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AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):

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Macroeconomics ECO 403
VU
LESSON 25
AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued...)
How shocking!!!
Shocks: exogenous changes in aggregate supply or demand
Shocks temporarily push the economy away from full-employment.
A demand shock
·
The economy begins in long-run equilibrium at point A. An increase in aggregate demand,
due to an increase in the velocity of money, moves the economy from point A to point B,
where output is above its natural level. As prices rise, output gradually returns to its natural
rate, and the economy moves from point B to point C.
LRAS
P
C
SRAS
B
AD'
A
AD
Y
Y
·
Exogenous decrease in velocity
·
If the money supply is held constant, then a decrease in V means people will be using their
money in fewer transactions, causing a decrease in demand for goods and services:
102
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Macroeconomics ECO 403
VU
The effects of a negative demand shock
The shock shifts AD left, causing output and employment to fall in the short run. Over time,
prices fall and the economy moves down its demand curve toward full-employment.
P
LRAS
A
B
SRAS
P
C
AD1
P2
AD2
Y
Y2
Y
Supply shocks
A supply shock alters production costs, affects the prices that firms charge. (Also price shocks)
Examples of adverse supply shocks:
·  Bad weather reduces crop yields, pushing up
food prices.
·  Workers unionize, negotiate wage increases.
·  New environmental regulations require firms to reduce emissions. Firms charge higher
prices to help cover the costs of compliance.
(Favorable supply shocks lower costs and prices)
P
LRAS
B
SRAS2
P
2
A
SRAS1
P1
AD1
Y
Y2
Y
The adverse supply shock moves the economy to point B.
103
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Macroeconomics ECO 403
VU
Stabilization policy
·
def: policy actions aimed at reducing the severity of short-run economic fluctuations.
·
Example: Using monetary policy to combat the effects of adverse supply shocks:
But central bank
accommodates the
shock by raising
aggregate demand.
P
LRAS
B
SRAS2
C
P1
A
AD2
P2
AD1
Y
Y2
Y1
1
Results:
P is permanently higher, but Y remains at its full-employment level.
The 1970s oil shocks
·
Early 1970s: OPEC coordinates a reduction in the supply of oil.
·
Oil prices rose
11% in 1973
68% in 1974
16% in 1975
·
Such sharp oil price increases are supply shocks because they significantly impact
production costs and prices.
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Macroeconomics ECO 403
VU
The oil price shock shifts SRAS up, causing output and employment to fall. In absence
of further price shocks, prices will fall over time and economy moves back toward full
employment.
P
LRAS
B
SRAS2
P
2
A
SRAS1
P1
AD1
Y
Y2
Y1
Predicted effects of the oil price shock:
· Inflation ↑
· Output ↓
· Unemployment ↑
105
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Macroeconomics ECO 403
VU
...and then a gradual recovery.
70%
12%
60%
50%
10%
40%
8%
30%
20%
6%
10%
0%
4%
1973
1974
1975
1976
1977
Change in oil prices (lef t scale)
Inf lation rate-CPI (right scale)
Unemployment rate (right scale)
106
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Macroeconomics ECO 403
VU
Late 1970s: As economy was recovering, oil prices shot up again, causing another huge
supply shock!!!
60%
14%
50%
12%
40%
10%
30%
8%
20%
6%
10%
0%
4%
1977
1978
1979
1980
1981
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
107
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Macroeconomics ECO 403
VU
The 1980s oil shocks
1980s: A favorable supply shock--a significant fall in oil prices.
As the model would predict, inflation and unemployment fell:
40%
10%
30%
8%
20%
10%
6%
0%
-10%
4%
-20%
-30%
2%
-40%
0%
-50%
1982
1983
1984
1985
1986
1987
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
Keynesian theory of Income & Employment
·
Model of aggregate demand & aggregate supply
·
Long run
­  Prices flexible
­  Output determined by factors of production & technology
­  Unemployment equals its natural rate
·
Short run
­  Prices fixed
­  Output determined by aggregate demand
­  Unemployment is negatively related to output
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Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand