Macroeconomics Chapter 20 Notes
• What are economic fluctuations? What are their characteristics?
• How does the model of aggregate demand and aggregate supply explain
• Why does the Aggregate-Demand curve slope downward? What shifts the AD
• What is the slope of the Aggregate-Supply curve in the short run? In the long
run? What shifts the AS curve(s)?
• 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.
• 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.
Classical Economics – A Recap
• The previous chapters are based on the ideas of classical economics,
• 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.
• 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.
The Model of Aggregate Demand and Aggregate Supply
• The model determines the equilibrium price level and equilibrium output
SRAS P = the price level
Y= Real GDP (the quantity of output)
SRAS = “short-run aggregate supply”
AD = “Aggregate Demand”
Y The Aggregate-Demand (AD) Curve
• The AD Curve shows the quantity of all goods and services demanded in the
economy at any given price level.
Why the AD Curve Slopes Downward
• Y = C + I + G + NX
• Assume G fixed by government policy.
• To understand the slope of AD, must determine how a change in P affects C, I,
The Wealthy Effect (P and C)
• Suppose P rises.
➢ The dollars people hold buy fewer goods and services, so real wealth is lower
➢ People feel poorer.
• Result: C falls.
The Interest-Rate Effect (P and I)
• Suppose P rises.
➢ Buying goods and services 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
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 the foreign exchange market
➢ U.S. exchange rate appreciates.
➢ U.S. exports more expensive to people abroad, imports cheaper to U.S.
• Result: NX falls. The Slope of the AD Curve: Summary
• An increase in P reduces the quantity of goods and services demanded
➢ The wealth effect: C falls
➢ The interest-rate effect: I falls
➢ The exchange-rate effect (NX falls)
Why the AD Curve Might Shift
• Any event that changes C, I, G, or NX – except a change in P – will shift the AD
• Example: A stock market boom makes households feel wealthier, C rises, the
AD curve shifts right.
• Changes in C
➢ Stock market boom/crash
➢ Preferences: 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
• 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
The Aggregate-Supply (AS) Curves
• The AS Curve shows the total quantity of goods and services firms produce
and sell at any given price level.
• AS is:
➢ Upward-sloping in the short run
➢ Vertical in the long run
Y 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.
Why LRAS Is Vertical
• Yn is determined by the economy’s stocks of labor, capital, and natural
resources, and on the level of technology.
• An increase in P does not affect any of these, so it does not affect Yn.