Download Chapter 17 - Aggregate Demand and Aggregate Supply

Chapter 17
Aggregate Demand
and Aggregate Supply
INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL
CHAPTER 17 / AGGREGATE DEMAND AND AGGREGATE SUPPLY
©2005, South-Western/Thomson Learning
Slides by John F. Hall
Animations by Anthony Zambelli
Figure 1: The Two-Way Relationship
Between Output and the Price Level
Aggregate Demand Curve
Price
Level
Real
GDP
Aggregate Supply Curve
Lieberman & Hall; Introduction to Economics, 2005
2
The Price Level and The Money Market


First effect of a change in the price level occurs in
the money market
Rise in the price increases the demand for money
and shifts the money demand curve rightward
 It makes purchases more expensive
 Drop in the price level
• Makes purchases cheaper
• Decreases the demand for money
• Shifts the money demand curve leftward

Rise in the price level causes the interest rate to
rise and interest-sensitive spending to fall
 Equilibrium GDP decreases by a multiple of the decrease
in interest-sensitive spending
Lieberman & Hall; Introduction to Economics, 2005
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The Price Level and Net Exports
The second effect of a higher price level
brings in the foreign sector
 A rise in the price level causes
 Net exports to drop and
 Equilibrium GDP to decrease by a multiple of the

drop in net exports
Lieberman & Hall; Introduction to Economics, 2005
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Deriving The Aggregate Demand (AD)
Curve
Figure 2 plots the price level on a vertical
axis and the economy’s real GDP on the
horizontal axis
 If we continued to change the price level to
other values we would find that each different
price level results in a different equilibrium
GDP
 The aggregate demand (AD) curve tells us
the equilibrium real GDP at any price level

Lieberman & Hall; Introduction to Economics, 2005
5
Figure 2: Deriving the Aggregate
Demand Curve
Price
Level
140
K
J
100
AD
6
Lieberman & Hall; Introduction to Economics, 2005
10
Real GDP
($ Trillions)
6
Movements Along The AD Curve

A variety of events can cause the price level to change, and move us
along the AD curve
 It’s important to understand what happens in the economy as we make such
a move

Opposite sequence of events will occur if the price level falls, moving us
rightward along the AD curve
Lieberman & Hall; Introduction to Economics, 2005
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Shifts of The AD Curve

The distinction between movements along the AD curve and
shifts of the curve itself is very important
 Always keep the following rule in mind
• When a change in the price level causes equilibrium GDP to change, we
•

move along the AD curve
Whenever anything other than the price level causes equilibrium GDP to
change, the AD curve itself shifts
What are these other influences on GDP?
 Equilibrium GDP will change whenever there is a change in any of
the following
•
•
•
•
•
•
Government spending
Taxes
Autonomous consumption spending
Investment spending
The money supply curve
The money demand curve
Lieberman & Hall; Introduction to Economics, 2005
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Spending Shocks

Spending shocks initially affect the economy by
changing total spending
 And then changing output by a multiple of that original
change in spending


The AD curve shifts rightward when government
purchases, investment spending, autonomous
consumption spending, or net exports increase, or
when taxes decrease
The AD curve shifts leftward when government
purchases, investment spending, autonomous
consumption spending, or net exports decrease, or
when taxes increase
Lieberman & Hall; Introduction to Economics, 2005
9
Figure 3: A Spending Shock Shifts the
AD Curve
Price
Level
100
H
E
AD1
10
Lieberman & Hall; Introduction to Economics, 2005
15
AD2
Real GDP
($ Trillions)
10
Changes in the Money Market
Changes that originate in the money market
will also shift the aggregate demand curve
 An increase in the money supply shifts the
AD curve rightward
 A decrease in the money supply shifts the AD

curve leftward
Lieberman & Hall; Introduction to Economics, 2005
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Figure 4(a): Effects of Key Changes on
the Aggregate Demand 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
Lieberman & Hall; Introduction to Economics, 2005
Q1
Q2
Real GDP
12
Figure 4(b): Effects of Key Changes on
the Aggregate Demand Curve
(b)
Price Level
Entire AD curve shifts rightward if:
• a, IP, G, or NX increases
• Net taxes decrease
• The money supply increases
AD2
AD1
Real GDP
Lieberman & Hall; Introduction to Economics, 2005
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Figure 4(c): Effects of Key Changes on
the Aggregate Demand Curve
(c)
Price Level
Entire AD curve shifts leftward if:
• a, IP, G, or NX decreases
decreases
• Net taxes increase
• The money supply decreases
AD1
AD2
Real GDP
Lieberman & Hall; Introduction to Economics, 2005
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The Aggregate Supply Curve

