Download Document

Chapter 9- Aggregate Supply,
Aggregate Demand
Is the market economy of U.S. stable?
How do we know?
What can keep the economy stable?
Government or Private Enterprise?
Real GDP Growth
Now you know why Market is
skiddish
Two Basic Questions?
U.S. economy is in a slump
 What can be done to get out and jumpstart economic engine for growth?
Answer:
Government can enter and stimulate AD
Leave economy alone- it will adjust by itself.
Government can stimulate AS

3 Theories on moving business cycle
1.
Keynesian Theory
2.
Supply-Side Theory
3.
Monetary Theory
Aggregate Demand and Supply
•
The forces of supply and demand are at
work in the macro economy.
•
The macro model shows how the macro
economy works, and it consists of
aggregate demand (AD) and
aggregate supply (AS).
8-6
Aggregate Demand
•
Aggregate demand (AD): the total
quantity of output (real GDP) demanded
at alternative price levels in a given time
period, ceteris paribus.


•
The collective behavior of all buyers in the
marketplace.
It comprises all goods and services.
AD slopes downward; people will buy
more goods and services at lower price
levels, and vice versa.
8-7
Aggregate Demand (AD)
•
Why does AD slope downward?
 Real balances effect (Wealth effect)
: the cash you hold is worth more when
the price level falls, so you can buy
more.
 Foreign trade effect: lower price
levels in the United States convince
customers to buy more American goods
and fewer foreign goods.
 Interest rate effect: lower interest
rates promote more borrowing and
more spending.
8-8
Effect on AD
Wealth
Why an Increase in Price
Level Reduces Quantity of
Real GDP Demanded
Why a Decrease in Price
Level Raises Quantity of
Real GDP Demanded
When P falls, consumers are
When P rises, consumers are
wealthier in real terms. This
poorer in real terms. This
primarily increases the
primarily decreases the demand
demand for consumption
for consumption goods.
goods.
When P rises, individuals save
less, which increases the
equilibrium interest rate. Higher
Interest Rate
interest rates reduce the
quantity demanded of
investment goods.
When P falls, individuals can
afford to save more, which
decreases the equilibrium
interest rate. Lower interest
rates increase the quantity
demanded of investment
goods.
When P rises in the United
States, all else equal, goods
International and services produced
Trade
elsewhere are less expensive.
Imports rise and exports fall so
that net exports fall.
When P falls in the United
States, all else equal, goods
and services produced
elsewhere are more
expensive. Imports fall and
exports rise so net exports fall.
Aggregate Supply
•
Aggregate supply (AS): the total quantity
of output (real GDP) producers are willing and
able to supply at alternative price levels in a
given time period, ceteris paribus.
 The
collective behavior of all
suppliers (sellers) in the marketplace.
 It comprises all goods and services.
•
AS slopes upward; suppliers will bring more
goods and services to market at higher price
levels, and vice versa.
8-10
Aggregate Supply (AS)
•
Why does AS slope upward?


Profit effect: if there is no change in the
cost of operating a business, rising prices will
improve profits, and suppliers will bring more
products to the market.
Cost effect: cost increases make producing
products more expensive. Producers will be
willing to supply more only if prices also rise
to cover those added costs.
• At high rates of output (near productive
capacity), costs rise steeply and AS
steepens sharply.
8-11
Aggregate Demand and Supply
8-12
Macro Equilibrium
•
•
AS and AD summarize
the market activity of
the macro economy.
Macro equilibrium: the
combination of price
level and real output
that is compatible with
both AD and AS.


Where AD and AS
intersect.
… at PE and QE.
8-13
Results of Shifts in AD and AS
•
A shift in either AD or AS can cause the
economy to:
 go
into recession,
 recover from a recession,
 cause the economy to stagnate, or
 cause the economy to overheat.
•
Business cycles likely result from recurrent
shifts of AS and AD.
8-14
Short-Run Instability: Theories
•
•
•
Classical economists believe the economy
will self-regulate and gravitate toward full
employment.
Keynes and his followers do not believe
this. They believe the economy might get
worse without government intervention.
In addition, there are controversies about
the shape of AS and AD and the potential
to shift these curves.
8-15
Keynesian Theory
•
•
This is a demand-side theory.
A recession originates with a deficiency of
spending.


•
AD is too far to the left.
Policy: increase government spending to shift
AD back to the right.
Inflation originates with an excess in
spending.


