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ECONOMICS: Principles and Applications 3e HALL & LIEBERMAN © 2005 Thomson Business and Professional Publishing Slides by: John & Pamela Hall Aggregate Demand and Aggregate Supply
ECONOMICS: Principles and Applications 3eHALL & LIEBERMAN© 2005 Thomson Business and Professional Publishing
Slides by: John & Pamela Hall
Aggregate Demand and Aggregate Supply
2
Figure 1: The Two-Way Relationship Between Output and the Price Level
PriceLevel
RealGDP
Aggregate Demand Curve
Aggregate Supply Curve
3
The Aggregate Demand Curve
• First step in understanding how price level affects economy is an important fact– When price level rises, money demand curve shifts rightward
• Shift in money demand, and its impact on the economy, is illustrated in Figure 2
• Imagine a rather substantial rise in price level—from 100 to 140• Compared with our initial position, this new equilibrium has the
following characteristics– Money demand curve has shifted rightward– Interest rate is higher– Aggregate expenditure line has shifted downward– Equilibrium GDP is lower
• All of these changes are caused by a rise in price level• A rise in price level causes a decrease in equilibrium GDP
4
Figure 2a: Deriving the Aggregate Demand Curve
(a)
E
H
500 Money ($ Billions)
Interest Rate
6%
9%
Ms
As the price level rises, money demand increases and interest rate rises.
d1M
d2M
5
Figure 2b/c: Deriving the Aggregate Demand Curve
(b) (c)
The rise in the interest rate causes real GDP to fall.
Real GDP($ Trillions)
Ag
gre
gat
e E
xpen
dit
ure
($ T
rill
ion
s)
6 10
E
AEr = 6%
AEr = 9%
H
140
100
Price Level
H
AD
E
On the AD curve, a higher price level is associated with a lower real GDP.
106 Real GDP($ Trillions)
6
Deriving the Aggregate Demand Curve
• Panel (c) of Figure 2 shows a new curve –Shows negative relationship
between price level and equilibrium GDP
• Call aggregate demand curve–Tells us equilibrium real GDP at any
price level
7
Understanding the AD Curve
• AD curve is unlike any other curve you’ve encountered in this text– In all other cases, our curves have represented simple behavioral
relationships
• But AD curve represents more than just a behavioral relationship between two variables– Each point on curve represents a short-run equilibrium in economy
• A better name for AD curve would be “equilibrium output at each price level” curve—not a very catchy name– AD curve gets its name because it resembles demand curve for an
individual product– AD curve is not a demand curve at all, in spite of its name
8
Movements Along the AD Curve
• As you will see later in this chapter, a variety of events can cause price level to change, and move us along AD curve– Suppose price level rises, and we move from point E to point H
along this curve– Following sequence of events occurs
– Opposite sequence of events will occur if price level falls, moving us rightward along AD curve
9
Shifts of the AD Curve
• When we move along AD curve in Figure 2, we assume that price level changes– But that other influences on equilibrium GDP are constant– Keep following rule in mind
• When a change in price level causes equilibrium GDP to change, we move along AD curve
• Whenever anything other than price level causes equilibrium GDP to change, AD curve itself shifts
• Equilibrium GDP will change whenever there is a change in any of the following– Government purchases– Taxes– Autonomous consumption spending– Investment spending– Net exports– Money supply
10
An Increase in Government Purchases
• Spending shocks initially affect economy by shifting aggregate expenditure line
• In Figure 3, we assume economy begins at a price level of 100
• Let’s increase government purchases by $2 trillion and ask what happens if price level remains at 100– An increase in government purchases shifts entire AD curve
rightward• AD curve shifts rightward when government purchases,
investment spending, autonomous consumption spending, or net exports increase, or when taxes decrease
• Analysis also applies in the other direction– AD curve shifts leftward when government purchases, investment
spending, autonomous consumption spending, or net exports decrease, or when taxes increase
11
Figure 3: A Spending Shock Shifts the AD Curve
(a) (b)
H
10 13.5
E
AE1
AE2
At any given price level, an increase in government purchases shifts the AE line upward, raising real GDP.
Rea
l A
gg
reg
ate
Exp
end
itu
re($
Tri
llio
ns)
Real GDP($ Trillions)
100
10 13.5
AD1 AD2
EH
Since real GDP is higher at the given price level, the AD curve shifts rightward.
Real GDP($ Trillions)
Price Level
12
Changes in the Money Supply
• Changes in money supply will also shift aggregate demand curve– Imagine that Fed conducts open market
operations to increase money supply– AD curve shifts rightward
• A decrease in money supply would have the opposite effect
13
Shifts vs. Movements Along the AD Curve: A Summary
• Figure 4 summarizes how some events in economy cause a movement along AD curve, and other events shift AD curve
• Panels (b) and (c) of Figure 4 tell us how a variety of events affect AD curve, but not how they affect real GDP
• Where will price level end up?– First step in answering that question is to
understand the other side of the relationship between GDP and price level
14
Figure 4a: Effects of Key Changes on the Aggregate Demand Curve
(a)
Real GDP
Price Level
P3
Q3 Q1 Q2
AD
P1
P2
Price level ↑ moves us leftward along the AD curve
Price level ↓ moves us rightward along the AD curve
15
Figure 4b: Effects of Key Changes on the Aggregate Demand Curve
Entire AD curve shifts rightward if:• a, IP, G, or NX increases• Net taxes decrease• The money supply increases
AD2
AD1
(b)
Real GDP
Price Level
16
Figure 4c: Effects of Key Changes on the Aggregate Demand Curve
AD2
decreasesEntire AD curve shifts rightward if:• a, IP, G, or NX decreases• Net taxes increase• The money supply decreases
(c)
Real GDP
Price Level
AD1
17
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• But 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
18
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
19
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
20
The Short Run
• All three of our reasons are important in explaining why a change in output affects price level– However, they operate within different time frames
• But 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
• 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 slow-moving
bureaucracies– Wage changes in either direction can be costly to firms– Firms may benefit from developing reputations for paying stable wages
21
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
22
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
23
Figure 5: The Aggregate Supply Curve
Price Level
Real GDP ($ Trillions)
130
100
80C
AS
13.5106
A
B
Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises.
Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price level falls.
24
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
25
Shifts of the AS Curve
• Figure 5 assumed that a number of important variables remained unchanged– But in real world, 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.
26
Figure 6: Shifts of the Aggregate Supply Curve
Price Level
Real GDP ($ Trillions)
100
AS1
A
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.
140
10
AS2
L
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Figure 7a: Effects of Key Changes on the Aggregate Supply Curve
(a)
Real GDP
Price Level
P3
Q2 Q1 Q3
P1
P2
ASReal GDP ↑ moves us rightward along the AS curve
Real GDP ↓ moves us leftward along the AS curve
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Figure 7b: Effects of Key Changes on the Aggregate Supply Curve
Real GDP
Price Level(b)
AS1
AS2
Entire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP
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Figure 7c: Effects of Key Changes on the Aggregate Supply Curve
Real GDP
Price Level(c)
AS1AS2
Entire AS curve shifts downward if unit costs ↓ for any reason besides an decrease in real GDP
30
AD and AS Together: Short-Run Equilibrium
• Where will the economy settle in short-run?– Where is our short-run macroeconomic
equilibrium?• We know that 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
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Figure 8: Short-Run Macroeconomic Equilibrium
Price Level
Real GDP ($ Trillions)
140
100
AS
106 14
E
B
AD
F
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What Happens When Things Change?
• Now that we know how short-run equilibrium is determined, and armed with our knowledge of AD and AS curves, we are ready to put model through its paces
• 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
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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
34
Figure 9: The Effect of a Demand Shock
Price Level
Real GDP($ Trillions)
100
130
AS
1012.5
13.5
E
J
H
AD1
AD2
115
35
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
36
An Decrease in Government Purchases
37
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
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Other Demand Shocks
• A positive demand shock—shifts AD curve rightward– Increases both real GDP and price level in
short-run
• A negative demand shock—shifts AD curve leftward– Decreases both real GDP and price level in
short-run
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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
40
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
41
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
42
Figure 10: The Long-Run Adjustment Process
Price Level
Real GDP
P2
P3
P4
P1
YFE Y3 Y2
H
E
AS2
AS1
AD2
AD1
J
K
43
Demand Shocks: Adjusting to the Long Run
• For a positive demand shock that shifts AD curve rightward, self-correcting mechanism works like this
44
Figure 11: Long-Run Adjustment After A Negative Demand Shock
Price Level
Real GDP
P2
AS1
P1
P3
YFEY2
AS2
AD2
AD1
E
M
N
45
Demand Shocks: Adjusting to the Long Run
• Complete sequence of events after a negative demand shock looks like this
46
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
47
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
• But 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
48
Figure 12: The Long-Run Adjustment Process
Price Level
Real GDP
P2
P4
P1
YFE Y2
H
E
AS2
AS1
AD2
AD1
K
Long-Run AS Curve
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
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Figure 13: The Effect of a Supply Shock
Price Level
Real GDP
P2
P1
YFEY2
E
AS2
AS1
AD
R
Long-RunAS Curve
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
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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
• However, the 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
53
Using the Theory: The Recession of 1990-91
• Story of 1990-91 recession begins in mid-1990, 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
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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
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Figure 14a: An AD and AS analysis of Two Recessions
P2
AS1990
P1
YFEY2
Price Level
Real GDP
AD1990
E
R
(a)
AS1991
1. In 1990, a supply shock from higher oil prices shifted the AS curve leftward . . .
2. causing output to fall . . .
3. and the price level to rise.
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Figure 14b: An AD and AS analysis of Two Recessions
YFEY2
AS2000
AD2000
AD2001
ER
(b)4. In 2001, a demand shock from
several factors caused the AD curve to shift leftward . . .
5. causing output to fall . . .
Price Level
Real GDP
P2
P1
6. and the price level to fall.
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Figure 15a/b: GDP and the Price Level in Two Recessions
The 1990-91 Recession(b)(a)
140
135
130
120
125
CPI
1989:3 1990:2 1991:1
Year and QuarterYear and Quarter
1989:3 1990:2 1991:1
6.75
6.72
6.66
6.60
6.69
6.63
Rea
l G
DP
($
Tri
llio
ns)
58
Figure 15c/d: GDP and the Price Level in Two Recessions
(d)
178
176
174
172
2000:1 2001:1
9.35
9.30
9.20
9.10
9.25
9.15
(c)
Year and Quarter
Rea
l G
DP
($
Tri
llio
ns)
2000:1 2001:1Year and Quarter
CPI
The 2001 Recession
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Using the Theory: Jobless Expansions
• After a recession, economy enters expansion phase of business cycle– Employment usually grows rapidly during this period as well
• 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– 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
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Figure 16: The Average ExpansionVersus Two Recent Jobless Expansions
EmploymentIndex
(Trough = 1)
-6 -4 -2 0 +2 +4 +6
Months Before and After the Trough
+8
0.99
1.00
1.01
1.02
1.03
1.04
+10 +12
After Average Recession
After 2001 Recession
After 1991 Recession
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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
62
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
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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