On the one hand, changes in the price level
affect output
 On the other hand, changes in output affect the
price level
 This relationship—summarized by the aggregate
supply curve—is the focus of this section

The effect of changes in output on the price
level is complex, involving a variety of forces
Lieberman & Hall; Introduction to Economics, 2005
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Costs and Prices

Price level in economy results from pricing behavior
of millions of individual business firms
 In any given year, some of these firms will raise their
prices, and some will lower them


Often, all firms in the economy are affected by the
same macroeconomic event
 Causing prices to rise or fall throughout the economy
To understand how macroeconomic events affect
the price level, we begin with a very simple
assumption
 A firm sets price of its products as a markup over cost per
unit
Lieberman & Hall; Introduction to Economics, 2005
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Costs and Prices


Percentage markup in any particular industry will depend on
degree of competition there
In macroeconomics, we are not concerned with how the
markup differs in different industries
 But rather with average percentage markup in economy
• Determined by competitive conditions
• Competitive structure changes very slowly, so average percentage
markup should be somewhat stable from year-to-year

But a stable markup does not necessarily mean a stable
price level, because unit costs can change
 In short-run, price level rises when there is an economy-wide
increase in unit costs
• Price level falls when there is an economy-wide decrease in unit costs
Lieberman & Hall; Introduction to Economics, 2005
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GDP, Costs, and the Price Level

Why should a change in output affect unit costs and
price level?
 As total output increases
• Greater amounts of inputs may be needed to produce a unit of
output
• Price of non-labor inputs rise
• Nominal wage rate rises

A decrease in output affects unit costs through the
same three forces, but with opposite result
Lieberman & Hall; Introduction to Economics, 2005
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The Short Run
All three of our reasons are important in
explaining why a change in output affects
price level
 They operate within different time frames
 Our third explanation—changes in nominal
wage rate—is a different story
 For a year or more after a change in output,
changes in average nominal wage are less
important than other forces that change unit
costs

Lieberman & Hall; Introduction to Economics, 2005
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The Short Run

Some of the more important reasons why wages in
many industries respond so slowly to changes in
output
 Many firms have union contracts that specify wages for



up to three years
Wages in many large corporations are set by slowmoving bureaucracies
Wage changes in either direction can be costly to firms
Firms may benefit from developing reputations for paying
stable wages
Lieberman & Hall; Introduction to Economics, 2005
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The Short Run

Nominal wage rate is fixed in short-run
 We assume that changes in output have no
effect on nominal wage rate in short-run

Since we assume a constant nominal wage
in short-run, a change in output will affect unit
costs through the other two factors
 In short-run, a rise (fall) in real GDP, by causing
unit costs to increase (decrease), will also cause
a rise (decrease) in price level
Lieberman & Hall; Introduction to Economics, 2005
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Deriving the Aggregate Supply Curve


Figure 5 summarizes discussion about effect of
output on price level in short-run
Each time we change level of output, there will be a
new price level in short-run
 Giving us another point on the figure
 If we connect all of these points, we obtain economy’s
aggregate supply curve
• Tells us price level consistent with firms’ unit costs and their
percentage markup at any level of output over short-run

A more accurate name for AS curve would be
“short-run-price-level-at-each-output-level” curve
Lieberman & Hall; Introduction to Economics, 2005
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Figure 5: The Aggregate Supply Curve
Price Level
AS
130
B
100
80
Starting at point A, an
increase in output
raises unit costs.
Firms raise prices,
and the overall price
level rises.
A
C
Starting at point A, a decrease
in output lowers unit costs.
Firms cut prices, and the
overall price level falls.
6
Lieberman & Hall; Introduction to Economics, 2005
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13.5
Real GDP ($ Trillions)
23
Movements Along the AS Curve

