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Slides by John F. Hall

Animations by Anthony Zambelli

INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALLCHAPTER 17 / AGGREGATE DEMAND AND AGGREGATE SUPPLY

2005, South-Western/Thomson Learning

Chapter 17

Aggregate Demand

and Aggregate Supply

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Lieberman & Hall; Introduction to Economics, 2005 2

Figure 1: The Two-Way Relationship

Between Output and the Price Level

PriceLevel

RealGDP

Aggregate Demand Curve

Aggregate Supply Curve

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The Price Level and The Money Market

First effect of a change in the price level occurs inthe money market

Rise in the price increases the demand for moneyand shifts the money demand curve rightward

It makes purchases more expensive Drop in the price level Makes purchases cheaper Decreases the demand for money Shifts the money demand curve leftward

Rise in the price level causes the interest rate torise and interest-sensitive spending to fall Equilibrium GDP decreases by a multiple of the decrease

in interest-sensitive spending

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The Price Level and Net Exports

The second effect of a higher price levelbrings in the foreign sector

A rise in the price level causes

Net exports to drop and

Equilibrium GDP to decrease by a multiple of the

drop in net exports

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Deriving The Aggregate Demand (AD)

Curve

Figure 2 plots the price level on a verticalaxis and the economys real GDP on the

horizontal axis

If we continued to change the price level toother values we would find that each different

price level results in a different equilibrium

GDP The aggregate demand (AD) curve tells us

the equilibrium real GDP at any price level

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Figure 2: Deriving the Aggregate

Demand Curve

AD

140

100

PriceLevel

K

J

106 Real GDP($ Trillions)

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7/57Lieberman & Hall; Introduction to Economics, 2005 7

Movements Along The AD Curve

A variety of events can cause the price level to change, and move usalong the AD curve

Its important to understand what happens in the economy as we make sucha move

Opposite sequence of events will occur if the price level falls, moving us

rightward along the AD curve

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Shifts of The AD Curve

The distinction between movements along the AD curve andshifts of the curve itself is very important Always keep the following rule in mind

When a change in the price level causes equilibrium GDP to change, wemove along the AD curve

Whenever anything other than the price level causes equilibrium GDP to

change, the AD curve itself shifts What are these other influences on GDP?

Equilibrium GDP will change whenever there is a change in any ofthe following

Government spending Taxes Autonomous consumption spending Investment spending The money supply curve The money demand curve

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Changes in the Money Market

Changes that originate in the money marketwill also shift the aggregate demand curve

An increase in the money supply shifts the

AD curve rightwardA decrease in the money supply shifts the AD

curve leftward

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Figure 4(a): Effects of Key Changes on

the Aggregate Demand Curve

(a)

Real GDP

Price Level

P3

Q3 Q1 Q2

AD

P1

P2

Price level movesus leftward along

the ADcurve

Price level movesus rightward alongthe ADcurve

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Figure 4(b): Effects of Key Changes on


Entire ADcurve shifts rightward if: a, IP, G, orNXincreases

Net taxes decrease The money supply increases

AD2

AD1

(b)

Real GDP

Price Level

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Figure 4(c): Effects of Key Changes on


AD2

decreasesEntire ADcurve shifts leftward if: a, IP, G, orNXdecreases

Net taxes increase The money supply decreases

(c)

Real GDP

Price Level

AD1

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The Aggregate Supply Curve

On the one hand, changes in the price levelaffect output

On the other hand, changes in output affect theprice level

This relationshipsummarized by the aggregatesupply curveis the focus of this section

The effect of changes in output on the price

level is complex, involving a variety of forces

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Costs and Prices

Price level in economy results from pricing behaviorof millions of individual business firms In any given year, some of these firms will raise their

prices, and some will lower them

Often, all firms in the economy are affected by thesame macroeconomic event Causing prices to rise or fall throughout the economy

To understand how macroeconomic events affectthe price level, we begin with a very simple

assumption A firm sets price of its products as a markup over cost

per unit

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Costs and Prices

Percentage markup in any particular industry will depend ondegree of competition there

