Lecture 7:

Aggregate Demand -
Aggregate Supply
& The Phillips curve

Chapter 33, 35
 Lecture Objectives
 Examine economic fluctuations and their
features.
 Study the basic model of fluctuations - the

aggregate demand and aggregate supply

model.
 Analyze sources of recession.

 Use the AD-AS Model & Phillips curve to

explain the trade-off between inflation and

unemployment.
 Economic Fluctuations
 Economic fluctuations
 Negative growth:

 Recession: a period of declining income and

falling unemployment

 Depression: a severe recession

 Positive growth:

 Boom
Economic Growth & Fluctuations
Real GDP fluctuates
500 around the long-term
growth trend every
year
400
Real GDP
B i l l i o n s o f 1998
R eal G D P
d o l l ars

300

200 Long-term
growth trend
100
1960 1970 1980 1990 2000
 Business Cycles
 Business cycle
Demonstrate short-run fluctuations
 Phases of a business cycle
• Expansion
• Peak
• Recession
• Trough
• Recovery
 Business Cycle
Peaks
Real GDP

Recession Expansion Real GDP

Troughs

Recession Time
Recovery
 Three Key Facts About
Economic Fluctuations
 Irregular and unpredictable fluctuations
 Simultaneous fluctuation of most
macroeconomic variables
 Fall in output & rise in unemployment
 Three Key Facts About
Economic Fluctuations
1. Economic fluctuations are irregular
and unpredictable.
 US Short-Run Economic Fluctuations
(a) Real GDP
Recession
Billions of s
1992 Dollars
$7,000
6,500 Real GDP
6,000
5,500
5,000
4,500
4,000
3,500
3,000
2,500
1965 1970 1975 1980 1985 1990 1995
 Three Key Facts About
Economic Fluctuations

2. Most macroeconomic variables

fluctuate together.
GDP falls => personal income,
corporate profits, consumption,
investment spending, industrial
production, retail sales, auto sales,
ect also fall
 US Short-Run Economic Fluctuations
(b) Investment Spending

Billions of Recession
1992 Dollars s

$1,100
1,000
900
800
700
Investment spending
600
500
400
300
1965 1970 1975 1980 1985 1990 1995
 Three Key Facts About
Economic Fluctuations

3. As output falls, unemployment rises.

 US Short-Run Economic Fluctuations
(c) Unemployment Rate
Percent of
Labor Force Recession
s
12

10
Unemployment rate
8

0
1965 1970 1975 1980 1985 1990 1995
GREAT DEPRESSION 1930s
JOHN MAYNARD KEYNES AND THE
CRITIC OF CLASSICAL ECONOMICS

“The long run is a misleading

to current affairs. In the long
run we are all dead.
Economists set themselves
too easy, too useless if in
tempestuous seasons they
can only tell us when the
storm is long past, the ocean
will be flat!!!”
 The Basic Model
of Economic Fluctuations
 Two variables used to develop a model to analyze
the short-run fluctuations.
 Output measured by Real GDP
 Overall price level measured by the CPI or the GDP
deflator.
 Aggregate Demand and Aggregate Supply Model:
used to explain short-run fluctuations in economic
activity around its long-run trend.
 Aggregate Demand and
Aggregate Supply
Price
Level
Short-run
Aggregate
Supply

Equilibrium
price level

Aggregate
demand

0 Equilibrium Quantity of
output Output
 Aggregate Demand
 GDP(E) = Aggregate Demand = Total
expenditures on final goods and services
 Personal Expenditure on consumer
Consumption (C) goods & services.
 Private Investment(I) Spending on capital goods
and services
 Govt Purchases (G) Spending on final goods &
services by Government
 Net Exports ( X-M) Expenditure by foreigners on
our output as well as by our
own citizens on foreign items
AD = C + I + G + NX
The Aggregate-Demand Curve
Price
Level

P1

P2
Aggregate
demand

0 Y1 Y2 Quantity of
Output
 Why the Aggregate Demand
Curve Is Downward Sloping
 The Price Level and Consumption: The
Wealth Effect
 The Price Level and Investment: The
Interest Rate Effect
 The Price Level and Net Exports: The
Exchange-Rate Effect
The Price Level and Consumption:
The Wealth Effect
A decrease in the price level
 Feel more wealthy
 Encourage consumers to spend more.
 Increase quantities of goods and services
demanded.
The Price Level and Investment:
The Interest Rate Effect
A lower price level
 lower quantity of money demanded for
any given interest rate
 reduce the interest rate
 encourage greater spending on
investment goods.
 increase quantity of goods and services
demanded.
The Price Level and net Exports:
The Exchange-Rate Effect
A fall in the price level
 Decrease interest rates
 Encourage outflow of capital
 Reduce real exchange rate
 Stimulate net exports.
 Increase quantity of goods and services
demanded.
 The Aggregate-Demand Curve
Change in Price Level and Movement
Price
Level