When a change in output causes price level to
change, we move along economy’s AS curve
 What happens in economy as we make such a

move?
As we move upward along AS curve, we can
represent what happens as follows
Lieberman & Hall; Introduction to Economics, 2005
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Shifts of the AS Curve

Figure 5 assumed that a number of important variables
remained unchanged
 Unit costs sometimes change for reasons other than a change in
output

In general, we distinguish between a movement along AS
curve, and a shift of curve itself, as follows
 When a change in real GDP causes the price level to change, we
move along AS curve
• When anything other than a change in real GDP causes price level to
change, AS curve itself shifts

What can cause unit costs to change at any given level of
output?
 Changes in world oil prices
 Changes in the weather
 Technological change
 Nominal wage, etc.
Lieberman & Hall; Introduction to Economics, 2005
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Figure 6: Shifts of the Aggregate
Supply Curve
AS2
Price Level
140
100
AS1
L
A
10
Lieberman & Hall; Introduction to Economics, 2005
When unit costs rise at any
given real GDP, the AS curve
shifts upward–e.g., an increase
in world oil prices or bad
weather for farm production.
Real GDP ($ Trillions)
26
Figure 7(a): Effects of Key Changes on
the Aggregate Supply Curve
(a)
Price Level
AS
Real GDP ↑ moves
us rightward along
the AS curve
P3
Real GDP ↓ moves
us leftward along
the AS curve
P1
P2
Q2
Lieberman & Hall; Introduction to Economics, 2005
Q1
Q3
Real GDP
27
Figure 7(b): Effects of Key Changes on
the Aggregate Supply Curve
(b)
Price Level
AS2
AS1
Entire AS curve shifts
upward if unit costs ↑ for
any reason besides an
increase in real GDP
Real GDP
Lieberman & Hall; Introduction to Economics, 2005
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Figure 7(c): Effects of Key Changes on
the Aggregate Supply Curve
(c)
Price Level
AS1
AS2
Entire AS curve shifts
downward if unit costs ↓
for any reason besides
an decrease in real GDP
Real GDP
Lieberman & Hall; Introduction to Economics, 2005
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AD and AS Together: Short-Run
Equilibrium

Where will the economy settle in short-run?
 Where is our short-run macroeconomic
equilibrium?
• In equilibrium, economy must be at some point on AD
curve
• Short-run equilibrium requires economy be operating
on its AS curve

Only when economy is at point E—on both
curves—will we have reached a sustainable
level of real GDP and the price level
Lieberman & Hall; Introduction to Economics, 2005
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Figure 8: Short-Run Macroeconomic
Equilibrium
AS
Price Level
B
140
E
100
F
AD
6
Lieberman & Hall; Introduction to Economics, 2005
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14
Real GDP ($ Trillions)
31
What Happens When Things Change?

Our short-run equilibrium will change when either
AD curve, AS curve, or both, shift
 An event that causes AD curve to shift is called a


demand shock
An event that causes AS curve to shift is called a supply
shock
In earlier chapters, we’ve used phrase spending
shock
 A change in spending by one or more sectors that
ultimately affects entire economy
 Demand shocks and supply shocks are just two different
categories of spending shocks
Lieberman & Hall; Introduction to Economics, 2005
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An Increase in Government Purchases
Shifts AD curve rightward
 Can see how it affects economy in short-run
 Process we’ve just described is not entirely
realistic
 Assumes that when government purchases rise,

first output increases, and then price level rises
 In reality, output and price level tend to rise
together
Lieberman & Hall; Introduction to Economics, 2005
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Figure 9: The Effect of a Demand
Shock
AS
Price Level
130
115
100
H
J
E
AD1
10
Lieberman & Hall; Introduction to Economics, 2005
13.5
12.5
AD2
Real GDP($ Trillions)
34
An Increase in Government Purchases

