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Chapter 4 Aggregate Demand and Aggregate Supply © 2005 Thomson Economic Principles The phases of the business cycle Gross Domestic Product (GDP) The CPI and GDP deflator Nominal and real GDP Aggregate demand and aggregate supply Macroeconomic equilibrium Demand-pull and cost-push inflation Gottheil - Principles of Economics, 4e © 2005 Thomson 2 Why Recession? Why Prosperity? • Recession •A phase in the business cycle in which the decline in the economy’s real GDP persists for at least a half-year. A recession is marked by relatively high unemployment. •Depression •Severe recession. Gottheil - Principles of Economics, 4e © 2005 Thomson 3 Why Recession? Why Prosperity? Prosperity • A phase in the business cycle marked by a relatively high level of real GDP, full employment, and inflation. Gottheil - Principles of Economics, 4e © 2005 Thomson 4 Why Recession? Why Prosperity? Business cycle • Alternating periods of growth and decline in an economy’s GDP. •No two business cycles are identical. The number of months in any given phase of the cycle varies from cycle to cycle. Gottheil - Principles of Economics, 4e © 2005 Thomson 5 Why Recession? Why Prosperity? Trough • The bottom of a business cycle. • This is the time period when the economy’s unemployment rate is greatest and output declines to the cycle’s minimum level. Gottheil - Principles of Economics, 4e © 2005 Thomson 6 Why Recession? Why Prosperity? Recovery • A phase in the business cycle, following a recession, in which real GDP increases and unemployment declines. Gottheil - Principles of Economics, 4e © 2005 Thomson 7 Why Recession? Why Prosperity? Peak • The top of a business cycle. • This is the time period when output reaches its maximum level, the labor force is fully employed, and increasing pressure on prices is likely to generate inflation. Gottheil - Principles of Economics, 4e © 2005 Thomson 8 Why Recession? Why Prosperity? Downturn • A phase in the business cycle in which real GDP declines, inflation moderates, and unemployment emerges. Gottheil - Principles of Economics, 4e © 2005 Thomson 9 EXHIBIT 1 THE BUSINESS CYCLE Gottheil - Principles of Economics, 4e © 2005 Thomson 10 Measuring the National Economy Gross Domestic Product (GDP) • Total value of all final goods and services, measured in current market prices, produced in the economy during a year. • Final goods and services refers to everything produced that is not itself used to produce other goods and services •During a given year refers to a specific calendar year. •Produced in the economy refers to any good or service produced in the United States, regardless of whether a US-owned or a foreign-owned company is producing. Gottheil - Principles of Economics, 4e © 2005 Thomson 11 Measuring the National Economy To compare GDP across years, we must devise some way of eliminating the effect of inflation. Gottheil - Principles of Economics, 4e © 2005 Thomson 12 Measuring the National Economy Nominal GDP • GDP measured in terms of current market prices—that is, the price level at the time of measurement. (It is not adjusted for inflation.) •Real GDP •GDP adjusted for changes in the price level. Gottheil - Principles of Economics, 4e © 2005 Thomson 13 Measuring the National Economy • Price indices are designed to remove the effect of price changes. • The consumer price index and the GDP deflator are the two indices most commonly used. Gottheil - Principles of Economics, 4e © 2005 Thomson 14 Measuring the National Economy Consumer Price Index (CPI) • A measure comparing the prices of consumer goods and services that a household typically purchases to the prices of those goods and services purchased in a base year. Gottheil - Principles of Economics, 4e © 2005 Thomson 15 Measuring the National Economy Price level • A measure of prices in one year expressed in relation to prices in a base year. Gottheil - Principles of Economics, 4e © 2005 Thomson 16 Measuring the National Economy Example: Suppose in 1998 (the base year) a basket of goods including such things as food, clothing, and fuel cost $350. The $350 converts to a price level index of 100, P = 100. Suppose in the next year, 1999, the same basket of goods cost $385. The 1999 CPI, measured against the 1998 base year of 100, is 110. P = ($385/$350) × 100 = 110. Gottheil - Principles of Economics, 4e © 2005 Thomson 17 Measuring the National Economy Example: A 1999 P = 110 indicates that from 1998 to 1999 the cost of goods and services that consumers typically buy increased by 10 percent. Gottheil - Principles of Economics, 4e © 2005 Thomson 18 Measuring the National Economy GDP deflator • A measure comparing the prices of all goods and services produced in the economy during a given year to the prices of those goods and services purchased in a base year. •This price index includes not only consumer goods and services, but also producer goods, investment goods, exports and imports, and goods and services purchased by government. Gottheil - Principles of Economics, 4e © 2005 Thomson 19 EXHIBIT 2 CONVERTING NOMINAL GDP TO REAL GDP: 1995–2002 ($ BILLIONS, 1996 = 100) Source: U.S. Department of Commerce, Bureau of Economic Analysis. Gottheil - Principles of Economics, 4e © 2005 Thomson 20 Deriving Equilibrium GDP in the Aggregate Demand and Supply Model The aggregate demand and aggregate supply model is one model used to explain how GDP is determined. Gottheil - Principles of Economics, 4e © 2005 Thomson 21 Deriving Equilibrium GDP in the Aggregate Demand and Supply Model Aggregate supply • The total quantity of goods and services that firms in the economy are willing to supply at varying price levels. Gottheil - Principles of Economics, 4e © 2005 Thomson 22 Deriving Equilibrium GDP in the Aggregate Demand and Supply Model There are three distinct segments of the aggregate supply curve: 1. Horizontal segment. Real GDP increases without affecting the economy’s price level. 