Third Edition Business Fluctuations: Aggregate Demand · PDF fileMODERN PRINCIPLES OF...

MODERN PRINCIPLES OF ECONOMICSThird Edition

Business Fluctuations:

Aggregate Demand

and Supply

Business Fluctuations:

Aggregate Demand

and Supply

Chapter 13

Outline

� The Aggregate Demand Curve

� The Long-Run Aggregate Supply Curve

� Real Shocks

� Aggregate Demand Shocks and the Short-Run

Aggregate Supply Curve

� Shocks to the Components of Aggregate Demand

� Understanding the Great Depression: Aggregate

Demand Shocks and Real Shocks

2

Introduction

� Economic growth is not a smooth process.

� Real GDP in the United States has grown at an

average rate of 3.2% per year over the past 60

years.

� The economy rarely grew at an average rate.

� Growth fluctuated from -5% to over 8%.

� Recessions are of special concern to

policymakers and the public because

unemployment typically increases.

3

Definition

Business fluctuations:

fluctuations in the growth rate of real

GDP around its trend growth rate.

4

Recession:

a significant, widespread decline in real

income and employment.

Introduction

Quarterly Growth Rate in Real GDP, 1947–20135

Bureau of Economic Analysis

Introduction

U.S. Civilian Unemployment Rate, 1948–2013 6

Bureau of Labor Statistics; National Bureau of Economic Research

Introduction

� To understand booms and recessions, we are

going to develop a model of aggregate demand

and aggregate supply (AD/AS), with 3 curves:

• Aggregate demand curve (AS)

• the long-run aggregate supply curve (LRAS or

Solow)

• the short-run aggregate supply curve (SRAS).

� The AD/AS model shows how unexpected

economic disturbances or “shocks” can

temporarily increase or decrease the rate of

growth.7

Definition

Aggregate demand curve:

shows all the combinations of inflation

and real growth that are consistent with

a specified rate of spending growth,

.

8

vM+

The Aggregate Demand Curve

� We can derive the AD curve using the quantity

theory of money in dynamic form,

Where: = growth rate of the money supply

= growth in velocity

= growth rate of prices (inflation)

= growth rate of real GDP

9

RYPM +=+ν

M

ν

P

RY


� We can also write the equation as:

� So if money growth = 5%, velocity = 0%, and

real growth is 0%, the inflation rate must = 5%.

� In other words, if the money supply is growing,

velocity is constant, and there are no additional

goods, then prices must go up.

10

Growth Real Inflation +=+νM


� Another example: if money growth = 5%,

velocity = 0%, and real growth is 3%, the

inflation rate must = 2%.

� An AD curve tells us all the combinations of

inflation and real growth that are consistent with

a specified rate of spending growth, .

� In our example, any combination of inflation and

real growth that adds up to 5% is on the same

AD curve.

11

ν+M


Real GDPgrowth rate

2%

-2% 0%

5%

0%7%5%3%

AD (spending growth = 5%)

5% + 0% = 5%

12

2% + 3% = 5%

InflationRate (π)

If spending and real growth increases, then inflation will fall down.

If spending and real growth increases, then inflation will fall down.

Self-Check

13

equals:

a. Real growth.

b. Inflation + nominal growth.

c. Inflation + real growth.

Answer: c : Growth Real Inflation +=+νM

Shifts in Aggregate Demand

� Increased spending must flow into either a

higher inflation rate or a higher growth rate.

� If spending growth increases, either because of

an increase in money supply or an increase in

velocity, then the AD curve shifts up and to the

right.

� A decrease in spending growth shifts the AD

curve inward.

14

Shifts in Aggregate Demand

Real GDPgrowth rate

2%

-2% 0%

5%

7%

0%7%5%3%

7% + 0% = 7%

15

2% + 5% = 7%

InflationRate (π)

AD (spending growth = 7%)

1. Increases in spending growth,

shift the AD curve to the right.

2. Decreases in spending growth,

shift the AD curve to the left.

ν↑↑ and/or M

ν↓↓ and/or M

Long Run Aggregate Supply

� Every economy has a potential growth rate

determined by:

• Increases in the stocks of labor and capital.

• Increases in productivity.

� The rate of growth, as given by these real

factors of production, is called the “Solow”

growth rate.

� The long-run aggregate supply curve is a

vertical line at the Solow growth rate,

independent of the inflation rate.

