© 2005 Thomson C hapter 19 Aggregate Demand and Aggregate Supply.

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CChapter 19hapter 19

Aggregate Demand Aggregate Demand and Aggregate and Aggregate

SupplySupply

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Gottheil - Principles of Economics, 4e

Economic PrinciplesEconomic Principles

The phases of the business cycle

Gross Domestic Product (GDP)

The CPI and GDP deflator

Nominal and real GDP

Aggregate demand and aggregate supply

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Economic PrinciplesEconomic Principles

Macroeconomic equilibrium

Demand-pull and cost-push inflation

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Why Recession? Why Why Recession? Why Prosperity?Prosperity?

Recession

• A phase in the business cycle in which the decline in the economy’s real GDP persists for at least a half-year. A recession is marked by relatively high unemployment.

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Depression

• Severe recession.

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Prosperity

• A phase in the business cycle marked by a relatively high level of real GDP, full employment, and inflation.

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Inflation

• An increase in the price level.

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Business cycle

• Alternating periods of growth and decline in an economy’s GDP.

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• No two business cycles are identical. The number of months in any given phase of the cycle varies from cycle to cycle.

Business cycle

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Trough

• The bottom of a business cycle.

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• This is the time period when the economy’s unemployment rate is greatest and output declines to the cycle’s minimum level.

Trough

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Recovery

• A phase in the business cycle, following a recession, in which real GDP increases and unemployment declines.

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Peak

• The top of a business cycle.

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• This is the time period when output reaches its maximum level, the labor force is fully employed, and increasing pressure on prices is likely to generate inflation.

Peak

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Downturn

• A phase in the business cycle in which real GDP declines, inflation moderates, and unemployment emerges.

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Trend lines trace the economy’s output performance over the course of a business cycle, measured either from recession to recession or from prosperity to prosperity.

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• Upward-sloping trend lines signify economic growth.

• The steeper the trend line, the higher the economy’s rate of growth.

• When no growth occurs, the trend line is horizontal.

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EXHIBIT 1 THE BUSINESS CYCLE

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Exhibit 1: The Business Exhibit 1: The Business CycleCycle

What does the trend line in Exhibit 1 tell us about the economy’s output performance?• The trend line shows that the economy is growing.

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Measuring the Measuring the National EconomyNational Economy

• Total value of all final goods and services, measured in current market prices, produced in the economy during a year.


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• “Final goods and services” refers to everything produced that is not itself used to produce other goods and services.


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• “During a given year” refers to a specific calendar year.


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• “Produced in the economy” refers to any good or service produced in the United States, regardless of whether a US-owned or a foreign-owned company produced the good.


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• Conversely, goods produced by US-owned firms in foreign countries are not included in GDP.


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To compare GDP across years, we must devise some way of eliminating the effect of inflation.

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Nominal GDP

• GDP measured in terms of current market prices—that is, the price level at the time of measurement. (It is not adjusted for inflation.)

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Real GDP

• GDP adjusted for changes in the price level.

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• Price indices are designed to remove the effect of price changes.

• The consumer price index and the GDP deflator are the two indices most commonly used.

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Consumer Price Index (CPI)

• A measure comparing the prices of consumer goods and services that a household typically purchases to the prices of those goods and services purchased in a base year.

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Base year

• The reference year with which prices in other years are compared in a price index.

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Price level

• A measure of prices in one year expressed in relation to prices in a base year.

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Example: Suppose in 1998 (the base year) a basket of goods including such things as food, clothing, and fuel cost $350. The $350 converts to a price level index of 100, P = 100.

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Example: Suppose in the next year, 1999, the same basket of goods cost $385. The 1999 CPI, measured against the 1998 base year of 100, is 110. P = ($385/$350) × 100 = 110.

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Example: A 1999 P = 110 indicates that from 1998 to 1999 the cost of goods and services that consumers typically buy increased by 10 percent.

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GDP deflator

• A measure comparing the prices of all goods and services produced in the economy during a given year to the prices of those goods and services purchased in a base year.

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GDP deflator

• This price index includes not only consumer goods and services, but also producer goods, investment goods, exports and imports, and goods and services purchased by government.

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GDP deflator

• This price index is used to convert nominal GDP to real GDP.

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The formula to convert from nominal GDP to real GDP is:

• Real GDP = (nominal GDP × 100)/GDP deflator.

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EXHIBIT 2 CONVERTING NOMINAL GDP TO REAL GDP: 1995–2002 ($ BILLIONS, 1996 = 100)

Source: U.S. Department of Commerce, Bureau of Economic Analysis.

