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CHAPTER Aggregate Demand and Aggregate Supply Chapter 15 1 The Price Level •Up to this point, we have not said much about prices and the price level (P) •In this chapter we derive the: • Aggregate Demand curve which shows the relation between aggregate expenditure (AE) and the price level (P) • Aggregate Supply curve shows the relation between aggregate production and the price level (P) 2 Derivation of Aggregate Demand (AD) Curve • Start with money demand. An increase in the price level shifts the money demand curve rightward – increasing the equilibrium interest rate (if the Fed does not increase the money supply) – causing the aggregate expenditure line to shift downward – resulting in a lower equilibrium level of GDP. 3 Deriving the Aggregate Demand Curve (a) Interest Rate 9% 6% MS B As the price level, say the CPI, increases from 100 to 140, money demand increases and the interest rate rises. A M2 d M1 d 500 Money ($ billions) 4 Deriving the Aggregate Demand Curve (b, c) Real Aggregate Expenditure ($ Trillions) AEr=6% E AEr=9% F The rise in the interest rate causes real GDP to fall. 45° 6 10 Price level On the AD curve, a higher price level is associated with a lower real GDP. K 140 Real GDP ($ Trillions) H 100 AD 6 10 Real GDP ($ Trillions) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5 The Aggregate Demand Curve • a curve indicating equilibrium GDP at each price level, with a constant money supply • its NOT a demand curve at all! • it is actually an “equilibrium-output-ateach-price-level” curve 6 The Aggregate Demand Curve • Movements along the AD curve – a change in the price level causes equilibrium GDP to change This inverse relationship between P and Y caused by the change in the interest rate is called the interest rate effect 7 The Aggregate Demand (AD) Curve • Another reason for a downward-sloping aggregate demand curve is the Real Wealth Effect • This is the change in consumption brought about by a change in real wealth that results from a change in the price level. Nominal and Real Wealth Nominal Wealth (W) = Assets – Liabilities Real Wealth is the purchasing power of wealth = Two things change real wealth: W or P W P As P↓ => (W/P)↑ => C↑=> AE↑ => Y↑ C AE1 B AE0 A 450 Y0 Y1 Y As P ↑ =>(W/P) ↓ => C ↓ => AE ↓ => Y ↓ P and Y move in opposite directions. The AD curve Slopes downward to the right. What shifts the AD curve ? • Changes in any of the variables that shift the AE curve: – – – – – – Government purchases (G) Planned Investment spending (IP) Autonomous consumption spending (a) Taxes (T) Net exports (NX) The money supply (M) 11 The Aggregate Demand Curve • AD curve shifts rightward when: – Government purchases (G) increase – Planned Investment spending (IP) increases – Autonomous consumption spending (a) increases – Net exports increase – Net taxes decrease – Money supply increases 12 A Spending Change Shifts the AD Curve Real Aggregate Expenditure ($ Trillions) AE2 F At any given price level, an increase in government purchases shifts the AE line upward, raising real GDP. Get the multiplier effect we introduced in chapter 11. AE1 E 45° 10 12.5 Real GDP ($ Trillions) Price level Since real GDP is higher at the given price level, the AD curve shifts rightward. H to J is the multiplier effect we introduced in chapter 11 J 100 H AD1 10 12.5 AD2 Real GDP ($ Trillions) 13 Change in Price Level Moves Along the AD Curve (a) Price Level Price level ↑ moves us leftward along the AD curve P3 Price level ↓ moves us rightward along the AD curve P1 P2 AD Q3 Q1 Q2 Real GDP © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14 Effects of Key Changes on the Aggregate Demand Curve (b, c) Price Level Price Level AD2 AD1 Real GDP Entire AD curve shifts rightward if: • a, Ip, G, or NX increases • Net taxes decrease • The money supply increases AD1 AD2 Real GDP Entire AD curve shifts leftward if: • a, Ip, G, or NX decreases • Net taxes increase • The money supply decreases © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15 The Aggregate Supply Curve Assumptions: • Firms set the price of their products as a markup over unit cost of production p = unit cost + mark-up • Average percentage markup in the economy is determined by competitive conditions in the economy – so we treat the mark-up as stable (fixed) from year to year • The competitive structure of the economy changes very slowly 16 The Aggregate Supply Curve • In general, changes in GDP affects unit costs of production – As total GDP(output) increases: greater amounts of inputs are needed to produce the greater output • the prices for non-labor inputs rise • the price of labor, the