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Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
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Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
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O’Sullivan, Sheffrin, Perez
Macroeconomics: Principles, Applications, and Tools
Aggregate Demand
and Aggregate Supply
As we explained in
previous chapters,
recessions occur when
output fails to grow and
unemployment rises.
PREPARED BY
FERNANDO QUIJANO, YVONN QUIJANO,
AND XIAO XUAN XU
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
APPLYING THE CONCEPTS
1
What does the behavior of prices in retail catalogs
demonstrate about how quickly prices adjust in the
U.S. economy?
Price Stickiness in Retail Catalogs
2
How can we determine what factors cause recessions?
The Causes of Recessions in U.S.
Economic History
3
Do changes in oil prices always hurt the U.S. economy?
How the U.S. Economy Has Coped with Oil
Price Fluctuations
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.1
STICKY PRICES AND THEIR
MACROECONOMIC CONSEQUENCES
Flexible and Sticky Prices
For most firms, the biggest cost of doing business is wages. If wages
are sticky, firms’ overall costs will be sticky as well. This means that
firms’ product prices will remain sticky, too. Sticky wages cause sticky
prices and hamper the economy’s ability to bring demand and supply
into balance in the short run.
How Demand Determines Output in the Short Run
● short run in macroeconomics
The period of time in which
prices do not change or do not
change very much.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
APPLICATION
1
PRICE STICKINESS IN RETAIL CATALOGS
APPLYING THE CONCEPTS #1: What does the behavior of prices
in retail catalogs demonstrate about how quickly prices adjust in
the U.S. economy?
To analyze the behavior of retail prices, economist Anil Kashyap of the University
of Chicago examined prices in consumer catalogs.
He looked at the prices of 12 selected goods from:
• L.L. Bean
• Recreational Equipment, Inc. (REI)
• The Orvis Company, Inc.
The goods included shoes, blankets, chamois shirts, binoculars, and a fishing rod
and fly.
What did he find?
• Considerable price stickiness.
• When prices did change, he observed a mixture of both large and small
changes.
• During periods of high inflation, prices tended to change more frequently.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
What Is the Aggregate Demand Curve?
● aggregate demand curve (AD)
A curve that shows the relationship
between the level of prices and the
quantity of real GDP demanded.
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9.2
UNDERSTANDING AGGREGATE DEMAND
The Components of Aggregate Demand
 FIGURE 9.1
Aggregate Demand
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
the quantity of aggregate
demand increases as the price
level in the economy falls.
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
CHAPTER 9
Aggregate Demand
and Aggregate Supply
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
Why the Aggregate Demand Curve Slopes Downward
As the purchasing power of money changes, the aggregate demand curve is
affected in three different ways:
THE WEALTH EFFECT
● wealth effect
The increase in spending that occurs
because the real value of money
increases when the price level falls.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
Why the Aggregate Demand Curve Slopes Downward
THE INTEREST RATE EFFECT
With a given supply of money in the economy, a lower price level will lead to
lower interest rates. With lower interest rates, both consumers and firms will
find it cheaper to borrow money to make purchases. As a consequence, the
demand for goods in the economy (consumer durables purchased by
households and investment goods purchased by firms) will increase.
THE INTERNATIONAL TRADE EFFECT
In an open economy, a lower price level will mean that domestic goods (goods
produced in the home country) become cheaper relative to foreign goods, so
the demand for domestic goods will increase.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
Shifts in the Aggregate Demand Curve
CHANGES IN THE SUPPLY OF MONEY
An increase in the supply of money in the economy will increase aggregate
demand and shift the aggregate demand curve to the right.
CHANGES IN TAXES
A decrease in taxes will increase aggregate demand and shift the aggregate
demand curve to the right.
CHANGES IN GOVERNMENT SPENDING
At any given price level, an increase in government spending will increase
aggregate demand and shift the aggregate demand curve to the right.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
Shifts in the Aggregate Demand Curve
ALL OTHER CHANGES IN DEMAND
 FIGURE 9.2
Shifting Aggregate Demand
Decreases in taxes, increases in
government spending, and an increase in
the supply of money all shift the aggregate
demand curve to the right.
Higher taxes, lower government spending,
and a lower supply of money shift the curve
to the left.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
How the Multiplier Makes the Shift Bigger
 FIGURE 9.3
The Multiplier
Initially, an increase in desired
spending will shift the
aggregate demand curve
horizontally to the right from a
to b.
The total shift from a to c will
be larger. The ratio of the total
shift to the initial shift is known
as the multiplier.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
How the Multiplier Makes the Shift Bigger
● multiplier
The ratio of the total shift in
aggregate demand to the initial shift
in aggregate demand.
● consumption function
The relationship between the level
of income and consumer spending.
C = Ca + by
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
How the Multiplier Makes the Shift Bigger
● autonomous consumption spending
The part of consumption spending that
does not depend on income.
● marginal propensity to consume (MPC)
The fraction of additional income that is spent.
● marginal propensity to save (MPS)
The fraction of additional income that is saved.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
How the Multiplier Makes the Shift Bigger
multiplier 
1
(1  MPC)
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.3
UNDERSTANDING AGGREGATE SUPPLY
● aggregate supply curve (AS)
A curve that shows the relationship
between the level of prices and the
quantity of output supplied.