AD is too far to the right.
Policy: increase taxes to shift AD back to the
left.
8-16
Monetary Theory
•
This is also a demand-side theory.

•
“Tight” money might cause AD to shift too
far to the left.

•
Emphasizes the role of money in financing AD.
Policy: increase money supply and lower
interest rates to shift AD back to the right.
“Easy” money might cause AD to shift too
far to the right.

Policy: decrease money supply and raise
interest rates to shift AD back to the left.
8-17
ASSUMPTION for Aggregate demand IS:
If Price level is decreasing, so are
incomes.
Economy moves down its AD curve
Moves to lower price level
*remember circular flow model- (when consumers pay lower
prices for goods and services – Less nominal income flows to
resource suppliers .
Shifts of Aggregate Demand
Curve shifts right or left according to
stimuli.
These shifts come from any or all
components of GDP (C, I, G, X-M)
DETERMINANTS OF AGGREGATE DEMAND
Change in Consumer Spending
•Consumer Wealth (people’s
houses fell in value)
•Consumer Expectations
(expect higher prices)
• Interest rate (interest
sensitive durables)
• Taxes
Think in aggregate terms
Changes in Investment Spending

Real Interest Rates (rates high- not much I
taking place)

Expected Future Sales (health of economy-
confidence is big)

Business Taxes (higher taxes less profit)
Government Spending
This will be discussed further, but anytime
government spends, it has an affect on
GDP.
Infrastructure –
Health Care
Supplies for military
Education
Etc.
Net Export Spending
National Income Abroad-(when foreign
nations do well, their incomes are higher- can buy
more U.S. goods and services. – U.S. exports rise)
Exchange Rates- Price of one nation’s currency
in terms of another. Dollar vs Euro
Our currency appreciates if it takes more foreign $
to buy it.. (depreciates if it takes more of ours to buy
theirs.) $1.00 to $1.25 Euro.
Depreciation of nation’s currency makes foreign
goods more expensive (but attracts foreigners to buy
our goods.) Our exports rise. *this is why the Fed
has not worried about our low dollar valuation.
Factors That Change Aggregate Demand &
Consumption/Interest Rates
Interest Rate ↑ → C↓ → AD↓
Interest Rate ↓ → C ↑ → AD↑
Factors That Change Aggregate Demand &
Investment/ Interest Rates
Interest rates ↑ → I↓ → AD↓
Interest rates ↓ → I ↑ → AD↑
Factors That Change Aggregate Demand &
Investment/ Business Taxes
Business taxes↓ → I↑ → AD↑
Business taxes↑ → I↓ → AD↓
Long-Run Equilibrium and the Price
Level
For the economy as a whole, long-run
equilibrium occurs at the price level where
the aggregate demand curve (AD) crosses
the long-run aggregate supply curve
(LRAS).
Figure 10-5 Long-Run
Economywide Equilibrium
OK… One more time…..
Component parts of GDP?
C + I + G + (X-M) = GDP
Long-Run Aggregate Supply Curve (LRAS)

A vertical line representing the real output of goods and
services after full adjustment has occurred

It represents the real GDP of the economy under
conditions of full employment; the economy is on its
production possibilities curve
The Production Possibilities and the
Economy’s Long-Run Aggregate Supply
Curve
Output Growth and the Long-Run
Aggregate Supply Curve (cont'd)

LRAS is vertical

Input prices fully adjust to changes in output
prices

Suppliers have no incentive to increase output

Unemployment is at the natural rate

Determined by endowments and technology
(or existing resources)
Output Growth and the Long-Run
Aggregate Supply Curve (cont'd)

Growth is shown by outward shifts of
either the production possibilities curve or
the LRAS curve caused by

Growth of population and the labor-force
participation rate

Capital accumulation

Improvements in technology
What does Long Run Equilibrium
Mean?





Economy is a full employment
Any additional production would be
difficult to achieve.
Economy operating at natural rate of
unemployment (anyone wanting job=have
it.)
Equate the LRAS curve with bowed line on
PPC.
To extend either would be to discover new
resources – R&D
Full Employment
The condition that
exists when the
unemployment rate
is equal to the
natural
unemployment rate.
 Full productive
capacity has been
 Reached.