2. Upward-sloping segment. A positive relationship between real GDP and price level. 3. Vertical segment. All resources are fully employed, so that real GDP cannot increase. Gottheil - Principles of Economics, 4e © 2005 Thomson 23 Deriving Equilibrium GDP in the Aggregate Demand and Supply Model Aggregate demand • The total quantity of goods and services demanded by households, firms, foreigners, and government at varying price levels. •Increases in the price level affect people’s real wealth, their lending and borrowing activity, and the nation’s trade with other nations. •The quantity of goods and services demanded in the economy declines when price levels increase. Gottheil - Principles of Economics, 4e © 2005 Thomson 24 EXHIBIT 3 AGGREGATE SUPPLY AND AGGREGATE DEMAND Gottheil - Principles of Economics, 4e © 2005 Thomson 25 Deriving Equilibrium GDP in the Aggregate Demand and Supply Model • The aggregate demand curve shifts when there is a change in the quantity of goods and services demanded at a particular price level. • Government spending, income levels, and expectations about the future are all factors that can cause the curve to shift. Gottheil - Principles of Economics, 4e © 2005 Thomson 26 Deriving Equilibrium GDP in the Aggregate Demand and Supply Model The aggregate supply curve shifts due to factors such as changes in resource availability and resource prices. Gottheil - Principles of Economics, 4e © 2005 Thomson 27 EXHIBIT 4 SHIFTS IN AGGREGATE DEMAND AND AGGREGATE SUPPLY Gottheil - Principles of Economics, 4e © 2005 Thomson 28 Exhibit 4: Shifts in Aggregate Demand and Aggregate Supply What might cause the aggregate demand curve in panel a of Exhibit 4 to shift to the right? • Increases in government spending, increases in incomes, and optimistic expectations could all cause the aggregate demand curve to shift to the right. Gottheil - Principles of Economics, 4e © 2005 Thomson 29 Macroeconomic Equilibrium Macroequilibrium • The level of real GDP and the price level that equate the aggregate quantity demanded and the aggregate quantity supplied. Gottheil - Principles of Economics, 4e © 2005 Thomson 30 Exhibit 5: Achieving Macroeconomic Equilibrium 1. At what price level and real GDP is macroequilibrium achieved in Exhibit 5? • Macroequilibrium is achieved at P = 101.95 and real GDP = $8.1595 trillion. Gottheil - Principles of Economics, 4e © 2005 Thomson 31 Exhibit 5: Achieving Macroeconomic Equilibrium 2. What happens when the price level increases to P = 110? • At P = 110, the aggregate quantity demanded falls to $5 trillion and the aggregate quantity supplied increases to $9 trillion. Gottheil - Principles of Economics, 4e © 2005 Thomson 32 Time Line on Equilibrium, Inflation, and Unemployment The U.S. commitment to support England during World War II changed the pace and direction of our national economy significantly. Gottheil - Principles of Economics, 4e © 2005 Thomson 33 Time Line on Equilibrium, Inflation, and Unemployment Demand-pull inflation • Inflation caused primarily by an increase in aggregate demand (such as during wars when government spending increases). Gottheil - Principles of Economics, 4e © 2005 Thomson 34 Equilibrium, Inflation, and Unemployment Stagflation • A period of stagnating real GDP, rapid inflation, and relatively high levels of unemployment (oil crisis in the 1970s). Gottheil - Principles of Economics, 4e © 2005 Thomson 35 Time Line on Equilibrium, Inflation, and Unemployment Cost-push inflation • Inflation caused primarily by a decrease in aggregate supply. Gottheil - Principles of Economics, 4e © 2005 Thomson 36 Time Line on Equilibrium, Inflation, and Unemployment • During the second half of the 1980s, the economy was performing about as well as it ever had in the last quarter century. • Tax reforms, ready credit, leveraged buyouts, a commercial real estate boom, and optimistic expectations contributed to the already strong aggregate demand. Gottheil - Principles of Economics, 4e © 2005 Thomson 37 Time Line on Equilibrium, Inflation, and Unemployment The recession of 1990-91 was caused by an inward shift in aggregate demand. Reduced federal revenue sharing with states, downsized government budgets, cuts in demand for military goods, and high levels of debt acquired during the 1980s are all to blame. Gottheil - Principles of Economics, 4e © 2005 Thomson 38 The Longest Prosperity Phase: 1992-2000 (Clinton years) Economists attribute the boom to supply-side factors: • A rise in the nation’s productivity caused by the diffusion of computer technology throughout the economy. • The absence of rising inflation. Gottheil - Principles of Economics, 4e © 2005 Thomson 39 The 2001-02 Recession and 9/11 • The 1992-2000 buying spree left consumers without the means to keep the spree alive. • Terrorist attacks created a heightened sense of economic uncertainty. Gottheil - Principles of Economics, 4e © 2005 Thomson 40 Can We Avoid Unemployment and Inflation? Although the desired macroequilibrium outcome would occur at a real GDP level consistent with full employment and no inflation, this level is not always achieved. Gottheil - Principles of Economics, 4e © 2005 Thomson 41 Can We Avoid Unemployment and Inflation? Some economists believe government should act in ways to help shift macroequilibrium to this position. Gottheil - Principles of Economics, 4e © 2005 Thomson 42 Can We Avoid Unemployment and Inflation? Increasing or decreasing government spending and income taxes are two methods government can use to attempt to shift the aggregate demand curve. Gottheil - Principles of Economics, 4e © 2005 Thomson 43 EXHIBIT 7 OBTAINING FULL-EMPLOYMENT GDP WITHOUT INFLATION Gottheil - Principles of Economics, 4e © 2005 Thomson 44 Exhibit 7: Obtaining Full-Employment GDP Without Inflation How might government shift the aggregate demand curve from AD to AD′ in Exhibit 7? • Government could increase spending and reduce income taxes in order to shift the demand curve to the right. Gottheil - Principles of Economics, 4e © 2005 Thomson 45