Short run economic fluctuations definition

Short-Run Economic Fluctuations

The Company is TORO. This is a group assignment and I am only responsible for the highlighted portion. Only 1-2 slides. PLEASE NO PLAGIARISM

Select an organization your team is familiar with or an organization where a team member currently works.

Create a 15- to 20-slide Microsoft® PowerPoint® presentation that will be presented to the organization's Executive Committee. The presentation should cover the following items:

Identify the three key facts about short-run economic fluctuations and how the economy in the short run differs from the economy in the long run.
Explain economic fluctuations and how shifts in either aggregate demand or aggregate supply can cause booms and recessions using the model of aggregate demand and aggregate supply.
Explain how monetary policy affects interest rates and aggregate demand.
Analyze how fiscal policy affects interest rates and aggregate demand.
Evaluate why policymakers face a short-run trade-off between inflation and unemployment.
Evaluate why the inflation-unemployment trade-off disappears in the long run.
Cite a minimum of 3 peer-reviewed sources not including your textbook.

Format consistent with APA guidelines.

Class,

I would like to make the following suggestions for this week's team PowerPoint presentation:

1. Remember that the focus of this paper should not be the organization you pick.

2. Read Chapter 20 of your textbook. The key facts about economic fluctuations are discussed in Section 20-1. Discuss how shifts of the AD and AS curves can affect the equilibrium price level and real output, but do not forget that these shifts also imply changes in the rate of unemployment.

3. Note that monetary policy and fiscal policy are different types of policies. I suggest you have a slide indicating what these policies mean. Also, the instructions imply that fiscal policy aims to change interest rates. That is not correct. While fiscal policy can potentially have any effect, that is not the purpose of fiscal policy. On the other hand, interest rate changes are a major objective of monetary policy.

CHAPTER 20 Aggregate Demand and Aggregate Supply

Economic activity fluctuates from year to year. In most years, the production of goods and services rises. Because of increases in the labor force, increases in the capital stock, and advances in technological knowledge, the economy can produce more and more over time. This growth allows everyone to enjoy a higher standard of living. On average, over the past half century, the production of the U.S. economy as measured by real GDP has grown by about 3 percent per year.

In some years, however, the economy experiences contraction rather than growth. Firms find themselves unable to sell all the goods and services they have to offer, so they cut back on production. Workers are laid off, unemployment rises, and factories are left idle. With the economy producing fewer goods and services, real GDP and other measures of income fall. Such a period of falling incomes and rising unemployment is called a recession if it is relatively mild and a depression if it is more severe.

recession

a period of declining real incomes and rising unemployment

depression

a severe recession

An example of such a downturn occurred in 2008 and 2009. From the fourth quarter of 2007 to the second quarter of 2009, real GDP for the U.S. economy fell by 4.7 percent. The rate of unemployment rose from 4.4 percent in May 2007 to 10.0 percent in October 2009—the highest level in more than a quarter century. Not surprisingly, students graduating during this time found that desirable jobs were hard to find.

What causes short-run fluctuations in economic activity? What, if anything, can public policy do to prevent periods of falling incomes and rising unemployment? When recessions and depressions occur, how can policymakers reduce their length and severity? These are the questions we take up now.

The variables that we study are largely those we have seen in previous chapters. They include GDP, unemployment, interest rates, and the price level. Also familiar are the policy instruments of government spending, taxes, and the money supply. What differs from our earlier analysis is the time horizon. So far, our goal has been to explain the behavior of these variables in the long run. Our goal now is to explain their short-run deviations from long-run trends. In other words, instead of focusing on the forces that explain economic growth from generation to generation, we are now interested in the forces that explain economic fluctuations from year to year.

There remains some debate among economists about how best to analyze short-run fluctuations, but most economists use the model of aggregate demand and aggregate supply. Learning how to use this model for analyzing the short-run effects of various events and policies is the primary task ahead. This chapter introduces the model's two pieces: the aggregate-demand curve and the aggregate-supply curve. Before turning to the model, however, let's look at some of the key facts that describe the ups and downs of the economy.

20-1 Three Key Facts about Economic Fluctuations

Short-run fluctuations in economic activity have occurred in all countries throughout history. As a starting point for understanding these year-to-year fluctuations, let's discuss some of their most important properties.

