more challenging chapters to teach. I’ve invested a lot of time and thought into making a good PowerPoint presentation for this chapter. But there is a lot of variation in the approaches instructors use to teach this material. You’ll want to look over this file and perhaps make changes to make it work with your approach to teaching this material.

In this chapter, look for the answers to these questions:

What are economic fluctuations? What are their characteristics?

How does the model of aggregate demand and aggregate supply explain economic fluctuations?

Why does the Aggregate-Demand curve slope downward? What shifts the AD curve?

What is the slope of the Aggregate-Supply curve in the short run? In the long run? What shifts the AS curve(s)?

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Introduction

Over the long run, real GDP grows about 3% per year on average.

In the short run, GDP fluctuates around its trend.

Recessions: periods of falling real incomes and rising unemployment

Depressions: severe recessions (very rare)

Short-run economic fluctuations are often called business cycles.

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Three Facts About Economic Fluctuations

FACT 1: Economic fluctuations are irregular and unpredictable.

U.S. real GDP, billions of 2005 dollars

The shaded bars are recessions

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Recessions (represented by the shaded bars) are of different durations and do not occur with any regularity. Hence, the common term “business cycle” is a bit misleading, as “cycle” implies something more regular and predictable.

UNITS: Billions of chained 2005 dollars

ORIGINAL SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis

WEBSITE WHERE I FOUND THIS DATA: http://research.stlouisfed.org/fred2/

SERIES: GDPC1

Recession 1965 1965.25 1965.5 1965.75 1966 1966.25 1966.5 1966.75 1967 1967.25 1967.5 1967.75 1968 1968.25 1968.5 1968.75 1969 1969.25 1969.5 1969.75 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012.25 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 value 1965 1965.25 1965.5 1965.75 1966 1966.25 1966.5 1966.75 1967 1967.25 1967.5 1967.75 1968 1968.25 1968.5 1968.75 1969 1969.25 1969.5 1969.75 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 20 12 2012.25 3513.3 3560.9 3633.2 3720.8 3812.2 3824.9 3850 3881.2 3915.4 3916.2 3947.5 3977.6 4059.5 4128.5 4156.7 4174.7 4240.5 4252.8 4279.7 4259.6000000000004 4252.8999999999996 4260.7 4298.6000000000004 4253 4370.3 4395.1000000000004 4430.2 4442.5 4521.8999999999996 4629.1000000000004 4673.5 4750.5 4872 4928.3999999999996 4902.1000000000004 4948.8 4905.3999999999996 4918 4869.3999999999996 4850.2 4791.2 4827.8 4909.1000000000004 4973.3 5086.3 5124.6000000000004 5149.7 5187.1000000000004 5247.3 5351.6 5447.3 5446.1 5464.7 5679.7 5735.4 5811.3 5821 5826.4 5868.3 5884.5 5903.4 5782.4 5771.7 5878.4 6000.6 5952.7 6025 5950 5852.3 5884 5861.4 5866 5938.9 6072.4 6192.2 6320.2 6442.8 6554 6617.7 6671.6 6734.5 6791.5 6897.6 6950 7016.8 7045 7112.9 7147.3 7186.9 7263.3 7326.3 7451.7 7490.2 7586.4 7625.6 7727.4 7799.9 7858.3 7920.6 7937.9 8020.8 8052.7 8052.6 7982 7943.4 7997 8030.7 8062.2 8150.7 8237.2999999999993 8322.2999999999993 8409.7999999999993 8425.2999999999993 8479.2000000000007 8523.7999999999993 8636.4 8720.5 8839.7999999999993 8896.7000000000007 8995.5 9017.6 9037 9112.9 9176.4 9239.2999999999993 9399 9480.7999999999993 9584.2999999999993 9658 9801.2000000000007 9924.2000000000007 10000.299999999999 10094.799999999999 10185.6 10320 10498.6 10592.1 10674.9 10810.7 11004.8 11033.6 11248.8 11258.3 11325 11287.8 11361.7 11330.4 11370 11467.1 11528.1 11586.6 11590.6 11638.9 11737.5 11930.7 12038.6 12117.9 12195.9 12286.7 12387.2 12515 12570.7 12670.5 12735.6 12896.4 12948.7 12950.4 13038.4 13056.1 13173.6 13269.8 13326 13266.8 13310.5 13186.9 12883.5 12711 12701 12746.7 12873.1 12947.6 13019.6 13103.5 13181.2 13183.8 13264.7 13306.9 13441 13506.4 13558

Three Facts About Economic Fluctuations

FACT 2: Most macroeconomic quantities fluctuate together.

Investment spending, billions of 2005 dollars

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Point out that investment falls during each recession. This is true of other variables as well: When the economy is in recession, incomes fall, consumer spending falls, profits fall, many stock prices fall, tax revenue falls (causing the budget deficit to rise), and spending on imports falls (causing the trade deficit to shrink).

