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33
Aggregate Demand and Aggregate
Supply
PRINCIPLES OF
ECONOMICS
FOURTH EDITION
N. G R E G O R Y M A N K I W
PowerPoint® Slides
by Ron Cronovich
© 2006 Thomson South-Western, all rights reserved
In this chapter, look for the answers to
these questions:
§ What are economic fluctuations? What are their
characteristics?
§ How does the model of aggregate demand and
aggregate supply explain economic fluctuations?
§ Why does the Aggregate-Demand curve slope
downward? What shifts the AD curve?
§ What is the slope of the Aggregate-Supply curve
in the short run? In the long run?
What shifts the AS curve(s)?
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
1
Introduction
§ Over the long run, real GDP grows about
3% per year on average.
§ In the short run,
• recessions:
• depressions:
§ Short-run economic fluctuations are often called
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2
1
Three facts about economic fluctuations
FACT 1:
$ 11,000
U.S.
U.S. real
real GDP,
GDP,
billions
billions of
of 2000
2000 dollars
dollars
10,000
9,000
8,000
7,000
6,000
The
The shaded
shaded
bars
bars are
are
recessions
recessions
5,000
4,000
3,000
2,000
1965
1970
1975
1980
1985
1990
1995
2000
2005
Three facts about economic fluctuations
FACT 2:
$ 1,800
Investment
Investment spending,
spending,
billions
billions of
of 2000
2000 dollars
dollars
1,600
1,400
1,200
1,000
800
600
400
200
1965
1970
1975
1980
1985
1990
1995
2000
2005
Three facts about economic fluctuations
FACT 3:
12
Unemployment
Unemployment rate,
rate,
percent
percent of
of labor
labor force
force
10
8
6
4
2
0
1965
1970
1975
1980
1985
1990
1995
2000
2005
2
Introduction, continued
§ Explaining these fluctuations is difficult, and the
theory of economic fluctuations is controversial.
§ Most economists use the model of
aggregate demand and aggregate supply
to study fluctuations.
§ This model differs from the classical economic
theories economists use to explain the long run.
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6
Classical economics—a recap
§ The previous chapters are based on the ideas of
classical economics, especially:
§ The Classical Dichotomy, the separation of
variables into two groups:
• real – quantities, relative prices
• nominal – measured in terms of money
§ The neutrality of money:
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7
Classical economics—a recap
§ Most economists believe classical theory
describes the world in the long run,
but not the short run.
§ In the short run, changes in
§ To study the short run, we use a new model.
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8
3
The model of aggregate demand and
aggregate supply
CHAPTER 33
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AGGREGATE DEMAND AND AGGREGATE SUPPLY
The Aggregate-Demand (AD) curve
P
The AD curve
shows
Y
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AGGREGATE DEMAND AND AGGREGATE SUPPLY
Why the AD curve slopes downward
Y = C + I + G + NX
C, I, G, NX are
the components
of agg. demand.
P
P2
Assume
To understand
the slope of AD,
must determine how
P1
AD
Y2
CHAPTER 33
Y1
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
11
4
The wealth effect (P and C )
§ Suppose P rises.
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12
The interest-rate effect (P and I )
§ Suppose P rises.
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The exchange-rate effect (P and NX )
§ Suppose P rises.
§ Interest rates go up (the interest-rate effect)
14
5
The slope of the AD curve: summary
An increase in P
reduces the quantity
of g&s demanded
because:
P
• the wealth effect
(C falls)
• the interest-rate
P1
AD
effect (I falls)
• the exchange-rate
CHAPTER 33
Y
Y1
effect (NX falls)
AGGREGATE DEMAND AND AGGREGATE SUPPLY
15
Why the AD curve might shift
P
P1
Example:
A stock market boom
makes households feel
wealthier, C rises,
the AD curve shifts right.
