Download Working with our basic Aggregate Demand / Supply Model

1. What will be the GDP?
2. Will it be long-run equilibrium?
3. What will be the relationship between the actual and
natural rates of unemployment?
AD105
6,900
6,600
6,300
6,000
5,700
5,400
Price Level
90
95
100
105
110
115
SRAS105
4,500
4,800
5,100
5,400
5,700
6,000
1. What will be the GDP?
2. Will it be long-run equilibrium?
3. What will be the relationship between the actual and
natural rates of unemployment?
AD105
6,300
6,000
5,700
5,400
5,100
4,800
Price Level
90
95
100
105
110
115
SRAS105
4,500
4,800
5,100
5,400
5,700
6,000
4. Will this GDP be sustainable?
Aggregate Demand
for Goods & Services
• Aggregate demand (AD) curve:
shows the various quantities of domestically
produced goods & services that purchasers are
willing to buy at different price levels .
• The AD curve slopes downward to the right,
indicating an inverse relationship between the
amount of goods & services demanded and the
price level.
Planned aggregate
expenditures
(trillions of $)
(AE = GDP)
AE = C + I + G + NX,P1
AE = C + I + G + NX,P2
AE = C + I + G + NX, P3
10.6
10.0
9.4
Output
(Real GDP -trillions of $)
45º
9.4 10.0 10.6
P3
P2
P1
AD
9.4 10.0 10.6
Aggregate Demand Curve
• When the
general price
level in the
economy declines
from P1 to P2,
• the quantity of
goods and
services
purchased will
increase from Y1
to Y2.
Price
Level
A reduction in the price
level will increase the
quantity of goods &
services demanded.
P1
P2
AD Goods & Services
Y1
Y2
(real GDP)
1. The Wealth Effect: A lower price level
increases the purchasing power of the fixed
quantity of money.
2. The Interest Rate Effect:
a lower price level will reduce the demand for
money and lower the real interest rate, which then
stimulates additional purchases during the current
period.
3. The International Trade Effect: A lower
price level will make domestically produced
goods less expensive relative to foreign goods.
Price
Level
P1
P2
A reduction in the price
level will increase the
quantity of goods &
services demanded.
AD Goods & Services
(real GDP)
Y1 Y2
• A lower price level will
1. increase the wealth of people holding the fixed quantity of money,
2. lead to lower interest rates, and
3. make domestic goods cheaper relative to foreign goods.
• Each of these factors tends to increase the quantity of goods
& services purchased at the lower price level.
Price
Level
AD1
AD0
AD2
Goods & Services
(real GDP)
a. Monetary policy
lowering interest rates reduces the cost
of borrowing and increases consumption and
investment.
b. Fiscal policy
changes in government purchases shifts the
aggregate demand curve by changing the G
component. Changing taxes affects the C component.
a. Optimism shifts the curve right
b. Pessimism shifts the curve left
c. Stock prices, world events affect expectations
Consumer Sentiment Index:
A Measure of Optimism 1978-2007
• Consumer optimism and pessimism regarding the future
of the economy.
• Note how the index turns down prior to (or during) the
recessions of the period.
Consumer Sentiment Index
120
100
80
60
40
20
0
1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006
Source: http://www.economagic.com.
a. Foreign economic growth
-Increased income shifts the curve right
-Decreased income shifts the curve left
-The large the trade sector, the larger the
effect
b. Exchange rates
-Appreciation shifts the curve right
-Depreciation shifts the curve left
1. How will each of the following factors influence
aggregate demand in the United States:
(a) An increased fear of recession.
(b) An increased fear of inflation.
(c) The rapid growth of real income in Canada
and Western Europe.
(d) A reduction in the real interest rate.
(e) A higher price level (be careful).
(f) A stock market decline.
Vote a for an increase in Aggregate Demand
Vote b for a decrease in Aggregate Demand
In the long run, the level of real GDP is determined by the number of
workers, the capital stock, and the available technology, none of which are
affected by changes in the price level.
Price
Level
Changes in the price level do not affect
the level of real GDP.
LRAS
The level of real GDP
in the long run is called potential GDP,
or full-employment GDP.
YF
Goods & Services
(real GDP)
Price
Level
LRAS1 LRAS2
YF,1
a. Minimum wage
b. Public policy
Goods & Services
YF,2
(real GDP)
Price
Level
SRAS
Goods & Services
(real GDP)
a. Firms are often slower to cut
wages than raise them
Price
Level
SRAS1 SRAS2
Goods & Services
(real GDP)
a. Expected higher reduces supply
b. Expected lower increases supply
a. If workers and firms are adjusting to prices
being higher than expected the curve will shift
left.
b. If they are adjusting to prices being lower than
expected the curve will shift right.
An unexpected event that causes the SRAS to shift.
2. How will each of the following factors influence
aggregate supply in the Short Run:
(a) An increase in real wages.
(b) 4 hurricanes that destroy half of the orange
crop in Florida.
(c) An increase in the expected rate of inflation.
(d) An increase in the world price of oil.
(e) Abundant rainfall during the growing season.