UNITS: Billions of chained 2005 dollars

ORIGINAL SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis

WEBSITE WHERE I FOUND THIS DATA: http://research.stlouisfed.org/fred2/

SERIES NAME: GPDIC1

Recession 1965 1965.25 1965.5 1965.75 1966 1966.25 1966.5 1966.75 1967 1967.25 1967.5 1967.75 1968 1968.25 1968.5 1968.75 1969 1969.25 1969.5 1969.75 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012.25 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 Investment 1965 1965.25 1965.5 1965.75 1966 1966.25 1966.5 1966.75 1967 1967.25 1967.5 1967.75 1968 1968.25 1968.5 1968.75 1969 1969.25 1969.5 1969.75 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.2 5 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012.25 427.6 427.6 442.8 444.9 482.5 473.7 469 471.2 458.3 438.8 451.4 461.1 471.2 490.2 474.3 479.2 510.8 506.7 518.5 490.5 475.2 476.7 484.8 456.7 516 532 539 522.20000000000005 559.1 593.29999999999995 601.79999999999995 604.9 643.29999999999995 673.4 647 671.8 628.9 625.79999999999995 590.5 596.1 491.4 474.4 514.5 528.70000000000005 583.4 608.29999999999995 609.4 613.70000000000005 643.79999999999995 693.6 731.4 710.8 724.9 774.6 798.5 816.7 816.6 814.7 798.8 783.9 778.3 708.1 654.1 720.6 792.2 754.5 801.3 770.2 690 689.4 681.3 620.70000000000005 642.79999999999995 704.8 752.2 831.4 918.4 949.4 971.4 955.5 924 939.9 929.6 965.9 963.9 942.5 913 914.4 942.3 943.6 944.6 1018.3 960.9 984.3 990.6 1003.7 1042.2 1030 1017.9 1007.4 1017.3 1017.6 993.7 930.8 892.9 888.5 910.6 945.4 924.4 985.3 995.5 1027 1051.0999999999999 1059.4000000000001 1058.5999999999999 1114.5 1162.5999999999999 1230.4000000000001 1208.2 1264.5999999999999 1277.4000000000001 1243.0999999999999 1231.0999999999999 1265.8 1282.4000000000001 1348.9 1416.9 1413 1446 1538.3 1565.7 1590.7 1666.6 1646.7 1693.9 1748.4 1803.4 1797.1 1842.2 1907.6 1880.9 2011.1 1979.7 1980.7 1876.1 1870 1830.3 1724. 5 1781.9 1803.4 1808 1808.3 1810.4 1821.8 1888.4 1959.9 1970.1 2055.6999999999998 2082.1 2124.9 2170 2131.3000000000002 2155.1 2232.8000000000002 2266.3000000000002 2263.1 2231.1999999999998 2166.6999999999998 2145.1 2193 2176.3000000000002 2123.6 2055.6999999999998 2024 1934.7 1744.6 1516 1400.7 1394.8 1521.1 1591.4 1646.4 1710.1 1684.3 1661.6 1711.3 1735.8 1867.3 1895.1 1934

Three Facts About Economic Fluctuations

FACT 3: As output falls, unemployment rises.

Unemployment rate, percent of labor force

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During each recession, the unemployment rate rises. When firms cut back on production, they don’t need as many workers. Similarly, during expansions, we see the unemployment rate falling—as firms increase their output, they need more workers.

UNITS: Percent of labor force (seasonally adjusted)

ORIGINAL SOURCE: U.S. Department of Labor, Bureau of Labor Statistics

WEBSITE WHERE I FOUND THIS DATA: http://research.stlouisfed.org/fred2/ series “UNRATE”

Note: The source data was monthly. To be consistent with Figure 1c of the text, this graph plots quarterly data, where each quarterly value is a simple average of the three monthly values.

Recession 1965 1965.25 1965.5 1965.75 1966 1966.25 1966.5 1966.75 1967 1967.25 1967.5 1967.75 1968 1968.25 1968.5 1968.75 1969 1969.25 1969.5 1969.75 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012.25 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 Unemployment Rate 1965 1965.25 1965.5 1965.75 1966 1966.25 1966.5 1966.75 1967 1967.25 1967.5 1967.75 1968 1968.25 1968.5 1968.75 1969 1969.25 1969.5 1969.75 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012.25 4.9000000000000004 4.7 4.4000000000000004 4.0999999999999996 3.9 3.8 3.8 3.7 3.8 3.8 3.8 3.9 3.7 3.6 3.5 3.4 3.4 3.4 3.6 3.6 4.2 4.8 5.2 5.8 5.9 5.9 6 5.9 5.8 5.7 5.6 5.4 4.9000000000000004 4.9000000000000004 4.8 4.8 5.0999999999999996 5.2 5.6 6.6 8.3000000000000007 8.9 8.5 8.3000000000000007 7.7 7.6 7.7 7.8 7.5 7.1 6.9 6.7 6.3 6 6 5.9 5.9 5.7 5.9 6 6.3 7.3 7.7 7.4 7.4 7.4 7.4 8.1999999999999993 8.8000000000000007 9.4 9.9 10.7 10.4 10.1 9.4 8.5 7.9 7.4 7.4 7.3 7.2 7.3 7.2 7 7 7.2 7 6.8 6.6 6.3 6 5.8 5.7 5.5 5.5 5.3 5.2 5.2 5.2 5.4 5.3 5.3 5.7 6.1 6.6 6.8 6.9 7.1 7.4 7.6 7.6 7.4 7.1 7.1 6.8 6.6 6.6 6.2 6 5.6 5.5 5.7 5.7 5.6 5.5 5.5 5.3 5.3 5.2 5 4.9000000000000004 4.7 4.5999999999999996 4.4000000000000004 4.5 4.4000000000000004 4.3 4.3 4.2 4.0999999999999996 4 3.9 4 3.9 4.2 4.4000000000000004 4.8 5.5 5.7 5.8 5.7 5.9 5.9 6.1 6.1 5.8 5.7 5.6 5.4 5.4 5.3 5.0999999999999996 5 5 4.7 4.5999999999999996 4.5999999999999996 4.4000000000000004 4.5 4.5 4.7 4.8 5 5.3 6 6.9 8.3000000000000007 9.3000000000000007 9.6 9.9 9.8000000000000007 9.6 9.5 9.6 9 9 9.1 8.6999999999999993 8.3000000000000007 8.1999999999999993