16

Long Run Aggregate Supply

Real GDPgrowth rate

InflationRate (π)

LRAS

The Solow growth rate

Potential growth does not

depend on the rate of inflation.

17

Definition

Solow growth rate:

an economy’s potential growth rate, the rate of

economic growth that would occur given flexible

prices and the existing real factors of production.

18

The long run aggregate supply curve (LRAS):

is vertical at the Solow growth rate.

Shifts in the LRAS Curve

� When we put the AD and LRAS curve together,

we can see how business fluctuations can be

caused by real shocks.

� In this model, the equilibrium inflation rate and

growth rate are determined by the intersection

of the AD and LRAS curves.

19

AD and LRAS Curves

Real GDPgrowth rate

InflationRate (π)

LRAS

3%

7%

)10% M( =+ vAD

20

If is 10% and

real growth is 3%,

then the inflation rate

will be 7%.

ν+M

Self-Check

21

An economy’s potential growth rate is called:

a. The Solow growth rate.

b. Aggregate supply.

c. Aggregate demand.

Answer: a – the potential growth rate is called

the Solow growth rate.

AD + LRAS: Real Business Cycle Model

(RBC)

� RBC – Real Business Cycle Model

� Pre-Keynesian model

� Prices assumed to be flexible, markets auto

adjust to changes in agg demand

� Consists of just the AD and LRAS curve

� A supply side model

� Shifts in the AD curve only causes changes in

inflation rate, not real growth rates

� Real growth rate changes only when there are

real shocks22

Shifts in the LRAS Curve

� Real shocks are rapid changes in economic

conditions that increase or diminish the

productivity of capital and labor.

� Economies are continually hit by real shocks,

which shift the Solow growth rate.

� This in turn influences GDP and employment.

� Possible shocks include wars, terrorist attacks,

major new regulations, tax rate changes, mass

strikes, and new technologies.

23

AD and LRAS Curves

Real GDPgrowth rate

InflationRate (π)

LRAS

7%

Negativeshock

Positiveshock

-1% 3%

3%

7%

1. A positive shock results

in a higher real growth

rate and lower inflation.

2. A negative shock

results in a lower real

growth rate and higher

inflation.

11%

)10% M( =+ vAD

24

Real Shocks

� Agricultural output depends on the quantity and

quality of the inputs of capital and labor.

� It also depends on the weather.

� If farmers struggle, many other sectors of the

economy suffer as well.

� When the weather fluctuates, so does output

and therefore so does GDP, especially in

agricultural economies.

25

Real Shocks: Weather

26

Real Shocks

� In an economy with a large manufacturing

sector, a reduction in the oil supply reduces

GDP.

� Oil and machines are complementary - they

work together with labor to produce output.

� When the oil supply is reduced, capital and

labor become less productive.

� The first OPEC oil shock came in late 1973, and

the price of oil more than tripled in two years.

27

Real Shocks

� Since oil is an important input in many sectors,

high oil prices—or oil shocks—hurt many

American industries.

� In each of the last six U.S. recessions, there

was a large increase in the price of oil just prior

to or coincident with the onset of recession.

� A 10% increase in the price of oil lowers the

GDP growth rate for just over two years.

28

Real Shocks

29The Price of Oil and U.S. Recessions

Real Shocks

30

Self-Check

31

Higher business taxes will shift the long run

aggregate supply curve:

a. To the left.

b. To the right.

c. Higher taxes will not shift the LRAS curve.

Answer: a – higher taxes will decrease LRAS,

shifting the curve to the left.

Introduction to the AD/AS Model

� Next model: AD-AS (New Keynesian)

• Explains the business cycle in terms of both

real shocks and/or aggregate demand shocks

• Both supply-side shocks and demand side

shocks are incorporated

� This is a model for the economic short run,

not the long run

• Trying to explain the “business cycle”

• Hence the need for the SRAS

� AD-AS is primarily a Demand Side model

32

John Maynard Keynes

� John Maynard Keynes (1883-1946)

• The General Theory of Employment, Interest, and

Money, 1936.

� Wrote in the context of the Great Depression.

� Explained that when prices are not perfectly

flexible (sticky), deficiencies in aggregate

demand could cause recessions

33

Key to the model: when prices are

sticky, the economy can grow

faster or slower than the Solow

growth rate.

Keynesianism

Keynesian economic philosophy:

The economy must be managed.

The economy is unstable, tends to fall into recessions

Government spending and money printing are the

solutions to “manage” the economy

(even if it means digging holes and then filling them up!)