nominal wage rate, can also increase (but we make an assumption about this in the short-run!) • 17 The Aggregate Supply Curve • We assume that in the short-run the price of labor, nominal wages, are “fixed”, “sticky” – union contracts – can be costly to firms – reputation for paying stable wages – slow-moving bureaucracies • THIS IS A KEY ASSUMPTION!!! – nominal wage rate is fixed in the short run – changes in output have no effect on the nominal wage rate in the short run 18 The Aggregate Supply Curve • In the short run, a change in output will affect non-labor costs of production – a rise in real GDP raises firms’ unit costs • Input requirements increase: coal, oil lumber, copper,……. • The prices of these non-labor inputs rise – A decrease in real GDP lowers unit costs • Input requirements decrease • Prices of non-labor inputs fall 19 The Aggregate Supply Curve • Aggregate Supply (AS) curve – a curve indicating the price level consistent with firms’ unit costs and markups for any level of output (Y) in the short run – it is actually a “short-run-price-level-ateach-output-level” curve – its upward sloping • Price level on the vertical axis • Total output on the horizontal axis 20 The Aggregate Supply Curve Price Level AS B 130 Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises. A 100 80 Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price level falls. C 6 10 12.5 Real GDP © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21 The Aggregate Supply Curve • Movements along the AS curve – A change in real GDP causes the price level to change Wages are sticky! Labor costs do not change in the short-run. Another View of the Aggregate Supply Curve • In the short run there must be a lag between changes in output prices and changes in input prices, otherwise the aggregate supply (price/output response) curve would be vertical. • If input and output prices rise by the same percentage amount, no firm would find it advantageous to change its level of output. Slope Matters! Shape of the Short-run Aggregate Supply Curve - Ordinary Conditions Moderate Levels of : Unemployment Unemployment Rate: 5 10% Some excess Capacity Ex. Cap Rate: 10-25% AS exhibits a Positive Slope Aggregate Supply Curve - Ordinary Conditions Implications With the positive slope: Change in output (Y) causes a moderate change in the price level (P) Shape of the Short-run Aggregate Supply Curve - Slack Conditions High Levels of: • Unemployment Unemployment Rate > 10% • Lot of excess Capacity - Ex Cap Rate > 25% • AS is Almost Flat •26 of Shape of the Short-run Aggregate Supply Curve - Slack Conditions - Implications With a flat slope: The economy can expand a lot with small increase in P because of the excess capacity. Shape of the Short-run Aggregate Supply Curve - Tight Conditions Low Levels of: Unemployment Unemployment Rate < 3% Little excess CapacityEx Cap Rate < 10% • AS is Very Steep Shape of the Short-run Aggregate Supply Curve Tight Conditions - Implication AS Large increase in P for a relatively small increase in GDP (Y). •29 of The Aggregate Supply Curve is not a straight line Capacity [--Slack-----] [--Ordinary--] [--Tight--] What Causes the Aggregate Supply Curve to Shift? • Increase in AS means the AS curve shifts downward: – – – – – Lower world oil prices Good weather Technological change Regulation Lower nominal wages • Decrease in AS means the AS curve shifts upward: – Higher world oil prices – – – – Bad weather Technological change(negative?), stupid pills(?) Regulation Higher nominal wages 31 Shift of the Aggregate Supply Curve Price Level AS2 AS1 L 140 100 A 10 When unit costs rise at any given real GDP—e.g., from an increase in world oil prices or bad weather for farm production—the AS curve shifts upward. Real GDP © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 32 Effects of Key Changes on the Aggregate Supply Curve (a) Price Level AS Real GDP ↑ moves us rightward along the AS curve P2 P1 Real GDP ↓ moves us leftward along the AS curve P3 Y3 Y1 Y2 Real GDP © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 33 Effects of Key Changes on the Aggregate Supply Curve (b, c) Price Level Price Level AS2 AS1 AS1 Real GDP Entire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP AS2 Real GDP Entire AS curve shifts downward if unit costs ↓ for any reason besides a decrease in real GDP 34 AD and AS: Short-Run Equilibrium • Short-run macroeconomic equilibrium – a combination of price level and GDP consistent with both the AD and AS curves 35 Short-Run Macroeconomic Equilibrium Price Level Excess Supply B 140 E 100 F 80 Excess Demand 6 10 14 AD Real GDP At point E, the price level of 100 is consistent with an output of $10 trillion along the AD curve. The output level of $10 trillion is consistent with a price level of 100 along the AS curve. At any other combination of price level and output, such as point F or point B, at least one condition for equilibrium will not be satisfied. 