Introduction, continued

Explaining these fluctuations is difficult, and the theory of economic fluctuations is controversial.

Most economists use the model of aggregate demand and aggregate supply to study fluctuations.

This model differs from the classical economic theories economists use to explain the long run.

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This is a slide you can probably cut if you wish to shorten your presentation of this chapter. It would be fine to just state this information verbally.

Classical Economics—A Recap

The previous chapters are based on the ideas of classical economics, especially:

The Classical Dichotomy, the separation of variables into two groups:

Real – quantities, relative prices

Nominal – measured in terms of money

The neutrality of money: Changes in the money supply affect nominal but not real variables.

‹#›

If you have covered the long-run chapters before this one, then your students have seen these terms already. It may be worth reminding your students that the Classical Dichotomy is what allowed us to study the real variables (like real GDP and its growth rate, the unemployment rate, investment, and the real wage) in separate chapters before we introduced nominal variables (like the price level and money supply).

Classical Economics—A Recap

Most economists believe classical theory describes the world in the long run, but not the short run.

In the short run, changes in nominal variables (like the money supply or P ) can affect real variables (like Y or the u-rate).

To study the short run, we use a new model.

‹#›

As in previous chapters, “u-rate” is short for unemployment rate.

The Model of Aggregate Demand and Aggregate Supply

SRAS

The price level

Real GDP, the quantity of output

The model determines the eq’m price level

and eq’m output (real GDP).

“Aggregate Demand”

“Short-Run Aggregate Supply”

‹#›

NOTE: In edit mode (what PowerPoint calls “Normal view”), this slide looks cluttered. But in presentation (or Slide Show) mode, it all works pretty well.

As in previous chapters, “eq’m” is short for “equilibrium.”

Suggestion: Briefly explain each element of the graph as it appears. (Brief is appropriate because each element will be discussed carefully in the following slides.)

Note that the graph measures a nominal variable (P) on the vertical axis, and a real one (Y) on the horizontal axis. Thus, the graph highlights the breakdown of the classical dichotomy.

If you are more of a micro person, then please disregard the following.

Still reading? Then you must be a macro person. Excellent! Here’s something you might tell your students. This model LOOKS like the basic supply and demand model from Chapter 4, but there’s a big difference. The basic supply & demand model determines the equilibrium price and quantity of a particular good, say, apples. The equilibrium price of apples is extremely important if you’re an apple grower. Ask your students to raise their hand if they plan on going into the apple-growing business. Chances are, none will raise their hands. The model of aggregate demand and supply, however, determines the equilibrium price and quantity of EVERYTHING (loosely speaking), i.e., the price level (cost of living) and real GDP (national income). So, the model of aggregate demand and aggregate supply is highly relevant to a broader group of people than just apple growers. How ’bout them apples!

The Aggregate-Demand (AD) Curve

The AD curve shows the quantity of all g&s demanded in the economy at any given price level.

‹#›

As in previous chapters, “g&s” stands for “goods and services.”

Why the AD Curve Slopes Downward

Y = C + I + G + NX

Assume G fixed by govt policy.

To understand the slope of AD, must determine how a change in P affects C, I, and NX.

‹#›

The Wealth Effect (P and C )

Suppose P rises.

The dollars people hold buy fewer g&s, so real wealth is lower.

People feel poorer.

Result: C falls.

‹#›

Note: the wealth effect concerns the impact of a change in P on wealth, not on income. When P falls, we are implicitly assuming that people’s real incomes are unchanged, and we are only considering the impact of the change in their real wealth on their consumption spending.

After all text on this slide has appeared, you might tell your students that this effect works in reverse, too: a fall in P raises real wealth, which causes consumption to rise.

The Interest-Rate Effect (P and I )

Suppose P rises.