20-1a Fact 1: Economic Fluctuations Are Irregular and Unpredictable

Fluctuations in the economy are often called the business cycle. As this term suggests, economic fluctuations correspond to changes in business conditions. When real GDP grows rapidly, business is good. During such periods of economic expansion, most firms find that customers are plentiful and that profits are growing. When real GDP falls during recessions, businesses have trouble. During such periods of economic contraction, most firms experience declining sales and dwindling profits.

The term business cycle is somewhat misleading because it suggests that economic fluctuations follow a regular, predictable pattern. In fact, economic fluctuations are not at all regular, and they are almost impossible to predict with much accuracy. Panel (a) of Figure 1 shows the real GDP of the U.S. economy since 1965. The shaded areas represent times of recession. As the figure shows, recessions do not come at regular intervals. Sometimes recessions are close together, such as the recessions of 1980 and 1982. Sometimes the economy goes many years without a recession. The longest period in U.S. history without a recession was the economic expansion from 1991 to 2001.

FIGURE 1 A Look at Short-Run Economic Fluctuations

This figure shows real GDP in panel (a), investment spending in panel (b), and unemployment in panel (c) for the U.S. economy using quarterly data since 1965. Recessions are shown as the shaded areas. Notice that real GDP and investment spending decline during recessions, while unemployment rises.

20-1b Fact 2: Most Macroeconomic Quantities Fluctuate Together

Real GDP is the variable most commonly used to monitor short-run changes in the economy because it is the most comprehensive measure of economic activity. Real GDP measures the value of all final goods and services produced within a given period of time. It also measures the total income (adjusted for inflation) of everyone in the economy.

It turns out, however, that for monitoring short-run fluctuations, it does not really matter which measure of economic activity one looks at. Most macroeconomic variables that measure some type of income, spending, or production fluctuate closely together. When real GDP falls in a recession, so do personal income, corporate profits, consumer spending, investment spending, industrial production, retail sales, home sales, auto sales, and so on. Because recessions are economy-wide phenomena, they show up in many sources of macroeconomic data.

Although many macroeconomic variables fluctuate together, they fluctuate by different amounts. In particular, as panel (b) of Figure 1 shows, investment spending varies greatly over the business cycle. Even though investment averages about one-seventh of GDP, declines in investment account for about two-thirds of the declines in GDP during recessions. In other words, when economic conditions deteriorate, much of the decline is attributable to reductions in spending on new factories, housing, and inventories.

20-1c Fact 3: As Output Falls, Unemployment Rises

Changes in the economy's output of goods and services are strongly correlated with changes in the economy's utilization of its labor force. In other words, when real GDP declines, the rate of unemployment rises. This fact is hardly surprising: When firms choose to produce a smaller quantity of goods and services, they lay off workers, expanding the pool of unemployed.

Panel (c) of Figure 1 shows the unemployment rate in the U.S. economy since 1965. Once again, the shaded areas in the figure indicate periods of recession. The figure shows clearly the impact of recessions on unemployment. In each of the recessions, the unemployment rate rises substantially. When the recession ends and real GDP starts to expand, the unemployment rate gradually declines. The unemployment rate never approaches zero; instead, it fluctuates around its natural rate of about 5 or 6 percent.

Quick Quiz List and discuss three key facts about economic fluctuations.

20-2 Explaining Short-Run Economic Fluctuations

Describing what happens to economies as they fluctuate over time is easy. Explaining what causes these fluctuations is more difficult. Indeed, compared to the topics we have studied in previous chapters, the theory of economic fluctuations remains controversial. In this chapter, we begin to develop the model that most economists use to explain short-run fluctuations in economic activity.

20-2a The Assumptions of Classical Economics

In previous chapters, we developed theories to explain what determines most important macroeconomic variables in the long run. Chapter 12 explained the level and growth of productivity and real GDP. Chapters 13 and 14 explained how the financial system works and how the real interest rate adjusts to balance saving and investment. Chapter 15 explained why there is always some unemployment in the economy. Chapters 16 and 17 explained the monetary system and how changes in the money supply affect the price level, the inflation rate, and the nominal interest rate. Chapters 18 and 19 extended this analysis to open economies to explain the trade balance and the exchange rate.

All of this previous analysis was based on two related ideas: the classical dichotomy and monetary neutrality. Recall that the classical dichotomy is the separation of variables into real variables (those that measure quantities or relative prices) and nominal variables (those measured in terms of money). According to classical macroeconomic theory, changes in the money supply affect nominal variables but not real variables. As a result of this monetary neutrality, Chapters 12 through 15 were able to examine the determinants of real variables (real GDP, the real interest rate, and unemployment) without introducing nominal variables (the money supply and the price level).

