macroeconomics, maclachlan 10/13/04 1 principles and policies i: macroeconomics chapter 9:aggregate...

Macroeconomics, Maclachlan 10/13/04

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Principles and Policies I: Macroeconomics

Chapter 9:Aggregate Demand, Aggregate Supply, and Modern

Macroeconomics


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Chapter 9 Learning ObjectivesYou should be able to …

• Discuss the historical development of macroeconomics.

• Explain the shape of the aggregate demand curve and what factors shift the curve.

• Explain the shape of the short run aggregate supply curve and what factors shift the curve.

• Explain the shape of the long-run aggregate supply curve.

• Show the effects of shifts of the aggregate demand and aggregate supply curves on price level and output in both the short run and long run.

• Discuss the limitations of the macro policy model.


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Classical Model

Equilibrium in each market leads to equilibrium in the economy as a whole.

Fallacy of composition.


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Considering the whole as more than sum of the parts.

First major macroeconomist:

John Maynard KeynesThe General Theory of

Employment, Interest and Money (1936)


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In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.--John Maynard Keynes


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The Paradox of Thrift

• This paradox of thrift is important to the Keynesian story.

• Paradox of thrift – an increase in savings can lead to a decrease in expenditures, decreasing output and causing a recession.


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The Aggregate Demand Curve

• The aggregate demand (AD) curve shows how a change in the price level changes aggregate expenditures on all goods and services in an economy.

• It shows the level of expenditures that would take place at every price level in the economy.


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The Slope of the AD Curve

• The AD is a downward sloping curve.

• Aggregate demand is composed of the sum of aggregate expenditures.

Expenditures = C + I + G +(X - M)


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The Slope of the AD Curve

• The slope of the AD curve is determined by the wealth effect, the interest rate effect, the international effect, and the multiplier effect.


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The Wealth Effect

• Wealth effect – a fall in the price level will make the holders of money and other financial assets richer, so they buy more.

• Most economists accept the logic of the wealth effect, however, they do not see the effect as strong.


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The Interest Rate Effect

• Interest rate effect – the effect a lower price level has on investment expenditures through the effect that a change in the price level has on interest rates.


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The Interest Rate Effect

• The interest rate effect works as follows:

a decrease in the price level increase of real cash

banks have more money to lend interest rates fall

investment expenditures increase


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The International Effect

• International effect – as the price level falls (assuming exchange rates do not change), net exports will rise.


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The International Effect

• The international effect works as follows:

a decrease in the price level in the U.S. the fall in price of U.S. goods relative to foreign

goods U.S. goods become more competitive

internationally U.S. exports rise and U.S. imports fall


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The Multiplier Effect

• Initial changes in expenditures set in motion a process in the economy that amplifies the initial effects.

• Multiplier effect – the amplification of initial changes in expenditures.


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The AD Curve

Pricelevel

Real output

Aggregate demand

P1

Y1

Wealth, interest rate, and international effects

Multiplier effect

Ye

P0

Y0


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Shifts in the AD Curve

• Except for a change in the price level, anything that changes aggregate expenditures shifts the AD curve.


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Shifts in the AD Curve

• The main shift factors of aggregate demand are:

– Foreign income.– Expectations about future output or prices.– Exchange rate fluctuations.– The distribution of income.– Government policies.


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Fiscal Policy

– Changing tax rates and/or government spending to influence aggregate demand.

– Expansionary macro policy shifts the curve to the right.

– Contractionary macro policy shifts it to the left.


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Effect of a Shift Factor on the AD Curve

Price level

Real output

AD0

P0

Initial effect

100

Change in total expenditures

300

AD1

Multipliereffect

200

Initial effect


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The Short-Run Aggregate Supply Curve

• The short-run aggregate supply (SAS) curve specifies how a shift in the aggregate demand curve affects the price level and real output in the short run, other things constant.


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Real output

Pric

e le

vel

The Short-Run Aggregate Supply Curve

SAS


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The Slope of the SAS Curve

• The SAS curve is upward-sloping.

• The SAS curve reflects two different types of microeconomic markets in our economy.– Auction markets – markets represented by the

supply/demand model.– Posted-price markets – prices are set by the

producers and change only infrequently.


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Shifts in the SAS Curve

• The AS curve shifts when a shift factor changes – other things are not constant:– Changes in input prices.– Changes in expectations of inflation.– Productivity.– Excise and sales taxes.– Import prices.


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The Long-Run Aggregate Supply Curve

• The LAS is vertical crossing output axis at POTENTIAL OUTPUT.

• At potential output, a rise in the price level means that all prices, including input prices rise.


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The Long-Run Aggregate Supply Curve

Long-run aggregate supply (LAS)

Pric

e le

vel

Real output


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Real output

A Range for Potential Output and the LAS Curve

Low-level potential output

High-level potential output

CSASB

A

LAS

Underutilizedresources

Overutilizedresources

P


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Shifts in the LAS Curve

• The LAS curve will shift whenever there is a changes in:– Capital.– Available resources.– Growth-compatible institutions.– Technological development.– Entrepreneurship.


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Equilibrium in the Aggregate Economy

• Changes in the SAS, AD, and LAS curves affect short-run and long-run equilibrium.


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Short-Run Equilibrium

• Short-run equilibrium is where the AS and AD curves intersect.