Image Cylinder= Economy…
Businesses, factories, economy
not working at full capacity
Full Employment
AD
AS
LRAS
SRAS (short run aggregate supply)

Period where adjustment occurs.

As the output increases that puts upward
pressure on price.

Movement on the curve denotes the
relationship between price level and real
output.
SRAS………….Shift
Shift in the curve denotes determinates
that affect more or less real output
production at various price levels.
 Determinants:
Change in input prices (steel, plastic, wool
change in resource availability )

Change in productivity (+ = Shift right; - =
Shift left) (more for less is the object)
Change in legal environment (contracts,
taxes, subsidies)
AD and SRAS
Non-governmental actions that shift AS
 Shift AS left:







Raw materials cost rise
Wages rise faster than productivity
Worker productivity decreases
Obsolescence
Wars
Natural disasters
Fiscal Policy


Governmental actions that shift AD
Shift AD right:




Govt spending increases
Taxes decreases
Money Supply increases
Shift AD left:



G decreases
T increases
MS decreases
Three States of the Economy. This applies to
Classical and Keynesian
Real GDP is less than Natural Real GDP
(recessionary gap)
2. Real GDP is more than Natural Real GDP
(inflationary gap)
3. Real GDP is equal to Natural Real GDP.
What is Natural Real GDP?
Real GDP that is produced at the natural
unemployment rate. (which we agree
around 5%)
1.
BOTH THEORIES CLASSICAL AND
KEYNESIAN DO AGREE……
TWO THINGS WE CAN DO WITH
DISPOSABLE INCOMESPEND OR SAVE!
We all know that consumption is 2/3 (or
more) of GDP
When are you coming home, mom?

The following slides are to assist you with
understanding of the graphs.
Equilibrium States of the Economy
During the time an economy moves from one
equilibrium to another, it is said to be in disequilibrium.
Supply-Side Theory
•
A shift in AS to the left causes output and
employment to decrease and inflation to
increase.
–
This problem cannot be corrected by shifting
AD.
•
•
–
Shift AD right and unemployment falls but inflation
worsens.
Shift AD left and inflation is reduced but
unemployment rises.
Policy: devise ways to shift AS back to the
right.
Unanticipated Increase
in Aggregate Demand
Price
level
LRAS
SRAS1
Short-run effects of an
unanticipated increase in AD
P105
P100
AD1
YF Y2

AD2
Goods & Services
(real GDP)
In response to an unanticipated increase in AD for
goods & services (shift from AD1 to AD2), prices will
rise to P105 and output will temporarily exceed fullemployment capacity (increases to Y2).
Growth in Aggregate
Supply
LRAS2
Price
level
LRAS1
SRAS1
SRAS2
P1
P2
AD
YFF1


Goods & Services
(real GDP)
YF2
YF2
Here we illustrate the impact of economic growth due to
capital formation or a technological advancement, for
example.
Both LRAS and SRAS increase (to LRAS2 and SRAS2); the
full employment output of the economy expands from YF1
to YF2.

A sustainable, higher level of real output and real income is the
result. ***If the money supply is held constant, a new long-run
equilibrium will emerge at a larger output rate (YF2) and lower
price level (P2).
Effects of Adverse Supply Shock
Price
LRAS
level
SRAS2 (Pr2)
SRAS1 (Pr1)
P110
P100
B
A
AD
YF
Goods & Services
(real GDP)
Y2

The higher resource prices shift the SRAS curve to the left; in
the short-run, the price level rises to P110 and output falls to
Y
2.
What
happens in the long-run depends on whether the
reduction in the supply of resources is temporary or
permanent.

If temporary, resource prices fall in the future, permitting the economy
to return to its original equilibrium (A).


If permanent, the productive potential of the economy
will shrink (LRAS shifts to the left) and (B) will become
the long-run equilibrium.
INCREASES IN AD:
DEMAND-PULL INFLATION
Price Level
P
AD1
AD2
AS
P2
P1
Qf
Q 1 Q2
Real Domestic Output, GDP
Q
DECREASES IN AS:
COST-PUSH INFLATION
AS2
Price Level
P
P2
P1
AS1
b
a
AD1
Q1 Qf
Real Domestic Output, GDP
Q
Long run growth
Capital
goods
PPC shifts out and
LRAS shifts right.
P
AD2
AD1
P1
P2 AS1
LRAS1 LRAS2
x
AS2
Consumer
goods
Yf1
Yf2 Y