Buying g&s requires more dollars.

To get these dollars, people sell bonds or other assets.

This drives up interest rates.

Result: I falls. (Recall, I depends negatively on interest rates.)

‹#›

Again, we are holding real income (and everything else) constant.

At this point, some students will not understand why an increase in household demand for bonds causes interest rates to fall. If you wish, you can explain it now, or you can tell them not to worry about it for now—it will be covered in more detail in the following chapter (in the section on the Liquidity Preference Theory).

After all the text on this slide has appeared, you might tell your students that the interest-rate effect also works in reverse: a decrease in P causes a decrease in interest rates, which increases investment.

The Exchange-Rate Effect (P and NX )

Suppose P rises.

U.S. interest rates rise (the interest-rate effect).

Foreign investors desire more U.S. bonds.

Higher demand for $ in foreign exchange market.

U.S. exchange rate appreciates.

U.S. exports more expensive to people abroad, imports cheaper to U.S. residents.

Result: NX falls.

‹#›

Again, the exchange-rate effect also works in reverse: A decrease in P causes interest rates and exchange rates to fall, which increases NX.

The Slope of the AD Curve: Summary

An increase in P reduces the quantity of g&s demanded because:

the wealth effect (C falls)

the interest-rate effect (I falls)

the exchange-rate effect (NX falls)

‹#›

Note that the red arrow is not equal to the fall in C, but rather to the fall in demand due to the fall in C. The difference is due to the Keynesian multiplier: the initial fall in C causes a fall in Y, which causes a further (but smaller) fall in C, which causes a further (but smaller) fall in Y, and so forth. It might not be appropriate to cover the Keynesian multiplier at this point—it will be discussed in the following chapter—but mentioning that the red arrow is not the same as the fall in C might prevent students from learning something they will later have to unlearn. Similarly, the green arrow represents not the fall in I, but the fall in demand due to the fall in I. And similarly for the goldish-brown arrow and NX.

Why the AD Curve Might Shift

Any event that changes C, I, G, or NX—except a change in P—will shift the AD curve.

Example: A stock market boom makes households feel wealthier, C rises, the AD curve shifts right.

AD1

AD2

‹#›

A change in P won’t shift the AD curve, but will cause a movement along the AD curve.

Why the AD Curve Might Shift

Changes in C

Stock market boom/crash

Preferences re: consumption/saving tradeoff

Tax hikes/cuts

Changes in I

Firms buy new computers, equipment, factories

Expectations, optimism/pessimism

Interest rates, monetary policy

Investment Tax Credit or other tax incentives

‹#›

Why the AD Curve Might Shift

Changes in G

Federal spending, e.g., defense

State & local spending, e.g., roads, schools

Changes in NX

Booms/recessions in countries that buy our exports

Appreciation/depreciation resulting from international speculation in foreign exchange market

‹#›

ACTIVE LEARNING 1 The Aggregate-Demand curve

What happens to the AD curve in each of the following scenarios?

A. A ten-year-old investment tax credit expires.

B. The U.S. exchange rate falls.

C. A fall in prices increases the real value of consumers’ wealth.

D. State governments replace their sales taxes with new taxes on interest, dividends, and capital gains.

‹#›

You might encourage your students to draw a separate diagram of the AD curve for each scenario and show on the diagram what happens to the curve.

ACTIVE LEARNING 1 Answers

A. A ten-year-old investment tax credit expires.

I falls, AD curve shifts left.

B. The U.S. 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. State governments replace sales taxes with new taxes on interest, dividends, and capital gains.

C rises, AD shifts right.

‹#›

The Aggregate-Supply (AS ) Curves

The AS curve shows the total quantity of g&s firms produce and sell at any given price level.

SRAS

LRAS

AS is:

upward-sloping in short run

vertical in long run

‹#›

The slope of the AS curve depends on the time horizon:

In the short run, the aggregate supply curve is upward-sloping. (“SR” = “short run”).

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

These slopes will be explained in the following slides.

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.

YN is also called potential output or full-employment output.

LRAS

‹#›

The book does not use the notation YN. I use it here to keep the slides from getting too cluttered, and also to make it easier for students to take notes: it’s easier for them to write “YN” than “the natural rate of output.”

Why LRAS Is Vertical

YN determined by the economy’s stocks of labor, capital, and natural resources, and on the level of technology.

An increase in P

LRAS

does not affect any of these, so it does not affect YN.

(Classical dichotomy)

‹#›

This is review from the chapter “Production and Growth.”

Why the LRAS Curve Might Shift

Any event that changes any of the determinants of YN will shift LRAS.

Example: Immigration increases L, causing YN to rise.