Economic corrections by themselves take too long

“In the Long Run, we’re all dead.”

Can not rely on the economy to correct itself

34

Keynesianism

� Utilizes big aggregated concepts/explanations

• – too aggregated, not enough information

� Became “intellectual cover” for big government spending, collectivism

� If WWII spending ended the Great Depression, why didn’t the huge reduction in government spending cause another recession/depression? Many predicted this.

� Regime uncertainty may be a better explanation

� Discredited in the early 1970’s but was resurrected big time in 2009 with the massive stimulus bill

35

Short Run Aggregate Supply (SRAS)

The short run aggregate supply curve:

shows the positive relationship between

the inflation rate and real growth during

the period when prices and wages are

sticky.

36


37


� The SRAS show the pathway of the economy in the

short run

� The short run macroeconomic equilibrium is at the intersection of the AD curve and the SRAS curve

� The intersection of these two curves indicates the rate of economic growth and the inflation rate (actual inflation)

� In the short run, an increase in AD will increase

both inflation and real growth.

• Increase in AD is split between growth & inflation

� i.e. a decrease in demand will decrease both the

inflation rate and the growth rate.38


� The position of the SRAS curve is anchored by

expected inflation E(π), and changes in E(π) will shift

SRAS. Such shifts occur only in the long run.

� Changes in actual inflation (π) cause a movement

along the SRAS curve. Such movements occur only in the short run.

� Each SRAS curve is associated with a specific rate of

expected inflation - E(π)

39

Why does the SRAS slope upwards?

� Given:

� When spending increases, the “stickiness” of

prices means that changes in the growth rate of

P can not change enough to compensate

� Therefore, real GDP growth rate must change to

balance both sides of the equation (in the short

run only)

� In the SR, output can change (temporarily)

� In the LR, prices can fully adjust (flexible)40

RYPM +=+ν

Sticky Prices

� Prices can be sticky (not fully flexible) due to

uncertainty, “menu costs,” and other factors

� There may be confusion as to whether price

changes are real or nominal.

� Firms may not respond immediately to

changes in AD/inflation

� “Menu costs” – represent the costs of

changing prices

� Changing prices may create mistrust among

the firm’s customers

� The “profit story” illustrates sticky prices41

Self-Check

42

The costs associated with changing the prices of

goods and services are called:

a. Inflation costs.

b. Inflationary expectations.

c. Menu costs.

Answer: c – menu costs.

Sticky Wages

� Another form of sticky prices

� Wages are the major expense for many firms

� Wages can be slow to adjust due to labor contracts,

uncertainty, human factors, etc

� When inflation falls, wages may remain high,

making labor expensive

� Firms may choose to do layoffs rather than wage

cuts

� Workers often become upset when there are

reductions to their nominal wages, morale drops

� Wages will change more slowly than actual inflation

in the short run

43

Definition

Nominal wage confusion:

occurs when workers respond to their

nominal wage instead of to their real

wage, that is, when workers respond to

the wage number on their paychecks

rather than to what their wage can buy

in goods and services (the wage after

correcting for inflation).

44

The “Profit” Story

45


� The SRAS is drawn with a steeper slope to the

right of the LRAS – reflects capacity limitations

in the economy

� Since wages are sticky downwards, a slowdown

in nominal spending growth results in more

unemployment than if wages/prices were

perfectly flexible (RBC model)

� With a negative AD shock, the ultimate effect of

sticky wages results in more unemployment

� This is reflected in the shape of the SRAS curve

46

Check It

If π > π e :

a) firms' profits will increase.

b) money growth will cause the short-run aggregate supply curve to shift.

c) firms' profits will decrease.

d) there will be no change in real GDP growth because it is determined by real factors.

SRAS Shifts

• What shifts the SRAS curve?

• Whenever the LRAS moves left or right, the SRAS moves with it, staying with the “anchor” point

• Changes in expected inflation rate

� When exp infl increases, SRAS shifts left

� When exp infl decreases, SRAs shifts right

• Whenever exp infl does not equal actual inflation, the SRAS shifts in the appropriate direction

48

Short-Run Aggregate Supply

49

Real GDP growth rate

InflationRate (π)

LRAS

3%

2%

)5% v M( =+

SRAS (E(π) = 2%)

AD

Aggregate Demand Shocks and the

Short-Run Aggregate Supply Curve

�


Inflation

Rate (ππππ)Solow growth

curve

3%

2%

(SRAS2)

(E(π)π)π)π) = 4%)

(SRAS1)

(E(π)π)π)π) = 2%)

4%

6%

7%

At ππππ = 2% and E(π)π)π)π) = 2%,

economy is at point a.

