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Aggregate Demand and Aggregate Supply © 2003 South-Western/Thomson Learning The Aggregate Demand Curve •The Price Level and the Money Market •Deriving the Aggregate Demand Curve •Understanding the AD Curve •Movements Along the AD Curve •Shifts of the AD Curve The Aggregate Demand Curve Aggregate Demand Curve Price Level Real GDP Aggregate Supply Curve The Aggregate Demand Curve A rise in price level causes the • money demand curve to shift rightward • interest rate to rise • aggregate expenditure line to shift downward • equilibrium GDP to decrease The Aggregate Demand Curve (a) Interest Rate 9% 6% M (b) Aggregate Expenditure ($ Trillions) s AEr = 6% AEr = 9% E H E H d M2 d M1 500 Money ($ Billions) 6 10 (c) Real GDP ($ Trillions) Price Level H 140 E 100 AD 6 10 Real GDP ($ Trillions) The Aggregate Demand Curve A rise in the price level causes a decrease in equilibrium GDP. Deriving the Aggregate Demand Curve Aggregate Demand (AD) Curve A curve indicating equilibrium GDP at each price level. Understanding the Aggregate Demand Curve Each point on the AD curve represents a short-run equilibrium in the economy. Understanding the Aggregate Demand Curve P768 fig 1 Price goes up Increase in money demand r goes up a and I P go down Equilibrium GDP goes down Understanding the Aggregate Demand Curve P768 fig 1 Price goes down Decrease in money demand r goes down a and I P go up Equilibrium GDP goes up Shifts of the Aggregate Demand Curve • 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. Shifts of the Aggregate Demand Curve (a) Real Aggregate Expenditure ($ Trillions) AE 2 AE 1 H E 10 13.5 Real GDP ($ Trillions) (b) Price Level 100 H E AD1 AD2 10 13.5 Real GDP ($ Trillions) Spending Shocks The AD curve shifts rightward when • government purchases • investment spending • autonomous consumption spending • or net exports increase • or when taxes decrease. Spending Shocks The AD curve shifts leftward when • government purchases • investment spending • autonomous consumption spending • or net exports decrease • or when taxes increase. Changes in the Money Supply •An increase in the money supply shifts the AD curve rightward. •A decrease in the money supply shifts the AD curve leftward. (a) Price Level Effects of Key Changes on the AD Curve Price level moves us leftward along the AD curve P3 Price level moves us rightward along the AD curve P1 P2 AD Q3 (b) Price Level Entire AD curve shifts rightward if: • A, Ip, G, or NX increases • Taxes decrease • The money supply increases AD 2 AD 1 Q1 Price Level Q2 Real GDP (c) Entire AD curve shifts leftward if: • A, I p, G, or NX decreases • Taxes increase • The money supply decreases AD 1 AD 2 Real GDP Real GDP The Aggregate Supply Curve • Prices and Costs in the Short Run • Deriving the Aggregate Supply Curve • Movements Along the AS Curve • Shifts of the AS Curve Costs and Prices A firm sets the price of its products as a markup over cost per unit. Costs and Prices The average percentage markup in the economy is determined by competitive conditions in the economy. Costs and Prices In the short run • the price level rises when there is an economy-wide increase in unit costs, and • the price level falls when there is an economy-wide decrease in unit costs. Outputs, Costs, and the Price Level As total output increases • Greater amounts of inputs may be needed to produce a unit of output. • The prices of non-labor inputs rise. • The nominal wage rate rises. Output, Costs, and the Price Level For a year or so after a change in output, changes in the average nominal wage are less important than other forces that change unit costs. Output, Costs, and the Price Level Assume that changes in output have no effect on the nominal wage rate in the short run. In the short run • a rise in real GDP will also cause a rise in the price level. • a fall in real GDP will also cause a decrease in the price level. Deriving 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 over the short run. Deriving the Aggregate Supply Curve Price Level AS 130 B 100 80 A C 6 10 13.5 Real GDP ($ Trillions) Movements Upward Along the Aggregate Supply Curve Prices of non-labor inputs go up Real GDP goes up Unit costs go up Input requirements per unit of output go up Price level goes up Movements Downward Along the Aggregate Supply Curve P768 fig 1Input requirements per unit of output go down Real GDP goes down Unit costs go down Prices of non-labor inputs go down Price level goes down Shifts of the Aggregate Supply Curve • When a change in real GDP causes the price level to change, we move along the AS curve. • When anything other than a change in real GDP causes the price level to change, the AS curve itself shifts. Shifts of the Aggregate Supply Curve Examples of changes that shift AS • Changes in world oil prices • Changes in the weather • Technological change • Adjustment to the long run Shifts of the Aggregate Supply Curve Price Level AS2 AS1 140 L 100 A 10 Real GDP ($ Trillions) (a) Price Level