Download Aggregate Demand and Aggregate Supply

CHAPTER 9
Aggregate Demand and
Aggregate Supply
Copyright © 2012 Pearson
Prentice
Hall.
All rights
reserved.
Copyright
© 2012
Pearson
Prentice
Hall. All rights reserved.
9-1
CHAPTER
Aggregate Demand and Aggregate Supply
9
As we explained in previous chapters, recessions occur when output
fails to grow and unemployment rises.
PREPARED BY
Brock Williams
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
CHAPTER 9
Aggregate Demand and
Aggregate Supply
APPLYING THE CONCEPTS
1
What does the behavior of prices in consumer markets
demonstrate about how quickly prices adjust in the
U.S. economy?
Measuring Price Stickiness in Consumer Markets
2
How can we determine what factors cause recessions?
Two Approaches to Determining the Causes of
Recessions
3
Do changes in oil prices always hurt the U.S. economy?
How the U.S. Economy Has Coped with Oil
Price Fluctuations
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9-3
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.1
STICKY PRICES AND THEIR
MACROECONOMIC CONSEQUENCES
Flexible and Sticky Prices
•For most firms, the biggest cost of doing business is wages. If wages
are sticky, firms’ overall costs will be sticky as well. This means that
firms’ product prices will remain sticky, too.
•Sticky wages cause sticky prices and hamper the economy’s ability to
bring demand and supply into balance in the short run.
How Demand Determines Output in the Short Run
●short run in macroeconomics
The period of time in which
prices do not change or do not
change very much.
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9-4
CHAPTER 9
Aggregate Demand and
Aggregate Supply
APPLICATION
1
MEASURING PRICE STICKINESS IN CONSUMER MARKETS
APPLYING THE CONCEPTS #1: What does the behavior of prices
in consumer markets demonstrate about how quickly prices adjust
in the U.S. economy?
To analyze the behavior of retail prices, economist Anil Kashyap of the University
of Chicago examined prices in consumer catalogs.
He looked at the prices of 12 selected goods from:
▪ L.L. Bean
▪ Recreational Equipment, Inc. (REI)
▪ The Orvis Company, Inc.
The goods included shoes, blankets, chamois shirts, binoculars, and a fishing rod
and fly.
What did he find?
▪ Considerable price stickiness.
▪ When prices did change, he observed a mixture of both large and small
changes.
▪ During periods of high inflation, prices tended to change more frequently.
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9-5
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
What Is the Aggregate Demand Curve?
●aggregate demand curve (AD)
A curve that shows the
relationship between the level of
prices and the quantity of real
GDP demanded.
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9-6
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
(cont’d)
The Components of Aggregate Demand
 FIGURE 9.1
Aggregate Demand
The aggregate demand curve
plots the total demand for real
GDP as a function of the price
level.
The aggregate demand curve
slopes downward, indicating that
the quantity of aggregate
demand increases as the price
level in the economy falls.
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9-7
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
(cont’d)
Why the Aggregate Demand Curve Slopes Downward
REAL-NOMINAL PRINCIPLE
What matters to people is the real value of money or income—its purchasing
power—not the face value of money or income.
As the purchasing power of money changes, the aggregate demand curve is
affected in three different ways:
THE WEALTH EFFECT
●wealth effect
The increase in spending that occurs
because the real value of money
increases when the price level falls.
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9-8
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
(cont’d)
Why the Aggregate Demand Curve Slopes Downward
THE INTEREST RATE EFFECT
With a given supply of money in the economy, a lower price level will lead to
lower interest rates.
With lower interest rates, both consumers and firms will find it cheaper to
borrow money to make purchases.
As a consequence, the demand for goods in the economy (consumer durables
purchased by households and investment goods purchased by firms) will
increase.
THE INTERNATIONAL TRADE EFFECT
In an open economy, a lower price level will mean that domestic goods (goods
produced in the home country) become cheaper relative to foreign goods, so
the demand for domestic goods will increase.