If economy moves to b (due to

an AD shift)

then ππππ = 4% and E(π)π)π)π) = 2%,

and real growth ↑ to 7%

When ππππ = 4% and E(π)π)π)π) = 4%,

SRAS shifts up and economy

moves to point c.If economy moves to d

then ππππ = 6% and E(π)π)π)π) = 4%,

and real growth ↑ to 7%a

bc

d

Equilibrium in SR/LR

� Equilibrium:

� Long Run -

• When all three curves intersect at the same point (the

anchor point)

• Expected inflation always equal actual inflation

� Short Run –

• Wherever the SRAS and AD curve intersect

� Determines actual inflation rate and economic

growth rate

• Does not necessarily have to be in LR equilibrium

51

Aggregate Demand Shocks

Aggregate demand shock:

a rapid and unexpected shift in the AD

curve (spending).

52

Aggregate Demand Shocks

� A positive shock to spending must either

increase inflation or the real growth rate.

� In the short run, an increase in spending will be

split between increases in inflation and

increases in real growth.

� In the long run, the real growth rate is equal to

the Solow rate, which is not influenced by

inflation. (“money is neutral’)

� In the long run, therefore, an increase in

spending will increase only the inflation rate.

53

An Increase in Aggregate Demand

54


InflationRate (π)

LRAS

3%

2%

SRAS (E(π) = 2%)

)5% v M( =+AD

If there is an unexpected ↑ in ,

both inflation and the growth rate

increase in the short run (a → b).

M

AD )10% v M( =+a

4%

6%

b


� Workers initially mistake the nominal wage

increase for a real increase.

� Prices also don’t move instantly because it is

costly to change prices (“menu costs”).

� Firms may also hold off on price changes

because they are not sure whether the change

in market conditions is temporary or permanent.

� As prices increase throughout the economy,

workers demand even higher wages to catch up

to the higher inflation rate.

55


56


InflationRate (π)

LRAS

3%

2%

SRAS (E(π) = 2%)

)5% v M( =+AD

Eventually, inflation expectations

adjust, wages are unstuck and

the growth rate returns to the

Solow rate (b → c).

AD )10% v M( =+a

4%

6%

SRAS (E(π) = 7%)

7%

b

c

A Decrease in Aggregate Demand

� When AD falls due to a fall in the money supply:

• The economy shifts to a new short run

equilibrium point.

• The inflation rate decreases a little.

• Real growth is reduced a lot (recession).

� Prices and wages are especially sticky in the

downward direction.

� It can take the economy a long time to move out

of a recession.

57


InflationRate (π)

LRAS

-1%

5%

(SRAS)

(E(π) = 7%)

7%

3%

a

b

Real Growth

)10% M( =+ vAD1

)5% M( =+ vAD2

58

A decrease in AD can

induce a lengthy

recession.


InflationRate (π)

LRAS

-1%

5%

(SRAS)

(E(π) = 7%)

7%

3%

a

b

Real Growth

)10% M( =+ vAD1

)5% M( =+ vAD2

59

In the long run, wages

become unstuck and

the economy moves to

a new equilibrium at c.

3% c


� In the previous graph, a negative AD shock

results in moving from A to B to C

� i.e. the economy will eventually recover to its

long run Solow growth rate

� Keynesian say that this process takes too long,

resulting in various social problems

� Rather than wait for this process (3 years?), the

government should actively manage the

economy via policies that increase aggregate

demand

� To be covered in Fiscal Policy chapter60

Shocks to Components of AD

� Changes in are the same as changes in the

spending rate, holding constant.

� If increases, the growth rate of C, I, G, or NX

must increase.

� Changes in tend to be temporary.

� The shares of GDP devoted to C, I, G, and NX

have been quite stable over time.

61

νM

ν

ν

A Shock to the Growth Rate of Spending

InflationRate (π)

LRAS

-1%

6%

(SRAS)

(E(π) = 7%)

7%

3%

a

b

Real Growth

)10% M( =+ vAD1

)5% M( =+ vAD2

62

Consumers’ fears → temporary decrease in AD � Short-run

• Wages are sticky

• Real growth ↓� Long-run

• AD returns• Real growth ↑

Factors That Shift AD

63

Self-Check

64

A slower growth in the money supply will:

a. Decrease AD.

b. Increase AD.

c. Not affect AD.