In a sense, money does not matter in a classical world. If the quantity of money in the economy were to double, everything would cost twice as much, and everyone's income would be twice as high. But so what? The change would be nominal (by the standard meaning of “nearly insignificant”). The things that people really care about—whether they have a job, how many goods and services they can afford, and so on—would be exactly the same.

This classical view is sometimes described by the saying, “Money is a veil.” That is, nominal variables may be the first things we see when we observe an economy because economic variables are often expressed in units of money. But what's important are the real variables and the economic forces that determine them. According to classical theory, to understand these real variables, we need to look behind the veil.

20-2b The Reality of Short-Run Fluctuations

Do these assumptions of classical macroeconomic theory apply to the world in which we live? The answer to this question is of central importance to understanding how the economy works. Most economists believe that classical theory describes the world in the long run but not in the short run.

Consider again the impact of money on the economy. Most economists believe that, beyond a period of several years, changes in the money supply affect prices and other nominal variables but do not affect real GDP, unemployment, or other real variables—just as classical theory says. When studying year-to-year changes in the economy, however, the assumption of monetary neutrality is no longer appropriate. In the short run, real and nominal variables are highly intertwined, and changes in the money supply can temporarily push real GDP away from its long-run trend.

Even the classical economists themselves, such as David Hume, realized that classical economic theory did not hold in the short run. From his vantage point in 18th-century England, Hume observed that when the money supply expanded after gold discoveries, it took some time for prices to rise, and in the meantime, the economy enjoyed higher employment and production.

To understand how the economy works in the short run, we need a new model. This new model can be built using many of the tools we developed in previous chapters, but it must abandon the classical dichotomy and the neutrality of money. We can no longer separate our analysis of real variables such as output and employment from our analysis of nominal variables such as money and the price level. Our new model focuses on how real and nominal variables interact.

IN THE NEWS: The Social Influences of Economic Downturns

The U.S. economy experienced a deep recession in 2008 and 2009. This event led some observers to ask how such events affect society more broadly.

Recession Can Change a Way of Life

By Tyler Cowen

As job losses mount and bailout costs run into the trillions, the social costs of the economic downturn become clearer. The primary question, to be sure, is what can be done to shorten or alleviate these bad times. But there is also a broader set of questions about how this downturn is changing our lives, in ways beyond strict economics.

All recessions have cultural and social effects, but in major downturns the changes can be profound. The Great Depression, for example, may be regarded as a social and cultural era as well as an economic one. And the current crisis is also likely to enact changes in various areas, from our entertainment habits to our health.

First, consider entertainment. Many studies have shown that when a job is harder to find or less lucrative, people spend more time on self-improvement and relatively inexpensive amusements. During the Depression of the 1930s, that meant listening to the radio and playing parlor and board games, sometimes in lieu of a glamorous night on the town. These stay-at-home tendencies persisted through at least the 1950s.

In today's recession, we can also expect to turn to less expensive activities—and maybe to keep those habits for years. They may take the form of greater interest in free content on the Internet and the simple pleasures of a daily walk, instead of expensive vacations and N.B.A. box seats.

In any recession, the poor suffer the most pain. But in cultural influence, it may well be the rich who lose the most in the current crisis. This downturn is bringing a larger-than-usual decline in consumption by the wealthy.

The shift has been documented by Jonathan A. Parker and Annette Vissing-Jorgensen, finance professors at Northwestern University, in their recent paper, “Who Bears Aggregate Fluctuations and How? E stimates and Implications for Consumption Inequality.” Of course, people who held much wealth in real estate or stocks have taken heavy losses. But most important, the paper says, the labor incomes of high earners have declined more than in past recessions, as seen in the financial sector.

Popular culture's catering to the wealthy may also decline in this downturn. We can expect a shift away from the lionizing of fancy restaurants, for example, and toward more use of public libraries. Such changes tend to occur in downturns, but this time they may be especially pronounced.

Recessions and depressions, of course, are not good for mental health. But it is less widely known that in the United States and other affluent countries, physical health seems to improve, on average, during a downturn. Sure, it's stressful to miss a paycheck, but eliminating the stresses of a job may have some beneficial effects. Perhaps more important, people may take fewer car trips, thus lowering the risk of accidents, and spend less on alcohol and tobacco. They also have more time for exercise and sleep, and tend to choose home cooking over fast food.