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9-9
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
(cont’d)
Shifts in the Aggregate Demand Curve
CHANGES IN THE SUPPLY OF MONEY
An increase in the supply of money in the economy will increase aggregate
demand and shift the aggregate demand curve to the right.
CHANGES IN TAXES
A decrease in taxes will increase aggregate demand and shift the aggregate
demand curve to the right.
CHANGES IN GOVERNMENT SPENDING
At any given price level, an increase in government spending will increase
aggregate demand and shift the aggregate demand curve to the right.
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9-10
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
(cont’d)
Shifts in the Aggregate Demand Curve
ALL OTHER CHANGES IN DEMAND
 FIGURE 9.2
Shifting Aggregate Demand
Decreases in taxes, increases in
government spending, and an increase in
the supply of money all shift the aggregate
demand curve to the right.
Higher taxes, lower government spending,
and a lower supply of money shift the curve
to the left.
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9-11
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
(cont’d)
How the Multiplier Makes the Shift Bigger
 FIGURE 9.3
The Multiplier
Initially, an increase in desired
spending will shift the
aggregate demand curve
horizontally to the right from a
to b.
The total shift from a to c will
be larger. The ratio of the total
shift to the initial shift is known
as the multiplier.
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9-12
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
(cont’d)
How the Multiplier Makes the Shift Bigger
●multiplier
The ratio of the total shift in
aggregate demand to the initial shift
in aggregate demand.
●consumption function
The relationship between the level
of income and consumer spending.
C = Ca + by
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9-13
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
(cont’d)
How the Multiplier Makes the Shift Bigger
●autonomous consumption spending
The part of consumption spending that
does not depend on income.
●marginal propensity to consume (MPC)
The fraction of additional income that is spent.
●marginal propensity to save (MPS)
The fraction of additional income that is saved.
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9-14
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.2
UNDERSTANDING AGGREGATE DEMAND
(cont’d)
How the Multiplier Makes the Shift Bigger
multiplier 
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1
(1  MPC)
9-15
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.3
UNDERSTANDING AGGREGATE SUPPLY
●aggregate supply curve (AS)
A curve that shows the relationship
between the level of prices and the
quantity of output supplied.
The Long-Run Aggregate Supply Curve
●long-run aggregate supply curve
A vertical aggregate supply curve that
represents the idea that in the long run,
output is determined solely by the
factors of production.
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9-16
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.3
UNDERSTANDING AGGREGATE SUPPLY
(cont’d)
The Long-Run Aggregate Supply Curve
 FIGURE 9.4
Long-Run Aggregate Supply
In the long run, the level of
output, yp, is independent of the
price level.
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9-17
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.3
UNDERSTANDING AGGREGATE SUPPLY
(cont’d)
The Long-Run Aggregate Supply Curve
DETERMINING OUTPUT AND THE PRICE LEVEL
 FIGURE 9.5
Aggregate Demand and the
Long-Run Aggregate Supply
Output and prices are
determined at the intersection
of AD and AS.
An increase in aggregate
demand leads to a higher price
level.
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9-18
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.3
UNDERSTANDING AGGREGATE SUPPLY
(cont’d)
The Short-Run Aggregate Supply Curve
●short-run aggregate supply
curve
A relatively flat aggregate supply
curve that represents the idea that
prices do not change very much in
the short run and that firms adjust
production to meet demand.
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9-19
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.3
UNDERSTANDING AGGREGATE SUPPLY
(cont’d)
The Short-Run Aggregate Supply Curve
 FIGURE 9.6
Aggregate Demand and
Short-Run Aggregate Supply
With a short-run aggregate
supply curve, shifts in
aggregate demand lead to
large changes in output but
small changes in price.
