MEAP

Prof. Biswa Swarup Misra

These two sessions address
▪ What are economic fluctuations? What are their
characteristics?
▪ Real Business Cycle Theory
▪ Leading Indicator Approach to Business Cycles
▪ How does the model of aggregate demand and
aggregate supply explain economic fluctuations?
▪ Why does the Aggregate-Demand curve slope
downward?
▪ What shifts the AD curve?
• What is the slope of the Aggregate-Supply curve in
the short run?
Sessions 11-12 AGGREGATE DEMAND AND AGGREGATE SUPPLY 1
These two sessions address
• How does the Aggregate-Supply curve look like in
the long run?
• What shifts the AS curve(s)?
• Determination of equilibrium GDP and Price level
• Characterizing Stagflation using AS-AD framework
• Characterizing an overheated economy using AS-AD
framework
• How does the self correcting mechanism work to
kick start an economy from a recession/depression
• What are Inflationary Gaps and Recessionary gaps?

AGGREGATE DEMAND AND AGGREGATE SUPPLY 2

The Model of Aggregate Demand and
Aggregate Supply
P
The price
level
SRAS
“Short-Run
The model P1 Aggregate
determines the Supply”
eq’m price level “Aggregate
Demand” AD

and eq’m output Y

Y1
(real GDP).
Real GDP, the
quantity of output
3
 The Aggregate-Demand (AD) Curve
P
The AD curve
shows the P2
quantity of
all g&s
demanded
in the economy P1
at any given AD
price level.
Y
Y2 Y1

4
 Why the AD Curve Slopes Downward

Y = C + I + G + NX P

Assume G fixed
P2
by govt policy.
To understand
the slope of AD,
P1
must determine
how a change in P AD
affects C, I, and NX.
Y
Y2 Y1

5
 The Wealth Effect (P and C )
Suppose P rises.
▪ The dollars people hold buy fewer g&s,
so real wealth is lower.
▪ People feel poorer.
Result: C falls.

6
 The Interest-Rate Effect (P and I )
Suppose P rises.
▪ Buying g&s 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.)

7
 What Are Exchange Rates?
• Exchange Rate Determination in the Short Run
$/¥
Supply of Yen

Exchange rate is
determined
by supply and
demand just
$0.0085
like any other
commodity.

Demand for Yen

Market for Yen Quantity of Yen

8
The Foreign Exchange Market and Exchange
Rates
Equilibrium in the Market for Foreign Exchange

Equilibrium in
the Foreign
Exchange
Market

9
 What Are Exchange Rates?
• Factors that Shift the Demand Curve
1. An increase (decrease) in the demand for a
country’s exports increases (decreases) the
value of its currency.
2. The more desirable (undesirable) a country is
for foreign investment, the higher (lower) the
value of that country’s currency.
3. An increase in the demand to hold dollar
reserves boosts the value of the dollar.
• Let’s use the supply and demand model to
illustrate each of these…

10
 What Are Exchange Rates?
1a. U.S. residents order more Toyotas
$/¥
Supply of yen

↑ demand for Japan’s

exports → ↑ value of
the yen
$0.0090
$0.0085 Demand for yen
w/↑ orders of
Toyotas

Demand for yen

Market for Yen Quantity of Yen

11
 What Are Exchange Rates?
1b. U.S. residents order fewer Toyotas
$/¥
Supply of yen

↓ demand for Japan’s

exports → ↓ value of
the yen

$0.0085 Demand for yen

$0.0080 w/↓ orders of
Toyotas

Demand for yen

Market for Yen Quantity of Yen

12
 What Are Exchange Rates?
2. Mexico becomes a better investment
$/peso
Supply of pesos

The Mexican peso

↑ in value
0.090

0.075 Demand for peso

w/↑ foreign
investment

Demand for pesos

Market for Pesos Quantity of Pesos

13
The Exchange-Rate Effect (P and NX )
Suppose P rises.
▪ India’s interest rates rise (the interest-rate effect).
▪ Foreign investors desire more Indian bonds.
▪ Higher demand for Rupees in foreign exchange market.
▪ India’s exchange rate appreciates.
▪ India’s exports more expensive to people abroad, imports
cheaper to Indian residents.
Result: NX falls.