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Exhibit 2: Converting Exhibit 2: Converting Nominal GDP to Real Nominal GDP to Real

GDP: 1995-2000GDP: 1995-20001. What is the nominal difference between GDP in 1996 and 1997?

• The nominal difference = $8,318.4 billion - $7,813.2 billion = $505.2 billion.

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GDP: 1995-2000GDP: 1995-20002. What is the real difference between GDP in 1996 and 1997?

• Real GDP in 1996 is = ($7,813.2 billion × 100)/100.00 = $7,813.2 billion.

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GDP: 1995-2000GDP: 1995-20002. What is the real difference between GDP in 1996 and 1997?• Real GDP in 1997 = ($8,318.4 billion × 100)/101.95 = $8,159.5 billion.

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GDP: 1995-2000GDP: 1995-20002. What is the real difference between GDP in 1996 and 1997?

• The real difference = $8,159.5 billion - $7,813.2 billion = $346.3 billion.

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Deriving Equilibrium GDP in Deriving Equilibrium GDP in the Aggregate Demand and the Aggregate Demand and

Supply ModelSupply ModelThe aggregate demand and aggregate supply model is one model used to explain how GDP is determined.

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Supply ModelSupply ModelAggregate supply

• The total quantity of goods and services that firms in the economy are willing to supply at varying price levels.

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Supply ModelSupply ModelThere are three distinct segments of the aggregate supply curve:

1. Horizontal segment. Real GDP increases without affecting the economy’s price level.

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Supply ModelSupply Model

2. Upward-sloping segment. A positive relationship between real GDP and price level.

There are three distinct segments of the aggregate supply curve:

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Supply ModelSupply Model

3. Vertical segment. All resources are fully employed, so that real GDP cannot increase.

There are three distinct segments of the aggregate supply curve:

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Supply ModelSupply ModelAggregate demand

• The total quantity of goods and services demanded by households, firms, foreigners, and government at varying price levels.

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Supply ModelSupply ModelIncreases in the price level affect people’s real wealth, their lending and borrowing activity, and the nation’s trade with other nations.

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Supply ModelSupply ModelThe quantity of goods and services demanded in the economy declines when price levels increase.

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EXHIBIT 3 AGGREGATE SUPPLY AND AGGREGATE DEMAND

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Exhibit 3: Aggregate Exhibit 3: Aggregate Supply and Aggregate Supply and Aggregate

DemandDemandAt what real GDP value is full-employment of resources realized in Exhibit 3? • Full-employment real GDP is $9.5 trillion.

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Supply ModelSupply Model• The aggregate demand curve shifts when there is a change in the quantity of goods and services demanded at a particular price level.

• Government spending, income levels, and expectations about the future are all factors that can cause the curve to shift.

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Supply ModelSupply ModelThe aggregate supply curve shifts due to factors such as changes in resource availability and resource prices.

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EXHIBIT 4 SHIFTS IN AGGREGATE DEMAND AND AGGREGATE SUPPLY

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Exhibit 4: Shifts in Exhibit 4: Shifts in Aggregate Demand and Aggregate Demand and

Aggregate SupplyAggregate SupplyWhat might cause the aggregate demand curve in panel a of Exhibit 4 to shift to the right?• Increases in government spending, increases in incomes, and optimistic expectations could all cause the aggregate demand curve to shift to the right.

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Macroeconomic Macroeconomic EquilibriumEquilibrium

Macroequilibrium

• The level of real GDP and the price level that equate the aggregate quantity demanded and the aggregate quantity supplied.

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EXHIBIT 5 ACHIEVING MACROECONOMIC EQUILIBRIUM

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Exhibit 5: Achieving Exhibit 5: Achieving Macroeconomic Macroeconomic

EquilibriumEquilibrium1. At what price level and real GDP is macroequilibrium achieved in Exhibit 5?• Macroequilibrium is achieved at P = 101.95 and real GDP = $8.1595 trillion.

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Exhibit 5: Achieving Exhibit 5: Achieving Macroeconomic Macroeconomic

EquilibriumEquilibrium2. What happens when the price level increases to P = 110?

• At P = 110, the aggregate quantity demanded falls to $5 trillion and the aggregate quantity supplied increases to $9 trillion.

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Equilibrium, Inflation, Equilibrium, Inflation, and Unemploymentand Unemployment

• The Depression of the 1930s produced one of the poorest GDP performance records in our economic history.

• Real GDP fell by 30 percent in the first four years of the decade.