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Real output

Pric

e le

vel

Short-Run Equilibrium:Shift in Aggregate Demand

Y0 Y1

P1

P0 EF

AD0

AD1

SAS


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Real output

Pric

e le

vel

Short-Run Equilibrium:Shift in Aggregate Supply

Y1 Y0

P1

P0

E

G

AD

SAS1

SAS0


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Long-Run Equilibrium

• Long-run equilibrium is where the AD and long-run aggregate supply curves intersect.

• In the long run, output is fixed and the price level is variable.


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Long-Run Equilibrium:Shift in Aggregate Demand

LAS

AD0

AD1

Real output

Price level

P0

Y0

E

HP1


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Integrating the Short-Run and Long-Run Frameworks

• The economy is in both short-run and long-run equilibrium when all three curves intersect in the same location.


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Integrating the Short-Run and Long-Run Frameworks

• The ideal situation is for aggregate demand to grow at the same rate as aggregate supply and potential output.

• Unemployment and growth are at their target rates with no inflation.


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Long-Run Equilibrium

AD

SAS

YP Real output

LAS

P0

E

Pric

e le

vel


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The Recessionary Gap

• A recessionary gap is the amount by which equilibrium output is below potential output.


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• If the economy remains at this level for a long time, there would be an excess supply of factors of production.

• Costs and wages would tend to fall.


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• As factor prices fall, the SAS curve will shift down to eliminate the recessionary gap.


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Real output

Pric

e le

vel


YPY1

LAS

AD

SAS0

SAS1

P0

A

P1

B

Recessionary gap


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The Inflationary Gap

• The inflationary gap occurs when the economy is above potential that exists at the current price level.

• Factor prices rise causing the SAS curve to shift up.

• The price level rises, and the inflationary gap is eliminated.


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The Inflationary Gap

Y2YPReal

output

LAS

SAS0AD

SAS2

P0

CP2

D

Inflationary gap

Pric

e le

vel


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The Economy Beyond Potential

• When the economy operates below its potential, firms can hire additional factors of production without increasing production costs.

• Once the economy reaches its potential output, that is no longer possible.


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• As firms compete for resources, costs rise beyond productivity increases.

• The short-run AS curve shifts up and the price level rises.


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• The economy will slow down by itself or the government will step in with a policy to contract output and eliminate the inflationary gap.


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Real output

Pric

e le

vel

Expansionary Fiscal Policy

YPY0

LAS

P1

P0

AD0

AD1

AS

A


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Contractionary Fiscal Policy

Real output

Pric

e le

vel

YP Y2

LAS

ASP2

AD2

AD0

B


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Some Additional Policy Examples

• Unemployment is 12 percent and there is no inflation.

• What policy would you recommend?

• Use expansionary fiscal policy to shift the AD curve out to its potential income.


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Real output

Price level

Expansionary Fiscal Policy

P1P0

SAS

AD0

Y0 YP

AD1

B

LAS

A


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• Unemployment is at its target rate and it is likely that consumer expenditures will rise.

• What policy would you recommend?

• Use contractionary fiscal policy to shift the AD curve inward to counteract the expected increase in AD.


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Real output

Price level

Contractionary Fiscal Policy

YP

LAS

AD0

SASP1

Y1

AD2

B


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• What would have happened if the government didn’t institute a contractionary fiscal policy?

• There would be an inflationary gap which would increase factor prices.

• The SAS curve would shift up until it intersects the AD curve at YP.


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Real output

Price level

Economy Above Potential

YP

LAS

AD1

SAS0

P0

Y1

AD0

D

SAS1

C

EP1


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The Problem of Implementing Fiscal Policy

• There is no guarantee that government will do what the economy needs to be done.– Implementing government spending and tax

changes is a slow legislative process.– Government spending and tax decisions are

made for political rather than for economic reasons.


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The Problem of Estimating Potential Output

• One way of estimating potential output is to estimate the target rate of unemployment.

• Target rate of unemployment – the rate below which inflation began to accelerate in the past.

Target rate is not constant. It’s hard to tell what’s structural and what’s cyclical.


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The Problem of Estimating Potential Output

• Another way to determine potential output is to add the normal growth factor (3%) the economy’s previous level.

• Estimating the economy’s potential from past growth rates is complicated by potentially dramatic changes in regulations, technology, and expectations.


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Problem 9-3

Explain what will likely happen to the slope or position of the AD curve in the following circumstances.

a) The exchange rate changes from fixed to flexible.

When the price level changes the exchange rate will change so the international effect won’t be as strong. The curve will get steeper.


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9-3 cont.b) A fall in the price level doesn’t make people feel richer.

The wealth effect will be weaker & curve will be steeper.

c) A fall in the price level creates expectations of a further falling price level.

The curve shifts downward.

d) Income is redistributed from rich people to poor people.

Since poor people consume a greater percentage of their income, the curve shifts to the right.

e) Autonomous exports increase by 20.

Curve shifts to the right.

f) Government spending decreases by 10.

Curve shifts to the left.


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Problem 9-5

Congratulations! You have been appointed an economic policy adviser to the United States. You are told that the economy is significantly below potential output, and that the following will happen next year: World income will fall significantly; and the price of oil will rise significantly. (The United States is an oil importer.)

a) What will happen to the price level and real output?

b) What policy might you suggest to the government?

macroeconomics, maclachlan 10/13/04 1 principles and policies i: macroeconomics chapter 9:aggregate...

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