In a 2003 paper, “Healthy Living in Hard Times,” Christopher J. Ruhm, an economist at the University of North Carolina at Greensboro, found that the death rate falls as unemployment rises. In the United States, he found, a 1 percent increase in the unemployment rate, on average, decreases the death rate by 0.5 percent.

David Potts studied the social history of Australia in the 1930s in his 2006 book, “The Myth of the Great Depression.” Australia's suicide rate spiked in 1930, but overall health improved and death rates declined; after 1930, suicide rates declined as well.

While he found in interviews that many people reminisced fondly about those depression years, we shouldn't rush to conclude that depressions are happy times.

Many of their reports are likely illusory, as documented by the Harvard psychologist Daniel Gilbert in his best-selling book “ Stumbling on Happiness.” According to P rofessor Gilbert, people often have rosy memories of very trying periods, which may include extreme poverty or fighting in a war.

In today's context, we are also suffering fear and anxiety for the rather dubious consolation of having some interesting memories for the distant future.

But this downturn will likely mean a more prudent generation to come. That is implied by the work of two professors, Ulrike Malmendier of the University of California, Berkeley, and Stefan Nagel of the Stanford Business School, in a 2007 paper, “Depression Babies: Do Macroeconomic Experiences Affect Risk-Taking?”

A generation that grows up in a period of low stock returns is likely to take an unusually cautious approach to investing, even decades later, the paper found. Similarly, a generation that grows up with high inflation will be more cautious about buying bonds decades later.

In other words, today's teenagers stand less chance of making foolish decisions in the stock market down the road. They are likely to forgo some good business opportunities, but also to make fewer mistakes.

When all is said and done, something terrible has happened in the United States economy, and no one should wish for such an event. But a deeper look at the downturn, and the social changes it is bringing, shows a more complex picture.

In addition to trying to get out of the recession—our first priority—many of us will be making do with less and relying more on ourselves and our families. The social changes may well be the next big story of this recession.

Mr. Cowen is an economics professor at George Mason University.

Source: New York Times, February 1, 2009.

20-2c The Model of Aggregate Demand and Aggregate Supply

Our model of short-run economic fluctuations focuses on the behavior of two variables. The first variable is the economy's output of goods and services, as measured by real GDP. The second is the average level of prices, as measured by the CPI or the GDP deflator. Notice that output is a real variable, whereas the price level is a nominal variable. By focusing on the relationship between these two variables, we are departing from the classical assumption that real and nominal variables can be studied separately.

We analyze fluctuations in the economy as a whole with the model of aggregate demand and aggregate supply , which is illustrated in Figure 2 . On the vertical axis is the overall price level in the economy. On the horizontal axis is the overall quantity of goods and services produced in the economy. The aggregate-demand curve shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level. The aggregate-supply curve shows the quantity of goods and services that firms produce and sell at each price level. According to this model, the price level and the quantity of output adjust to bring aggregate demand and aggregate supply into balance.

model of aggregate demand and aggregate supply

the model that most economists use to explain short-run fluctuations in economic activity around its long-run trend

aggregate-demand curve

a curve that shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level

aggregate-supply curve

a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level

It is tempting to view the model of aggregate demand and aggregate supply as nothing more than a large version of the model of market demand and market supply introduced in Chapter 4 . In fact, this model is quite different. When we consider demand and supply in a specific market—ice cream, for instance—the behavior of buyers and sellers depends on the ability of resources to move from one market to another. When the price of ice cream rises, the quantity demanded falls because buyers will use their incomes to buy products other than ice cream. Similarly, a higher price of ice cream raises the quantity supplied because firms that produce ice cream can increase production by hiring workers away from other parts of the economy. This microeconomic substitution from one market to another is impossible for the economy as a whole. After all, the quantity that our model is trying to explain—real GDP—measures the total quantity of goods and services produced by all firms in all markets. To understand why the aggregate-demand curve slopes downward and why the aggregate-supply curve slopes upward, we need a macroeconomic theory that explains the total quantity of goods and services demanded and the total quantity of goods and services supplied. Developing such a theory is our next task.

FIGURE 2 Aggregate Demand and Aggregate Supply

Economists use the model of aggregate demand and aggregate supply to analyze economic fluctuations. On the vertical axis is the overall level of prices. On the horizontal axis is the economy's total output of goods and services. Output and the price level adjust to the point at which the aggregate-supply and aggregate-demand curves intersect.

