Download Issues in Microeconomics Econ 101

Chapter 8
Aggregate Demand,
Aggregate Supply,
and the Great
Depression
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
Review of Demand Shocks
•
Consumption: Changes in consumer confidence, stock
market prices and housing prices can alter autonomous C
• Planned Investment: Changes in business optimism
and expectations of future profits can alter I
• Money Supply: Changes in the money supply affect the
interest rate, which affects interest-sensitive components of
autonomous C and I
• Exchange Rates: Changes in e can affect net exports
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8-2
Aggregate Demand
• The aggregate demand (AD) curve shows the
different combinations of the price level and real
output at which the money and commodity markets
are both in equilibrium
• Recall: Any increase in C + I + G + NX will cause
the AD curve to shift to the right
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8-3
Figure 8-1 Effect on Real Income
of Different Values of the Price Level
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8-4
Figure 8-2 The Effect on the AD Curve of a
Doubling of the Nominal Money Supply
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8-5
Figure 8-3 The Effect on the AD Curve of a
Decline in Planned Autonomous Spending
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8-6
AD and the Global Economic Crisis
• The global economic crisis starting in 2008 occurred
primarily because of a sharp leftward shift in AD
– Crisis originated in the U.S. financial market due to the bursting
of the housing bubble caused by:
•
•
•
•
Lax regulation
Financial innovation
Securitization
Highly stimulative monetary policy
– Spread to foreign countries via interconnected capital markets
and foreign ownership of “toxic” MBS’s
• Aggregate supply (see next slide) did not play an important
role because the inflation rate and price level remained stable
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8-7
Aggregate Supply
• The Short-Run Aggregate Supply (SAS) curve
shows the amount of output that business firms are
willing to produce at different price levels, holding
constant the nominal wage rate
– The SAS curve is upward sloping since an increase in the
price level will increase profits for firms assuming wages
and other input costs are fixed. This results in firms
increasing output at higher prices
• The Long-Run Aggregate Supply (LAS) curve
shows the amount that business firms are willing to
produce when the nominal wage rate has fully
adjusted to any changes in the price level
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8-8
Controversies Surrounding AS
• The three possible shapes of the AS curve has
created decades of controversy.
• The horizontal AS curve assumes prices are
fixed, but is unrealistic because it cannot explain
inflation.
• The vertical AS curve assumes prices are
perfectly flexible and is useful to analyze inflation,
but cannot explain unemployment.
• The positively sloped short run AS curve
assumes that wages are fixed, so it cannot be
applied to the long run, but it helps to explain
short-run fluctuations in output.
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8-9
Figure 8-4 Effect of a Rightward Shift in the
AD Curve with Three Alternative Short-Run
Aggregate Supply Curves
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8-10
Deriving the SAS Curve
• Assume that wages are fixed in the short run and
that prices are merely “sticky.”
• If prices rise, firms benefit because the real wage
paid to their workers falls.
• Thus, firms can increase output if the price level
rises because their profits increase!
– P but W fixed  Y  SAS curve is upward sloping!
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8-11
Figure 8-5 The Short-Run Aggregate Supply
Curve (SAS) for Two Different Values of the
Wage Rate, W0 and W1
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8-12
Figure 8-6 Effects on the Price Level and Real
Income of an Increase in Planned Autonomous
Spending from AD0 to AD1
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8-13
Interpretations of the Business Cycle
• The theory discussed in Figure 8-6 assumes that
prices are flexible while wages are fixed
– This implies a countercyclical movement in the real wage:
Y↑  (W/P)↓
– But statistical evidence do not show consistent or strong
countercyclical real wages
• An alternative view is that both prices and wages
are sticky in the short run  SAS relatively flat
– When GDP rises above natural real GDP, there is inflationary
pressure that causes both W and P to rise
– Wage and price rigidity theories discussed in Ch 17
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8-14
The Quantity Theory of Money
• Classical economists believed that flexible prices were the
self-correcting forces that could stabilize real GDP
– Believed that U was voluntary and/or transitory condition
– Alfred Pigou (1913) argued that U came from the slow
adjustment of wages that kept labor markets from equilibrium
• The “Quantity Equation” was a model developed by
classical economists:
MSV = PY
• The Quantity Theory of Money holds that:
– Actual output tends to grow steadily
– Velocity is determined by payment practices
– MS changes therefore affect the price level and have little effect
on output
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8-15
Figure 8-7 Effect of a Decline in Planned
Spending When the Price Level Is Perfectly
Flexible
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8-16
The Failure of Self-Correction
• The Keynesian Revolution started with
publication of John Maynard Keyne’s The General
Theory in 1936 in response to failures of classical
economic ideas during The Great Depression.
• Monetary Impotence is the failure of real GDP to
respond to an increase in the real MS when:
– The IS curve is vertical
– The LM curve is horizontal (i.e. Liquidity Trap)
– “Zero lower bound” is reached: r ≥ 0
• Rigid Wages refers to the failure of the nominal
wage rate to adjust by the amount needed to
maintain equilibrium in the labor market.
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8-17
Figure 8-8 The Lack of Effect of a Drop in
the Price Level When There Is a Failure of
Self-Correction
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8-18
Stabilizing and Destabilizing Effects
of P
• Stabilizing Effects of P
– The Pigou or Real Balance Effect is the direct stimulus
to AD caused by an increase in the real money supply
and does not require a decline in the interest rate.
– The Keynes Effect is the stimulus to AD caused by a
decline in the interest rate.
• Destabilizing Effects of P
– The Expectations Effect is the decline in AD caused by
the postponement of purchases when consumers expect
P.
– The Redistribution Effect is the decline in AD caused by
the effect of falling prices in redistributing income from
high-spending debtors to low-spending savers.
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8-19
Figure 8-9 Effect of a Decline in Planned
Spending When the Nominal Rate is Fixed at W0
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8-20
What Caused the Great Depression?
• Real investment fell by 74% from 1929 to 1933
• Sharp fall in consumption spending
• Fall in NX due to failure to devalue the USD until
1933 and protective tariffs
• Bank failures
• Tight monetary policy: nominal MS fell by 25% from
1929 to 1933
• No price decline from 1936 to 1940
– 26% decline from 1929 to 1933
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8-21
Figure 8-10 The Output Ratio in
1929-41 and After 2007
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8-22
Table 8-1 Money, Output, Unemployment,
Prices, and Wages in the Great Depression,
1929–41
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8-23
International Perspective
Why Was the Great Depression Worse in the
United States than in Europe?
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8-24
Figure 8-11 The Price Level (P) and the Ratio
of Actual to Natural Real GDP (Y /YN) During the
Great Depression, 1929–41
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