LRAS1

LRAS2

’

‹#›

Why the LRAS Curve Might Shift

Changes in L or natural rate of unemployment

Immigration

Baby-boomers retire

Govt policies reduce natural u-rate

Changes in K or H

Investment in factories, equipment

More people get college degrees

Factories destroyed by a hurricane

‹#›

Why the LRAS Curve Might Shift

Changes in natural resources

Discovery of new mineral deposits

Reduction in supply of imported oil

Changing weather patterns that affect agricultural production

Changes in technology

Productivity improvements from technological progress

‹#›

It might be worth mentioning that the change in weather patterns or reduction in imported resources would have to be reasonably long-lasting for the LRAS curve to shift. Short-lived changes are more likely to affect SRAS than LRAS.

LRAS1990

Using AD & AS to Depict Long-Run Growth and Inflation

Over the long run, tech. progress shifts LRAS to the right

AD2000

LRAS2000

AD1990

Y2000

and growth in the money supply shifts AD to the right.

Y1990

AD2010

LRAS2010

Y2010

P1990

Result: ongoing inflation and growth in output.

P2000

P2010

‹#›

In the following chapter, it will be more clear why money supply growth shifts the AD curve rightward.

Short Run Aggregate Supply (SRAS)

The SRAS curve is upward sloping:

Over the period of 1–2 years, an increase in P

SRAS

causes an increase in the quantity of g & s supplied.

‹#›

Why the Slope of SRAS Matters

If AS is vertical, fluctuations in AD do not cause fluctuations in output or employment.

AD1

SRAS

LRAS

ADhi

ADlo

If AS slopes up, then shifts in AD do affect output and employment.

Plo

Ylo

Phi

Yhi

Phi

Plo

‹#›

Before introducing the three theories of short-run aggregate supply, it’s worth taking a moment to show students why the slope of SRAS is critically important in the theory of economic fluctuations.

Three Theories of SRAS

In each,

some type of market imperfection

result: Output deviates from its natural rate when the actual price level deviates from the price level people expected.

‹#›

Each of these theories provides a reason why the aggregate supply curve might have a positive slope in the short run.

It would be most helpful if students carefully read this section of the chapter!

1. The Sticky-Wage Theory

Imperfection: Nominal wages are sticky in the short run, they adjust sluggishly.

Due to labor contracts, social norms

Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail.

‹#›

1. The Sticky-Wage Theory

If P > PE, revenue is higher, but labor cost is not.

Production is more profitable, so firms increase output and employment.

Hence, higher P causes higher Y, so the SRAS curve slopes upward.

‹#›

“If P > PE”

means

“If the actual price level turns out to be higher than the price level firms had expected...”

2. The Sticky-Price Theory

Imperfection: Many prices are sticky in the short run.

Due to menu costs, the costs of adjusting prices.

Examples: cost of printing new menus, the time required to change price tags

Firms set sticky prices in advance based on PE.

‹#›

2. The Sticky-Price Theory

Suppose the Fed increases the money supply unexpectedly. In the long run, P will rise.

In the short run, firms without menu costs can raise their prices immediately.

Firms with menu costs wait to raise prices. Meanwhile, their prices are relatively low,

which increases demand for their products, so they increase output and employment.

Hence, higher P is associated with higher Y, so the SRAS curve slopes upward.

‹#›

3. The Misperceptions Theory

Imperfection: Firms may confuse changes in P with changes in the relative price of the products they sell.

If P rises above PE, a firm sees its price rise before realizing all prices are rising.

The firm may believe its relative price is rising, and may increase output and employment.

So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping.

‹#›

Of the three theories, this one seems the least plausible.

Firms certainly have a strong incentive to not mistake a general price increase for a relative price increase. And information about the price level is costless and available with only a short lag (especially the CPI, which is published monthly and very widely reported the moment it comes out).

My remarks here are not officially part of the textbook, so they are not supported in the study guide or test bank. Feel free to ignore them.

What the 3 Theories Have in Common:

In all 3 theories, Y deviates from YN when P deviates from PE.

Y = YN + a (P – PE)

Output

Natural rate of output (long-run)

a > 0, measures how much Y responds to unexpected changes in P

Actual price level

Expected price level

‹#›

Economists debate which of these theories is correct. It’s possible that each of them contains some element of truth.

For our purposes here, the similarities between these theories are more important than their differences: all three imply that output deviates from its long-run level (the “natural rate of output”) when the price level (P) deviates from the level people had expected (PE).

What the 3 Theories Have in Common:

SRAS

When P > PE

Y > YN

When P < PE

Y < YN

the expected price level

Y = YN + a (P – PE)

‹#›

The preceding slide introduced an equation of aggregate supply that shows how output deviates from full-employment when the actual price level is different than expected.

This slide illustrates these concepts using a graph.

When P = PE, Y = YN

When P < PE, Y < YN

When P > PE, Y > YN

SRAS and LRAS

The imperfections in these theories are temporary. Over time,

sticky wages and prices become flexible

misperceptions are corrected

In the LR,

PE = P

AS curve is vertical

‹#›

LRAS

SRAS and LRAS

SRAS

In the long run, PE = P

and Y = YN.

Y = YN + a (P – PE)

‹#›

Notice that when the price level equals the expected price level, output is equal to its long-run value, the natural rate of output.