Answer: a – decrease AD.

The Great Depression

� The Great Depression was due primarily to a

large fall in aggregate demand.

� In 1929, the U.S. stock market crashed.

� Common belief - “Capitalism is inherently

unstable and goes through regular panics and

recessions.”

� World finances were a mess as a result of WWI.

The US economy boomed during the “Roaring

20s” fueled by easy money from the recently

created Federal Reserve.

65


� The boom was largely due to too much credit

and when the brakes were put on in the late

1920’s, the stock market crashed (just like 2008-

2009).

� Few supporters of the “common” belief

recognize or mention the sharp depression

experienced in 1920-21.

� GDP fell by over 10% though the economy

recovered quickly within 18 months

� How did the US get out of the 1920-1921

depression so quickly?66


� The government largely did nothing.

� Many people believe that monetary flows from Europe

energized spending and economic growth in the US.

� In 1922, the “Roaring 20s” began.

� High flying tech stocks like RCA (radio) led the frenzied

creation of a stock market bubble.

� Until the crash of October 1929 - where 25% of the

market value was lost over two days.

• Many stocks down 90%

• Loss of confidence in the system

� In the October 1989 crash, market down 25% in one day

67


� People felt poorer and decreased spending,

reducing aggregate demand.

� In 1930, depositors lost confidence in the banks.

� From 1930 to 1932, there were four waves of

banking panics.

� By 1933, more than 40% of all American banks

had failed.

� The fear and uncertainty also reduced

investment spending.

� The U.S. capital stock was lower in 1940 than it

had been in 1930. 68


� In 1931, instead of increasing the money supply

to boost the economy, the Federal Reserve

allowed the money supply to contract even

further.

� There was an additional monetary contraction

during 1937–1938.

• This was the infamous “Depression within a

depression.”

• Much of the previous economic gains were gone.

� At the time of Pearl Harbor, the unemployment

rate was still 14%

69



InflationRate (π) LRAS

-13%

0%

)23%- M( =+ vAD

SRAS

-10%

4%

M↓

C↓

I↓

AD )4% M( =+ v

70


� Real shocks also played a role in the Great

Depression.

� Bank failures not only reduced the money supply

and spending (AD), but they also reduced the

efficiency of financial intermediation.

� Economic policy mistakes also impeded

recovery; government agencies tried to increase

prices by reducing supply.

� The Smoot–Hawley Tariff of 1930 raised tariffs

on imports; other countries retaliated.

71


� A severe drought and decades of ecologically

unsustainable farming practices turned millions

of acres of farmland into a “dust bowl”.

72

� The shocks

compounded

one another

and made a

desperate

situation even

worse.NOAA GEORGE E. MARSH ALBUM

Video Links for Ch 13

� Business Cycle –� https://www.youtube.com/watch?v=O-IZB0Ndl8s&index=22&list=PLJ-

qCyb18paTjIoFpfHVwOj6dI5WJmmH2

� Real Business Cycle� https://www.youtube.com/watch?v=rcezRoO7xfA&index=23&list=PLJ-


� AS-AD model - Intro� https://www.youtube.com/watch?v=-DvANk24ge0&list=PLJ-

qCyb18paTjIoFpfHVwOj6dI5WJmmH2&index=24

� More on AS-AD model (Part 1)� https://www.youtube.com/watch?v=ZWbyZtmyNj4&index=25&list=PLJ-


� More on AS-AD model (Part 2)� https://www.youtube.com/watch?v=sGcIoqK80YU&index=26&list=PLJ-


73

Takeaway

� The aggregate demand and supply model can

be used to analyze fluctuations in the growth

rate of real GDP.

� Real shocks are analyzed through shifts in the

LRAS curve, while aggregate demand shocks

are analyzed using shifts in the AD curve.

� Nominal wage and price confusion, sticky

wages and prices, menu costs, and uncertainty

create an upward-sloped short run aggregate

supply curve.74

Takeaway

� The Great Depression resulted from an

unfortunate, concentrated, and interrelated

series of aggregate demand and real shocks.

� It can be illustrated using the AD/AS model.

75

Third Edition Business Fluctuations: Aggregate Demand · PDF fileMODERN PRINCIPLES OF...

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