Akash Cherukuri

Akash Cherukuri

An Undergraduate at the Indian Institute of Technology, Bombay.

Aggregate Demand and Supply

Recession: Periods of mild economic decrease in incomes and increase in unemployment

Depression: Periods of strong economic decrease in incomes and increase in unemployment

Economic Fluctuations

1. Economic Fluctuations are irregular and unpredictable

The fluctuations in the economy are called as the Business Cycle. This is a misleading term because the fluctuations are very irregular and are also very difficult to predict.

2. Most Macro Economic variables vary together

However, the amount of change in each variable depends on the variable under consideration. That is, even if real GDP and Income decrease during a depression, they would decrease by (obviously) different amounts.

3. As output falls, the rate of unemployment rises

Obviously, when there is less to produce, companies lay off workers.

Model of Aggregate Supply and Aggregate Demand

In the short run, the assumptions of classical dichotomy and monetary neutrality do not hold. We cannot separate our analysis of real and nominal variables. We build a new model to see how they interact with each other. Similar to a demand supply curve, we draw a graph between the price level on the y-axis and the real GDP on the x-axis. The aggregate demand is the amount of goods and services that people and companies wish to consume at a given price level and the aggregate supply is how much goods and supplies can be produced at a given price level.

Do keep in mind that the curves have been drawn assuming that all other factors such as money supply are fixed.

Why is Aggregate Demand Sloping downwards?

\[\text{Y} = \text{C}+\text{I}+\text{G}+\text{NX}\]

Assume that $\text{G}$ is fixed by a government policy. We discuss the effect of decrease in Price Level $\text{P}$ for the three cases.

  1. Wealth Effect: $\text{P}$ decreases, causing consumers to become more richer by which they would tend to buy more goods.
  2. Interest Rate Effect: Decrease in $\text{P}$ would cause a decrease in interest rates, incentivizing people to borrow money and invest.
  3. Exchange Rate Effect: Decrease in $\text{P}$ causes the currency to depreciate, meaning that prices have fallen on global scale for the economy which would cause other countries to buy from our economy, increasing net exports.

The aggregate demand curve can shift due to the following reasons:

  1. Change in Consumption: When the government increases taxes, it discourages people to spend and thus the curve shifts to the left. Similarly, when people become obsessed with savings, the curve shifts to the left as well.
  2. Change in Investment: Investment Tax Credits, promising new technology and a increase in money supply shift the curve to the right.
  3. Change in Government Spending: Governments having new projects and stuff shifts curve to the right.
  4. Change in Net Exports: self-explanatory

Long-run Aggregate Supply Curve

The long run aggregate supply curve is a vertical line because the theory of classical dichotomy and monetary neutrality hold in this case. The value of the supply in the long run is called the Natural Level of Output. The long run supply curve can shift due to variety of reasons. (733/734 of Mankiw)

Stagflation: A period in which both production falls (stagnation) and the prices rise (inflation). It can be caused when the aggregate supply curve shifts to the left, due a sudden increase in costs of production and the effect is self-reinforcing.