Can summarize impact of price-level changes
 When government purchases increase, horizontal shift of AD curve
measures how much real GDP would increase if price level
remained constant
• But because price level rises, real GDP rises by less than horizontal
shift in AD curve
Lieberman & Hall; Introduction to Economics, 2005
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An Decrease in Government Purchases
Lieberman & Hall; Introduction to Economics, 2005
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An Increase in the Money Supply

Although monetary policy stimulates economy
through a different channel than fiscal policy
 Once we arrive at AD and AS diagram, two look very

much alike
Can represent situation as follows
Lieberman & Hall; Introduction to Economics, 2005
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Other Demand Shocks

A positive demand shock—shifts AD curve
rightward
 Increases both real GDP and price level in shortrun

A negative demand shock—shifts AD curve
leftward
 Decreases both real GDP and price level in
short-run
Lieberman & Hall; Introduction to Economics, 2005
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An Example: The Great Depression


U.S. economy collapsed far more seriously during
1929 through 1933—the onset of the Great
Depression—than it did at any other time
What do we know about demand shocks that
caused Great Depression?
 Fall of 1929, bubble of optimism burst
 Stock market crashed, and investment and consumption


spending plummeted
Demand for products exported by United States fell
Fed reacted by cutting money supply sharply
• Each of these events contributed to a leftward shift of AD curve

Causing both output and price level to fall
Lieberman & Hall; Introduction to Economics, 2005
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Demand Shocks: Adjusting to the
Long-Run

In Figure 9, point H shows new equilibrium after a
positive demand shock in short-run—a year or so
after the shock
 But point H is not necessarily where economy will end up
in long-run

In short-run, we treat wage rate as given
 But in long-run, wage rate can change
 When output is above full employment, wage rate will

rise, shifting AS curve upward
When output is below full employment, wage rate will fall,
shifting AS curve downward
Lieberman & Hall; Introduction to Economics, 2005
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Demand Shocks: Adjusting to the Long
Run

Increase in government purchases has no effect on
equilibrium GDP in long-run
 Economy returns to full employment, which is just where


it started
This is why long-run adjustment process is often called
economy’s self-correcting mechanism
If a demand shock pulls economy away from full
employment
 Change in wage rate and price level will eventually cause
economy to correct itself and return to full-employment
output
Lieberman & Hall; Introduction to Economics, 2005
41
Figure 10: The Long-Run Adjustment
Process
Price Level
AS2
AS1
P4
K
J
P3
P2
P1
H
E
AD2
AD1
YFE Y3 Y2
Lieberman & Hall; Introduction to Economics, 2005
Real GDP
42
Demand Shocks: Adjusting to the Long
Run

For a positive demand shock that shifts AD curve
rightward, self-correcting mechanism works like
this
Lieberman & Hall; Introduction to Economics, 2005
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Figure 11: Long-Run Adjustment After
a Negative Demand Shock
Price Level
AS1
AS2
P1
P2
E
N
P3
M
AD1
AD2
Y2
Lieberman & Hall; Introduction to Economics, 2005
YFE
Real GDP
44
Demand Shocks: Adjusting to the Long
Run

Complete sequence of events after a negative
demand shock looks like this
Lieberman & Hall; Introduction to Economics, 2005
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Demand Shocks: Adjusting to the Long
Run

Can summarize economy’s self-correcting
mechanism as follows
 Whenever a demand shock pulls economy away from full

employment
• Self-correcting mechanism will eventually bring it back
When output exceeds its full-employment level, wages
will eventually rise
• Causing a rise in 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 price level and a rise in GDP until full
employment is restored
Lieberman & Hall; Introduction to Economics, 2005
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The Long-Run Aggregate Supply Curve


Self-correcting mechanism provides an important link
between economy’s long-run and short-run behaviors
Long-run aggregate supply curve also illustrates another
classical conclusion
 An increase in government purchases causes complete crowding out
• Rise in government purchases is precisely matched by a drop in
consumption and investment spending



