Transcript ECONOMICS

CHAPTER
Aggregate Demand
and Aggregate Supply
Chapter 15
1
The Price Level
•Up to this point, we have not said much
about prices and the price level (P)
•In this chapter we derive the:
• Aggregate Demand curve which shows the
relation between aggregate expenditure (AE)
and the price level (P)
• Aggregate Supply curve shows the relation
between aggregate production and the price
level (P)
2
Derivation of Aggregate Demand (AD) Curve
• Start with money demand. An increase in
the price level shifts the money demand
curve rightward
– increasing the equilibrium interest rate (if
the Fed does not increase the money supply)
– causing the aggregate expenditure line to
shift downward
– resulting in a lower equilibrium level of
GDP.
3
Deriving the Aggregate Demand Curve (a)
Interest
Rate
9%
6%
MS
B
As the price level, say the
CPI, increases from 100 to
140, money demand
increases and the interest
rate rises.
A
M2 d
M1 d
500
Money ($ billions)
4
Deriving the Aggregate Demand Curve (b, c)
Real Aggregate
Expenditure
($ Trillions)
AEr=6%
E
AEr=9%
F
The rise in the interest rate
causes real GDP to fall.
45°
6
10
Price level
On the AD curve, a higher price level is
associated with a lower real GDP.
K
140
Real GDP ($ Trillions)
H
100
AD
6
10
Real GDP ($ Trillions)
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5
The Aggregate Demand Curve
• a curve indicating equilibrium GDP at
each price level, with a constant money
supply
• its NOT a demand curve at all!
• it is actually an “equilibrium-output-ateach-price-level” curve
6
The Aggregate Demand Curve
• Movements along the AD curve
– a change in the price level causes equilibrium
GDP to change
This inverse relationship between P and Y caused
by the change in the interest rate is called the
interest rate effect
7
The Aggregate Demand (AD) Curve
• Another reason for a downward-sloping
aggregate demand curve is the Real
Wealth Effect
• This is the change in consumption
brought about by a change in real
wealth that results from a change in
the price level.
Nominal and Real Wealth
Nominal Wealth (W) = Assets – Liabilities
W
Real Wealth is the purchasing power of wealth =
P
Two things change real wealth: W or P
As P↓ => (W/P)↑ => C↑=> AE↑ => Y↑
C
AE1
B
AE0
A
450
Y0
Y1
Y
As P ↑ =>(W/P) ↓ => C ↓ => AE ↓ => Y ↓
P and Y move in opposite directions. The AD curve
Slopes downward to the right.
What shifts the AD curve ?
• Changes in any of the variables that
shift the AE curve:
–
–
–
–
–
–
Government purchases (G)
Planned Investment spending (IP)
Autonomous consumption spending (a)
Taxes (T)
Net exports (NX)
The money supply (M)
11
The Aggregate Demand Curve
• AD curve shifts rightward when:
– Government purchases (G) increase
– Planned Investment spending (IP) increases
– Autonomous consumption spending (a)
increases
– Net exports increase
– Net taxes decrease
– Money supply increases
12
A Spending Change Shifts the AD Curve
Real Aggregate
Expenditure
($ Trillions)
AE2
F
At any given price level, an increase
in government purchases shifts the
AE line upward, raising real GDP.
Get the multiplier effect we
introduced in chapter 11.
AE1
E
45°
10
12.5
Real GDP ($ Trillions)
Price level
Since real GDP is higher at the
given price level, the AD curve
shifts rightward.
H to J is the multiplier effect we
introduced in chapter 11
J
100
H
AD1
10
12.5
AD2
Real GDP ($ Trillions)
13
Change in Price Level Moves Along the AD Curve (a)
Price
Level
Price level ↑ moves us
leftward along the AD curve
P3
Price level ↓ moves
us rightward along
the AD curve
P1
P2
AD
Q3
Q1
Q2
Real GDP
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14
Effects of Key Changes on the Aggregate Demand Curve (b, c)
Price Level
Price Level
AD2
AD1
Real GDP
Entire AD curve shifts rightward if:
• a, Ip, G, or NX increases
• Net taxes decrease
• The money supply increases
AD1
AD2
Real GDP
Entire AD curve shifts leftward if:
• a, Ip, G, or NX decreases
• Net taxes increase
• The money supply decreases
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
15
The Aggregate Supply Curve
Assumptions:
• Firms set the price of their products as a
markup over unit cost of production
p = unit cost + mark-up
• Average percentage markup in the
economy is determined by competitive
conditions in the economy
– so we treat the mark-up as stable (fixed)
from year to year
• The competitive structure of the economy
changes very slowly
16
The Aggregate Supply Curve
• In general, changes in GDP affects unit
costs of production
– As total GDP(output) increases:
greater amounts of inputs are needed to
produce the greater output
• the prices for non-labor inputs rise
• the price of labor, the nominal wage rate,
can also increase (but we make an
assumption about this in the short-run!)
