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Chapter
33 Aggregate Demand and Aggregate Supply
Aggregate Demand & Aggregate Supply • Economic activity – Fluctuates from year to year
• Economic fluctuation – Business cycle
• Recession – Economic contraction – Period of declining real incomes and rising unemployment
• Depression – Severe recession 2
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3 Key Facts About Economic Fluctuations 1. Econom Economic ic fluctu fluctuati ations ons are are irregul irregular ar and unpredictable 2. Most Most macroec macroeconom onomic ic quantiti quantities es fluctuat fluctuate e together 3. As output output fal falls, ls, unemp unemploym loymen entt rises rises
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Figure 1 A look at short-run economic fluctuations (a)
This figure shows real GDP in panel (a), investment spending in panel (b), and unemployment in panel (c) for the U.S. economy using quarterly data since 1965. Recessions are shown as the shaded areas. Notice that real GDP and investment spending decline during recessions, while unemployment rises. 4
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Figure 1 A look at short-run economic fluctuations (b)
This figure shows real GDP in panel (a), investment spending in panel (b), and unemployment in panel (c) for the U.S. economy using quarterly data since 1965. Recessions are shown as the shaded areas. Notice that real GDP and investment spending decline during recessions, while unemployment rises. 5
Figure 1 A look at short-run economic fluctuations (c)
This figure shows real GDP in panel (a), investment spending in panel (b), and unemployment in panel (c) for the U.S. economy using quarterly data since 1965. Recessions are shown as the shaded areas. Notice that real GDP and investment spending decline during recessions, while unemployment rises. 6
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Explaining Short-Run Economic Fluctuations • The assumptions of classical economics • Classical dichotomy – Separation of variables into • Real variables • Nominal variables
• Monetary neutrality – Changes in the money supply • Affect nominal variables • Do not affect real variables
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Explaining Short-Run Economic Fluctuations • The reality of short-run fluctuations • Long-run – Classical theory holds • Changes in money supply – Affect prices, and other nominal variables – Do not affect real GDP, GDP, unemployment, or other real variables
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Explaining Short-Run Economic Fluctuations
• The reality of short-run fluctuations • Short-run Assumption of monetary monetary neutrality neutrality - no – Assumption longer appropriate
– Real and nominal variables are highly intertwined
– Changes in the money supply • Can temporarily push real GDP away from its long-run trend 9
Explaining Short-Run Economic Fluctuations • Model of aggregate demand & aggregate supply – Model that most economists use to explain eco nomic activity activity – Short-run fluctuations in economic • Around its long-run trend
• Aggregate-demand curve – Shows the quantity quantity of goods and services ser vices • That households, firms, the government, and customers abroad
• Want to buy at each price level
– Downward sloping 10
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Explaining Short-Run Economic Fluctuations • Model of aggregate demand & aggregate supply
• Aggregate-supply curve – Shows the quantity quantity of goods and services ser vices • That firms choose to produce and sell • At each price level
– Upward sloping
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Figure 2 Aggregate demand and aggregate supply Price Level
Aggregate Aggregate supply
Equilibrium price level
Aggregate Aggregate demand demand Equilibrium output
Quantity of Output
Economists use the model of aggregate demand and aggregate supply to analyze economic fluctuations. On the vertical axis is the overall level of prices. On the horizontal axis is the economy’s total output of goods and services. Output and the price level adjust to the point at which the aggregate-supply and aggregate-demand curves intersect.
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The Aggregate-Demand Curve • Why the aggregate-demand (AD) curve slopes downward
• Y = C + I + G + NX • Three effects: – Wealth effect (C ) – Interest-rate effect (I) – Exchange-rate effect (NX)
• Assumption: government spending (G) – Fixed by policy
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The Aggregate-Demand Curve • Why the AD curve slopes downward • Price level & consumption cons umption (C ): wealth effect effect – Decrease in price level • Increase - real value value of money money • Consumer Consumerss – wealthier wealthier • Increase in consumer spending • Increase in quantity demanded of goods & services
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The Aggregate-Demand Curve • Why the AD curve slopes downward • Price level & investment (I): interest-rate interest-rate effect – Decrease in price level • Decrease – interest interest rate • Increase spending on investment goods • Increase in quantity demanded of goods & services
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The Aggregate-Demand Curve • Why the AD curve slopes downward • Price level & net exports (NX): (NX ): exchange-rate effect effect – Decrease in U.S. price level • Decrease – interest interest rate • U.S. dollar – depreciates depreciates • Stimulates U.S. net exports • Increase in quantity demanded of goods & services
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The Aggregate-Demand Curve • Why the AD curve slopes downward • A fall in price level – Increases quantity of goods& services demanded
– Because: 1. Consum Consumer erss are are wealthi wealthier er - stimu stimulat lates es the the demand demand for for consumption goods 2.