In macroeconomics, we are not concerned with how themarkup 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 stableprice level, because unit costs can change

In short-run, price level rises when there is an economy-wideincrease in unit costs

Price level falls when there is an economy-wide decrease in unit costs

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GDP, Costs, and the Price Level

Why should a change in output affect unit costs andprice 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

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The Short Run

All three of our reasons are important inexplaining why a change in output affectsprice level They operate within different time frames

Our third explanationchanges in nominalwage rateis a different story

For a year or more after a change in output,changes in average nominal wage are lessimportant than other forces that change unitcosts

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The Short Run

Some of the more important reasons why wages inmany 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

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The Short Run

Nominal wage rate is fixed in short-runWe assume that changes in output have no

effect on nominal wage rate in short-run

Since we assume a constant nominal wagein 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 causingunit costs to increase (decrease), will also cause

a rise (decrease) in price level

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Deriving the Aggregate Supply Curve

Figure 5 summarizes discussion about effect ofoutput on price level in short-run

Each time we change level of output, there will be anew price level in short-run

Giving us another point on the figure If we connect all of these points, we obtain economys

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 beshort-run-price-level-at-each-output-level curve

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Figure 5: The Aggregate Supply Curve

Price Level

Real GDP ($ Trillions)

130

100

80C

AS

13.5106

A

B

Starting at point A, anincrease in outputraises unit costs.Firms raise prices,and the overall pricelevel rises.

Starting at point A, a decrease

in output lowers unit costs.Firms cut prices, and theoverall price level falls.

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Movements Along the AS Curve

When a change in output causes price level tochange, we move along economys AS curve

What happens in economy as we make such a

move?

As we move upward along AS curve, we canrepresent what happens as follows

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Shifts of the AS Curve

Figure 5 assumed that a number of important variablesremained unchanged Unit costs sometimes change for reasons other than a change in

output

In general, we distinguish between a movement along AScurve, 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.

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Figure 7(a): Effects of Key Changes on

the Aggregate Supply Curve

(a)

Real GDP

Price Level

P3

Q2 Q1 Q3

P1

P2

AS

Real GDP movesus rightward alongthe AScurve

Real GDP movesus leftward alongthe AScurve

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Figure 7(b): Effects of Key Changes on


Real GDP

Price Level

(b)

AS1

AS2

Entire AScurve shiftsupward if unit costs for

any reason besides anincrease in real GDP

( ) ff f C

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Figure 7(c): Effects of Key Changes on


Real GDP

Price Level

(c)

AS1AS2

Entire AScurve shiftsdownward if unit costs for any reason besidesan decrease in real GDP

Fi 8 Sh R M i

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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?

Our short-run equilibrium will change when eitherAD 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 supplyshock

In earlier chapters, weve used phrase spendingshock

A change in spending by one or more sectors thatultimately affects entire economy

Demand shocks and supply shocks are just two differentcategories 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 weve 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 risetogether

Fi 9 Th Eff t f D d

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Figure 9: The Effect of a Demand

Shock

Price Level

Real GDP($ Trillions)

100

130

AS

10

12.5

13.5

E

J

H

AD1

AD2

115

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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 horizontalshift in AD curve

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An Decrease in Government Purchases

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An Increase in the Money Supply

Although monetary policy stimulates economythrough 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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An Example: The Great Depression

U.S. economy collapsed far more seriously during1929 through 1933the onset of the Great

Depressionthan 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

D d Sh k Adj ti t th

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Demand Shocks: Adjusting to the

Long-Run

In Figure 9, point H shows new equilibrium after apositive demand shock in short-runa year or soafter 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

D d Sh k Adj ti t th L

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Demand Shocks: Adjusting to the Long

Run

Increase in government purchases has no effect onequilibrium GDP in long-run

Economy returns to full employment, which is just where

it started

This is why long-run adjustment process is often calledeconomys 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

Fi 10 Th L R Adj t t

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Figure 10: The Long-Run Adjustment