•
17
The Aggregate Supply Curve
• We assume that in the short-run the
price of labor, nominal wages, are
“fixed”, “sticky”
– union contracts
– can be costly to firms
– reputation for paying stable wages
– slow-moving bureaucracies
• THIS IS A KEY ASSUMPTION!!!
– nominal wage rate is fixed in the short run
– changes in output have no effect on the
nominal wage rate in the short run
18
The Aggregate Supply Curve
• In the short run, a change in output will
affect non-labor costs of production
– a rise in real GDP raises firms’ unit costs
• Input requirements increase: coal, oil lumber,
copper,…….
• The prices of these non-labor inputs rise
– A decrease in real GDP lowers unit costs
• Input requirements decrease
• Prices of non-labor inputs fall
19
The Aggregate Supply Curve
• Aggregate Supply (AS) curve
– a curve indicating the price level
consistent with firms’ unit costs and
markups for any level of output (Y) in the
short run
– it is actually a “short-run-price-level-ateach-output-level” curve
– its upward sloping
• Price level on the vertical axis
• Total output on the horizontal axis
20
The Aggregate Supply Curve
Price
Level
AS
B
130
Starting at point A, an increase in
output raises unit costs. Firms
raise prices, and the overall price
level rises.
A
100
80
Starting at point A, a decrease in
output lowers unit costs. Firms cut
prices, and the overall price level
falls.
C
6
10
12.5 Real GDP
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21
The Aggregate Supply Curve
• Movements along the AS curve
– A change in real GDP causes the price level to
change
Wages are sticky! Labor costs do not change in the short-run.
Another View of the Aggregate Supply Curve
• In the short run there must be a lag between
changes in output prices and changes in
input prices, otherwise the aggregate supply
(price/output response) curve would be
vertical.
• If input and output prices rise by the same
percentage amount, no firm would find it
advantageous to change its level of output.
Slope Matters!
Shape of the Short-run Aggregate Supply
Curve - Ordinary Conditions
Moderate Levels of :
Unemployment Unemployment Rate: 5 10%
Some excess Capacity Ex. Cap Rate: 10-25%
AS exhibits a Positive
Slope
Aggregate Supply Curve - Ordinary Conditions
Implications
With the positive slope:
Change in output (Y)
causes a moderate
change in the price level
(P)
Shape of the Short-run Aggregate Supply
Curve - Slack Conditions
High Levels of:
• Unemployment Unemployment Rate > 10%
• Lot of excess Capacity
- Ex Cap Rate > 25%
• AS is Almost Flat
•26 of
Shape of the Short-run Aggregate Supply
Curve - Slack Conditions - Implications
With a flat slope:
The economy can
expand a lot with
small increase in P
because of the
excess capacity.
Shape of the Short-run Aggregate Supply
Curve - Tight Conditions
Low Levels of:
Unemployment Unemployment Rate < 3%
Little excess CapacityEx Cap Rate < 10%
• AS is Very Steep
Shape of the Short-run Aggregate Supply Curve Tight Conditions - Implication
AS
Large increase in
P for a relatively
small increase in
GDP (Y).
•29 of
The Aggregate Supply Curve is not a straight line
Capacity
[--Slack-----]
[--Ordinary--] [--Tight--]
What Causes the Aggregate Supply Curve to Shift?
• Increase in AS means the AS curve shifts downward:
–
–
–
–
–
Lower world oil prices
Good weather
Technological change
Regulation
Lower nominal wages
• Decrease in AS means the AS curve shifts
upward:
– Higher world oil prices
–
–
–
–
Bad weather
Technological change(negative?), stupid pills(?)
Regulation
Higher nominal wages
31
Shift of the Aggregate Supply Curve
Price
Level
AS2
AS1
L
140
100
A
10
When unit costs rise at any given real
GDP—e.g., from an increase in world
oil prices or bad weather for farm
production—the AS curve shifts
upward.
Real GDP
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
32
Effects of Key Changes on the Aggregate Supply Curve (a)
Price
Level
AS
Real GDP ↑ moves us
rightward along the AS curve
P2
P1
Real GDP ↓ moves us
leftward along the AS curve
P3
Y3
Y1
Y2
Real GDP
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
33
Effects of Key Changes on the Aggregate Supply Curve (b, c)
Price Level
Price Level
AS2
AS1
AS1
Real GDP
Entire AS curve shifts
upward if unit costs ↑ for
any reason besides an
increase in real GDP
AS2
Real GDP
Entire AS curve shifts
downward if unit costs ↓
for any reason besides a
decrease in real GDP
34
AD and AS: Short-Run Equilibrium
• Short-run macroeconomic equilibrium
– a combination of price level and GDP
consistent with both the AD and AS curves
35
Short-Run Macroeconomic Equilibrium
Price
Level
Excess Supply B
140
E
100
F
80
Excess Demand
6
10
14
AD
Real GDP
At point E, the price level of 100 is consistent with an output of $10 trillion
along the AD curve. The output level of $10 trillion is consistent with a price
level of 100 along the AS curve. At any other combination of price level and
output, such as point F or point B, at least one condition for equilibrium will
not be satisfied.
