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Chapter 12: Aggregate Demand and Aggregate Supply Analysis CHAPTER 12 Aggregate Demand and Aggregate Supply Analysis Prepared by: Fernando Quijano Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 1 of 48 12.1 LEARNING OBJECTIVE Aggregate Demand Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Aggregate demand and aggregate supply model A model that explains short-run fluctuations in real GDP and the price level. FIGURE 12-1 Aggregate Demand and Aggregate Supply Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 2 of 48 12.1 LEARNING OBJECTIVE Chapter 12: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. Aggregate demand (AD) curve A curve that shows the relationship between the price level (P) and the quantity of real GDP (Y) demanded by households, firms, and the government. Short-run aggregate supply (SRAS) curve A curve that shows the relationship in the short-run between the price level (P) and the quantity of real GDP (Y) supplied by firms. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 3 of 48 12.1 LEARNING OBJECTIVE Aggregate Demand Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Why does the AD curve slope downward? GDP has four components: consumption (C), investment (I), government purchases (G), and net exports (NX). If we let Y stand for GDP, we can write the following: Y = C + I + G + NX Reason # 1: The Wealth Effect How a Change in the Price Level Affects Consumption The impact of the price level on consumption is called the wealth effect. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 4 of 48 12.1 LEARNING OBJECTIVE Aggregate Demand Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Reason # 2: The Interest-Rate Effect How a Change in the Price Level Affects Investment The impact of the price level on investment is known as the interest-rate effect. Reason # 3: The International-Trade Effect How a Change in the Price Level Affects Net Exports The impact of the price level on net exports is known as the international-trade effect. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 5 of 48 12.1 LEARNING OBJECTIVE Aggregate Demand Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. Chapter 12: Aggregate Demand and Aggregate Supply Analysis A “shift” of the aggregate demand curve vs a “movement along” An important point to remember is that the aggregate demand curve tells us the relationship between the price level and the quantity of real GDP demanded, holding everything else constant. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 6 of 48 12.1 LEARNING OBJECTIVE Aggregate Demand Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. Variables That Shift the AD Curve Chapter 12: Aggregate Demand and Aggregate Supply Analysis The variables that cause the aggregate demand curve to shift fall into three categories: 1. changes in government policies 2. changes in the expectations of households and firms 3. changes in foreign variables Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 7 of 48 12.1 LEARNING OBJECTIVE Aggregate Demand Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Changes in Government Policies Monetary policy The actions the Federal Reserve takes to manipulate the money supply or the interest rate to pursue macroeconomic policy objectives. Fiscal policy Changes in federal taxes or purchases that are intended to achieve macroeconomic policy objectives. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 8 of 48 12.1 LEARNING OBJECTIVE Aggregate Demand Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Changes in the Expectations of Households and Firms If households become more optimistic about their future incomes, they are likely to increase their current consumption. Changes in Foreign Variables If firms and households in other countries buy fewer U.S. goods or if firms and households in the United States buy more foreign goods, net exports will fall, and the aggregate demand curve will shift to the left. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 9 of 48 12.1 LEARNING OBJECTIVE Solved Problem 12-1 Chapter 12: Aggregate Demand and Aggregate Supply Analysis Movements along the Aggregate Demand Curve versus Shifts of the Aggregate Demand Curve Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 10 of 48 12.2 LEARNING OBJECTIVE Chapter 12: Aggregate Demand and Aggregate Supply Analysis Aggregate Supply Identify the determinants of aggregate supply and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve. Long-run aggregate supply (LRAS) curve A curve that shows the relationship in the long-run between the price level (P) and the quantity of real GDP supplied (Y). Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 11 of 48 12.2 LEARNING OBJECTIVE Aggregate Supply The Long-Run Aggregate Supply Curve Identify the determinants of aggregate supply and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve. FIGURE 12-2 Chapter 12: Aggregate Demand and Aggregate Supply Analysis The LRAS Curve Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 12 of 48 12.2 LEARNING OBJECTIVE Aggregate Supply The Short-Run Aggregate Supply Curve Identify the determinants of aggregate supply and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve. Chapter 12: Aggregate Demand and Aggregate Supply Analysis The three most common explanations as to why the Keynesian short-run aggregate supply curve slopes upward include: 1. Contracts make some wages and prices “sticky.” 2. Firms are often slow to adjust wages. 3. Menu costs make some prices sticky. Menu costs The costs to firms of changing prices. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 13 of 48 12.2 LEARNING OBJECTIVE Aggregate Supply Variables That Shift the SRAS Curve Identify the determinants of aggregate supply and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve. 1. increases in the labor force and in the capital stock (K) Chapter 12: Aggregate Demand and Aggregate Supply Analysis 2. positive or negative technological change 3. expected changes in the future price level 4. unexpected changes in the price of a natural resource Supply shock An unexpected event that causes the short-run aggregate supply curve to shift. 