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CHAPTER 9

CHAPTER 9. COORDINATING ECONOMIC ACTIVITY: AGGREGATE DEMAND AND SUPPLY. ECONOMIC FLUCTUATIONS. Movements of GDP away from potential output; Also referred to as business cycles;. KEYNESIAN ECONOMICS. Models based on the idea that demand determines output in the short run;

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CHAPTER 9

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  1. CHAPTER 9 COORDINATING ECONOMIC ACTIVITY: AGGREGATE DEMAND AND SUPPLY

  2. ECONOMIC FLUCTUATIONS • Movements of GDP away from potential output; • Also referred to as business cycles;

  3. KEYNESIAN ECONOMICS • Models based on the idea that demand determines output in the short run; • Short run -- The period of time when prices are fixed;

  4. REAL SHOCKS TO THE ECONOMY One cause of economic fluctuations : • Developing countries dependent on agriculture, which suffer loss to cash crop • Sharp increases in the price of oil can hurt modern economies • Wars can devastate entire regions of the world • Natural disasters can cause sharp reductions in GDP • Major shifts in technology leading to the birth of new industries have profound effects on the economy

  5. REAL BUSINESS CYCLE THEORY • School of economic thought that emphasizes the role that shocks to technology can play in causing economic fluctuations • Led by Edward Prescott of the University of Minnesota • Developed models that integrate technology shocks into classical models • Changes in technology will usually change the level of full employment or potential output • It portrays economic fluctuations as movements in potential output, not as deviations away from potential output

  6. INITIAL PATTERN OF DEMAND AND PRICES Price S P0 D Tennis Racquets Quantity Q0

  7. INITIAL PATTERNS OF DEMAND AND PRICES Price Price S S P0 P1 D D Tennis Racquets Quantity Roller blades Quantity Q0 Q1

  8. DEMAND AND PRICES AFTER CHANGES IN TASTES Price Price S S P1 PA DB D D DA Tennis Racquets Quantity Roller blades Quantity QA Q1 Suppose rollerblading starts to replace tennis. Demand shifts to DA in the market in tennis racquets and DB in the market for roller blades.

  9. DEMAND AND PRICES AFTER CHANGES IN TASTES Price Price S S PB P0 P1 PA DB D D DA Tennis Racquets Quantity Roller blades Quantity QA Q0 Q1 QB Suppose rollerblading starts to replace tennis. Demand shifts to DA in the market in tennis racquets and DB in the market for roller blades. Prices of rollerblades will rise to PB, prices of tennis racquets will fall to PA.

  10. PRICES AND ECONOMIC COORDINATION • The change in tastes from tennis racquets to rollerblading has caused the economy to produce more roller blades and fewer tennis racquets • The economy accomplishes this through prices • When roller blading became more popular than tennis, the price of roller blades rose and the price of tennis racquets fell • The producers of roller blades were given a signal to step up production • The producers of tennis racquets were given a signal to cut back their production • Workers will leave tennis racquet industry to be employed by roller blade industry

  11. FUTURE PRICES • There is no price for automobiles to be delivered five years from now, so automobiles do not receive any direct signals that consumers wish to purchase automobiles in the future • Only a few commodities, such as metals and certain agricultural commodities, can be traded for future delivery in worldwide markets

  12. TOO LITTLE INFORMATION • Prices may not always contain all the information that producers need • What matters to any firm is the real price: its price relative to all other prices in the economy • Reality Principle: What matters to people is the real value or purchasing power of money or income, not its face value

  13. TOO LITTLE INFORMATION • Problems can occur if firms are uncertain about whether a change in their output price is an increase in the real price or only on the nominal or dollar price • If producers believe demand for their product has fallen, they will cut back production • If this happened throughout the economy, it would lead to a recession

  14. “STICKY” PRICES • If prices are “sticky” or not sufficiently flexible, prices will not coordinate activity as efficiently • In modern economies, some prices are flexible, while others are not • Auction Prices -- those determined on nearly a daily basis • Prices for fresh fish, vegetables, and other food are very flexible • Custom Prices -- those that adjust rather slowly • Prices for industrial commodities, such as steel rods or machine tools, are custom prices

  15. STICKY PRICES IN THE MARKET FOR TENNIS RACQUETS Price S P0 E D Tennis Racquets Quantity Q0

  16. STICKY PRICES IN THE MARKET FOR TENNIS RACQUETS Price S F P0 E D DA Tennis Racquets Quantity Q0

  17. STICKY PRICES IN THE MARKET FOR TENNIS RACQUETS Price S F P0 E D DA Tennis Racquets Quantity Q0

  18. STICKY PRICES IN THE MARKET FOR TENNIS RACQUETS Price S F P0 E D DA Tennis Racquets Quantity Q0 When demand falls to DA, prices are sticky and remain at P0. The result is unsold production measured by the distance between E and F.