Interpretation:

In the short run, people may be fooled about the price level, or they may be locked into wages or prices that were set before they knew what the price level would actually be. Hence, in the short run, P may differ from PE.

But in the long run, expectations catch up to reality, P = PE, and therefore Y = YN, as in the Classical model.

Thus, our theory of economic fluctuations is basically the Classical model (which we studied for several chapters) augmented with some kind of market imperfection (such as sticky wages). The impact of the market imperfection occurs only in the short run, so the long-run behavior of our model is Classical.

Why the SRAS Curve Might Shift

Everything that shifts LRAS shifts SRAS, too.

Also, PE shifts SRAS:

If PE rises,

workers & firms set higher wages.

At each P, production is less profitable, Y falls, SRAS shifts left.

LRAS

SRAS

‹#›

The Long-Run Equilibrium

In the long-run equilibrium,

PE = P,

Y = YN ,

and unemployment is at its natural rate.

SRAS

LRAS

‹#›

Economic Fluctuations

Caused by events that shift the AD and/or AS curves.

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.

‹#›

This four-step approach is based on the three-step approach used in Chapter 4 to analyze changes in the basic supply & demand model.

LRAS

The Effects of a Shift in AD

Event: Stock market crash

1. Affects C, AD curve

2. C falls, so AD shifts left

3. SR eq’m at B. P and Y lower, unemp higher

4. Over time, PE falls, SRAS shifts right, until LR eq’m at C. Y and unemp back at initial levels.

AD1

SRAS1

AD2

SRAS2

‹#›

The results from this exercise apply to any event that shifts AD to the left, whether a stock market crash, recession abroad, wave of pessimism, or other.

The stock market crash reduces consumers’ wealth, which depresses their spending. The AD curve shifts to the left.

The new short-run equilibrium is at point B, where P and Y are lower, and hence unemployment is higher. (Remember Fact #3 about economic fluctuations: unemployment and output move in opposite directions.)

At point B, P < PE. Over time, PE falls, wages fall, and sticky prices become flexible and fall. The SRAS curve moves rightward.

This process continues until the economy arrives at point C, where GDP and unemployment are back at their natural rates, and PE = P once again.

Notice that, in the absence of policy intervention, the economy “self-corrects.” Of course, this process takes time, and policymakers may not want to wait. At point B, policymakers could use fiscal or monetary policy to shift aggregate demand to the right and move the economy back to A.

Two Big AD Shifts: 1. The Great Depression

From 1929–1933,

money supply fell 28% due to problems in banking system

stock prices fell 90%, reducing C and I

Y fell 27%

P fell 22%

u-rate rose from 3% to 25%

U.S. Real GDP, billions of 2000 dollars

‹#›

Two possible causes of the Great Depression: the fall in the money supply, and the stock market crash. Either would shift the AD curve left, causing P and Y to fall and causing unemployment to rise.

Data source: Bureau of Economic Analysis, U.S. Department of Commerce

http://www.bea.doc.gov/bea/dn/home/gdp.htm

Two Big AD Shifts: 2. The World War II Boom

From 1939–1944,

govt outlays rose from $9.1 billion to $91.3 billion

Y rose 90%

P rose 20%

unemp fell from 17% to 1%

U.S. Real GDP, billions of 2000 dollars

‹#›

This boom was clearly caused by a surge in govt spending. Our model predicts an increase in G would shift AD to the right, increasing P and Y, and reducing unemployment. These predictions are consistent with the data.

Source for GDP data: Bureau of Economic Analysis, U.S. Department of Commerce

http://www.bea.doc.gov/bea/dn/home/gdp.htm

Source for data on government outlays: Economic Report of the President, 2005 edition, Table B-78. http://www.gpoaccess.gov/eop/

ACTIVE LEARNING 2 Working with the model

Draw the AD-SRAS-LRAS diagram for the U.S. economy starting in a long-run equilibrium.

A boom occurs in Canada. Use your diagram to determine the SR and LR effects on U.S. GDP, the price level, and unemployment.

‹#›

ACTIVE LEARNING 2 Answers

LRAS

AD2

SRAS2

AD1

SRAS1

Event: Boom in Canada

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.

‹#›

The boom in Canada increases the incomes of Canadian consumers. In turn, their spending rises. Some of their spending is on products from the U.S., so their spending increase causes U.S. exports to rise.

This shifts the U.S. AD curve to the right. The new short-run equilibrium is at point B, where P and Y are higher, and hence unemployment is lower.

At B, P > PE. Over time, PE rises, wages rise, and sticky prices become flexible and rise. The SRAS curve moves leftward.

This process continues until the economy arrives at point C, where GDP and unemployment are back at their natural rates and expectations about P have caught up to reality.

CASE STUDY: The 2008–2009 Recession

From 12/2007 to 6/2009, real GDP fell about 4%

Unemployment rose from 4.4% in 5/2007 to 10.1% in 10/2009

The housing market played a central role in this recession…

‹#›

The next few slides correspond to a new Case Study in the 6th edition. See the Case Study for more information.