Interes Interestt rate ratess fall fall - stimulat stimulates es the the demand demand for investm investment ent goods
3.
Currency Currency deprecia depreciates tes - stimulat stimulates es the demand demand for net exports
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The Aggregate-Demand Curve • Why the AD curve slopes downward • A rise in price level – Decrease - quantity of goods goods and services demanded, because: 1. Consum Consumer erss are are poore poorerr – depre depress ss consu consume merr spendin spending g 2.
Higher Higher inte interes restt rates rates fall fall - depress depress investm investment ent spending spending
3. Curre Currency ncy appre apprecia ciates tes – depre depress ss net net expo exports rts
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Figure 3 The Th e aggregate-d -dem eman and d cu curve Price Level
P1 1. A decrease in the price level . . .
P2
Aggregate Aggregate demand demand Y1
Y2
Quantity of Output
2. . . . increases the quantity of goods and services demanded A fall in the price level level f rom P1 to P2 increases the quantity of goods and services demanded from Y1 to Y2. There are three reasons for this negative relationship. As the price level falls, real wealth rises, interest rates fall, and the exchange rate depreciates. These effects stimulate spending on consumption, investment, and net exports. Increased spending on any or all of 19 these components of output means a larger quantity of goods and services demanded.
The Aggregate-Demand Curve • Why the AD curve might shift • Changes in consumption, C Events - change how much much people want to to consume – Events at a given price level • Level of taxation
– Increase in consumer spending • Aggregate Aggregate demand demand - shift right
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The Aggregate-Demand Curve • Why the AD curve might shift • Changes in investment, I Events - change how much firms want want to invest invest at a – Events given price level • Better technology • Tax policy • Money supply
– Increase in investment • Aggregate Aggregate demand demand - shift right
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The Aggregate-Demand Curve • Why the AD curve might shift • Changes in government purchases, G makerss – change government government spending spending at a – Policy maker given price level • Build new roads
– Increase in government purchases • Aggregate Aggregate demand demand - shift right
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The Aggregate-Demand Curve • Why the AD curve might shift • Changes in net exports, NX Events - change net exports exports for a given price price level – Events • Recession in Europe • International International speculators speculators – change in exchange rate rate
– Increase in net exports • Aggregate Aggregate demand demand - shift right
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Tab Ta ble
1
The Th e aggregate-d -dem eman and d cu curve: su sum mmary (a) Why Does the Aggregate-Demand Curve Slope Downward? 1. The Wealth Effect: A lower price level increases real wealth, which stimulates spending on consumption. consumption. 2. The Interest-Rate Interest-Rate Effect: A lower price level reduces the interest rate, which stimulates spending on investment. investment. 3. The Exchange-Rate Exchange-Rate Effect: A lower price level causes the real exchange rate to depreciate, which stimulates spending on net exports
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Tab Ta ble
1
The Th e aggregate-d -dem eman and d cu curve: su sum mmary (b) Why Might the Aggregate-Demand Aggregate-Demand Curve Shift? 1. Shifts Arising from Consumption: An event that makes consumers spend more at a given price level (a tax cut, a stock-market boom) shifts the aggregate-demand curve to the right. An event that makes consumers consumers spend less at a given price level (a tax hike, a stock-market decline) shifts the aggregate-demand aggregate-demand curve to the left. .
