Slide1 : Chapter 17
Aggregate Demand and Aggregate Supply
Figure 1: The Two-Way Relationship Between Output and the Price Level : Figure 1: The Two-Way Relationship Between Output and the Price Level
The Price Level and The Money Market : The Price Level and The Money Market First effect of a change in the price level occurs in the money market
Rise in the price increases the demand for money and shifts the money demand curve rightward
It makes purchases more expensive
Drop in the price level
Makes purchases cheaper
Decreases the demand for money
Shifts the money demand curve leftward
Rise in the price level causes the interest rate to rise and interest-sensitive spending to fall
Equilibrium GDP decreases by a multiple of the decrease in interest-sensitive spending
The Price Level and Net Exports : The Price Level and Net Exports The second effect of a higher price level brings in the foreign sector
A rise in the price level causes
Net exports to drop and
Equilibrium GDP to decrease by a multiple of the drop in net exports
Deriving The Aggregate Demand (AD) Curve : Deriving The Aggregate Demand (AD) Curve Figure 2 plots the price level on a vertical axis and the economy’s real GDP on the horizontal axis
If we continued to change the price level to other values we would find that each different price level results in a different equilibrium GDP
The aggregate demand (AD) curve tells us the equilibrium real GDP at any price level
Figure 2: Deriving the Aggregate Demand Curve : Figure 2: Deriving the Aggregate Demand Curve AD 140 100 Price
Level K J 10 6 Real GDP
($ Trillions)
Movements Along The AD Curve : Movements Along The AD Curve A variety of events can cause the price level to change, and move us along the AD curve
It’s important to understand what happens in the economy as we make such a move Opposite sequence of events will occur if the price level falls, moving us rightward along the AD curve
Shifts of The AD Curve : Shifts of The AD Curve The distinction between movements along the AD curve and shifts of the curve itself is very important
Always keep the following rule in mind
When a change in the price level causes equilibrium GDP to change, we move along the AD curve
Whenever anything other than the price level causes equilibrium GDP to change, the AD curve itself shifts
What are these other influences on GDP?
Equilibrium GDP will change whenever there is a change in any of the following
Government spending
Taxes
Autonomous consumption spending
Investment spending
The money supply curve
The money demand curve
Changes in the Money Market : Changes in the Money Market Changes that originate in the money market will also shift the aggregate demand curve
An increase in the money supply shifts the AD curve rightward
A decrease in the money supply shifts the AD curve leftward
Figure 4(a): Effects of Key Changes on the Aggregate Demand Curve : Figure 4(a): Effects of Key Changes on the Aggregate Demand Curve (a) Real GDP Price Level P3 Q3 Q1 Q2 AD P1 P2
Figure 4(b): Effects of Key Changes on the Aggregate Demand Curve : Figure 4(b): Effects of Key Changes on the Aggregate Demand Curve AD2 AD1 (b) Real GDP Price Level
Figure 4(c): Effects of Key Changes on the Aggregate Demand Curve : Figure 4(c): Effects of Key Changes on the Aggregate Demand Curve AD2 decreases (c) Real GDP Price Level AD1
The Aggregate Supply Curve : The Aggregate Supply Curve On the one hand, changes in the price level affect output
On the other hand, changes in output affect the price level
This relationship—summarized by the aggregate supply curve—is the focus of this section
The effect of changes in output on the price level is complex, involving a variety of forces
Costs and Prices : Costs and Prices Price level in economy results from pricing behavior of millions of individual business firms
In any given year, some of these firms will raise their prices, and some will lower them
Often, all firms in the economy are affected by the same macroeconomic event
Causing prices to rise or fall throughout the economy
To understand how macroeconomic events affect the price level, we begin with a very simple assumption
A firm sets price of its products as a markup over cost per unit
Costs and Prices : Costs and Prices Percentage markup in any particular industry will depend on degree of competition there
In macroeconomics, we are not concerned with how the markup differs in different industries
But rather with average percentage markup in economy
Determined by competitive conditions
Competitive structure changes very slowly, so average percentage markup should be somewhat stable from year-to-year
But a stable markup does not necessarily mean a stable price level, because unit costs can change
In short-run, price level rises when there is an economy-wide increase in unit costs
Price level falls when there is an economy-wide decrease in unit costs
GDP, Costs, and the Price Level : GDP, Costs, and the Price Level Why should a change in output affect unit costs and price level?