CHAPTER 33
AD1
Y1
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
16
AD shifts arising from changes in C
§ people decide to save more:
§ stock market crash:
§ tax cut:
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6
AD shifts arising from changes in I
§ Firms decide to upgrade their computers:
§ Firms become pessimistic about future demand:
§ Central bank uses monetary policy to reduce
interest rates:
§ Investment Tax Credit or other tax incentive:
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AD shifts arising from changes in G
§ Congress increases spending on homeland
security:
§ State govts cut spending on road construction:
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AD shifts arising from changes in NX
§ A boom overseas increases foreign demand for
our exports:
§ International speculators cause exchange rate to
appreciate:
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7
A C T I V E L E A R N I N G 1:
Exercise
Try this without looking at your notes.
What happens to the AD curve in each of the
following scenarios?
A. A ten-year-old investment tax credit expires.
B. The U.S. exchange rate falls.
C. A fall in prices increases the real value of
consumers’ wealth.
D. State governments replace their sales taxes
with new taxes on interest, dividends, and
capital gains.
21
The Aggregate-Supply (AS) Curves
The AS curve shows
P
In the short run,
Y
In the long run,
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AGGREGATE DEMAND AND AGGREGATE SUPPLY
The long-run aggregate-supply curve (LRAS)
The natural rate of
output (YN) is
P
YN is also called
potential output
or
full-employment
output.
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AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
24
8
Why LRAS is vertical
YN depends on
An increase in P
P
LRAS
P1
YN
CHAPTER 33
Y
25
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Why the LRAS curve might shift
P
Example:
Immigration
increases L,
CHAPTER 33
LRAS1
YN
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
26
LRAS shifts arising from changes in L
§ The Baby Boom generation retires:
§ New govt policies reduce the natural rate of
unemployment:
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9
LRAS shifts arising from changes in
physical or human capital
§ Investment in factories or equipment:
§ More people get college degrees:
§ Earthquakes or hurricanes destroy factories:
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LRAS shifts arising from changes in
natural resources
§ A change in weather patterns makes farming
more difficult:
§ Discovery of new mineral deposits:
§ Reduction in supply of imported oil or other
resources:
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LRAS shifts arising from changes in
technology
§ Technological advances allow
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10
Using AD & AS to depict LR growth and
inflation
Over the long run,
P
LRAS1980
P1980
Result:
AD1980
Y
Y1980
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AGGREGATE DEMAND AND AGGREGATE SUPPLY
Short Run Aggregate Supply (SRAS)
P
Over the period
of 1-2 years,
an increase in P
Y
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AGGREGATE DEMAND AND AGGREGATE SUPPLY
Why the slope of SRAS matters
If AS is vertical,
fluctuations in AD
do not cause
fluctuations in output
or employment.
P
LRAS
If AS slopes up,
AD1
Y1
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Y
33
11
Three theories of SRAS
In each,
• some type of market imperfection
• result:
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AGGREGATE DEMAND AND AGGREGATE SUPPLY
Three theories of SRAS
P
SRAS
the expected
price level
PE
YN
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Y
35
1. The Sticky-Wage Theory
§ Imperfection:
Nominal wages are sticky in the short run,
§ Firms and workers set the nominal wage in
advance based on PE, the price level they
expect to prevail.
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12
1. The Sticky-Wage Theory
§ If P > PE,
§ Hence, higher P causes higher Y,
so the SRAS curve slopes upward.
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2. The Sticky-Price Theory
§ Imperfection:
•
Due to
•
Examples: cost of printing new menus,
the time required to change price tags.
§ Firms
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2. The Sticky-Price Theory
§ Suppose the Fed increases the money supply
unexpectedly. In the long run, P will rise.
§ In the short run, firms without menu costs can
raise their prices immediately.
§ Firms with menu costs wait to raise prices.
Meantime, their prices are relatively low,
§ Hence, higher P is associated with higher Y,
so the SRAS curve slopes upward.
CHAPTER 33
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39
13
3. The Misperceptions Theory
§ Imperfection:
§ If P rises above PE, a firm sees its price rise
before realizing all prices are rising.
§ So, an increase in P can cause an increase in Y,
making the SRAS curve upward-sloping.
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What the 3 theories have in common:
Each of the 3 theories implies Y deviates from YN
when P deviates from PE.