5. workers and firms adjusting to errors in their past expectations about the price level Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 14 of 48 12.2 LEARNING OBJECTIVE Aggregate Supply Identify the determinants of aggregate supply and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve. Most important: Expected changes in the future price level! Chapter 12: Aggregate Demand and Aggregate Supply Analysis FIGURE 12-3 How Expectations of the Future Price Level Affect the SRAS curve Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 15 of 48 12.3 LEARNING OBJECTIVE Macroeconomic Equilibrium in the Long-Run and the Short-Run Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium. FIGURE 12-4 Chapter 12: Aggregate Demand and Aggregate Supply Analysis Long-Run Macroeconomic Equilibrium A “long-run equilibrium” is also called a “general” equilibrium because all markets are simultaneously in equilibrium. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 16 of 48 Macroeconomic Equilibrium in the Long-Run and the Short-Run 12.3 LEARNING OBJECTIVE Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium. Chapter 12: Aggregate Demand and Aggregate Supply Analysis The simple (static) AD-LRAS-SRAS model Because the full analysis of the aggregate demand and aggregate supply model can be complicated, we begin with a simplified case, using two assumptions: 1. The economy has not been experiencing any inflation. The price level is currently 100, and workers and firms expect it to remain at 100 in the future. 2. The economy is not experiencing any longrun growth. Potential real GDP is $14.0 trillion and will remain at that level in the future. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 17 of 48 Macroeconomic Equilibrium in the Long-Run and the Short-Run 12.3 LEARNING OBJECTIVE Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium. The simple (static) AD-LRAS-SRAS model Chapter 12: Aggregate Demand and Aggregate Supply Analysis FIGURE 12-5 The SR and LR equilibria from a decrease in aggregate demand Example: A negative AD shock in the simple (static) model Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 18 of 48 Macroeconomic Equilibrium in the Long-Run and the Short-Run 12.3 LEARNING OBJECTIVE Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium. The simple (static) AD-LRAS-SRAS model Chapter 12: Aggregate Demand and Aggregate Supply Analysis FIGURE 12-6 The SR and LR equilibria from an increase in aggregate demand Example: A positive AD shock in the simple (static) model Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 19 of 48 Macroeconomic Equilibrium in the Long-Run and the Short-Run The simple (static) AD-LRAS-SRAS model 12.3 LEARNING OBJECTIVE Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium. Chapter 12: Aggregate Demand and Aggregate Supply Analysis FIGURE 12-7 The SR and LR equilibria from a decrease in aggregate supply Example: A negative supply shock in the simple (static) model Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 20 of 48 Macroeconomic Equilibrium in the Long-Run and the Short-Run 12.3 LEARNING OBJECTIVE Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Why are negative supply shocks so dangerous to an economy? Stagflation A combination of inflation and recession, usually resulting from a supply shock. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 21 of 48 Making 12.3 LEARNING OBJECTIVE Chapter 12: Aggregate Demand and Aggregate Supply Analysis How Long Does It Take to Return the to Potential GDP? A View from Connection the Obama Administration Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium. The difficulty in predicting how much aggregate demand and aggregate supply will shift means that economists often have difficulty correctly predicting the beginning and end of recessions. Christina Romer, the chair of the Council of Economic Advisers in the Obama Administration, provided an estimate of how long the economy would take to return to potential GDP. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 22 of 48 A Dynamic Aggregate Demand and Aggregate Supply Model 12.4 LEARNING OBJECTIVE Use the dynamic aggregate demand and aggregate supply model to analyze macroeconomic conditions. Chapter 12: Aggregate Demand and Aggregate Supply Analysis The complete (dynamic) AD-LRAS-SRAS model We can create a dynamic aggregate demand and aggregate supply model by making three changes to our simple (static) model. 1. Potential real GDP increases continually, shifting the LRAS curve to the right. 2. During most years, the AD curve shifts to the right. 3. Except during periods when workers and firms expect high rates of inflation, the SRAS curve shifts to the right. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 23 of 48 A Dynamic Aggregate Demand and Aggregate Supply Model 12.4 LEARNING OBJECTIVE Use the dynamic aggregate demand and aggregate supply model to analyze macroeconomic conditions. The complete (dynamic) AD-LRAS-SRAS model Chapter 12: Aggregate Demand and Aggregate Supply Analysis FIGURE 12-8 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 24 of 48 A Dynamic Aggregate Demand and Aggregate Supply Model 12.4 LEARNING OBJECTIVE Use the dynamic aggregate demand and aggregate supply model to analyze macroeconomic conditions. The complete (dynamic) AD-LRAS-SRAS model FIGURE 12-9 Chapter 12: Aggregate Demand and Aggregate Supply Analysis Using dynamic AD-LRASSRAS to understand inflation Example: An overheating economy where AD grows faster than LRAS Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 25 of 48 A Dynamic Aggregate Demand and Aggregate Supply Model 12.4 LEARNING OBJECTIVE Use the dynamic aggregate demand and aggregate supply model to analyze macroeconomic conditions. Chapter 12: Aggregate Demand and Aggregate Supply Analysis The Great Recession of 2007-2009 The Great Recession began in December 2007,with the end of the economic expansion that had begun in November 2001. Several factors contributed to bring on the recession: the bursting of the housing bubble the Financial Crisis of 2008 the rapid increase in oil prices during 2008 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 26 of 48 A Dynamic Aggregate Demand and Aggregate Supply Model 12.4 LEARNING OBJECTIVE Use the dynamic aggregate demand and aggregate supply model to analyze macroeconomic conditions. The Great Recession in the dynamic AD-LRAS-SRAS model FIGURE 12-10 Chapter 12: Aggregate Demand and Aggregate Supply Analysis The Beginning of the Great Recession of 2007–2009 Example: The economy grows too slowly because LRAS grew faster than AD (plus there is a negative shock to SRAS) Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 27 of 48 KEY TERMS Aggregate demand and aggregate supply model Chapter 12: Aggregate Demand and Aggregate Supply Analysis Aggregate demand (AD) curve Fiscal policy Long-run aggregate supply (LRAS) curve Menu costs Monetary policy Short-run aggregate supply (SRAS) curve Stagflation Supply shock Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 28 of 48