As total output increases
Greater amounts of inputs may be needed to produce a unit of output
Price of non-labor inputs rise
Nominal wage rate rises
A decrease in output affects unit costs through the same three forces, but with opposite result
The Short Run : The Short Run All three of our reasons are important in explaining why a change in output affects price level
They operate within different time frames
Our third explanation—changes in nominal wage rate—is a different story
For a year or more after a change in output, changes in average nominal wage are less important than other forces that change unit costs
The Short Run : The Short Run Some of the more important reasons why wages in many industries respond so slowly to changes in output
Many firms have union contracts that specify wages for up to three years
Wages in many large corporations are set by slow-moving bureaucracies
Wage changes in either direction can be costly to firms
Firms may benefit from developing reputations for paying stable wages
The Short Run : The Short Run Nominal wage rate is fixed in short-run
We assume that changes in output have no effect on nominal wage rate in short-run
Since we assume a constant nominal wage in short-run, a change in output will affect unit costs through the other two factors
In short-run, a rise (fall) in real GDP, by causing unit costs to increase (decrease), will also cause a rise (decrease) in price level
Deriving the Aggregate Supply Curve : Deriving the Aggregate Supply Curve Figure 5 summarizes discussion about effect of output on price level in short-run
Each time we change level of output, there will be a new price level in short-run
Giving us another point on the figure
If we connect all of these points, we obtain economy’s aggregate supply curve
Tells us price level consistent with firms’ unit costs and their percentage markup at any level of output over short-run
A more accurate name for AS curve would be “short-run-price-level-at-each-output-level” curve
Figure 5: The Aggregate Supply Curve : Figure 5: The Aggregate Supply Curve Price Level Real GDP ($ Trillions) 130 100 80 C AS 13.5 10 6 A B
Movements Along the AS Curve : Movements Along the AS Curve When a change in output causes price level to change, we move along economy’s AS curve
What happens in economy as we make such a move?
As we move upward along AS curve, we can represent what happens as follows
Shifts of the AS Curve : Shifts of the AS Curve Figure 5 assumed that a number of important variables remained unchanged
Unit costs sometimes change for reasons other than a change in output
In general, we distinguish between a movement along AS curve, and a shift of curve itself, as follows
When a change in real GDP causes the price level to change, we move along AS curve
When anything other than a change in real GDP causes price level to change, AS curve itself shifts
What can cause unit costs to change at any given level of output?
Changes in world oil prices
Changes in the weather
Technological change
Nominal wage, etc.
Figure 7(a): Effects of Key Changes on the Aggregate Supply Curve : Figure 7(a): Effects of Key Changes on the Aggregate Supply Curve (a) Real GDP Price Level P3 Q2 Q1 Q3 P1 P2 AS
Figure 7(b): Effects of Key Changes on the Aggregate Supply Curve : Figure 7(b): Effects of Key Changes on the Aggregate Supply Curve Real GDP Price Level (b) AS1 AS2
Figure 7(c): Effects of Key Changes on the Aggregate Supply Curve : Figure 7(c): Effects of Key Changes on the Aggregate Supply Curve Real GDP Price Level (c) AS1 AS2
Figure 8: Short-Run Macroeconomic Equilibrium : Figure 8: Short-Run Macroeconomic Equilibrium Price Level Real GDP ($ Trillions) 140 100 AS 10 6 14 E B AD F
What Happens When Things Change? : What Happens When Things Change? Our short-run equilibrium will change when either AD curve, AS curve, or both, shift
An event that causes AD curve to shift is called a demand shock
An event that causes AS curve to shift is called a supply shock
In earlier chapters, we’ve used phrase spending shock
A change in spending by one or more sectors that ultimately affects entire economy
Demand shocks and supply shocks are just two different categories of spending shocks
An Increase in Government Purchases : An Increase in Government Purchases Shifts AD curve rightward
Can see how it affects economy in short-run
Process we’ve just described is not entirely realistic
Assumes that when government purchases rise, first output increases, and then price level rises
In reality, output and price level tend to rise together
Figure 9: The Effect of a Demand Shock : Figure 9: The Effect of a Demand Shock Price Level Real GDP($ Trillions) 100 130 AS 10 12.5 13.5 E J H AD1 AD2 115
An Increase in Government Purchases : An Increase in Government Purchases Can summarize impact of price-level changes
When government purchases increase, horizontal shift of AD curve measures how much real GDP would increase if price level remained constant
But because price level rises, real GDP rises by less than horizontal shift in AD curve
An Decrease in Government Purchases : An Decrease in Government Purchases
An Increase in the Money Supply : An Increase in the Money Supply Although monetary policy stimulates economy through a different channel than fiscal policy
Once we arrive at AD and AS diagram, two look very much alike
Can represent situation as follows
An Example: The Great Depression : An Example: The Great Depression U.S. economy collapsed far more seriously during 1929 through 1933—the onset of the Great Depression—than it did at any other time
What do we know about demand shocks that caused Great Depression?