P1
1. A
decrease
in the price
level... P2
Aggregate
demand

0 Y1 Y2 Quantity of
Output
2. …increases the quantity of goods
and services demanded.
Why the Aggregate Demand
Curve Might Shift
AD = C + I + G + NX
 Shifts arising from Consumption
 Shifts arising from Investment

 Shifts arising from Government

Purchases
 Shifts arising from Net Exports
 Aggregate Demand Curve
Change in Other Factors and Shift
Price
Level

P1

D2
Aggregate
demand, D1

0 Y1 Y2 Quantity of
Output
 Aggregate Supply Curve

 Long run: vertical AS curve

 Short run: upward sloping AS

curve
Long-Run Aggregate Supply Curve
 Long run: vertical AS curve
 An economy’s production of goods and
services depends on resources (land, labour
and capital) and available technology
 The price level does not affect these variables
in the long run.
Long-Run Aggregate Supply Curve
Pric
e
Leve
l
Long-run
aggregate
supply
P1

P2 2. …does not
affect the quantity
1. A change of goods and
in the price services supplied
level… in the long run.
0
Natural rate Quantity of
of output Output
Long-Run Aggregate Supply Curve
 Thelong-run aggregate supply
curve: vertical at
 natural rate of output or
 potential output or
 full-employment output.
Why the Long-Run Aggregate
Supply Curve Might Shift
 Shifts arising from Labor
 Shifts arising from Capital

 Shifts arising from Natural

Resources
 Shifts arising from Technological

Knowledge
 Long-Run Growth and Inflation
2. …and growth in the money
supply shifts aggregate-demand...
Price
LRAS1980 LRAS1990 LRAS2000 1. In the
Level
long-run,
technological
progress
shifts long-
4. …and P2000 run
ongoing aggregate
P1990 supply...
inflation.

P1980
AD2000
AD1980 AD1990
0
Y1980 Y1990 Y2000 Quantity of
Output
3. …leading to growth in output...
 Short-Run Fluctuation
and Long-Run Growth
Short-run fluctuations
in output and price level
should be viewed as deviations
from the continuing long-run trends.
Short Run Aggregate Supply Curve

 Short run: upward sloping AS curve

 An increase in the overall level of prices in
the economy tends to raise the quantity of
goods and services supplied.
Short-Run Aggregate Supply Curve
Changes in Price Level & Movement
Price
Leve
l Short-run
aggregate
supply

P1

1. A
decrease in P2 2. reduces the
the price quantity of goods
level and services
supplied in the
short run.

0 Y2 Y1 Quantity of
Output
Why the Aggregate Supply Curve
Slopes Upward in the Short Run
 The Misperceptions Theory
 The Sticky-Wage Theory

 The Sticky-Price Theory

Why the Aggregate Supply Curve
Might Shift in the Short Run
 Shifts arising from Labor (wages)
 Shifts arising from Capital (interest rates)

 Shifts arising from Natural Resources

(resource availability)
 Shifts arising from Technology

 Shifts arising from the Expected Price

Level
 Why the Short-Run Aggregate
Supply Curve Might Shift
 Shifts arising from the Expected Price Level.
 An increase in the expected price level reduces
the quantity of goods and services supplied at any
given price level and shifts the short-run
Aggregate Supply curve to the left.
 A decrease in the expected price level shifts the
short-run Aggregate Supply curve to the right.
 Macro-Equilibrium

The level of real GDP

and the price level that equate the
aggregate quantity demanded and the
aggregate quantity supplied
 Short-run Macro-Equilibrium
Price
Level
Short-
run
Aggregat
e
E Supply
Equilibrium
price level

Aggregate
Demand

0 Equilibrium Quantity of
output Output
 The Long-Run Equilibrium
Price
Level Long-run Short-run
aggregate aggregate
supply supply

Equilibriu A
m
price

Aggregate
demand
0 Natural rate Quantity of
of output Output
 Sources of Recession

A decrease in AD
 A decrease/ adverse shift in SRAS
 A Decrease in Aggregate Demand
2. …causes output to
fall in the short run…
Price
Level Long-run Short-run aggregate
aggregate supply, AS1
supply
AS
2 3. …but over
time,
P1 A the short-run
aggregate-
supply curve
P2 B 1. A decrease
shifts…in
aggregate demand…
P3 C
Aggregate
AD demand, AD1
0 Y2 Y1 2 Quantity of
4. …and output Output
returns
 Shifts in Aggregate Demand