Source of GDP and unemployment data: textbook

CASE STUDY: The 2008–2009 Recession

Case-Shiller Home Price Index

2000 = 100

‹#›

Data: The Case-Shiller 20-city composite index, seasonally adjusted, monthly

Source: http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff--p-us----

The cities in this index have, on average, more extreme price movement than the country as a whole.

For an excellent (though very conservative) discussion of these issues, see The Housing Boom and Bust (revised and updated edition) by Thomas Sowell.

SPCS20R-SA 2000 2000.0833333333333 2000.1666666666665 2000.2499999999998 2000.333333333333 2000.4166666666663 2000.4999999999995 2000.5833333333328 2000.6666666666661 2000.7499999999993 2000.8333333333326 2000.9166666666658 2000.9999999999991 2001.0833333333323 2001.1666666666656 2001.2499999999989 2001.3333333333321 2001.4166666666654 2001.4999999999986 2001.5833333333319 2001.6666666666652 2001.7499999999984 2001.8333333333317 2001.9166666666649 2001.9999999999982 2002.0833333333314 2002.1666666666647 2002.249999999998 2002.3333333333312 2002.4166666666645 2002.4999999999977 2002.583333333331 2002.6666666666642 2002.7499999999975 2002.8333333333308 2002.916666666664 2002.9999999999973 2003.0833333333305 2003.1666666666638 2003.249999999997 2003.3333333333303 2003.4166666666636 2003.4999999999968 2003.5833333333301 2003.6666666666633 2003.7499999999966 2003.8333333333298 2003.9166666666631 2003.9999999999964 2004.0833333333296 2004.1666666666629 2004.2499999999961 2004.3333333333294 2004.4166666666626 2004.4999999999959 2004.5833333333292 2004.6666666666624 200 4.7499999999957 2004.8333333333289 2004.9166666666622 2004.9999999999955 2005.0833333333287 2005.166666666662 2005.2499999999952 2005.3333333333285 2005.4166666666617 2005.499999999995 2005.5833333333283 2005.6666666666615 2005.7499999999948 2005.833333333328 2005.9166666666613 2005.9999999999945 2006.0833333333278 2006.1666666666611 2006.2499999999943 2006.3333333333276 2006.4166666666608 2006.4999999999941 2006.5833333333273 2006.6666666666606 2006.7499999999939 2006.8333333333271 2006.9166666666604 2006.9999999999936 2007.0833333333269 2007.1666666666601 2007.2499999999934 2007.3333333333267 2007.4166666666599 2007.4999999999932 2007.5833333333264 2007.6666666666597 2007.749999999993 2007.8333333333262 2007.9166666666595 2007.9999999999927 2008.0833333333 26 2008.1666666666592 2008.2499999999925 2008.3333333333258 2008.416666666659 2008.4999999999923 2008.5833333333255 2008.6666666666588 2008.749999999992 2008.8333333333253 2008.9166666666586 2008.9999999999918 2009.0833333333251 2009.1666666666583 2009.2499999999916 2009.3333333333248 2009.4166666666581 2009.4999999999914 2009.5833333333246 2009.6666666666579 2009.7499999999911 2009.8333333333244 2009.9166666666576 2009.9999999999909 2010.0833333333242 2010.1666666666574 2010.2499999999907 2010.3333333333239 2010.4166666666572 2010.4999999999905 2010.5833333333237 2010.666666666657 2010.7499999999902 2010.8333333333235 2010.9166666666567 2010.99999999999 2011.0833333333233 2011.1666666666565 100.59 101.69 102.78 104 105.26 106.4 107.14 107.86 108.61 109.49 110.57 111.8 113.05 114.12 115.08 115.84 116.3 116.9 117.5 118.25 119.03 119.69 120.28 120.67 121.36 122.19 123.31 124.5 125.93 127.39 128.88 130.31 131.53 132.85 134.1 135.41 136.47 137.44999999999999 138.37 139.22999999999999 140.15 140.93 142.12 143.55000000000001 145.26 146.99 148.83000000000001 150.76 152.63 154.54 156.9 159.33000000000001 161.76 164.32 166.39 168.08 169.66 171.3 173.09 175.09 177.55 180.25 183.15 185.46 187.55 189.56 191.41 193.41 195.65 197.89 200.14 202.17 203.75 205.33 206.11 206.52 206.5 205.86 205.08 204.23 203.64 203.55 203.61 203.41 203.65 203.96 203.95 202.62 201.05 198.96 197.18 195.12 193.23 190.97 187.8 184.94 181.93 178.31 175.16 172.05 169.61 167.39 164.9 5 162.47 159.27000000000001 156.26 153.47 150.44 147.38 145.25 142.80000000000001 141.13 140.97 141.62 143 143.96 144.26 144.69999999999999 145.13999999999999 145.77000000000001 146.38 146.35 146.37 146.59 147.56 147.6 147.46 146.19 144.78 143.43 142.72 142.22 141.87 141.52000000000001 141.19999999999999

CASE STUDY: The 2008–2009 Recession

Rising house prices during 2002–2006 due to:

low interest rates

easier credit for “sub-prime” borrowers

government policies to increase homeownership

securitization of mortgages:

Investment banks purchased mortgages from lenders, created securities backed by these mortgages, sold the securities to banks, insurance companies, and other investors.