Quick Quiz How does the economy's behavior in the short run differ from its behavior in the long run? • Draw the model of aggregate demand and aggregate supply. What variables are on the two axes?

20-3 The Aggregate-Demand Curve

The aggregate-demand curve tells us the quantity of all goods and services demanded in the economy at any given price level. As Figure 3 illustrates, the aggregate- demand curve slopes downward. This means that, other things being equal, a decrease in the economy's overall level of prices (from, say, P1 to P2) raises the quantity of goods and services demanded (from Y1 to Y2). Conversely, an increase in the price level reduces the quantity of goods and services demanded.

20-3a Why the Aggregate-Demand Curve Slopes Downward

Why does a change in the price level move the quantity of goods and services demanded in the opposite direction? To answer this question, it is useful to recall that an economy's GDP (which we denote as Y) is the sum of its consumption (C), investment (I), government purchases (G), and net exports (NX):

Y = C + I + G + NX.

FIGURE 3 The Aggregate-Demand Curve

A fall in the price level from P1 to P2 increases the quantity of goods and services demanded from Y1 to Y2. There are three reasons for this negative relationship. As the price level falls, real wealth rises, interest rates fall, and the exchange rate depreciates. These effects stimulate spending on consumption, investment, and net exports. Increased spending on any or all of these components of output means a larger quantity of goods and services demanded.

Each of these four components contributes to the aggregate demand for goods and services. For now, we assume that government spending is fixed by policy. The other three components of spending—consumption, investment, and net exports—depend on economic conditions and, in particular, on the price level. Therefore, to understand the downward slope of the aggregate-demand curve, we must examine how the price level affects the quantity of goods and services demanded for consumption, investment, and net exports.

The Price Level and Consumption: The Wealth Effect Consider the money that you hold in your wallet and your bank account. The nominal value of this money is fixed: One dollar is always worth one dollar. Yet the real value of a dollar is not fixed. If a candy bar costs one dollar, then a dollar is worth one candy bar. If the price of a candy bar falls to 50 cents, then one dollar is worth two candy bars. Thus, when the price level falls, the dollars you are holding rise in value, which increases your real wealth and your ability to buy goods and services.

This logic gives us the first reason the aggregate-demand curve slopes downward. A decrease in the price level raises the real value of money and makes consumers wealthier, which in turn encourages them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded. Conversely, an increase in the price level reduces the real value of money and makes consumers poorer, which in turn reduces consumer spending and the quantity of goods and services demanded.

The Price Level and Investment: The Interest-Rate Effect The price level is one determinant of the quantity of money demanded. When the price level is lower, households do not need to hold as much money to buy the goods and services they want. Therefore, when the price level falls, households try to reduce their holdings of money by lending some of it out. For instance, a household might use its excess money to buy interest-bearing bonds. Or it might deposit its excess money in an interest-bearing savings account, and the bank would use these funds to make more loans. In either case, as households try to convert some of their money into interest-bearing assets, they drive down interest rates. (The next chapter analyzes this process in more detail.)

Interest rates, in turn, affect spending on goods and services. Because a lower interest rate makes borrowing less expensive, it encourages firms to borrow more to invest in new plants and equipment, and it encourages households to borrow more to invest in new housing. (A lower interest rate might also stimulate consumer spending, especially spending on large durable purchases such as cars, which are often bought on credit.) Thus, a lower interest rate increases the quantity of goods and services demanded.

This logic gives us a second reason the aggregate-demand curve slopes downward. A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded. Conversely, a higher price level raises the interest rate, discourages investment spending, and decreases the quantity of goods and services demanded.

The Price Level and Net Exports: The Exchange-Rate Effect As we have just discussed, a lower price level in the United States lowers the U.S. interest rate. In response to the lower interest rate, some U.S. investors will seek higher returns by investing abroad. For instance, as the interest rate on U.S. government bonds falls, a mutual fund might sell U.S. government bonds to buy German government bonds. As the mutual fund tries to convert its dollars into euros to buy the German bonds, it increases the supply of dollars in the market for foreign-currency exchange.

The increased supply of dollars to be turned into euros causes the dollar to depreciate relative to the euro. This leads to a change in the real exchange rate—the relative price of domestic and foreign goods. Because each dollar buys fewer units of foreign currencies, foreign goods become more expensive relative to domestic goods.