 Short run: shifts in AD

 fluctuations in the economy’s output
 Long run: shifts in AD
 the overall price level, but not output.
 An Adverse Shift in
Short-Run Aggregate Supply
 A decrease in one of the determinants
of short-run aggregate supply
 shift the curve to the left
 An Adverse Shift in
Short-run Aggregate Supply
1. An adverse shift in
Price Long-run the short-run
Level aggregate aggregate-supply
supply curve…
AS2
Short-run
aggregate
supply, AS1

B
P2
A
P1
3. …and
the price
level to
rise. Aggregate demand
0 Y2 Y1 Quantity of
Output
2. …causes output to
fall…
 Stagflation
 Adverse shifts in aggregate supply
 stagflation - a combination of
recession and inflation.
 A fall in output
 A rise in the price level .
 cannot offset both of these adverse
effects simultaneously.
Policy Responses to Recession
 Do nothing and wait for prices and wages
to adjust.
 Take action to increase aggregate
demand by using monetary and fiscal
policy.
 Accommodating an Adverse
Shift in Aggregate Supply
Price 1. When short-run aggregate supply
Level falls…
Long-run
aggregate AS Short-run
2
supply
aggregate
supply, AS1

P3 C 2. …policymakers
P2 can
A accommodate the
P1 shift
by expanding
3....which aggregate
causes 4. …but demand…
AD2
the price keeps
level to output at its Aggregate demand, AD1
rise natural rate.
0 Natural rate Quantity of
of output Output
AD-AS Model & Phillips Curve

 Unemployment & Inflation

 AD-AS Model & Phillips Curve

 Cost of reducing Inflation

 Unemployment and Inflation
 Misery index: one measure of the “health” of
the economy adding together the inflation
rate and unemployment rate.
 A short-run tradeoff between unemployment

and inflation:
 expand AD  lower unemployment but only at
the cost of higher inflation.
 contract AD  lower inflation but at the cost of
temporarily higher unemployment.
 The Phillips Curve
Inflation
Rate
(percent
per year)
B
6

A
2

Phillips curve

0 4 7 Unemploymen
t Rate
Aggregate Demand, Aggregate
Supply, and the Phillips Curve
 The Phillips curve shows the short-run
combinations of unemployment and
inflation that arise as shifts in the
aggregate demand curve move the
economy along the short-run aggregate
supply curve.
Aggregate Demand, Aggregate
Supply, and the Phillips Curve
 The greater aggregate demand
 the greater economy’s output
 the higher overall price level.
 the lower level of unemployment.
 How the Phillips Curve is Related
to the Model of AD and AS
(a) The Model of AD and AS (b) The Phillips Curve

Short-run Inflation
Price Level AS Rate
(percent per
106 B year) B
6
102 High AD
A
2 A
Low AD Phillips curve
0 7,500 8,000 0 4 7 Unemployment
(unemploymen (unemployme (output (output Rate (percent)
t is 7%) nt is 7%) is is
8,000) 7,500)
 The Long-Run Phillips Curve

 Friedman and Phelps: inflation and

unemployment are unrelated in the long
run.
 The long-run Phillips curve is vertical at the
natural rate of unemployment.
 Monetary policy could be effective in the
short run but not in the long run.
 The Long-Run Phillips Curve
Inflatio
n Rate Long-run
Phillips
curve
High
1. When the inflation B
Central
Bank 2. … but
increases unemploymen
the growth t remains at
rate of the its natural rate
money Low A in the long
supply, the inflation run.
rate of
inflation
increases… 0 Natural rate of Unemployme
unemployment nt Rate
 How the Phillips Curve is Related
to the Model of AD and AS
(a) The Model of Aggregate
Demand and Aggregate (b) The Phillips Curve
Supply
Price Long-run aggregate Inflation Long-run Phillips
Level supply Rate curve
1. An increase in the 3. …and
money supply increases the
increases aggregate inflation
P2 B rate…
demand…

P1 A
AD2
Aggregate
demand, AD1
0 Natural rate of Quantity of 0 Natural rate of Unemploy-
output Output unemployment ment Rate
2. …raises the
price level…
4. …but leaves output and
unemployment at their natural rates.
The Cost of Reducing Inflation
 To reduce inflation: pursue
contractionary monetary policy.
 reduce the quantity of goods and services that
firms produce.
 lead to a rise in unemployment.
 The sacrifice ratio: the number of
percentage points of annual output that is
lost in the process of reducing inflation by
one percentage point.
 An estimate of the sacrifice ratio: five
The Cost of Reducing Inflation
Rational Expectations
 The theory of rational expectations suggests
that people optimally use all the information
they have, including information about
government policies, when forecasting the
future.
 Expected inflation explains why there is a
tradeoff between inflation and unemployment
in the short run but not in the long run.
SELF-STUDY
 Lecture Review
 Economic fluctuations and business cycle
 The aggregate demand and aggregate

supply model
 Sources of Recession

 AD-AS Model and the Phillips curve

 Cost of reducing inflation