14
The Slope of the AD Curve: Summary
An increase in P P
reduces the quantity
of g&s demanded P2
because:
• the wealth effect
(C falls)
P1
• the interest-rate
AD
effect (I falls)
• the exchange-rate Y
Y2 Y1
effect (NX falls)

15
Why the Aggregate Demand Curve is
Downward-Sloping?

16
Why the Aggregate Demand Curve is
Downward-Sloping?

17
Why the Aggregate Demand Curve is
Downward-Sloping?

18
Shifts in the Aggregate Demand Curve
(Continued)

Factors That Factors That

Increase Decrease
Aggregate Aggregate
Demand Demand
A decrease in An increase in
taxes taxes
An increase in A decrease in
government government
spending spending
An increase in A decrease in
the money the money
supply supply
Other factors Other factors
19
Factors That Change Aggregate Demand

20
Factors That Change Aggregate Demand
(Continued)

21
 Why the AD Curve Might Shift
Any event that changes
C, I, G, or NX P
– except a change in P –
will shift the AD curve.

Example: P1
A stock market boom
makes households feel
wealthier, C rises, AD2
AD1
the AD curve shifts right.
Y
Y1 Y2

22
 Why the AD Curve Might Shift
▪ Changes in C
• Stock market boom/crash
• Preferences re: 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

23
 Why the AD Curve Might Shift
▪ 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

24
ACTIVE LEARNING 1:
Exercise
What happens to the AD curve in each of the
following scenarios?
A. A ten-year-old investment tax credit expires.
B. The U.S. exchange rate falls.
C. A fall in prices increases the real value of
consumers’ wealth.

25
 The Aggregate-Supply (AS) Curves

The AS curve shows P LRAS

the total quantity of
g&s firms produce and SRAS
sell at any given price
level.

AS is:
▪ upward-sloping
in short run
▪ vertical in Y
long run

26
 The Long-Run Aggregate-Supply Curve (LRAS)

The natural rate of P LRAS

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 Y
YN
output.

27
 Why LRAS Is Vertical

YN determined by the P LRAS

economy’s stocks of
labor, capital, and
natural resources, and
on the level of P2
technology.
An increase in P P1

does not affect

any of these,
so it does not Y
YN
affect YN.

28
 Why the LRAS Curve Might Shift

P LRAS1 LRAS2
Any event that changes
any of the
determinants of YN
will shift LRAS.
Example: Immigration
increases L,
causing YN to rise.

Y
YN Y’
N

29
 Why the LRAS Curve Might Shift

▪ Changes in L or natural rate of unemployment

• Immigration
• Baby-boomers retire
• Govt policies reduce natural u-rate
▪ Changes in K or H
• Investment in factories, equipment
• More people get college degrees
• Factories destroyed by a hurricane

30
 Why the LRAS Curve Might Shift
▪ Changes in natural resources
• discovery of new mineral deposits
• reduction in supply of imported oil
• changing weather patterns that affect
agricultural production
▪ Changes in technology
• productivity improvements from technological
progress

31
 Using AD & AS to Depict LR Growth and
Inflation
LRAS2000
Over the long run, P LRAS1990
tech. progress shifts LRAS1980
LRAS to the right
and growth in the P2000
money supply shifts
P1990
AD to the right.
AD2000
P1980
Result:
ongoing inflation AD1990
and growth in AD1980
Y
output. Y1980 Y1990 Y2000

32
 Short Run Aggregate Supply (SRAS)

The SRAS curve P

is upward sloping:
SRAS
Over the period
of 1-2 years, P2
an increase in P
causes an P1
increase in the
quantity of g & s
supplied. Y
Y1 Y2

33
 Why the Slope of SRAS Matters
P LRAS
If AS is vertical,
fluctuations in AD Phi
SRAS
do not cause
fluctuations in output Phi
or employment.
ADhi
If AS slopes up, Plo
then shifts in AD AD1
Plo
do affect output ADlo
Y
and employment. Ylo Y1 Yhi

34
 Three Theories of SRAS
In each,
• some type of market imperfection
• result:
Output deviates from its natural rate
when the actual price level deviates
from the price level people expected.

