Chapter 17 Aggregate Demand and Aggregate Supply

1. Chapter 17 Aggregate Demand and Aggregate Supply

2. Figure 1: The Two-Way Relationship Between Output and the Price Level Aggregate Demand Curve Price Real Level GDP Aggregate Supply Curve

3. 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

4. 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

5. 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

6. Figure 2: Deriving the Aggregate Demand Curve Price Level K 140 J 100 AD Real GDP ($ Trillions) 6 10

7. 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

8. 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

9. Spending Shocks • Spending shocks initially affect the economy by changing total spending • And then changing output by a multiple of that original change in spending • The AD curve shifts rightward when government purchases, investment spending, autonomous consumption spending, or net exports increase, or when taxes decrease • The AD curve shifts leftward when government purchases, investment spending, autonomous consumption spending, or net exports decrease, or when taxes increase

10. Figure 3: A Spending Shock Shifts the AD Curve Price Level 100 H E AD2 AD1 Real GDP ($ Trillions) 10 15

11. 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

12. Figure 4(a): Effects of Key Changes on the Aggregate Demand Curve Price level ↑ moves us leftward along the AD curve Price level ↓ moves us rightward along the AD curve (a) Price Level P3 P1 P2 AD Real GDP Q3 Q1 Q2

13. Figure 4(b): Effects of Key Changes on the Aggregate Demand Curve • Entire AD curve shifts rightward if: • a, IP, G, orNXincreases • Net taxes decrease • The money supply increases (b) Price Level AD2 AD1 Real GDP

14. Figure 4(c): Effects of Key Changes on the Aggregate Demand Curve • Entire AD curve shifts leftward if: • a, IP, G, orNXdecreases • Net taxes increase • The money supply decreases (c) Price Level decreases AD1 AD2 Real GDP

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. Figure 5: The Aggregate Supply Curve Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises. Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price levelfalls. Price Level AS 130 B 100 A 80 C Real GDP ($ Trillions) 6 10 13.5

24. 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

25. 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.

26. Figure 6: Shifts of the Aggregate Supply Curve When unit costs rise at any given real GDP, the AS curve shifts upward–e.g., an increase in world oil prices or bad weather for farm production. AS2 Price Level AS1 L 140 100 A Real GDP ($ Trillions) 10

27. Figure 7(a): Effects of Key Changes on the Aggregate Supply Curve Real GDP ↑ moves us rightward along the AS curve Real GDP ↓ moves us leftward along the AS curve (a) Price Level AS P3 P1 P2 Real GDP Q2 Q1 Q3

28. Figure 7(b): Effects of Key Changes on the Aggregate Supply Curve Entire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP (b) AS2 Price Level AS1 Real GDP

29. Figure 7(c): Effects of Key Changes on the Aggregate Supply Curve Entire AS curve shifts downward if unit costs ↓ for any reason besides an decrease in real GDP (c) Price Level AS1 AS2 Real GDP

30. AD and AS Together: Short-Run Equilibrium • Where will the economy settle in short-run? • Where is our short-run macroeconomic equilibrium? • In equilibrium, economy must be at some point on AD curve • Short-run equilibrium requires economy be operating on its AS curve • Only when economy is at point E—on both curves—will we have reached a sustainable level of real GDP and the price level

31. Figure 8: Short-Run Macroeconomic Equilibrium AS Price Level B 140 E 100 F AD Real GDP ($ Trillions) 6 10 14

32. 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

33. 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

34. Figure 9: The Effect of a Demand Shock AS Price Level 130 H 115 J 100 E AD2 AD1 Real GDP($ Trillions) 10 13.5 12.5

35. 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

36. An Decrease in Government Purchases

37. 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

38. Other Demand Shocks • A positive demand shock—shifts AD curve rightward • Increases both real GDP and price level in short-run • A negative demand shock—shifts AD curve leftward • Decreases both real GDP and price level in short-run

39. 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

40. 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

41. 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

42. Figure 10: The Long-Run Adjustment Process Price Level AS2 AS1 P4 K J P3 P2 H P1 E AD2 AD1 YFE Y3 Y2 Real GDP

43. Demand Shocks: Adjusting to the Long Run • For a positive demand shock that shifts AD curve rightward, self-correcting mechanism works like this

44. Figure 11: Long-Run Adjustment After a Negative Demand Shock Price Level AS1 AS2 P1 E P2 N P3 M AD1 AD2 Real GDP Y2 YFE

45. Demand Shocks: Adjusting to the Long Run • Complete sequence of events after a negative demand shock looks like this

46. 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

47. 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

48. Figure 12: The Long-Run Aggregate Supply Curve Long-Run AS Curve Price Level K E M AD2 AD1 AD3 Real GDP YFE

49. Some Important Provisos about the AS Curve • Upward-sloping aggregate supply curve we’ve presented in this chapter gives a realistic picture of how economy behaves after a demand shock • Story we have told about what happens as we move along AS curve is somewhat incomplete • Made assumption that prices are completely flexible—that they can change freely over short periods of time • In fact, however, some prices take time to adjust, just as wages take time to adjust • Assumed that wages are completely inflexible in short-run • But in some industries, wages respond quickly • More to process of recovering from a shock than adjustment of prices and wages

50. 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