36 Short-Run Macroeconomic Equilibrium Price Level Excess Supply B 140 E 100 F 80 Excess Demand AD At point B, AS > AD. Excess Supply. P will fall from 140 to 100 and Y will fall from 14 to 10. As P and Y fall, the interest rate falls which means C and Ip increases causing AD to increase. Movements along the curves! 6 10 14 Real GDP The is a lot more complicated than the basic AE model presented in chapters 10 and 11 where only Y fell as inventories increased. Here, Y, P , money demand, the interest rate(r) and AE all adjust. 37 Short-Run Macroeconomic Equilibrium At point F, AD > AS. Excess Demand. Price Level P will increase from 80 to 100 and Y will increase from 6 to 10. Excess Supply B 140 E 100 F 80 Excess Demand 6 10 14 AD As P and Y increase, the interest rate rises which means C and Ip fall causing AD to decrease Real GDP Movements along the curves! The is a lot more complicated than the basic AE model presented in chapters 10 and 11 where only Y fell as inventories decreased. Here, Y, P , money demand, the interest rate(r) and AE all adjust. 38 What Happens When Things Change? • Demand shock – this is any event that causes the AD curve to shift – for example, a change in government purchases or a change in the money supply • Supply shock – an event that causes the AS curve to shift – e.g., increase or decrease in world oil price, regulation, nominal wages. 39 The Effect of a Demand Shock: Increase G Price Level AS N Starting at point E, an increase in government purchases would shift the AD curve rightward to AD2 110 E 100 J Relate back to the Keynesian 450 graph. AD2 Multiplier= (1/(1-MPC). AD1 10.0 11.5 12.5 Real GDP $ Trillions Point J illustrates where the economy would move if the price level remained constant; multiplier = (1/(1-MPC). But, as output increases, the price level rises. Thus, the economy moves along the AS curve from point E to point N. 40 What Happens When Things Change? • Increase in government purchases Crowding-out of interest-sensitive spending. Multiplier is less than (1/(1-MPC). Inflation and rising interest rates reduce the size of the multiplier. The Effect of a Demand Shock • As P increases, money demand increases. If the money supply is constant, the interest rate rises and crowds-out interest sensitive investment and consumer spending. Move up along the AD curve from point J to N. •Crowding-out of interest-sensitive spending means the size of the multiplier is reduced. •Inflation and the increase in the interest rate reduce the size of the multiplier. What Happens When Things Change? • Decrease in government purchases Crowding-in of interest-sensitive spending. Multiplier is larger than (1/(1-MPC). Falling prices and falling interest rates increase the size of the multiplier. 43 What Happens When Things Change? • Increase in money supply © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 44 To sum up the short-run • A positive demand shock – shifts the AD curve rightward – increases both real GDP and the price level in the short run • A negative demand shock – shifts the AD curve leftward – decreases both real GDP and the price level in the short run 45 Demand Shocks: Adjusting to Long Run • In the short run we treat the wage rate and labor costs as given • In the long run – the wage rate will change – when output is above full employment • Wage rate will rise, shifting the AS curve upward – when output is below full employment • Wage rate will fall, shifting the AS curve downward 46 Demand Shocks: Adjusting to Long Run • Self-correcting mechanism – the adjustment process where price and wage changes return the economy to fullemployment output in the long run • If a demand shock pulls the economy away from full employment – changes in the wages and the price level will eventually cause the economy to correct itself and return to full-employment output 47 Demand Shocks: Adjusting to Long Run • Positive demand shock NOTE: Y >YFE => U <Un 48 Long-Run Adjustment after a Positive Demand Shock AS2 Price Level AS1 L P4 P2 P1 In the short-run the economy moves to point N, output is above the fullemployment level, YFE. N E AD2 AD1 YFE Y2 St point E, a positive demand shock would shift the aggregate demand curve to AD2, raising both output and the price level. Real GDP Firms compete to hire scarce workers, driving up the wage rate. In the longrun the higher wage rate will shift the AS curve to AS2. The