Vote a for an increase in Aggregate Supply
Vote b for a decrease in Aggregate Supply
Price
Level
LRAS1
LRAS2
SRAS1
SRAS2
P100
P95
AD
YF1 YF2
Goods & Services
(real GDP)
• Start with Equilibrium, then increase LRAS (How?).
• Both LRAS and SRAS increase
full employment output expands from YF1 to YF2.
• A sustainable, higher level of real output is the result.
• Prices are high relative to production costs
• Unanticipated increase in AD.
• Supply shock
• Increased output is unsustainable
Price
Level
P105
LRAS
SRAS1
Short-run effects of
an unanticipated
increase in AD
P100
• Improves
profits.
AD2
AD1
• Output
Goods & Services
(real GDP)
increases
YF Y2
• Unemployment drops below the natural rate,
Price
Level
SRAS2
LRAS
SRAS1
P110
Long-run effects of
an unanticipated
increase in AD
P105
P105
AD2
AD1
YF Y 2
Goods & Services
(real GDP)
• Resource prices will rise. (SRAS shifts)
• Output will recede to the long-run potential.
• Prices are low relative to production costs
• Unanticipated decrease in AD.
• Supply shock
• Causes losses, so production decreases
Price
Level
LRAS
SRAS1
Short-run effects of
an unanticipated
reduction in AD
P100
P95
AD2 AD1
Y2 YF
• Profits fall.
• Output decreases
• Unemployment rises,
Goods & Services
(real GDP)
Price
Level
LRAS
SRAS1
SRAS2
Long-run effects of
an unanticipated
reduction in AD
P100
P95
P90
AD2 AD1
Y 2 YF
Goods & Services
(real GDP)
• Resource prices adjust down. (SRAS shifts)
• Output will recede to the long-run potential.
Price
Level
LRAS
SRAS1
SRAS2
Due to some
favorable supply
shock
P100
P95
AD
YF Y2
Goods & Services
(real GDP)
• Prices fall
• Output increases
• But conditions return to normal SRAS shifts back
Decrease in SRAS
Resource
Market
S2
Price
Level
S1
Pr2
Pr1
D
Q2
Q1
Quantity of
resources
• An adverse supply shock, (crop failure or oil price increase)
• prices rise from Pr1 to Pr2.
Decrease in SRAS
Price
Level
SRAS2 (Pr2 )
LRAS
SRAS1 (Pr1 )
P110
P100
AD
Y2 YF
Goods & Services
(real GDP)
• The higher resource prices shift SRAS to the left
• the price level rises to P110 and output falls to Y2.
• What happens in the long-run depends on whether the supply
shock is temporary or permanent.
Decrease
in SRAS
Price
Level
LRAS
SRAS2 (Pr2 )
SRAS1 (Pr1 )
B
P110
P100
A
AD
Y 2 YF
Goods & Services
(real GDP)
• If temporary, resource prices fall in the future, shifting
SRAS2 back to SRAS1, returning equilibrium to (A).
• If permanent, the productive potential of the economy
will shrink (LRAS shifts left and Y2 becomes YF2) and
(B) will become the long-run equilibrium.
How Long Does It Take to Return to Potential GDP?
Economic Forecasts Following the Recession of
2007–2009
Price Level, Inflation, and the AD-AS Model
The actual price level will also differ from the level
people anticipated when the rate of inflation
differs from what is expected.
When the inflation rate is greater than anticipated,
profit margins will be attractive and business firms will
respond with an expansion in output.
When the inflation rate is less than anticipated, profit
margins will be unattractive and businesses will reduce
their output.
Which way will the AS or AD curves move after:
A. A widespread fear of depression on the part of
consumers.
B. A large purchase of American wheat by Russia.
C.
A cut in Federal spending for health care.
D. The complete disintegration of OPEC, causing oil
prices to fall by one-half.
E. A 10 percent reduction in personal income taxes.
F. An increase in labor productivity.
G. Depreciation in the international value of the dollar.
H. A decline in the percentage of the American labor
force which is unionized.
H.
D. A
AA
The
decline
complete
in
the
disintegration
percentage
of
ofwheat
the
OPEC,
causing
labor
oil
A.
widespread
fear
of American
depression
on American
the
part
of
B.
large
purchase
of
by
Russia.
C.
A
cut
in
Federal
spending
for
health
care.
G.
Depreciation
in the
international
valueincome
of thetaxes.
dollar.
labor
productivity.
E.F.
AAn
10increase
percent
inone-half.
personal
prices
forceinreduction
to
which
fall is
byunionized.
consumers.
Price
level
LRAS
SRAS
Price level
P
Employment
GDP
AD
YF
Goods & Services
(real GDP)
Real GDP (billions of 1996 $)
9,000
• Expansion and
8,000
contraction in the
U.S. economy since
1960.
6,000
Recessions:
2001
1990
1982
1980
1974-75
1970
1960
4,000
• Reductions in real
GDP in the top
graph relate with
increases in the rate
of unemployment
above the natural
rate (bottom graph).