Fall of 1929, bubble of optimism burst
Stock market crashed, and investment and consumption spending plummeted
Demand for products exported by United States fell
Fed reacted by cutting money supply sharply
Each of these events contributed to a leftward shift of AD curve
Causing both output and price level to fall
Demand Shocks: Adjusting to the Long-Run : Demand Shocks: Adjusting to the Long-Run In Figure 9, point H shows new equilibrium after a positive demand shock in short-run—a year or so after the shock
But point H is not necessarily where economy will end up in long-run
In short-run, we treat wage rate as given
But in long-run, wage rate can change
When output is above full employment, wage rate will rise, shifting AS curve upward
When output is below full employment, wage rate will fall, shifting AS curve downward
Demand Shocks: Adjusting to the Long Run : Demand Shocks: Adjusting to the Long Run Increase in government purchases has no effect on equilibrium GDP in long-run
Economy returns to full employment, which is just where it started
This is why long-run adjustment process is often called economy’s self-correcting mechanism
If a demand shock pulls economy away from full employment
Change in wage rate and price level will eventually cause economy to correct itself and return to full-employment output
Figure 10: The Long-Run Adjustment Process : Figure 10: The Long-Run Adjustment Process Price Level Real GDP P2 P3 P4 P1 YFE Y3 Y2 H E AS2 AS1 AD2 AD1 J K
Demand Shocks: Adjusting to the Long Run : Demand Shocks: Adjusting to the Long Run For a positive demand shock that shifts AD curve rightward, self-correcting mechanism works like this
Figure 11: Long-Run Adjustment After a Negative Demand Shock : Figure 11: Long-Run Adjustment After a Negative Demand Shock Price Level Real GDP P2 AS1 P1 P3 YFE Y2 AS2 AD2 AD1 E M N
Demand Shocks: Adjusting to the Long Run : Demand Shocks: Adjusting to the Long Run Complete sequence of events after a negative demand shock looks like this
Demand Shocks: Adjusting to the Long Run : Demand Shocks: Adjusting to the Long Run Can summarize economy’s self-correcting mechanism as follows
Whenever a demand shock pulls economy away from full employment
Self-correcting mechanism will eventually bring it back
When output exceeds its full-employment level, wages will eventually rise
Causing a rise in price level and a drop in GDP until full employment is restored
When output is less than its full employment level wages will eventually fall
Causing a drop in price level and a rise in GDP until full employment is restored
The Long-Run Aggregate Supply Curve : The Long-Run Aggregate Supply Curve Self-correcting mechanism provides an important link between economy’s long-run and short-run behaviors
Long-run aggregate supply curve also illustrates another classical conclusion
An increase in government purchases causes complete crowding out
Rise in government purchases is precisely matched by a drop in consumption and investment spending
Leaving total output and total spending unchanged
Self-correcting mechanism shows that, in long-run, economy will eventually behave as classical model predicts
Notice the word eventually in the previous statement
This is why governments around the world are reluctant to rely on self-correcting mechanism alone to keep economy on track
Figure 12: The Long-Run Aggregate Supply Curve : Figure 12: The Long-Run Aggregate Supply Curve Price Level Real GDP YFE E M AD1 AD3 K Long-Run AS Curve AD2
Short-Run Effects of Supply Shocks : Short-Run Effects of Supply Shocks Figure 13 shows an example of a supply shock
An increase in world oil prices that shifts aggregate supply curve upward, from AS1 and AS2
Called negative supply shock, because of negative effect on output
In short-run a negative supply shock shifts AS curve upward, decreasing output and increasing price level
Notice sharp contrast between effects of negative supply shocks and negative demand shocks in short-run
Economists and journalists have coined term “stagflation” to describe a stagnating economy experiencing inflation
A negative supply shock causes stagflation in short-run
Examples of positive supply shocks include unusually good weather, a drop in oil prices, and a technological change that lowers unit costs
In addition, a positive supply shock can sometimes be caused by government policy
Figure 13: The Effect of Supply Shocks : Figure 13: The Effect of Supply Shocks Price Level Real GDP P2 P1 YFE Y2 E AS2 AS1 AD R Long-Run
AS Curve AS3 T P2 Y3
Long-Run Effects of Supply Shocks : Long-Run Effects of Supply Shocks What about effects of supply shocks in long-run?