Mortgage-backed securities perceived as safe, since house prices “never fall”

‹#›

CASE STUDY: The 2008–2009 Recession

Consequences of 2006–2009 housing market crash:

Millions of homeowners “underwater”—owed more than house was worth

Millions of mortgage defaults and foreclosures

Banks selling foreclosed houses increased surplus and downward price pressures

Housing crash badly damaged construction industry: 2010 unemployment rate was 20.6% in construction vs. 9.6% overall

‹#›

Source of construction and overall unemployment rates:

BLS.gov, “Characteristics of the Unemployed”

ftp://ftp.bls.gov/pub/special.requests/lf/aat26.txt

CASE STUDY: The 2008–2009 Recession

Consequences of 2006–2009 housing market crash:

Mortgage-backed securities became “toxic,” heavy losses for institutions that purchased them, widespread failures of banks and other financial institutions

Sharply rising unemployment and falling GDP

‹#›

CASE STUDY: The 2008–2009 Recession

The policy response:

Federal Reserve reduced Fed Funds rate target to near zero.

Federal Reserve purchased mortgage-backed securities and other private loans.

U.S. Treasury injected capital into the banking system, to increase banks’ liquidity and solvency in hopes of staving off a “credit crunch”

Fiscal policymakers increased government spending and reduced taxes by $800 billion

‹#›

LRAS

The Effects of a Shift in SRAS

Event: Oil prices rise

1. Increases costs, shifts SRAS (assume LRAS constant)

2. SRAS shifts left

3. SR eq’m at point B. P higher, Y lower, unemp higher

From A to B, stagflation, a period of falling output and rising prices.

AD1

SRAS1

SRAS2

‹#›

An increase in oil prices might also affect LRAS. For simplicity, and to be consistent with the textbook, we assume it only affects the SRAS curve.

LRAS

Accommodating an Adverse Shift in SRAS

If policymakers do nothing,

4. Low employment causes wages to fall, SRAS shifts right, until LR eq’m at A.

AD1

SRAS1

SRAS2

AD2

Or, policymakers could use fiscal or monetary policy to increase AD and accommodate the AS shift:

Y back to YN, but P permanently higher.

‹#›

The 1970s Oil Shocks and Their Effects

# of unemployed persons

Real GDP

CPI

+ 1.4 million

+ 2.9%

+ 26%

+ 99%

+ 3.5 million

– 0.7%

+ 21%

+ 138%

Real oil prices

1978–80

1973–75

‹#›

The first oil shock: 1973–75

Oil prices more than doubled in just two years, causing SRAS to shift leftward. As our model predicts, the price level rose, GDP fell, and unemployment rose.

From 1975 to 1978, oil prices rose at less than the rate of inflation, the number of unemployed persons fell by 1.7 million, and real GDP grew by 16%. The economy was self-correcting.

But just when things were getting better, the second oil shock hit. Oil prices doubled, due in part to a revolution in Iran in 1979. Again, as our model predicts, SRAS shifted left, inflation rose, and unemployment increased. The table shows that real GDP rose 2.9% during this period—but remember, this is not an annual rate, it is 2.9% for the entire period, which is substantially below the long-run average growth rate of about 3% per year.

Data sources:

CPI and unemployment: Bureau of Labor Statistics, http://www.bls.gov

GDP and oil prices: FRED database, Federal Reserve Bank of St Louis, http://research.stlouisfed.org/fred2/

John Maynard Keynes, 1883–1946

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:

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.

The long run is a misleading guide to current affairs. In the long run, we are all dead.

‹#›

Much of the theory in this chapter and the one that follows originates in the work of Keynes. This slide reproduces his famous critique of the long-run focus of classical macroeconomics.

In one way, this slide is a good candidate for cutting if you think this PowerPoint file is too long. Students can easily read about Keynes on their own in the FYI box that appears in the textbook at the end of this chapter.

On the other hand, showing this in class gives students a nice break from all the theory they have sat through. And students may not read the FYI box on their own.

CONCLUSION

This chapter has introduced the model of aggregate demand and aggregate supply, which helps explain economic fluctuations.

Keep in mind: these fluctuations are deviations from the long-run trends explained by the models we learned in previous chapters.

In the next chapter, we will learn how policymakers can affect aggregate demand with fiscal and monetary policy.

‹#›

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 effect on net exports.

‹#›

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 labor, 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 misperceptions theory.

The short-run aggregate-supply curve shifts in response to changes in the expected price level and to anything that shifts the long-run 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 rightward. In the long run, the economy returns to the natural rates of output and unemployment, but with a lower price level.

‹#›

SUMMARY

A fall in aggregate supply results in stagflation—falling output and rising prices. Wages, prices, and perceptions adjust over time, and the economy recovers.

‹#›

550

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192919301931193219331934

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