36
Short-Run Macroeconomic Equilibrium
Price
Level
Excess Supply B
140
E
100
F
80
Excess Demand
AD
At point B, AS > AD.
Excess Supply.
P will fall from 140 to
100 and Y will fall
from 14 to 10.
As P and Y fall, the
interest rate falls
which means C and Ip
increases causing AD
to increase.
Movements along the
curves!
6
10
14
Real GDP
The is a lot more complicated than the basic AE model presented
in chapters 10 and 11 where only Y fell as inventories increased.
Here, Y, P , money demand, the interest rate(r) and AE all adjust.
37
Short-Run Macroeconomic Equilibrium
At point F, AD > AS.
Excess Demand.
Price
Level
P will increase from
80 to 100 and Y will
increase from 6 to 10.
Excess Supply B
140
E
100
F
80
Excess Demand
6
10
14
AD
As P and Y increase,
the interest rate rises
which means C and
Ip fall causing AD to
decrease
Real GDP Movements along the
curves!
The is a lot more complicated than the basic AE model presented
in chapters 10 and 11 where only Y fell as inventories decreased.
Here, Y, P , money demand, the interest rate(r) and AE all adjust.
38
What Happens When Things Change?
• Demand shock
– this is any event that causes the AD curve
to shift
– for example, a change in government
purchases or a change in the money
supply
• Supply shock
– an event that causes the AS curve to shift
– e.g., increase or decrease in world oil
price, regulation, nominal wages.
39
The Effect of a Demand Shock: Increase G
Price
Level
AS
N
Starting at point E, an
increase in
government
purchases would shift
the AD curve
rightward to AD2
110
E
100
J
Relate back to the
Keynesian 450 graph.
AD2
Multiplier= (1/(1-MPC).
AD1
10.0 11.5 12.5
Real GDP
$ Trillions
Point J illustrates where the economy would move if the price
level remained constant; multiplier = (1/(1-MPC).
But, as output increases, the price level rises. Thus, the
economy moves along the AS curve from point E to point N.
40
What Happens When Things Change?
• Increase in government purchases
Crowding-out of interest-sensitive spending. Multiplier is less
than (1/(1-MPC). Inflation and rising interest rates reduce the
size of the multiplier.
The Effect of a Demand Shock
• As P increases, money demand increases.
If the money supply is constant, the
interest rate rises and crowds-out interest
sensitive investment and consumer
spending. Move up along the AD curve
from point J to N.
•Crowding-out of interest-sensitive spending
means the size of the multiplier is reduced.
•Inflation and the increase in the interest rate
reduce the size of the multiplier.
What Happens When Things Change?
• Decrease in government purchases
Crowding-in of interest-sensitive spending. Multiplier is larger
than (1/(1-MPC). Falling prices and falling interest rates
increase the size of the multiplier.
43
What Happens When Things Change?
• Increase in money supply
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44
To sum up the short-run • A positive demand shock
– shifts the AD curve rightward
– increases both real GDP and the price
level in the short run
• A negative demand shock
– shifts the AD curve leftward
– decreases both real GDP and the price
level in the short run
45
Demand Shocks: Adjusting to Long Run
• In the short run we treat the wage rate
and labor costs as given
• In the long run
– the wage rate will change
– when output is above full employment
• Wage rate will rise, shifting the AS curve
upward
– when output is below full employment
• Wage rate will fall, shifting the AS curve
downward
46
Demand Shocks: Adjusting to Long Run
• Self-correcting mechanism
– the adjustment process where price and
wage changes return the economy to fullemployment output in the long run
• If a demand shock pulls the economy
away from full employment
– changes in the wages and the price level
will eventually cause the economy to
correct itself and return to full-employment
output
47
Demand Shocks: Adjusting to Long Run
• Positive demand shock
NOTE: Y >YFE => U <Un
48
Long-Run Adjustment after a Positive Demand Shock
AS2
Price
Level
AS1
L
P4
P2
P1
In the short-run the
economy moves to point N,
output is above the fullemployment level, YFE.
N
E
AD2
AD1
YFE
Y2
St point E, a positive
demand shock would shift
the aggregate demand
curve to AD2, raising both
output and the price level.