Effects of Key Changes on the Aggregate Supply Curve AS Real GDP moves us rightward along the AS curve P2 Real GDP moves us leftward along the AS curve P1 P3 Q3 Q1 (b) Price Level Real GDP (c) AS2 Entire AS curve shifts upward if unit costs for any reason besides an increase in real GDP Q2 AS1 Real GDP Price Level AS1 Entire AS curve shifts downward if unit costs for any reason besides a decrease in real GDP AS2 Real GDP AD and AS Together: Short-Run Equilibrium Short-Run Macroeconomic Equilibrium A combination of price level and GDP consistent with both the AD and AS curves AD and AS Together: Short-Run Equilibrium Price Level AS B 140 E 100 F AD 6 10 14 Real GDP ($ Trillions) What Happens When Things Change? • Demand Shocks in the Short Run • Demand Shocks: Adjusting to the Long Run • The Long-Run Aggregate Supply Curve • Supply Shocks What Happens When Things Change? Demand Shock Any event that causes the AD curve to shift. Supply Shock Any event that causes the AS curve to shift. Demand Shocks in the Short Run Price Level AS 130 H 100 J E AD2 AD1 10 12 13.5 Real GDP ($ Trillions) Demand Shocks in the Short Run An increase in government purchases: • the horizontal shift of the AD curve measures how much real GDP would increase if the price level remained constant. • because the price level does rise, real GDP rises by less than the horizontal shift in the AD curve. Increase in Government Purchases AD curve shifts leftward GDP G Movement along new AD curve Unit cost Price Movement along AS curve Money demand Interest rate a and IP GDP Net Effect: GDP but by less, due to effect of P Increase in Government Purchases AD curve shifts rightward GDP G Movement along new AD curve Unit cost Price Movement along AS curve Money demand Interest rate a and IP GDP Net Effect: GDP but by less, due to effect of P Increase in Money Supply AD curve shifts rightward Money Supply Interest rate a and IP GDP Movement along new AD curve Unit costs Price Movement along AS curve Money demand Interest rate a and IP GDP Net Effect: GDP but by less, due to effect of P Other Demand Shocks A positive demand shock • shifts the AD curve rightward and increases both real GDP and the price level in the short run. A negative demand shock • shifts the AD curve leftward and decreases both real GDP and the price level in the short run. Demand Shocks: Adjusting to the Long Run In the short run, we treat the wage rate as given. But in the long run, the wage rate can change. • When output is above full employment, the wage rate will rise, shifting the AS curve upward. • When output is below full employment, the wage rate will fall, shifting the AS curve downward. Demand Shocks: Adjusting to the Long Run Price Level Long Run AS Curve AS2 AS 1 P4 K J P3 P2 P1 H E AD2 AD 1 YFEY3 Y2 Real GDP Demand Shocks: Adjusting to the Long Run Self-Correcting Mechanism The adjustment process through which price and wage changes return the economy to full-employment output in the long run. Positive Demand Shocks: Adjusting to the Long Run Change in short-run equilibrium P and Y Positive demand shock Y > YFE Wage rate Unit costs Price Long run adjustment process Y until Y = YFE Demand Shocks: Adjusting to the Long Run Price Level Long-Run AS CurveAS 1 AS2 P1 P2 E N P3 M AD1 AD2 Y2 YFE Real GDP Negative Demand Shocks: Adjusting to the Long Run Change in short-run equilibrium P and Y Negative demand shock Y < YFE Wage rate Unit costs Price Long run adjustment process Y until Y = YFE Demand Shocks: Adjusting to 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. The Long-Run Aggregate Supply Curve Long-Run Aggregate Supply Curve A vertical line indicating all possible output and price-level combinations at which the economy could end up in the long run The Long-Run Aggregate Supply Curve The self-correcting mechanism shows us that, in the long run, the economy will eventually behave as the classical model predicts. Short-Run Effects of Supply Shocks In the short run, a negative supply shock shifts the AS curve upward • decreasing output • increasing the price level. Short-Run Effects of Supply Shocks Price Level Long-Run AS Curve AS2 AS1 R P2 P1 E AD Y2 YFE Real GDP Short-Run Effects of Supply Shocks Stagflation The combination of falling output and rising prices Short-Run Effects of Supply Shocks A negative supply shock causes stagflation in the short run. Short-Run Effects of Supply Shocks A positive supply shock shifts the AS curve downward, increasing output and decreasing the price level. Long-Run Effects of Supply Shocks In the long run, the economy selfcorrects after a supply shock, just as it does after a demand shock. Long-Run Effects of Supply Shocks When output differs from its fullemployment level, the wage rate changes, and the AS curve shifts until full employment is restored. Some Important Provisos About the AS Curve • Some prices take time to adjust. • In some industries, wages respond quickly. • There is more to the process of recovering from a shock than the adjustment of prices and wages.