2. Shifts Arising from Investment: An event that makes firms invest more at a given price level (optimism about the future, a fall in interest rates due to an increase in the money supply) shifts the aggregate-demand aggregate-demand curve to the right. An event that makes firms invest less at a given price level (pessimism about the future, a rise in i nterest rates due due to a decrease in the money supply) shifts the aggregate-demand aggregate-demand curve to the left. 3. Shifts Arising from Government Purchases: An increase in government purchases of goods and services (greater spending on defense or highway construction) shifts the aggregate-demand aggregate-demand curve to the right. A decrease in government purchases on goods and services (a c utback in defense or highway spending) shifts the aggregate-demand curve to the left. 4. Shifts Arising from Net E xports: An event that raises spending spending on net exports exports at a given price level (a boom overseas, speculation that causes an exchange-rate exchange-rate depreciation) depreciation) shifts the aggregate-demand curve to the right. An event that reduces spending on net exports at a given price level (a recession overseas, speculation that causes an exchange-r exchange-rate ate appreciation) shifts the aggregate-demand aggregate-demand curve to the left
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The Aggregate Supply Curve • Long run – Aggregate-supply curve is vertical
• Short run – Aggregate-supply curve is upward sloping
• Why the aggregate-supply curve (LRAS) is vertical in the long run – Price level does not affect the long-run determinants of GDP: • Supplies of labor, capital, and natural resources • Available technology 26
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Figure 4 The Th e long-r -ru un aggregate-su -sup pply cu curve Price Level
Long-run aggregate supply
P1 1. A change in the price level . . .
2. . . . does not affect the quantity of goods and services supplied in the long run
P2
Natural rate of output
Quantity of Output
In the long run, the quantity of output supplied depends on the economy’s quantities of labor, capital, and natural resources and on the technology for turning these inputs into output. Because the quantity supplied does not depend on the overall price level, the long-run aggregate-supply curve is vertical at the natural rate of output.
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The Aggregate Supply Curve • Why the LRAS curve might shift • Natural rate rate of output – Production of goods and services – That an economy achieves in the long run • When unemployment is at its normal rate
– Potential output – Full-employment output
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The Aggregate Supply Curve • Why the LRAS curve might shift – Any change in natural rate of output
• Changes in labor – Quantit Quantity y of labor – increases increases • Aggregate Aggregate supply supply – shifts right
– Natural Natural rate of unemployment unemployment – increases • Aggregate Aggregate supply supply – shifts left
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The Aggregate Supply Curve • Why the LRAS curve might might shift • Changes in capital Capital stock stock – increase increase – Capital • Aggregate Aggregate supply supply – shifts left
– Physical capital – Human capital
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The Aggregate Supply Curve • Why the LRAS might shift • Changes in natural resources – New discovery of natural resource • Aggregate Aggregate supply supply – shifts right
– Weather – Availability of natural resources
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The Aggregate Supply Curve • Why the LRAS curve might shift • Changes in technology – New technology, for given labor, capital and natural resources • Aggregate Aggregate supply supply – shifts right
– International trade – Government regulation
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The Aggregate Supply Curve • Using AD and LRAS to depict long-run growth and inflation
• In long run: both AD and LRAS curve shift • Continual Continual shifts of LRAS curve to right – Technological progress
• AD curve shifts to right – Monetary policy – The Fed increases money supply over time
• Result: – Continuing growth in output – Continuing inflation
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Figure 5 Long-run growth and inflation in in the the model model of aggregate demand and aggregate supply Price Level 2. . . . and growth in the money supply shifts aggregate demand . . .
1. In t he long run, technological progress shifts long-run aggregate Long-run aggregate supply, supply… LRAS1980 LRAS1990 LRAS2000
P2000 3. . . . leading to growth in output . . .
P1990 P1980
AD2000
4. . . . and ongoing inflation
AD1980 Y1980
Y1990
AD1990 Y2000
Quantity of Output
As the economy becomes better better able to produce goods goods and services over time, primarily because of of technological progress, the long-run aggregate-supply curve shifts to the right. At the same tim e, as the Fed increases the money supply, supply, the aggregate-demand curve curve also s hifts to the r ight. In this figure, output grows from Y1980 to Y1990 and then to Y2000 , and the price level rises from P1980 to P1990 and then to P2000. Thus, the model of aggregate 34 demand and aggregate supply offers a new way to describe the classical analysis analysis of growth and inflation
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The Aggregate Supply Curve • Why the aggregate-supply (AS) curve slopes upward in the short-run – Increase in overall level of prices in economy • Tends to raise the quantity of goods and services supplied
– Decrease in level of prices • Tends to reduce quantity of goods and services supplied
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Figure 6 The Th e sh sho ort-r -ru un aggregate-su -sup pply cu curve Price Level
Short-run aggregate supply
P1 1. A decrease in the price level . . .