  19. WAGES • Wages, the price of labor, adjust extremely slowly • Workers often have long-term contracts that do not allow wages to change at all during a given year • Even unskilled, low-wage workers are often protected from decreases in their wages by minimum wage laws • For most firms, wages are the single most important cost of doing business • If wages are sticky, their overall costs will be sticky • Stickiness of wages reinforces stickiness of prices

  20. SHORT-RUN PRICES ARE STICKY • Firms let demand determine level of output in the short run • Automaker may have higher demand if autos are popular or lower demand if autos are unpopular • Steelmaker who provides steel to automaker may provide more or less steel without adjusting price • The same principle applies to workers • During good times a company will employ many workers and may even require some to work overtime with no wage change • The short run in macroeconomics is the period when prices are fixed

  21. LONG-RUN PRICES • In the long run, price adjust fully to changes in demand • Over short periods of time, the presence of formal and informal contracts mean that demand will be reflected primarily in changes in output, not prices

  22. AGGREGATE DEMAND • The aggregate demand curve plots the total demand for GDP as a function of price level • The aggregate demand curve is downward sloping • As the price level falls, the total demand for goods and services increases

  23. AGGREGATE DEMAND Price Level P AD: aggregate demand Real GDP, Y The aggregate demand curve plots the total demand for real GDP as a function of the price level. The aggregate demand curve slopes downward, indicating that aggregate demand increases as the price level falls.

  24. REALITY PRINCIPLE What matters to people is the real value or purchasing power of money or income, not its face value.

  25. WEALTH EFFECT • Increase in spending that occurs because the real value of money increases when the price level falls • One of the key reasons that aggregate demand slopes downward

  26. TWO OTHER REASONS WHY DEMAND CURVE SLOPES DOWNWARD • Interest rate effect With a given supply of money in the economy, a lower price level will lead to lower interest rates As interest rates fall, demand for investment goods in the economy increase. • Effects from international trade In an open economy, a lower price level will mean that domestic goods become cheaper relative to foreign goods and demand for domestic goods will increase

  27. SHIFTS OF AGGREGATE DEMAND • At any price level, an increase in aggregate demand means that total demand for real GDP has increased, and the curve shifts to the right • Factors that decrease the aggregate demand will shift the aggregate demand curve to the left • At any price level, a decrease in aggregate demand means that total demand for real GDP has decreased

  28. KEY FACTORS THAT SHIFT THE AGGREGATE DEMAND CURVE • Changes in the supply of money • Changes in taxes • Changes in government spending • other factors

  29. CHANGES IN THE SUPPLY OF MONEY • An increase in the supply of money in the economy will increase aggregate demand and shift the demand curve right • At any price level, a higher supply of money will mean more consumer wealth and an increased demand for goods and services • A decrease in the supply of money will decrease aggregate demand and shift the aggregate demand curve to the left

  30. CHANGES IN TAXES • A decrease in taxes will increase aggregate demand and shift the aggregate demand curve to the right • Lower taxes will increase income available to households and increase their spending on goods and services • Increases in taxes will decrease the aggregate demand and shift the aggregate demand curve left

  31. CHANGES IN GOVERNMENT SPENDING • An increase in government spending will increase aggregate demand and shift the aggregate demand curve right • Since the government is a source of demand for goods and services, higher government spending naturally leads to an increase in total demand for goods and services • Decreases in government spending will decrease aggregate demand and shift the curve to the left

  32. OTHER FACTORS • Any change in demand from households, firms, or the foreign sector will also change aggregate demand • When shifts in aggregate demand are discussed, any changes that arise from movements in the price level are not to be included

  33. FACTORS THAT SHIFT DEMAND Factors That Increase Factors That Decrease Aggregate Demand Aggregate Demand Decrease in Taxes Increase in Taxes Increase in Decrease in Government Spending Government Spending Increase in Money Decrease in Money Supply Supply

  34. SHIFTING AGGREGATE DEMAND Price Level P Original aggregate demand Output, Y

  35. SHIFTING AGGREGATE DEMAND Price Level P Increased aggregate demand Original aggregate demand Output, Y

  36. SHIFTING AGGREGATE DEMAND Price Level P Increased aggregate demand Original aggregate demand Output, Y Decreases in taxes, increases in government spending, or an increase in the supply of money all shift the aggregate demand curve to the right.

