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CAUSES: Shifts of The Aggregate Demand Curve

(1) Demand shocks shift the aggregate demand curve, causing output and prices to move in the same direction in the short run. A negative demand shock reduces output and prices, while a positive demand shock increases output and prices. (2) Supply shocks shift the short-run aggregate supply curve, causing output and prices to move in opposite directions. A negative supply shock reduces output but increases prices, known as stagflation. A positive supply shock increases output but reduces prices. (3) Fiscal and monetary policies can be used to counteract negative demand shocks through expansionary policies or positive demand shocks through contractionary policies.

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51 views8 pages

CAUSES: Shifts of The Aggregate Demand Curve

(1) Demand shocks shift the aggregate demand curve, causing output and prices to move in the same direction in the short run. A negative demand shock reduces output and prices, while a positive demand shock increases output and prices. (2) Supply shocks shift the short-run aggregate supply curve, causing output and prices to move in opposite directions. A negative supply shock reduces output but increases prices, known as stagflation. A positive supply shock increases output but reduces prices. (3) Fiscal and monetary policies can be used to counteract negative demand shocks through expansionary policies or positive demand shocks through contractionary policies.

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DEMAND SHOCKS

(1) CAUSES: Shifts of the Aggregate Demand Curve


Factors Can Shift the Aggregate Demand Curve
(2) Types(Short-Run Effects)

In panel (a), a negative demand shock shifts the aggregate demand curve
leftward from AD1 to AD2. The economy moves down along the SRAS curve
from E1 to E2, reducing the aggregate price level from P1 to P2 and
aggregate output from Y1 to Y2.

In panel (b), a positive demand shock shifts the aggregate demand curve
rightward from AD1 to AD2. The economy moves up along the SRAS curve,
from E1 to E2, increasing the aggregate price level from P1 to P2 and
aggregate output from Y1 to Y2.

Characteristics: shifts the aggregate demand curve, moving the aggregate


price level and aggregate output in the same direction.

Convenient policy:
negative demand shock: expansionary fiscal or monetary

positive demand shock: contractionary fiscal or monetary


Effects of a Negative Demand Shock on the equilibrium in the short run

(1) The initial macroeconomic equilibrium is at E1, where aggregate


output equals potential output at Y1.

(2) If the aggregate demand falls (a negative demand shock), the


aggregate demand curve shifts leftward from AD1 to AD2.

(3) In the short run, the economy moves to E2 and the aggregate price
level declines from P1 to P2, the aggregate output declines from Y1 to
Y2.

(4) Aggregate output in this new short-run equilibrium, E2, is below


potential output. When this happens, the economy faces a
recessionary gap which leads to high unemployment.

(5) But in the long run, nominal wages eventually fall in response to high
unemployment at Y2, as do any other sticky prices, ultimately leading
producers to increase output. As a result, SRAS1 curve gradually
shifts to the right over time until reaches its new position at SRAS2,
bringing the economy to equilibrium at E3, where AD2, SRAS2, and
LRAS all intersect.

(6) At E3, the economy is back in long run macroeconomic equilibrium; it


is back at potential output Y1 but at a lower aggregate price level, P3,
reflecting a long-run fall in the aggregate price level. That is , the
economy is self-correcting in the long run. demand shocks have only
a short-run effect on aggregate output.

Effects of a positive Demand Shock on the equilibrium in the short run

(1) The initial macroeconomic equilibrium is at E1, where aggregate


output equals potential output at Y1.

(2) If a positive demand shock happens (an increase in aggregate


demand), the AD curve shifts rightward from AD1 to AD2, and the
economy moves to E2 in the short run. This results in a higher
aggregate price level, at P2, and a higher aggregate output level, at
Y2.

(3) At E2, Aggregate output is above potential output, and


unemployment falls to a low level in order to produce this higher
level of aggregate output. When this happens, the economy
experiences an inflationary gap.

(4) In the long run, a rise in nominal wages occurs in response to low
unemployment at Y2 move the economy to long-run macroeconomic
equilibrium, shifts SRAS1 leftward to SRAS2.

(5) Aggregate output falls back to Y1, the aggregate price level rises
again to P3, and the economy self-corrects as it returns to long-run
macroeconomic equilibrium at E3. It is back at potential output, but
at a higher price level, P3, reflecting a long-run rise in the aggregate
price level. That is , the economy is self-correcting in the long run.
demand shocks have only a short-run effect on aggregate output.
SUPPLY SHOCKS
(1) CAUSES : shifts of the short-run aggregate supply curve
Factors Can Shift the Short Run Aggregate Supply Curve (SRAS)

(3) Types(Short-Run Effects)


Panel (a) a negative supply shock, which raises production costs and
reduces the quantity producers are willing to supply at any given aggregate
price level, leading to a leftward shift of the short-run aggregate supply
curve .
The initial equilibrium is at E1, with aggregate price level P1 and aggregate
output Y1. The short-run aggregate supply curve shifts from SRAS1 to
SRAS2, and the economy moves from E1 to E2.
As a consequence, the aggregate output falls from Y1 to Y2, and the
aggregate price level rises from P1 to P2, an upward movement along the
AD curve.

The combination of inflation and falling aggregate output shown in panel


(a) is called stagflation, which causes a falling in aggregate output leads to
rising unemployment, and people feel that their purchasing power is
squeezed by rising prices.

Panel (b) shows a positive supply shock, which reduces production costs
and increases the quantity supplied at any given aggregate price level,
leading to a shift in the shift of the SRAS curve rightward from SRAS1 to
SRAS2, generating higher aggregate output and a lower aggregate price
level. The economy moves from E1 to E2. The aggregate price level falls from
P1 to P2, a downward movement along the AD curve and aggregate output
rises from Y1 to Y2.

This combination produced, for a time, a great wave of national optimism.

Characteristics: Unlike demand shocks, they cause the aggregate price level
and aggregate output to move in opposite directions.
Fiscal and monetary policies
(1)Monetary Policy

(2) Fiscal Policy


EXPANSIONARY
1. A increase in government purchases of goods and services
2. An cut in taxes
3. A increase in government transfers

Increases disposable income leads to higer consumer spending and consequently


increase aggregate demand and AD shifts to right.

CONTRACTIONARY
1. A reduction in government purchases of goods and services
2. An increase in taxes
3. A reduction in government transfers

decreases disposable income leads to lower consumer spending and consequently


reducing aggregate demand and AD shifts to left.

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