P2
Y2
Y1
Quantity of Output
2. . . . reduces the quantity of goods and services supplied in the short run In the short run, a fall in the price level from P 1 to P2 reduces the quantity of output supplied from Y1 to Y2. This positive relationship could be due to sticky wages, sticky prices, or misperceptions. Over time, wages, prices, and perceptions adjust, so this positive relationship is only temporary. 36
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The Aggregate Supply Curve • Why the AS curve slopes upward in short-run • Sticky-wage theory wages - slow to to adjust to changing changing – Nominal wages economic conditions • Long-term contracts: workers and firms • Slowly changing social norms • Notions of of fairness - influence wage wage setting
– Nominal wages wages - based on expected expected prices • Don’t respond immediately when: – Actual price level – different from from what was expected
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The Aggregate Supply Curve • Why the AS curve slopes upward in short-run • Sticky-wage theory – If price level < expected • Firms – incentive to produce produce less output
– If price level > expected • Firms – incentive to produce produce more output
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The Aggregate Supply Curve • Why the AS curve slopes upward in short-run • Sticky-price theory – Prices of some goods & services • Slow to adjust to changing economic conditions • Menu costs – Costs to adjusting prices
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The Aggregate Supply Curve • Why the AS curve slopes upward in short-run • Misperceptions theory – Changes in the overall price level • Can temporarily mislead suppliers – About changes in individual markets – Changes in relative prices
• Suppliers Suppliers - respond to changes in level of of prices – Change - quantity supplied of goods and services
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The Aggregate Supply Curve • Why the AS curve slopes upward in short-run Quantity of output supplied = Natural rate of output + + a(Actual price price level – Expected price price level) • Where a - number that determines determines how much output responds to unexpected changes in the price level
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The Aggregate Supply Curve • Why the short-run AS curve might shift • Changes in labor, capital, natural resources, or technological knowledge – Shift the short-run AS curve
• Expected price level increases – Aggregate-supp Aggregate-supply ly curve – shifts left left
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Tab Ta ble
2
The Th e sh sho ort-r -ru un aggregate-su -sup pply cu curve: su sum mmary (a) Why Does the Short-Run Aggregate-Supply Curve Slope Upward? 1. The Sticky-Wage Theory: Theory: An unexpectedly low price level raises the real wage, which causes firms to hire fewer workers workers and produce produce a smaller quantity of goods and services. 2. The Sticky-Price Theory: An unexpectedly unexpectedly low price level leaves some firms with higher-than desired prices, which depresses their sales and leads them to cut back production. 3. The Misperceptions Misperceptions Theory: An unexpectedly low price level leads some suppliers to think their relative prices have fallen, which induces a fall i n production.
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Tab Ta ble
2
The Th e sh sho ort-r -ru un aggregate-su -sup pply cu curve: su sum mmary (b) Why Might the Short-Run Aggregate-Supply Curve Shift? 1. Shifts Arising from Labor: An increase in the quantity of labor available (perhaps due to a fall in the natural rate of unemployment) unemployment) shifts the aggregate-supply curve to the right. A decrease in the quantity of labor available (perhaps due to a rise in the natural rate of unemployment) unemployment) shifts the aggregate-supply curve to the left. 2. Shifts Arising from Capital: An increase in physical or human capital shifts the aggregate-supply curve to the rig ht. A decrease decrease i n physical or human capital shifts the aggregate-supply curve to the left. 3. Shifts Arising from Natural Resources: An increase in the availability of natural resources shifts the aggregate-supply curve to the right. A decrease in the availability of natural resources shifts the aggregate-supply curve to the left. 4. Shifts Arising from Technology: Technology: An advance in technological knowledge shifts the aggregate-supply curve to the rig ht. A decrease decrease i n the available technology (perhaps due to government regulation) shifts the aggregate-supply curve to the left. 5. Shifts Arising from the Expected Pri ce Level: A decrease in the expected pri ce level shifts the shortrun aggregate-supply curve to the right. An increase in the expected pri ce level shifts the short-run aggregate-supply curve to the left.