The change in relative prices affects spending, both at home and abroad. Because foreign goods are now more expensive, Americans buy less from other countries, causing U.S. imports of goods and services to decrease. At the same time, because U.S. goods are now cheaper, foreigners buy more from the United States, so U.S. exports increase. Net exports equal exports minus imports, so both of these changes cause U.S. net exports to increase. Thus, the fall in the real exchange value of the dollar leads to an increase in the quantity of goods and services demanded.

This logic yields a third reason the aggregate-demand curve slopes downward. When a fall in the U.S. price level causes U.S. interest rates to fall, the real value of the dollar declines in foreign exchange markets. This depreciation stimulates U.S. net exports and thereby increases the quantity of goods and services demanded. Conversely, when the U.S. price level rises and causes U.S. interest rates to rise, the real value of the dollar increases, and this appreciation reduces U.S. net exports and the quantity of goods and services demanded.

Summing Up There are three distinct but related reasons a fall in the price level increases the quantity of goods and services demanded:

· 1. Consumers are wealthier, which stimulates the demand for consumption goods.

· 2. Interest rates fall, which stimulates the demand for investment goods.

· 3. The currency depreciates, which stimulates the demand for net exports.

The same three effects work in reverse: When the price level rises, decreased wealth depresses consumer spending, higher interest rates depress investment spending, and a currency appreciation depresses net exports.

Here is a thought experiment to hone your intuition about these effects. Imagine that one day you wake up and notice that, for some mysterious reason, the prices of all goods and services have fallen by half, so the dollars you are holding are worth twice as much. In real terms, you now have twice as much money as you had when you went to bed the night before. What would you do with the extra money? You could spend it at your favorite restaurant, increasing consumer spending. You could lend it out (by buying a bond or depositing it in your bank), reducing interest rates and increasing investment spending. Or you could invest it overseas (by buying shares in an international mutual fund), reducing the real exchange value of the dollar and increasing net exports. Whichever of these three responses you choose, the fall in the price level leads to an increase in the quantity of goods and services demanded. This is what the downward slope of the aggregate- demand curve represents.

It is important to keep in mind that the aggregate-demand curve (like all demand curves) is drawn holding “other things equal.” In particular, our three explanations of the downward-sloping aggregate-demand curve assume that the money supply is fixed. That is, we have been considering how a change in the price level affects the demand for goods and services, holding the amount of money in the economy constant. As we will see, a change in the quantity of money shifts the aggregate-demand curve. At this point, just keep in mind that the aggregate-demand curve is drawn for a given quantity of the money supply.

20-3b Why the Aggregate-Demand Curve Might Shift

The downward slope of the aggregate-demand curve shows that a fall in the price level raises the overall quantity of goods and services demanded. Many other factors, however, affect the quantity of goods and services demanded at a given price level. When one of these other factors changes, the quantity of goods and services demanded at every price level changes and the aggregate-demand curve shifts.

Let's consider some examples of events that shift aggregate demand. We can categorize them according to the component of spending that is most directly affected.

Shifts Arising from Changes in Consumption Suppose Americans suddenly become more concerned about saving for retirement and, as a result, reduce their current consumption. Because the quantity of goods and services demanded at any price level is lower, the aggregate-demand curve shifts to the left. Conversely, imagine that a stock market boom makes people wealthier and less concerned about saving. The resulting increase in consumer spending means a greater quantity of goods and services demanded at any given price level, so the aggregate-demand curve shifts to the right.

Thus, any event that changes how much people want to consume at a given price level shifts the aggregate-demand curve. One policy variable that has this effect is the level of taxation. When the government cuts taxes, it encourages people to spend more, so the aggregate-demand curve shifts to the right. When the government raises taxes, people cut back on their spending and the aggregate-demand curve shifts to the left.

Shifts Arising from Changes in Investment Any event that changes how much firms want to invest at a given price level also shifts the aggregate-demand curve. For instance, imagine that the computer industry introduces a faster line of computers and many firms decide to invest in new computer systems. Because the quantity of goods and services demanded at any price level is higher, the aggregate- demand curve shifts to the right. Conversely, if firms become pessimistic about future business conditions, they may cut back on investment spending, shifting the aggregate-demand curve to the left.