In some cases, we need not concern ourselves with this question, because some supply shocks are temporary
In other cases, however, a supply shock can last for an extended period
In long-run, economy self-corrects after a supply shock, just as it does after a demand shock
When output differs from its full-employment level
Wage rate changes
AS curve shifts until full employment is restored
Using the Theory: The Recession of 1990-91 : Using the Theory: The Recession of 1990-91 Story of 1990-91 recession begins in mid-1990, when Iraq invaded Kuwait
During this conflict, Kuwait’s oil was taken off world market, as was Iraq’s
Reduction in oil supplies resulted in a rapid and substantial increase in price of oil
Using the Theory: The Recession of 2001 : Using the Theory: The Recession of 2001 Story of 2001 recession was quite different
This time, there was no spike in oil prices and no other significant supply shock to plague economy
Rather, there was a demand shock, and a Federal Reserve policy during the year before the recession that might have made it a bit worse
During late 1990s, Fed had become concerned that investment boom and consumer optimism were shifting AD curve rightward too rapidly
Creating a danger that we would overshoot potential GDP and set off higher inflation
Fed responded by tightening money supply and raising interest rate
Effects of this policy may have continued into early 2001, exacerbating decrease in investment that was occurring for other reasons
In this way, rate hikes themselves may have contributed to a further leftward shift of AD curve
Figure 14(a): An AD and AS analysis of Two Recessions : Figure 14(a): An AD and AS analysis of Two Recessions P2 AS1990 P1 YFE Y2 AD1990 E R (a) AS1991
Figure 14(b): An AD and AS analysis of Two Recessions : Figure 14(b): An AD and AS analysis of Two Recessions YFE Y2 AS2000 AD2000 AD2001 E R (b) P2 P1
Figure 15(a/b): GDP and the Price Level in Two Recessions : Figure 15(a/b): GDP and the Price Level in Two Recessions The 1990-91 Recession (b) (a) 140 135 130 120 125 CPI Year and Quarter
Figure 15(c/d): GDP and the Price Level in Two Recessions : Figure 15(c/d): GDP and the Price Level in Two Recessions (d) 178 176 174 172 2000:1 2001:1 9.35 9.30 9.20 9.10 9.25 9.15 (c) Year and Quarter Real GDP ($ Trillions) CPI The 2001 Recession
Using the Theory: Jobless Expansions : Using the Theory: Jobless Expansions After a recession, economy enters expansion phase of business cycle
Employment usually grows rapidly during this period as well
But in our two most recent recessions, economy experienced abnormal, prolonged periods during which employment did not grow at all
Figure 16 illustrates behavior of employment during our two most recent recession
Called trough of recession
Vertical axis shows an employment index—employment divided by employment at the trough
Blue line shows that employment falls during the contraction phase of average cycle
Rises rapidly during the first year of the expansion phase
But red and pink lines show what happened in first year of our most recent expansions—during 1992 and 2002
In both cases, employment drifted slightly downward, telling us that total number of jobs decreased during year
Figure 16: The Average Expansion Versus Two Recent Jobless Expansions : Figure 16: The Average Expansion Versus Two Recent Jobless Expansions Employment
Index
(Trough = 1) -6 -4 -2 0 +2 +4 +6 Months Before and After the Trough +8 0.99 1.00 1.01 1.02 1.03 1.04 +10 +12
Explaining Jobless Expansions : Explaining Jobless Expansions Since story is similar for both of these expansions, let’s focus on period from late 2001 to late 2002—the first year of expansion after our most recent recession
Using equation for economic growth
Real GDP = productivity x average hours x (emp/pop) x population
But equation can be used in different ways
Now we’re using equation to account for deviations in employment away from full employment in short-run
For this purpose, we’ll need to make some adjustments to equation
Real GDP = productivity x average hours x employment
Explaining Jobless Expansions : Explaining Jobless Expansions Let’s convert equation to percentage changes
%Δ real GDP = %Δ productivity + %Δ employment
Finally, rearranging
%Δ employment (-0.3%) = %Δ real GDP (2.9%) - %Δ productivity (3.2%)
Numbers in parentheses show actual percentage changes for each of these variables during 2002
Explaining Jobless Expansions : Explaining Jobless Expansions Why didn’t real GDP growth keep up with productivity?
Because growth in real GDP was unusually low
Productivity grew at about the same rate as average expansion, in spite of the low growth in output
Throughout period, firms were reluctant to hire full-time, permanent workers
Created uncertainty about strength and duration of expansion
Instead, business expanded output by hiring part-time and temporary workers
Why would this boost productivity?
Enabled firms to adjust their workforce more easily to fluctuations in production
Phrase “jobless expansion” refers to just part of expansion phase
Eventually, employment catches up—even to higher levels of output made possible by productivity growth