2,000
1960 1965 1970 1975 1980 1985 1990 1995 2000
% Labor force unemployed
10 %
8%
6%
4%
2%
Actual rate of
unemployment
Natural rate of
unemployment
1960 1965 1970 1975 1980 1985 1990 1995 2000
Source: Derived from computerized data supplied by FAME Economics.
The Recession of 2007-2009
1. The end of the housing bubble. A speculative bubble
contributed to the rapidly rising housing prices between 2002 and
2005 before deflating in 2006, as both new home sales and existing
home values began to decline.
The growth of aggregate demand slowed as spending on residential
construction fell more than 60 percent over the next four years.
2. The financial crisis. The financial crisis led to a “credit
crunch” that made it difficult for many households and firms to
obtain the loans they needed to finance their spending, which
contributed to declines in consumption spending and investment
spending.
3. The rapid increase in oil prices during 2008. Although rising
oil prices can result in a supply shock that causes the short-run
aggregate supply curve to shift to the left, it did not shift as far to
the left during 2008 as it had from the increases in oil prices 30
years earlier because many firms had since switched to less oildependent production processes.
The Beginning of the Recession of 2007–2009
2007 - 2008, the AD curve shifted to the
right, but not by nearly
enough to offset the shift
to the right of the LRAS
curve, which represented
the increase in potential
real GDP from $13.20
trillion to $13.51 trillion.
Because of a sharp
increase in oil prices,
short-run aggregate
supply shifted to the left,
from SRAS2007 to SRAS2008.
Real GDP decreased from
$13.21 trillion in 2007 to
$13.16 trillion in 2008,
which was far below the potential real GDP, shown by LRAS2008.
As a result, the unemployment rate rose from 4.6 percent in 2007 to 5.8 percent
in 2008.
Because the increase in aggregate demand was small, the price level increased
only from 106.2 in 2007 to 108.6 in 2008, so the inflation rate for 2008 was
only 2.3 percent.
1.
Which of the following would be most likely to cause an increase
in current aggregate demand in the United States?
a.
increased fear that the U.S. economy was going into a recession
b.
an increase in the real interest rate
c.
sharp increase in the value of stocks owned by Americans
d.
a recession in Canada, Mexico, and Western Europe
2.
Which of the following will most likely accompany an
unanticipated increase in aggregate demand?
a.
an increase in real output
b.
an increase in unemployment
c.
a decrease in real GDP
d.
a decrease in the demand for resources
3.
In the aggregate demand/aggregate supply model, when the output of
an economy is less than its long-run potential, the economy will experience
a.
declining real wages and interest rates that will stimulate employment
and real output.
b.
rising interest rates that will stimulate aggregate demand and restore
full employment.
c.
a budget surplus that will stimulate demand and, thereby, help restore
full employment.
d.
rising real wages and real interest rates that will restore equilibrium at
a higher price level.
4.
Which of the following will most likely result from an
unanticipated decrease in aggregate supply due to unfavorable weather
conditions in agricultural areas?
a.
a decrease in inflation
b.
a decrease in unemployment
c.
an increase in the general level of prices
d.
an increase in the natural rate of unemployment
5.
Which of the following will most likely increase aggregate
supply in the long run?
a.
unfavorable weather conditions in agricultural areas
b.
an increase in the expected inflation rate
c.
higher real interest rates
d.
an increase in the rate of capital formation
6.
Within the AD/AS model, an unanticipated increase in short-run
aggregate supply will cause real output to
a.
increase and the general level of prices to fall.
b.
decrease and the general level of prices to rise.
c.
increase and the general level of prices to rise.
d.
decrease and the general level of prices to fall.
7. An increase in the long-run aggregate supply curve indicates that
a.
the natural rate of unemployment has increased.
b.
unemployment has increased.
c.
the general level of prices has increased.
d.
potential real GDP has increased.
8.
If the general level of prices is lower than business decision
makers anticipated when they entered into long-term contracts for raw
materials and other resources, which of the following is most likely to
occur?
a.
an economic boom
b.
highly attractive profit margins
c.
output less than the economy’s long-run potential
d.
a sharp increase in imports
9.
When output is less than the economy’s long-run capacity,
which of the following is most likely to occur?
a.
an abnormally low rate of unemployment
b.
reductions in real interest rates and real resource prices
c.
a sharp increase in imports
d.
a government budget surplus
10.
Suppose there was a sharp reduction in stock prices and a sharp
increase in the world price of crude oil. Within the framework of the
AD/AS model, how would these two changes influence the U.S.
economy?
a.
The lower stock prices would increase SRAS, and the
higher crude oil prices would reduce AD; as a result, there would be
downward pressure on the general level of prices.
b.
The lower stock prices would reduce SRAS, and the
higher crude oil prices would increase AD; as a result, there would be
upward pressure on the general level of prices.
c.
The lower stock prices would increase AD, and the
higher crude oil prices would increase SRAS; as a result, output would
tend to increase.
d.
The lower stock prices would reduce AD, and the higher
crude oil prices would reduce SRAS; as a result, output would tend to
decline.