Real GDP
Firms compete to hire
scarce workers, driving up
the wage rate. In the longrun the higher wage rate
will shift the AS curve to
AS2.
The economy returns to
full-employment output at
point L in the long-run.
49
Demand Shocks: Adjusting to Long Run
• Negative demand shock
NOTE: Y <YFE => U >Un
50
Long-Run Adjustment after a Negative Demand Shock
AS1
Price
Level
AS2
E
P1
P2
N
P3
M
AD1
AD2
Y2
YFE
Real GDP
Starting from point E, a negative demand shock shifts the AD curve to AD2, lowering
GDP and the price level. In the short-run, output is below the full-employment level at
point N. With unemployed labor available, wages and unit costs will fall, causing firms
to lower their prices. The AS curve shifts downward until full employment is regained
at point M, with a lower price level in the long-run.
51
Demand shock : The self-correcting
mechanism in the long-run
• When output exceeds its full-employment
level
– Wages will eventually rise
– Causing a rise in the 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 the price level and a rise in
GDP until full employment is restored
52
Long-run Aggregate Supply Curve
• Long-run aggregate supply curve
– A vertical line
– Indicating all possible output and pricelevel combinations at which the economy
could end up in the long run
• The self-correcting mechanism
– Shows us that, in the long run, the
economy will eventually behave as the
classical model predicts
53
The Long-Run AS Curve
Price
Level
Long-Run AS Curve
AS2
AS1
L
P4
P2
P1
N
E
AD2
AD1
YFE
Y2
Real GDP
This figure illustrates a
positive demand shock, but
focuses on the long-run
effects. The initial equilibrium
is at point E, with output at full
employment (YFE) and price
level P1. After the positive
demand shock and all the
long-run adjustments to it, the
economy ends up at point L
with a higher price level (P4),
but the same full-employment
output level (YFE). The longrun AS curve—a vertical
line—shows all possible
combinations of price level
and output for the economy,
skipping over the short-run
changes. The vertical, longrun AS curve shows that in
the long run, demand shocks
can affect the price level but
not output.
54
Supply Shocks
• Negative supply shock. In the short run
– the AS curve shifts upward
• Decreasing output and increasing the price
level
– causes stagflation (falling output and
rising prices)
• Positive supply shock. In the short run
– the AS curve shifts downward
• Increasing output and decreasing the price
level
55
The Effect of a Negative Supply Shock
Price
Level
Long-Run AS Curve
AS2
AS1
A negative supply shock
would shift the AS curve
upward from AS1 to AS2.
In the short-run, equilibrium
is at point R, the price level
is higher and output (Y2) is
below YFE.
R
P2
E
Eventually, wages will fall,
causing unit costs to fall,
and the AS curve will shift
back down to its original
position.
P1
AD
Y2 YFE
Real GDP
56
The Effect of a Positive Supply Shock
Price
Level
Long-Run AS Curve
AS1
AS2
A positive supply shock
would shift the AS curve
down from AS1 to AS2. In
the short-run equilibrium at
point R, the price level is
lower and output is above
YFE.
Eventually, wages will rise,
causing unit costs to rise,
and the AS curve will shift
back up to its original
position.
E
P1
R
P2
AD
YFE
Y2
Real GDP
57
Supply Shocks
• In the long run
– The economy self-corrects after a longlasting supply shock
– When output differs from its fullemployment level
• The wage rate changes
• AS curve shifts until full employment is
restored
58
The Story of Two Recessions
• The recession of 1990-91
– a supply-shock recession
– caused by a reduction in oil supply
• Price of oil doubled
• The recession of 2008-09
– a powerful, negative demand shock
• Home prices – falling
• Stock prices – plunged
59
An AD and AS Analysis of Two Recessions:
1990-91Recession
Price
1. In 1990, a supply shock
Level
AS1991
P2
from higher oil prices
shifted the AS curve
leftward …
AS1990
R
E
P1
AD1990
3. and the price
level to rise
Y2
YFE
2. causing
output to fall…
Real GDP
60
An AD and AS Analysis of Two Recessions:
2008-09 Recession
4. In 2008-09, a demand shock from several
factors caused the AD curve to shift leftward …
Price
Level
AS2007
E
P1
P2
AD2007 5. causing
output to fall…
R
AD2009
6. and the price
level to fall
Y2
YFE
Real GDP
61
GDP and the Price Level in Two Recessions
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62
More Real World Examples
The Aggregate Supply Curve is not a straight line
Expansionary policy is
inflationary and has small
impact on aggregate output (Y)
P4
AD4
P3
AD3
Expansionary policy is not
inflationary and has relatively
large impact on aggregate
output (Y)
P2
P1
AD2
AD1
[--Slack-----]
Capacity
[--Ordinary--] [--Tight--]