Process

Price Level

Real GDP

P2

P3

P4

P1

YFEY3 Y2

H

E

AS2

AS1

AD2

AD1

JK

Demand Shocks Adj sting to the Long

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Run

For a positive demand shock that shifts AD curverightward, self-correcting mechanism works like

this

Figure 11: Long Run Adjustment After

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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


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Run

Complete sequence of events after a negativedemand shock looks like this


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Run

Can summarize economys self-correctingmechanism 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, wageswill 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 wageswill eventually fall Causing a drop in price level and a rise in GDP until full

employment is restored

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The Long-Run Aggregate Supply Curve

Self-correcting mechanism provides an important linkbetween economys 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 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

Figure 12: The Long Run Aggregate

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Figure 12: The Long-Run Aggregate

Supply Curve

Price Level

Real GDPYFE

E

MAD1

AD3

K

Long-Run ASCurve

AD2

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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 curveupward, 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 supplyshocks 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 goodweather, a drop in oil prices, and a technological changethat 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 Supply Shocks

Price Level

Real GDP

P2

P1

YFEY2

E

AS2

AS1

AD

R

Long-RunASCurve

AS3

TP

2

Y3

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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

Using the Theory: The Recession of

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1990-91

Story of 1990-91 recession begins in mid-1990, when Iraq invaded Kuwait

During this conflict, Kuwaits oil was taken off

world market, as was Iraqs Reduction in oil supplies resulted in a rapid and

substantial increase in price of oil


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2001

Story of 2001 recession was quite different This time, there was no spike in oil prices and no other significantsupply shock to plague economy

Rather, there was a demand shock, and a Federal Reserve policyduring the year before the recession that might have made it a bitworse

During late 1990s, Fed had become concerned thatinvestment boom and consumer optimism were shifting ADcurve 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 otherreasons

In this way, rate hikes themselves may have contributed to a furtherleftward shift of AD curve

Figure 14(a): An AD and AS analysis

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Figure 14(a): 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 fromhigher oil prices shifted theAScurve leftward . . .

2. causing outputto fall . . .

3. and the pricelevel to rise.

Figure 14(b): An AD and AS analysis

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Figure 14(b): 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 ADcurve to shift leftward . . .

5. causing outputto fall . . .

Price Level

Real GDP

P2

P1

6. and the pricelevel to fall.

Figure 15(a/b): GDP and the Price

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Figure 15(a/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

R

ealGDP

($Trillions)

Figure 15(c/d): GDP and the Price

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Figure 15(c/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

R

ealGDP

($Trillions)

2000:1 2001:1

Year 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 recentrecession Called trough of recession

Vertical axis shows an employment indexemployment divided byemployment at the trough

Blue line shows that employment falls during the contraction phase ofaverage cycle Rises rapidly during the first year of the expansion phase

But red and pink lines show what happened in first year of our mostrecent expansionsduring 1992 and 2002 In both cases, employment drifted slightly downward, telling us that total

number of jobs decreased during year

Figure 16: The Average Expansion

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Figure 16: The Average Expansion

Versus 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 AverageRecession

After 2001Recession

After 1991Recession

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Explaining Jobless Expansions

Since story is similar for both of these expansions,lets focus on period from late 2001 to late 2002the first year of expansion after our most recentrecession Using equation for economic growth

Real GDP = productivity x average hours x (emp/pop) xpopulation

But equation can be used in different ways Now were using equation to account for deviations in

employment away from full employment in short-run

For this purpose, well need to make someadjustments to equation Real GDP = productivity x average hours x employment

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Lets convert equation to percentagechanges

% real GDP = % productivity + %employment

Finally, rearranging% employment (-0.3%) = % real GDP (2.9%) -

% productivity (3.2%)

Numbers in parentheses show actualpercentage changes for each of thesevariables during 2002

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Why didnt 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, inspite of the low growth in output

Throughout period, firms were reluctant to hire full-time, permanentworkers

Created uncertainty about strength and duration of expansion Instead, business expanded output by hiring part-time and temporaryworkers

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 expansionphase Eventually, employment catches upeven to higher levels of output

made possible by productivity growth

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