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41
SRAS and LRAS
§ The imperfections in these theories are
temporary. Over time,
§ In the LR,
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14
SRAS
and LRAS
Y = YN + a (P – PE)
P
LRAS
In the long run,
SRAS
PE = P
and
Y = YN.
PE
Y
YN
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AGGREGATE DEMAND AND AGGREGATE SUPPLY
Why the SRAS curve might shift
Everything that shifts
LRAS shifts SRAS, too.
P
LRAS
Also,
SRAS
If PE rises,
workers & firms set
higher wages.
PE
At each P,
Y
YN
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AGGREGATE DEMAND AND AGGREGATE SUPPLY
The long-run equilibrium
In the long-run
equilibrium,
P
LRAS
SRAS
PE = P,
Y = YN ,
and unemployment
is at its natural rate.
PE
AD
YN
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Y
45
15
Economic fluctuations
§ Caused by
§ Four steps to analyzing economic fluctuations:
1. Determine whether the event shifts AD or AS.
2. Determine whether curve shifts left or right.
3. Use AD-AS diagram to see how the shift
changes Y and P in the short run.
4. Use AD-AS diagram to see how economy
moves from new SR eq’m to new LR eq’m.
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AGGREGATE DEMAND AND AGGREGATE SUPPLY
The effects of a shift in AD
Event: stock market crash
P
LRAS
SRAS1
P1
A
AD1
Y
YN
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AGGREGATE DEMAND AND AGGREGATE SUPPLY
Two big AD shifts:
1. The Great Depression
From 1929-1933,
•
money supply
U.S. Real GDP,
billions of 2000 dollars
900
850
•
800
stock prices
750
700
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AGGREGATE DEMAND AND AGGREGATE SUPPLY
1934
unemp
1933
550
1932
P fell 22%
1931
600
1930
Y fell 27%
1929
650
•
•
•
48
16
Two big AD shifts:
2. The World War II Boom
From 1939-1944,
•
govt outlays
U.S. Real GDP,
billions of 2000 dollars
2,000
1,800
1,600
1,400
Y
1,200
P
1,000
unemp
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1944
1943
1942
1941
1940
800
1939
•
•
•
49
A C T I V E L E A R N I N G 2:
Exercise
§ Draw the AD-SRAS-LRAS diagram
for the U.S. economy,
starting in a long-run equilibrium.
§ A boom occurs in Canada.
Use your diagram to determine
the SR and LR effects on U.S. GDP,
the price level, and unemployment.
50
A C T I V E L E A R N I N G 2:
Answers
Event: boom in Canada
51
17
The effects of a shift in SRAS
Event: oil prices rise
P
LRAS
SRAS1
A
P1
AD1
Y
YN
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AGGREGATE DEMAND AND AGGREGATE SUPPLY
Accomodating an adverse shift in SRAS
If policymakers do nothing,
P
LRAS
SRAS2
Or, policymakers could
P2
P1
SRAS1
B
A
AD1
Y2 YN
CHAPTER 33
Y
AGGREGATE DEMAND AND AGGREGATE SUPPLY
53
The 1970s oil shocks and their effects
1973-75
1978-80
Real oil prices
+ 138%
+ 99%
CPI
+ 21%
+ 26%
Real GDP
– 0.7%
+ 2.9%
# of unemployed
persons
+ 3.5
million
+ 1.4
million
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18
John Maynard Keynes, 1883-1946
•
The General Theory of Employment,
Interest, and Money, 1936
•
Argued recessions and depressions
can result from inadequate demand;
policymakers should shift AD.
•
Famous critique of classical theory:
The long run is a misleading guide
to current affairs. In the long run,
we are all dead. Economists set themselves
too easy, too useless a task if in tempestuous seasons
they can only tell us when the storm is long past,
the ocean will be flat.
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55
CONCLUSION
§ This chapter has introduced the model of
aggregate demand and aggregate supply,
which helps explain economic fluctuations.
§ Keep in mind: these fluctuations are deviations
from the long-run trends explained by the
models we learned in previous chapters.
§ In the next chapter, we will learn how
policymakers can affect aggregate demand
with fiscal and monetary policy.
CHAPTER 33
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19