Tax policy can also influence aggregate demand through investment. For example, an investment tax credit (a tax rebate tied to a firm's investment spending) increases the quantity of investment goods that firms demand at any given interest rate and therefore shifts the aggregate-demand curve to the right. The repeal of an investment tax credit reduces investment and shifts the aggregate- demand curve to the left.

Another policy variable that can influence investment and aggregate demand is the money supply. As we discuss more fully in the next chapter, an increase in the money supply lowers the interest rate in the short run. This decrease in the interest rate makes borrowing less costly, which stimulates investment spending and thereby shifts the aggregate-demand curve to the right. Conversely, a decrease in the money supply raises the interest rate, discourages investment spending, and thereby shifts the aggregate-demand curve to the left. Many economists believe that throughout U.S. history, changes in monetary policy have been an important source of shifts in aggregate demand.

Shifts Arising from Changes in Government Purchases The most direct way that policymakers shift the aggregate-demand curve is through government purchases. For example, suppose Congress decides to reduce purchases of new weapons systems. Because the quantity of goods and services demanded at any price level is lower, the aggregate-demand curve shifts to the left. Conversely, if state governments start building more highways, the result is a greater quantity of goods and services demanded at any price level, so the aggregate-demand curve shifts to the right.

Shifts Arising from Changes in Net Exports Any event that changes net exports for a given price level also shifts aggregate demand. For instance, when Europe experiences a recession, it buys fewer goods from the United States. This reduces U.S. net exports at every price level and shifts the aggregate-demand curve for the U.S. economy to the left. When Europe recovers from its recession, it starts buying U.S. goods again and the aggregate-demand curve shifts to the right.

Net exports can also change because international speculators cause movements in the exchange rate. Suppose, for instance, that these speculators lose confidence in foreign economies and want to move some of their wealth into the U.S. economy. In doing so, they bid up the value of the U.S. dollar in the foreign exchange market. This appreciation of the dollar makes U.S. goods more expensive compared to foreign goods, which depresses net exports and shifts the aggregate-demand curve to the left. Conversely, speculation that causes a depreciation of the dollar stimulates net exports and shifts the aggregate-demand curve to the right.

Summing Up In the next chapter, we analyze the aggregate-demand curve in more detail. There we examine more precisely how the tools of monetary and fiscal policy can shift aggregate demand and whether policymakers should use these tools for that purpose. At this point, however, you should have some idea about why the aggregate-demand curve slopes downward and what kinds of events and policies can shift this curve. Table 1 summarizes what we have learned so far.

TABLE 1 The Aggregate-Demand Curve: Summary

Why Does the Aggregate-Demand Curve Slope Downward?

· 1. The Wealth Effect: A lower price level increases real wealth, which stimulates spending on consumption.

· 2. The Interest-Rate Effect: A lower price level reduces the interest rate, which stimulates spending on investment.

· 3. The Exchange-Rate Effect: A lower price level causes the real exchange rate to depreciate, which stimulates spending on net exports.

Why Might the Aggregate-Demand Curve Shift?

· 1. Shifts Arising from Changes in Consumption: An event that causes consumers to spend more at a given price level (a tax cut, a stock market boom) shifts the aggregate-demand curve to the right. An event that causes consumers to spend less at a given price level (a tax hike, a stock market decline) shifts the aggregate-demand curve to the left.

· 2. Shifts Arising from Changes in Investment: An event that causes firms to invest more at a given price level (optimism about the future, a fall in interest rates due to an increase in the money supply) shifts the aggregate-demand curve to the right. An event that causes firms to invest less at a given price level ( pessimism about the future, a rise in interest rates due to a decrease in the money supply) shifts the aggregate-demand curve to the left.

· 3. Shifts Arising from Changes in Government Purchases: An increase in government purchases of goods and services (greater spending on defense or highway construction) shifts the aggregate-demand curve to the right. A decrease in government purchases on goods and services (a cutback in defense or highway spending) shifts the aggregate-demand curve to the left.

· 4. Shifts Arising from Changes in Net Exports: An event that raises spending on net exports at a given price level (a boom overseas, speculation that causes an exchange-rate depreciation) shifts the aggregate-demand curve to the right. An event that reduces spending on net exports at a given price level (a recession overseas, speculation that causes an exchange-rate appreciation) shifts the aggregate-demand curve to the left.

Quick Quiz Explain the three reasons the aggregate-demand curve slopes downward. • Give an example of an event that would shift the aggregate-demand curve. Which way would this event shift the curve?