  37. SHIFTING AGGREGATE DEMAND Price Level P Increased aggregate demand Original aggregate demand Decreased aggregate demand Output, Y Decreases in taxes, increases in government spending, or an increase in the supply of money all shift the aggregate demand curve to the right.

  38. SHIFTING AGGREGATE DEMAND Price Level P Increased aggregate demand Original aggregate demand Decreased aggregate demand Output, Y Decreases in taxes, increases in government spending, or an increase in the supply of money all shift the aggregate demand curve to the right. Higher taxes, lower government spending, or a lower supply of money shift the curve to the left.

  39. AGGREGATE SUPPLY • Depicts the relationship between the level of prices and real GDP • Two different aggregate supply curves, which correspond to the long run and the short run: -- classical aggregate supply curve -- Keynesian aggregate supply curve

  40. CLASSICAL AGGREGATE SUPPLY CURVE • Aggregate supply curve for the long run when the economy is at full employment • Full-employment output depends solely on the supply of capital and labor and the state of technology • full-employment output does not depend on the price level • Classical aggregate supply curve is plotted as a vertical line ( unaffected by prices )

  41. CLASSICAL AGGREGATE SUPPLY AS p Price y * Output, y In the long run, the level of output y* is independent of the price level.

  42. AGGREGATE DEMAND AND CLASSICAL AGGREGATE SUPPLY p Classical AS Price Original AD y * Output, y Output and prices are determined at the intersection of AD and AS.

  43. COMBINING AGGREGATE DEMAND AND AGGREGATE SUPPLY • The price level and level of output are determined by the intersection of aggregate supply and aggregate demand • At that point, total amount demanded will just equal the total amount supplied • The position of the aggregate demand curve will depend on the level of taxes, government spending, and the supply of money • The full-employment output determines the classical aggregate supply curve

  44. AGGREGATE DEMAND AND CLASSICAL AGGREGATE SUPPLY p Classical AS Price Increased AD Original AD y * Output, y Output and prices are determined at the intersection of AD and AS. An increase in aggregate demand to a higher price level.

  45. COMBINING AGGREGATE DEMAND AND AGGREGATE SUPPLY • An increase in demand will shift the aggregate demand curve right • With a classical aggregate supply curve, the increase in aggregate demand will raise the prices but leave the level of output unchanged

  46. THE KEYNESIAN AGGREGATE SUPPLY CURVE • The Keynesian aggregate supply curve is horizontal in the short run • Firms are assumed to supply all output that is demanded at the current price • Formal and informal contracts commit producers to supply all that is demanded at the going price • The entire Keynesian supply curve can shift up or down as prices adjust to their long-run levels

  47. KEYNESIAN AGGREGATE SUPPLY p Price Keynesian AS p0 Output, y

  48. AGGREGATE DEMAND AND KEYNESIAN AGGREGATE SUPPLY p Price E0 Keynesian AS p0 Original AD y 0 Output, y

  49. AGGREGATE DEMAND AND KEYNESIAN AGGREGATE SUPPLY p Price E0 E1 Keynesian AS p0 Increased AD Original AD y 0 y 1 Output, y With a Keynesian aggregate supply curve, shifts in aggregate demand lead to changes in output but no changes in prices.

  50. AGGREGATE DEMAND AND KEYNESIAN AGGREGATE SUPPLY CURVES • The intersection of AD and AS curves determines the price level and the level of output at point E • Since aggregate demand is horizontal, aggregate demand totally determines the level of output • As aggregate demand increases, the new equilibrium will be at the same price p0, but output will increase from y0 to y1 • The Keynesian aggregate supply curve need not correspond to full-employment output • Changes in demand will lead to economic fluctuations with sticky prices and a Keynesian aggregate supply curve

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