economy returns to full-employment output at point L in the long-run. 49 Demand Shocks: Adjusting to Long Run • Negative demand shock NOTE: Y <YFE => U >Un 50 Long-Run Adjustment after a Negative Demand Shock AS1 Price Level AS2 E P1 P2 N P3 M AD1 AD2 Y2 YFE Real GDP Starting from point E, a negative demand shock shifts the AD curve to AD2, lowering GDP and the price level. In the short-run, output is below the full-employment level at point N. With unemployed labor available, wages and unit costs will fall, causing firms to lower their prices. The AS curve shifts downward until full employment is regained at point M, with a lower price level in the long-run. 51 Demand shock : The self-correcting mechanism in the long-run • When output exceeds its full-employment level – Wages will eventually rise – Causing a rise in the price level and a drop in GDP until full employment is restored • When output is less than its full-employment level – Wages will eventually fall – Causing a drop in the price level and a rise in GDP until full employment is restored 52 Long-run Aggregate Supply Curve • Long-run aggregate supply curve – A vertical line – Indicating all possible output and pricelevel combinations at which the economy could end up in the long run • The self-correcting mechanism – Shows us that, in the long run, the economy will eventually behave as the classical model predicts 53 The Long-Run AS Curve Price Level Long-Run AS Curve AS2 AS1 L P4 P2 P1 N E AD2 AD1 YFE Y2 Real GDP This figure illustrates a positive demand shock, but focuses on the long-run effects. The initial equilibrium is at point E, with output at full employment (YFE) and price level P1. After the positive demand shock and all the long-run adjustments to it, the economy ends up at point L with a higher price level (P4), but the same full-employment output level (YFE). The longrun AS curve—a vertical line—shows all possible combinations of price level and output for the economy, skipping over the short-run changes. The vertical, longrun AS curve shows that in the long run, demand shocks can affect the price level but not output. 54 Supply Shocks • Negative supply shock. In the short run – the AS curve shifts upward • Decreasing output and increasing the price level – causes stagflation (falling output and rising prices) • Positive supply shock. In the short run – the AS curve shifts downward • Increasing output and decreasing the price level 55 The Effect of a Negative Supply Shock Price Level Long-Run AS Curve AS2 AS1 A negative supply shock would shift the AS curve upward from AS1 to AS2. In the short-run, equilibrium is at point R, the price level is higher and output (Y2) is below YFE. R P2 E Eventually, wages will fall, causing unit costs to fall, and the AS curve will shift back down to its original position. P1 AD Y2 YFE Real GDP 56 The Effect of a Positive Supply Shock Price Level Long-Run AS Curve AS1 AS2 A positive supply shock would shift the AS curve down from AS1 to AS2. In the short-run equilibrium at point R, the price level is lower and output is above YFE. Eventually, wages will rise, causing unit costs to rise, and the AS curve will shift back up to its original position. E P1 R P2 AD YFE Y2 Real GDP 57 Supply Shocks • In the long run – The economy self-corrects after a longlasting supply shock – When output differs from its fullemployment level • The wage rate changes • AS curve shifts until full employment is restored 58 The Story of Two Recessions • The recession of 1990-91 – a supply-shock recession – caused by a reduction in oil supply • Price of oil doubled • The recession of 2008-09 – a powerful, negative demand shock • Home prices – falling • Stock prices – plunged 59 An AD and AS Analysis of Two Recessions: 1990-91Recession Price 1. In 1990, a supply shock Level AS1991 P2 from higher oil prices shifted the AS curve leftward … AS1990 R E P1 AD1990 3. and the price level to rise Y2 YFE 2. causing output to fall… Real GDP 60 An AD and AS Analysis of Two Recessions: 2008-09 Recession 4. In 2008-09, a demand shock from several factors caused the AD curve to shift leftward … Price Level AS2007 E P1 P2 AD2007 5. causing output to fall… R AD2009 6. and the price level to fall Y2 YFE Real GDP 61 GDP and the Price Level in Two Recessions © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 62 More Real World Examples The Aggregate Supply Curve is not a straight line Expansionary policy is inflationary and has small impact on aggregate output (Y) P4 AD4 P3 AD3 Expansionary policy is not inflationary and has relatively large impact on aggregate output (Y) P2 P1 AD2 AD1 [--Slack-----] Capacity [--Ordinary--] [--Tight--]