35
 1. The Sticky-Wage Theory
▪ Imperfection:
Nominal wages are sticky in the short run,
they adjust sluggishly.
• Due to labor contracts, social norms.
▪ Firms and workers set the nominal wage in
advance based on PE, the price level they
expect to prevail.

36
 1. The Sticky-Wage Theory
▪ If P > PE,
revenue is higher, but labor cost is not.
Production is more profitable,
so firms increase output and employment.
▪ Hence, higher P causes higher Y,
so the SRAS curve slopes upward.

37
 2. The Sticky-Price Theory
▪ Imperfection:
Many prices are sticky in the short run.
• Due to menu costs, the costs of adjusting
prices.
• Examples: cost of printing new menus,
the time required to change price tags.
▪ Firms set sticky prices in advance based
on PE.

38
 2. The Sticky-Price Theory
▪ Suppose the Fed increases the money supply
unexpectedly. In the long run, P will rise.
▪ In the short run, firms without menu costs can
raise their prices immediately.
▪ Firms with menu costs wait to raise prices.
Meantime, their prices are relatively low,
which increases demand for their products,
so they increase output and employment.
▪ Hence, higher P is associated with higher Y,
so the SRAS curve slopes upward.

39
 3. The Misperceptions Theory
▪ Imperfection:
Firms may confuse changes in P with changes
in the relative price of the products they sell.
▪ If P rises above PE, a firm sees its price rise
before realizing all prices are rising.
The firm may believe its relative price is rising,
and may increase output and employment.
▪ So, an increase in P can cause an increase in
Y,
making the SRAS curve upward-sloping.

40
 What the 3 Theories Have in Common:
In all 3 theories, Y deviates from YN when
P deviates from PE.

Y = YN + a (P – PE)
Output Expected
price level
Natural rate
of output
a > 0,
measures Actual
(long-run) price level
how much Y
responds to
unexpected
changes in P

41
 What the 3 Theories Have in Common:

Y = YN + a(P – PE)
P

SRAS
When P > PE

the expected
PE
price level

When P < PE

Y
YN
Y < YN Y > YN
 SRAS and LRAS
▪ The imperfections in these theories are
temporary. Over time,
• sticky wages and prices become flexible
• misperceptions are corrected
▪ In the LR,
• PE = P
• AS curve is vertical

43
 SRAS and LRAS
Y = YN + a(P – PE)
P LRAS

SRAS
In the long run,
PE = P
PE
and
Y = Y N.

Y
YN
44
 Why the SRAS Curve Might Shift
Everything that shifts
LRAS shifts SRAS, too.
P LRAS
Also, PE shifts SRAS: SRAS
If PE rises, SRAS
workers & firms set PE
higher wages.
At each P, PE
production is less
profitable, Y falls,
SRAS shifts left. Y
YN

45
 The Long-Run Equilibrium

In the long-run P LRAS

equilibrium,
SRAS
PE = P,
Y = YN ,
PE
and unemployment
is at its natural rate.
AD
Y
YN

46
Changes in Short-Run Aggregate Supply

47
Short-Run Equilibrium

48
Changes in Short-Run Equilibrium in
the Economy

49
How a Factor Affects the Price Level, Real GDP,
and the Unemployment Rate in the Short Run

50
Supply Shocks

▪ Supply shocks are

external events that shift
the aggregate supply
curve.
▪ Adverse supply shocks can
cause a recession (a fall in
output) with increasing
prices. This phenomenon
is known as stagflation.

51
A Summary Exhibit of AD and SRAS

52