ECN 204 Lecture Notes - Aggregate Demand, Aggregate Supply, Classical Dichotomy
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Chapter 14: Aggregate Demand and Aggregate Supply
Recession: falling incomes and rising unemployment when normal growth does not occur, more sever is
called a depression
Three Key Facts about Economic Fluctuations
Fact 1: Economic Fluctuations are Irregular and Unpredictable
-Fluctuations are often called business cycles; economic fluctuations correspond to changes in business
conditions. When real GDP grows rapidly, business is good. When real GDP falls during recessions,
businesses have trouble.
Fact 2: Most Macroeconomic Quantities Fluctuate Together
-Real GDP is the variable that is most commonly used to monitor short-run changes; real GDP measures
the value of all final goods and series produced within a given period of time and also the total income
(adjusted for inflation) of everyone in the economy. Most variables that measure some type of income,
spending or production fluctuate closely together but by different amounts. When real GDP falls in a
recession, so do personal income, corporate profits, consumer spending, investment spending,
industrial production, and so on (most decline is in investments)
Fact 3: As Output falls, Unemployment Rises
-Changes in the economy’s output of goods and services are strong correlated with changes in the
economy’s utilization of its labor force. When real GDP declines, the rate of unemployment rises.
Explaining Short-Run Economic Fluctuations
Most economists use the model of aggregate demand and aggregate supply to study fluctuations. This
model differs from the classical theories economists use to explain the long run.
The Assumption of Classical Economics
Previous chapters are based on the ideas of classical economics, especially:
Classical Dichotomy: the separation of variables in two groups: real (quantities, relative prices) and
nominal (measured in terms of money)
Neutrality of Money: changes in the money supply affect nominal but not real variables
-In a sense money does not matter in a classical economic world. Nominal variables may be the first
thing we see when we observe an economy because they are expressed in units of money. But what are
important are the real variables and economic forces that determine them.
The Reality of Short-Run Fluctuations
-Most economists believe that classical theory describes the world in the long run, not in the short run.
To examine the short run, we no longer separate our analysis of real variables such as output and
employment from nominal variables such as money and price level.
The Model of Aggregate Demand and Aggregate Supply
Economists use the model of aggregate demand and
aggregate supply to explain short run fluctuations in
economic activity around its long run trend.
Vertical Axis: overall price level, Horizontal Axis: quantity
of goods and services
Aggregate-Demand Curve: a curve that shows the quantity
of goods and services that households, firms, and the
government want to buy at each price level
Aggregate-Supply Curve: a curve that shows goods and services that firms choose to produce and sell at
each price level
The Aggregate Demand Curve
-The aggregate demand curve tells us the quantity of all
goods and services demanded in the economy at any
given price level. It is downward sloping because other
things equal, a fall in the economy’s overall level of price
(from P1 to P2) tends to raise the quantity of
goods/services demanded from (y1 to y2).
Why the Aggregate Demand Curve Slopes Downwards
Y = C + I + G + NX
-Assume G is fixed by government policy. To understand the slope of AD, must determine how a change
in P (price level) affects C, I, and NX.
The Price Level and Consumption: The Wealth Effect
-Suppose P (price level) rises, the dollars people hold buy fewer goods/services so real wealth is lower
and people feel poorer therefore it results in C (consumption) to fall.
Therefore: A decrease in the price level makes consumers wealthier which encourages them to spend
more. The increase in consumer spending means a larger quantity of goods and services demanded.
The Price Level and Investment: The Interest Rate Effect
-Suppose P rises, buying goods/services requires more dollars. To get these dollars, people sell bonds or
other assets which drives up interest rates. Results = I (Investment) falls. When price level falls,
households try to reduce their holding of money by lending some out, as households try to convert
some of their money into interest-bearing assets, they drive down interest rates which affects spending
Therefore: A lower price level reduces the interest rate, encourages greater spending on investment
goods, and thereby increases the quantity of goods and services demanded. Higher price raises interest
rate, discourages investment spending, and decreases the quantity of goods and services demanded
The Price Level and Net Exports: The Real Exchange-Rate Effect
-Suppose P rises. Canadian interest rate rises (the interest rate effect). Foreign investors desire more
Canadian bonds. Higher demand for $ in foreign exchange market, Canadian exchange rate appreciates.
Canadian exports more expensive goods to people abroad, imports cheaper to Canadian residents, NX
Therefore: a fall in the Canadian price level causes the real exchange rate to depreciate, and this
depreciation stimulates Canadian net exports and thereby increases the quantity of goods and services
demanded. An increase in the Canadian price level causes the real exchange rate to appreciate, and this
appreciation reduces Canadian net exports and thereby decreases the quantity of goods/services