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9-20
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.3
UNDERSTANDING AGGREGATE SUPPLY
(cont’d)
The Short-Run Aggregate Supply Curve
What factors determine the costs firms must incur to produce output? The key
factors are
• Input prices (wages and materials)
• The state of technology
• Taxes, subsidies, or economic regulations
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9-21
CHAPTER 9
Aggregate Demand and
Aggregate Supply
APPLICATION
2
TWO APPROACHES TO DETERMING THE CAUSES OF
RECESSIONS
APPLYING THE CONCEPTS #2: How can we determine what
factors cause recessions?
Economists have used the basic framework of aggregate demand and supply
analysis to explain recessions. Recessions can occur either when there is a sharp
decrease in demand or a decrease in aggregate supply.
Economic historian Peter Temin looked at all recessions from 1893 to 1990 to
determine their causes. He found, recessions were caused by many different
factors.
• Sometimes, as in 1929, they were caused by shifts in aggregate demand from
the private sector, as consumers cut back their spending.
• Other times, as in 1981, the government cut back on aggregate demand to
reduce inflation.
• Supply shocks were the cause of the recessions in 1973 and 1979.
• The most severe shock hit the U.S. economy in 1931 and converted an
economic downturn into the Great Depression. He believes that foreign
monetary developments were the ultimate source of this shock to the U.S.
economy.
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9-22
CHAPTER 9
Aggregate Demand and
Aggregate Supply
APPLICATION
3
HOW THE U.S. ECONOMY HAS COPED WITH OIL PRICE FLUCTUATIONS
APPLYING THE CONCEPTS #3: Do changes in oil prices always hurt the
U.S. economy?
During the 1970s, the world economy was hit with unfavorable supply shocks that
raised prices and lowered output, including spikes in oil prices.
• Increases in oil prices shift the aggregate supply curve. However, they also have an
adverse effect on aggregate demand.
• Because the United States is a net importer of foreign oil, an increase in oil prices is
just like a tax that decreases the income of consumers.
• An increase in taxes will shift the aggregate demand curve to the left.
Between 1997 and 1998, the price of oil on the world market fell from $22 a barrel to
less than $13 a barrel. The result: gasoline prices adjusted for inflation were lower
than they had been in over 50 years.
In 2008, oil prices shot up to $145 a barrel.
• Reason: increased demand throughout the world, particularly in fast-growing
countries such as China and India.
• Although prices fell again in 2009 and 2010, the increase of 2008 helped
exacerbate the recession.
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9-23
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.3
UNDERSTANDING AGGREGATE SUPPLY
(cont’d)
Supply Shocks
●supply shocks
External events that shift the aggregate supply curve.
 FIGURE 9.7
Supply Shock
An adverse supply shock, such
as an increase in the price of oil,
will cause the AS curve to shift
upward.
The result will be higher prices
and a lower level of output.
●stagflation
A decrease in real output with increasing prices.
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9-24
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.4
FROM THE SHORT RUN TO THE LONG RUN
 FIGURE 9.8
The Economy in the
Short Run
In the short run, the
economy produces at y0,
which exceeds potential
output yp.
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9-25
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.4
FROM THE SHORT RUN TO THE LONG RUN
(cont’d)
 FIGURE 9.9
Adjusting to the
Long Run
With output exceeding
potential, the short-run
AS curve shifts
upward over time.
The economy adjusts
to the long-run
equilibrium at a1.
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9-26
CHAPTER 9
Aggregate Demand and
Aggregate Supply
9.4
FROM THE SHORT RUN TO THE LONG RUN
(cont’d)
Looking Ahead
•The aggregate demand and aggregate supply model in this chapter provides an
overview of how demand affects output and prices in both the short run and the
long run.
•The next several chapters explore more closely how aggregate demand
determines output in the short run.
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9-27
CHAPTER 9
Aggregate Demand and
Aggregate Supply
KEY TERMS
aggregate demand curve (AD)
multiplier
aggregate supply curve (AS)
short-run aggregate supply curve
autonomous consumption spending
short run in macroeconomics
consumption function
stagflation
long-run aggregate supply curve
supply shocks
marginal propensity to consume (MPC)
wealth effect
marginal propensity to save (MPS)
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9-28