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Two Causes of Economic Fluctuations • Assumption – Economy begins in long-run equilibrium
• Long-run equilibrium: – Intersection Intersection of o f AD and LRAS curves • Output - natural natural rate • Actual price level
– And: Intersection Intersection of AD A D and short-run AS curve • Expected price price level leve l = Actual price level
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Figure 7 The Th e long-r -ru un equilibrium Price Level
Equilibrium price
Long-run aggregate supply
Short-run aggregate supply
A
Aggregate Aggregate demand Natural rate of output
Quantity of Output
The long-run equilibrium of the economy is found where the aggregate-demand curve crosses the long-run aggregate-supply curve (point A). When the economy reaches this long-run equilibrium, the expected price level will have adjusted to equal the actual price level. As a result, the short-run aggregate-supply curve crosses this point as well.
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Two Causes of Economic Fluctuations • The effects of a shift in aggregate demand • Wave Wave of pessimism – Affects aggregate demand • Aggregate Aggregate demand demand – shifts left
– Short-run • Output falls & Price level falls
– Long-run • Short-run Short-run aggregate supply supply curve – shifts right • Output – natural natural rate rate • Price Price level – falls falls
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Tab Ta ble
3
Four steps for analyzing macroeconomic fluctuations 1. Decide whether whether the event event shifts the aggregate aggregate demand demand curve curve or the aggregate supply curve (or perhaps both). 2. Decide Decide in which direc direction tion the the curve curve shifts. 3. Use the diagram of aggregate demand and and aggregate aggregate supply to determine determine the impact on output and the price level in the short run. 4. Use the diagram of aggregate demand and and aggregate aggregate supply to analyze analyze how the economy economy moves from its new short-run equilibrium to its long-run equilibrium.
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Figure 8 A contraction in aggregate demand Price Level
Short-run aggregate supply, AS1
Long-run aggregate supply
AS2
P1
3. . . . but over time, the short-run aggregate-supply curve shifts . . .
A B
P2
C
4. . . . and output returns to its natural rate.
P3 1. A de decre crea ase in in aggregate demand . . . AD2 Y2
Aggregate Aggregate demand, demand, AD 1
Y1
Quantity of Output
2. . . . causes output to fall in the short run . . . A fall in aggrega aggregate te dem demand and is represented represented with a leftward shift in the aggre aggregate-demand gate-demand curve from AD1 to AD2. In the short run, the economy moves from point A to point B. Output falls from Y1 to Y2, and the price level falls from P 1 to P2. Over time, as the expected price level adjusts, the short-run aggregate-supply curve shifts to the right from AS 1 to AS2, and the economy reaches point C, where the new aggregate-demand curve crosses the long-run aggregatesupply curve. In the long run, the price level falls to P 3, and output returns to its natural rate, Y 1. 49
Two big shifts in aggregate demand: Great Depression and World War II
• Early 1930s: large drop in real GDP – The Great Depression – Largest economic downturn in U.S. history – From 1929 to 1933 • Real GDP fell by 27% • Unemployment rose from 3 to 25% • Price level fell by 22%
– Cause: decrease in aggregate aggregate demand • Decline in money supply (by 28%) • Decreasing: consumer spending, investment spending 50
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Two big shifts in aggregate demand: Great Depression and World War II
• Early 1940s: large increase in real GDP – Economic boom – World War II • More resources to the military • Government Governme nt purchases increased • Aggregat Aggregate e demand demand – increased increased 1939 - 1944 • Doubled the economy’s production of goods and services • 20% increase in the price level • Unemployment fell from 17 to 1%
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Figure 9 U.S. real GDP growth since 1900
Over the course of U.S. economic history, two fluctuations stand out as especially large. During the early 1930s, the economy went through the Great Depression, when the production of goods and services plummeted. During the early 1940s, the United States entered World War II, and the economy experienced rapidly rising production. Both of these events are usually explained by large shifts in aggregate demand.
