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Chapter 14 Aggregate Demand and Aggregate Supply

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ECN 204
Paul Missios

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 economys output of goods and services are strong correlated with changes in the economys 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 thegovernment 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 economys 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
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