Leaving total output and total spending unchanged
Self-correcting mechanism shows that, in long-run,
economy will eventually behave as classical model predicts
Notice the word eventually in the previous statement
 This is why governments around the world are reluctant to rely on
self-correcting mechanism alone to keep economy on track
Lieberman & Hall; Introduction to Economics, 2005
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Figure 12: The Long-Run Aggregate
Supply Curve
Price Level
Long-Run AS Curve
K
E
M
AD1
AD2
AD3
YFE
Lieberman & Hall; Introduction to Economics, 2005
Real GDP
48
Some Important Provisos about the AS
Curve


Upward-sloping aggregate supply curve we’ve presented in
this chapter gives a realistic picture of how economy
behaves after a demand shock
Story we have told about what happens as we move along
AS curve is somewhat incomplete
 Made assumption that prices are completely flexible—that they can
change freely over short periods of time
• In fact, however, some prices take time to adjust, just as wages take
time to adjust
 Assumed that wages are completely inflexible in short-run
• But in some industries, wages respond quickly
 More to process of recovering from a shock than adjustment of
prices and wages
Lieberman & Hall; Introduction to Economics, 2005
49
Short-Run Effects of Supply Shocks

Figure 13 shows an example of a supply shock
 An increase in world oil prices that shifts aggregate supply curve
upward, from AS1 and AS2
 Called negative supply shock, because of negative effect on output
• In short-run a negative supply shock shifts AS curve upward, decreasing
output and increasing price level

Notice sharp contrast between effects of negative supply
shocks and negative demand shocks in short-run
 Economists and journalists have coined term “stagflation” to describe
a stagnating economy experiencing inflation
• A negative supply shock causes stagflation in short-run

Examples of positive supply shocks include unusually good
weather, a drop in oil prices, and a technological change
that lowers unit costs
 In addition, a positive supply shock can sometimes be caused by
government policy
Lieberman & Hall; Introduction to Economics, 2005
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Figure 13: The Effect of Supply Shocks
Price Level
Long-Run
AS Curve
AS2
AS1
R
AS3
P2
P1
E
T
P2
AD
Y2
Lieberman & Hall; Introduction to Economics, 2005
YFE
Y3
Real GDP
51
Long-Run Effects of Supply Shocks

What about effects of supply shocks in long-run?
 In some cases, we need not concern ourselves with this
question, because some supply shocks are temporary


In other cases, however, a supply shock can last for
an extended period
In long-run, economy self-corrects after a supply
shock, just as it does after a demand shock
 When output differs from its full-employment level
• Wage rate changes
• AS curve shifts until full employment is restored
Lieberman & Hall; Introduction to Economics, 2005
52
Using the Theory: The Recession of
1990-91

Story of 1990-91 recession begins in mid1990, when Iraq invaded Kuwait
 During this conflict, Kuwait’s oil was taken off
world market, as was Iraq’s
 Reduction in oil supplies resulted in a rapid and
substantial increase in price of oil
Lieberman & Hall; Introduction to Economics, 2005
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Using the Theory: The Recession of
2001

Story of 2001 recession was quite different
 This time, there was no spike in oil prices and no other significant
supply shock to plague economy
 Rather, there was a demand shock, and a Federal Reserve policy
during the year before the recession that might have made it a bit
worse