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The recession of 2001
• 2001: Recession – Unemployment rate • December 2000: 3.9% • August 2001: 4.9% • June 2003: 6.3% • January 2005: 5.2%
events – decrease decrease in aggregate aggregate demand • Three events 1. The end of dot-com dot-com bubb bubble le in stock stock mark market et • Stock prices fell (25%) • Reduced consumer & investment spending • Aggregate-demand Aggregate-demand curve - shifted to left 53
The recession of 2001 events – decrease decrease in aggregate aggregate demand • Three events 2. Terroris erroristt attack attackss on Septem September ber 11, 11, 2001 2001 • Stock market fell (12%) in one week • Increased uncertainty about the future • Aggregate-demand Aggregate-demand curve curve – shifted further to left
3. Series Series of corpor corporat ate e account accountin ing g scandals scandals • Enron and WorldCom • Stock market fell • Aggregate-demand Aggregate-demand curve curve – shifted further to left
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The recession of 2001
• 2001: Recession – Policymakers Policymakers - quick to respond – The Fed Fed - expansionary monetary monetary policy • Interest rates fell; Federal funds rate fell • Stimulated spending
– Congress • Tax cut in 2001; Immediate tax rebate; Tax cut in 2003 • To stimulate consumer & investment spending
– Aggregate-dem Aggregate-demand and curve – shifted to right • Offset the three contractionary shocks 55
Two Causes of Economic Fluctuations • The effects of a shift in aggregate supply • Start: long run equilibrium production costs – Firms – increase in production • Aggregate Aggregate supply supply curve – shifts left • Short-run – Output falls & Price level rises – Stagflation
• Long-run, if AD is held constant – Short-run AS shifts back to right – Output – natural natural rate rate – Price level level - falls
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Figure 10 An adverse shift in aggregate supply Price Level
Long-run aggregate supply
AS2
1. An adverse shift in the short-run aggregate-supply curve . . .
Short-run aggregate supply, AS1 B 3. . . . and the price level to rise
P2 A
P1
Aggregate Aggregate demand demand Y2
Y1
Quantity of Output
2. . . . causes output to fall . . . When some event increases firms’ costs, the short-run aggregate-supply curve shifts to the left from AS1 to AS2. The economy economy move moves s from point A to point B. The result is stagflation: Output falls from Y1 to Y2, and the price level rises from P 1 to P2.
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Two Causes of Economic Fluctuations • The effects of a shift in aggregate supply • Start: long run equilibrium production costs – Firms – increase in production • Aggregate Aggregate supply supply curve – shifts left • Short-run – Output falls and Price level rises
• Long-run – Policymakers – shift AD to right natural rate rate – Output – natural
– Price level level – rises
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Figure 11 Acco ccom mmodating an adverse shi shift ft in aggregate supply Price Level
3. . . . which causes the price level to rise further . . .
Long-run aggregate supply
P3 P2
C
P1
A
AS2
1. When short-run aggregate supply falls . . .
Short-run aggregate supply, AS1 2. . . . policymakers can accommodate the shift by expanding aggregate demand . . . AD2 Aggregate Aggregate demand, demand, AD 1
4. . . . but keeps output at its natural rate.
Y1
Quantity of Output
Faced with an adverse shift in aggregate supply from AS 1 to AS2, policymakers who can influence aggregate demand might try to shift the aggregate-demand curve to the right from AD 1 to AD2. The economy would move from point A to point C. This policy would prevent the supply shift from reducing output in the short run, but the price level would permanently rise from P 1 to P3.
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Oil and the economy • Economic fluctuations fluctuations in the U.S. economy – Since 1970 – Some: originated in the oil fields of the Middle East
• Some event event - reduces the supply supply of crude oil flowing from Middle East – Price of oil - rises around around the world world – Aggregate-supply Aggregate-supply curve – shifts left – Stagflation • Mid-1970s • Late-1970s
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Oil and the economy event – increases increases the supply of crude crude oil • Some event from Middle East – Price of oil decreases – Aggregate-sup Aggregate-supply ply curve – shifts right right • Output – rapid growth • Unemployment Unemployment – falls • Inflation rate rate – falls
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Oil and the economy Recent years: World World market market for oil – not an • Recent important source of economic fluctuations – Conservation efforts – Changes in technology
• 2008 - world world oil prices prices – rising rising signific significan antly tly – Increased demand from a rapidly growing China
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