The Long-Run Aggregate Supply Curve
● long-run aggregate supply curve
A vertical aggregate supply curve that
represents the idea that in the long run,
output is determined solely by the
factors of production.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.3
UNDERSTANDING AGGREGATE SUPPLY
The Long-Run Aggregate Supply Curve
 FIGURE 9.4
Long-Run Aggregate Supply
In the long run, the level of
output, yp, is independent of the
price level.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.3
UNDERSTANDING AGGREGATE SUPPLY
The Long-Run Aggregate Supply Curve
DETERMINING OUTPUT AND THE PRICE LEVEL
 FIGURE 9.5
Aggregate Demand and the
Long-Run Aggregate Supply
Output and prices are
determined at the intersection
of AD and AS.
An increase in aggregate
demand leads to a higher price
level.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.3
UNDERSTANDING AGGREGATE SUPPLY
The Short-Run Aggregate Supply Curve
● short-run aggregate supply curve
A relatively flat aggregate supply curve
that represents the idea that prices do
not change very much in the short run
and that firms adjust production to
meet demand.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.3
UNDERSTANDING AGGREGATE SUPPLY
The Short-Run Aggregate Supply Curve
 FIGURE 9.6
Aggregate Demand and
Short-Run Aggregate Supply
With a short-run aggregate
supply curve, shifts in
aggregate demand lead to
large changes in output but
small changes in price.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.3
UNDERSTANDING AGGREGATE SUPPLY
The Short-Run Aggregate Supply Curve
What factors determine the costs firms must incur to produce output? The key
factors are
• Input prices (wages and materials)
• The state of technology
• Taxes, subsidies, or economic regulations
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.3
UNDERSTANDING AGGREGATE SUPPLY
Supply Shocks
● supply shocks
External events that shift the aggregate supply curve.
 FIGURE 9.7
Supply Shock
An adverse supply shock, such
as an increase in the price of oil,
will cause the AS curve to shift
upward.
The result will be higher prices
and a lower level of output.
● stagflation
A decrease in real output with increasing prices.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
APPLICATION
2
THE CAUSES OF RECESSIONS IN U.S. ECONOMIC HISTORY
APPLYING THE CONCEPTS #2: How can we determine what
factors cause recessions?
Economists have used the basic framework of aggregate
demand and supply analysis to explain recessions. Recessions
can occur either when there is a sharp decrease in demand or a
decrease in aggregate supply.
Economic historian Peter Temin looked back at all recessionary episodes from
1893 to 1990 to try to determine their ultimate causes. According to his
analysis, recessions were caused by many different factors.
• Sometimes, as in 1929, they were caused by shifts in aggregate
demand from the private sector, as consumers cut back their
spending.
• Other times, as in 1981, the government cut back on aggregate
demand to reduce inflation.
• Supply shocks were the cause of the recessions in 1973 and 1979.
• The most severe shock hit the U.S. economy in 1931 and converted
an economic downturn into the Great Depression. Professor Temin
believes that foreign monetary developments were the ultimate source
of this shock to the U.S. economy.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
APPLICATION
3
HOW THE U.S. ECONOMY HAS COPED WITH OIL PRICE FLUCTUATIONS
APPLYING THE CONCEPTS #3: Do changes in oil prices always hurt the
U.S. economy?
During the 1970s, the world economy was hit with unfavorable supply
shocks that raised prices and lowered output, including spikes in oil prices.
• Increases in oil prices shift the aggregate supply curve. However, they also
have an adverse effect on aggregate demand.
• Because the United States is a net importer of foreign oil, an increase in oil
prices is just like a tax that decreases the income of consumers.
• An increase in taxes will shift the aggregate demand curve to the left.
Between 1997 and 1998, the price of oil on the world market fell from $22 a barrel to
less than $13 a barrel. The result: gasoline prices were lower than they had been in
over 50 years.
In 2008, oil prices shot up to $145 a barrel.
• Reason: increased demand throughout the world, particularly in fast-growing
countries such as China and India.
• The economy had been weak prior to these increases, and policymakers
feared the negative effects this major supply disturbance would have both on
inflation and GDP.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.4
FROM THE SHORT RUN TO THE LONG RUN
 FIGURE 9.8
The Economy in the
Short Run
In the short run, the
economy produces at y0,
which exceeds potential
output yp.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.4
FROM THE SHORT RUN TO THE LONG RUN
 FIGURE 9.9
Adjusting to the
Long Run
With output exceeding
potential, the short-run
AS curve shifts
upward over time.
The economy adjusts
to the long-run
equilibrium at a1.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
9.4
FROM THE SHORT RUN TO THE LONG RUN
Looking Ahead
The aggregate demand and aggregate supply model in this chapter provides an
overview of how demand affects output and prices in both the short run and the
long run. The next several chapters explore more closely how aggregate demand
determines output in the short run.
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CHAPTER 9
Aggregate Demand
and Aggregate Supply
KEY TERMS
aggregate demand curve (AD)
multiplier
aggregate supply curve (AS)
short-run aggregate supply curve
autonomous consumption spending
short run in macroeconomics
consumption function
stagflation
long-run aggregate supply curve
supply shocks
marginal propensity to consume (MPC)
wealth effect
marginal propensity to save (MPS)
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