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Time Line on Time Line on Equilibrium, Inflation, Equilibrium, Inflation, and Unemploymentand Unemployment

The U.S. commitment to support England during World War II changed the pace and direction of our national economy significantly.

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Time Line on Time Line on Equilibrium, Inflation, Equilibrium, Inflation, and Unemploymentand Unemployment• Government war-related spending shifted the aggregate demand curve to the right.

• With millions of men and women joining the armed forces, the size of the civilian labor pool declined and the aggregate supply curve shifted to the left.

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Time Line on Time Line on Equilibrium, Inflation, Equilibrium, Inflation, and Unemploymentand Unemployment• The same basic shifts in aggregate demand and supply occurred during the Vietnam War.

• Unlike the poor economic condition prior to WWII, however, the economy was already relatively vigorous prior to the Vietnam war. Inflation resulted.

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Demand-pull inflation

• Inflation caused primarily by an increase in aggregate demand.

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Equilibrium, Inflation, Equilibrium, Inflation, and Unemploymentand Unemployment

Stagflation

• A period of stagnating real GDP, rapid inflation, and relatively high levels of unemployment.

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The oil price increases imposed by OPEC during the 1970s caused the cost of producing nearly everything in the economy to increase. The aggregate supply curve shifted to the left. GDP declined while the price level increased.

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Cost-push inflation

• Inflation caused primarily by a decrease in aggregate supply.

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EXHIBIT 6 AGGREGATE DEMAND AND AGGREGATE SUPPLY DURING THE DEPRESSION AND WAR PERIOD AND THE OIL PRICE INCREASES

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Exhibit 6: Aggregate Exhibit 6: Aggregate Demand and Aggregate Demand and Aggregate

Supply During the Supply During the Depression and War Period Depression and War Period and the Oil Price Increasesand the Oil Price Increases

• The aggregate supply curve shifts to the left after OPEC.

How does macroeconomic equilibrium change before and after OPEC in panel b of Exhibit 6?

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Exhibit 6: Aggregate Exhibit 6: Aggregate Demand and Aggregate Demand and Aggregate

Supply During the Supply During the Depression and War Depression and War

Period and the Oil Price Period and the Oil Price IncreasesIncreasesHow does macroeconomic

equilibrium change before and after OPEC in panel b of Exhibit 6?• A new equilibrium is obtained at a lower level of real GDP and at a higher price level.

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Time Line on Time Line on Equilibrium, Inflation, Equilibrium, Inflation, and Unemploymentand Unemployment• During the second half of the 1980s, the economy was performing about as well as it ever had in the last quarter century.

• Tax reforms, ready credit, leveraged buyouts, a commercial real estate boom, and optimistic expectations contributed to the already strong aggregate demand.

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Leveraged buyout

• A primarily debt-financed purchase of all the stock or assets of a company.

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Time Line on Time Line on Equilibrium, Inflation, Equilibrium, Inflation, and Unemploymentand UnemploymentThe recession of 1990-91 was caused

by an inward shift in aggregate demand. Reduced federal revenue sharing with states, downsized government budgets, cuts in demand for military goods, and high levels of debt acquired during the 1980s are all to blame.

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The Longest The Longest Prosperity Phase: Prosperity Phase:

1992-20001992-2000Economists attribute the boom to supply-side factors: • A rise in the nation’s productivity caused by the diffusion of computer technology throughout the economy.

• The absence of rising inflation.

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The 2001-02 Recession The 2001-02 Recession and 9/11and 9/11

• The 1992-2000 buying spree left consumers without the means to keep the spree alive.

• Terrorist attacks created a heightened sense of economic uncertainty.

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Can We Avoid Can We Avoid Unemployment and Unemployment and

Inflation?Inflation?Although the desired macroequilibrium outcome would occur at a real GDP level consistent with full employment and no inflation, this level is not always achieved.

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Inflation?Inflation?Some economists believe government should act in ways to help shift macroequilibrium to this position.

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Inflation?Inflation?Increasing or decreasing government spending and income taxes are two methods government can use to attempt to shift the aggregate demand curve.

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EXHIBIT 7 OBTAINING FULL-EMPLOYMENT GDP WITHOUT INFLATION

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Exhibit 7: Obtaining Full-Exhibit 7: Obtaining Full-Employment GDP Without Employment GDP Without

InflationInflationHow might government shift the aggregate demand curve from AD to AD′ in Exhibit 7? • Government could increase spending and reduce income taxes in order to shift the demand curve to the right.

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