Long Run vs. Short Run Long Run: A period long enough for nominal wages and other input prices to change in response to a change in the nation s price level.
The Basic Model of Economic Fluctuations Two variables are used to develop a model to analyze the short-run fluctuations. Real GDP Price Level
The Basic Model of Economic Fluctuations The AS-AD Model Economist use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.
The Basic Model of Economic Fluctuations The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level. The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.
Aggregate Demand and Aggregate Supply... Price Level Aggregate supply Equilibrium price level Aggregate demand 0 Equilibrium output Quantity of Output
THE AGGREGATE-DEMAND CURVE The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX
Figure 3 The Aggregate-Demand Curve... Price Level P P 2 1. A decrease in the price level... Aggregate demand 0 Y Y 2 2.... increases the quantity of goods and services demanded. Quantity of Output
Why the Aggregate-Demand Curve Is Downward Sloping The Real Balances Effect (Wealth Effect) The Interest Rate Effect The Foreign Purchases Effect (Exchange-Rate Effect)
The Real Balances Effect (Wealth Effect) The Price Level and Consumption A lower price level leads to more consumption spending due to the increase in the purchasing power of the public s accumulated savings balances. This makes consumers feel more wealthy, which in turn encourages them to spend more. This increase in consumer spending means larger quantities of goods and services demanded.
The Interest Rate Effect The Price Level and Investment A higher price level increases money demand. Assuming a fixed supply of money, the interest rate increases. This causes a decrease in business investment and a decrease in interest sensitive consumption, leading to a larger quantity of goods and services demanded..
The Foreign Purchases Effect (Exchange-Rate Effect) The Price Level and Net Exports When the price level rises relative to foreign price levels, foreigners buy fewer domestic goods (exports) and domestic consumers buy more foreign goods (imports). Also, when a fall in the domestic price level causes domestic interest rates to fall, the real exchange rate depreciates, which stimulates net exports.
Determinants of Aggregate Demand What shifts AD? Consumption Investment Government Purchases Net Exports
Increase in AD
Decrease in AD
Consumer Spending Each of the following influence consumption Consumer wealth Consumer expectations Consumer indebtedness Personal income taxes
Business Spending Each of the following influence investment Interest rates Profit expectations on business projects Technology Degree of excess capacity
Government Spending The amount of government spending depends on outlays in the national budget. G will increase as outlays increase and decrease as outlays decrease.
Net Export Spending Net Exports = Exports - Imports Each of the following influence net exports National income abroad Exchange rates