During late 1990s, Fed had become concerned that
investment boom and consumer optimism were shifting AD
curve rightward too rapidly
 Creating a danger that we would overshoot potential GDP and set off
higher inflation
 Fed responded by tightening money supply and raising interest rate
 Effects of this policy may have continued into early 2001,
exacerbating decrease in investment that was occurring for other
reasons
• In this way, rate hikes themselves may have contributed to a further
leftward shift of AD curve
Lieberman & Hall; Introduction to Economics, 2005
54
Figure 14(a): An AD and AS analysis of
Two Recessions
1. In 1990, a supply shock from
(a)higher oil prices shifted the
AS curve leftward . . .
Price Level
AS1991
AS1990
R
P2
E
P1
2. causing output
to fall . . .
AD1990
3. and the price
level to rise.
Lieberman & Hall; Introduction to Economics, 2005
Y2
YFE
Real GDP
55
Figure 14(b): An AD and AS analysis of
Two Recessions
4. In 2001, a demand shock from
(b) factors caused the AD
several
curve to shift leftward . . .
Price Level
AS2000
P2
E
R
P1
5. causing output
to fall . . .
AD2000
6. and the price
level to fall.
AD2001
Y2
Lieberman & Hall; Introduction to Economics, 2005
YFE
Real GDP
56
Figure 15(a/b): GDP and the Price
Level in Two Recessions
The 1990-91 Recession
(b)
Real GDP ($ Trillions)
(a)
6.75
CPI 140
6.72
135
6.69
6.66
130
6.63
125
6.60
120
1989:3 1990:2 1991:1
Year and Quarter
Lieberman & Hall; Introduction to Economics, 2005
1989:3 1990:2 1991:1
Year and Quarter
57
Figure 15(c/d): GDP and the Price
Level in Two Recessions
The 2001 Recession
(d)
Real GDP ($ Trillions)
(c)
9.35
CPI 178
9.30
176
9.25
9.20
174
9.15
172
9.10
2000:1
2001:1
Year and Quarter
Lieberman & Hall; Introduction to Economics, 2005
2000:1
2001:1
Year and Quarter
58
Using the Theory: Jobless Expansions

After a recession, economy enters expansion phase of business cycle

But in our two most recent recessions, economy experienced abnormal,
prolonged periods during which employment did not grow at all
Figure 16 illustrates behavior of employment during our two most recent
recession

 Employment usually grows rapidly during this period as well
 Called trough of recession


Vertical axis shows an employment index—employment divided by
employment at the trough
Blue line shows that employment falls during the contraction phase of
average cycle
 Rises rapidly during the first year of the expansion phase

But red and pink lines show what happened in first year of our most
recent expansions—during 1992 and 2002
 In both cases, employment drifted slightly downward, telling us that total
number of jobs decreased during year
Lieberman & Hall; Introduction to Economics, 2005
59
Figure 16: The Average Expansion
Versus Two Recent Jobless Expansions
Employment 1.04
Index
(Trough = 1)
1.03
After Average
Recession
1.02
After 2001
Recession
1.01
1.00
After 1991
Recession
0.99
-6
-4
-2
0
+2
+4
+6
+8
+10 +12
Months Before and After the Trough
Lieberman & Hall; Introduction to Economics, 2005
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Explaining Jobless Expansions

Since story is similar for both of these expansions,
let’s focus on period from late 2001 to late 2002—
the first year of expansion after our most recent
recession
 Using equation for economic growth
• Real GDP = productivity x average hours x (emp/pop) x
population

But equation can be used in different ways
 Now we’re using equation to account for deviations in
employment away from full employment in short-run

For this purpose, we’ll need to make some
adjustments to equation
 Real GDP = productivity x average hours x employment
Lieberman & Hall; Introduction to Economics, 2005
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Explaining Jobless Expansions

Let’s convert equation to percentage
changes
 %Δ real GDP = %Δ productivity + %Δ
employment

Finally, rearranging
 %Δ employment (-0.3%) = %Δ real GDP (2.9%) %Δ productivity (3.2%)

Numbers in parentheses show actual
percentage changes for each of these
variables during 2002
Lieberman & Hall; Introduction to Economics, 2005
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Explaining Jobless Expansions

Why didn’t real GDP growth keep up with productivity?
 Because growth in real GDP was unusually low
 Productivity grew at about the same rate as average expansion, in
spite of the low growth in output
 Throughout period, firms were reluctant to hire full-time, permanent
workers
• Created uncertainty about strength and duration of expansion
• Instead, business expanded output by hiring part-time and temporary
workers

Why would this boost productivity?
 Enabled firms to adjust their workforce more easily to fluctuations in
production

Phrase “jobless expansion” refers to just part of expansion
phase
 Eventually, employment catches up—even to higher levels of output
made possible by productivity growth
Lieberman & Hall; Introduction to Economics, 2005
63