Chapter 17 Aggregate Demand and Aggregate Supply

Slides by John F. Hall

Animations by Anthony ZambelliINTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALLCHAPTER 17 / AGGREGATE DEMAND AND AGGREGATE SUPPLY©2005, South-Western/Thomson Learning

Chapter 17Aggregate Demand

and Aggregate Supply

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


The Price Level and The Money Market First effect of a change in the price level occurs in

the money market Rise in the price increases the demand for money

and 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 to rise and interest-sensitive spending to fall Equilibrium GDP decreases by a multiple of the decrease

in interest-sensitive spending


The Price Level and Net Exports The second effect of a higher price level

brings 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


Deriving The Aggregate Demand (AD) Curve

Figure 2 plots the price level on a vertical axis and the economy’s real GDP on the horizontal axis

If we continued to change the price level to other 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


Figure 2: Deriving the Aggregate Demand Curve

AD

140

100

Price Level

K

J

106 Real GDP($ Trillions)


Movements Along The AD Curve

A variety of events can cause the price level to change, and move us along the AD curve It’s important to understand what happens in the economy as we make such

a move

Opposite sequence of events will occur if the price level falls, moving us rightward along the AD curve


Shifts of The AD Curve The distinction between movements along the AD curve and

shifts 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, we move 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 of

the following• Government spending• Taxes• Autonomous consumption spending• Investment spending• The money supply curve• The money demand curve


Spending Shocks Spending shocks initially affect the economy by

changing total spending And then changing output by a multiple of that original

change in spending The AD curve shifts rightward when government

purchases, investment spending, autonomous consumption spending, or net exports increase, or when taxes decrease

The AD curve shifts leftward when government purchases, investment spending, autonomous consumption spending, or net exports decrease, or when taxes increase


Figure 3: A Spending Shock Shifts the AD Curve

100

10 15

AD1AD2

E H

Real GDP($ Trillions)

Price Level


Changes in the Money Market Changes that originate in the money market

will also shift the aggregate demand curve An increase in the money supply shifts the

AD curve rightward A decrease in the money supply shifts the AD

curve leftward


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 ↑ moves us leftward along the AD curve

Price level ↓ moves us rightward along the AD curve


Figure 4(b): 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


Figure 4(c): Effects of Key Changes on the Aggregate Demand Curve

AD2

decreasesEntire AD curve shifts leftward if:• a, IP, G, or NX decreases• Net taxes increase• The money supply decreases

(c)

Real GDP

Price Level

AD1


The Aggregate Supply Curve On the one hand, changes in the price level

affect output On the other hand, changes in output affect the

price level This relationship—summarized by the aggregate

supply curve—is the focus of this section The effect of changes in output on the price

level is complex, involving a variety of forces


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 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


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


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


The Short Run All three of our reasons are important in

explaining why a change in output affects price level They operate within different time frames

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


The Short Run 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


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


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


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.


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


Shifts of the AS Curve Figure 5 assumed that a number of important variables

remained unchanged 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.


Figure 6: Shifts of the Aggregate Supply Curve

Price Level


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


Figure 7(a): 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


Figure 7(b): 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


Figure 7(c): Effects of Key Changes on the Aggregate Supply Curve

Real GDP

Price Level(c)

AS1 AS2

Entire AS curve shifts downward if unit costs ↓ for any reason besides an decrease in real GDP


AD and AS Together: Short-Run Equilibrium

Where will the economy settle in short-run? Where is our short-run macroeconomic

equilibrium?• 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


Figure 8: Short-Run Macroeconomic Equilibrium

Price Level


140

100

AS

106 14

E

B

ADF


What Happens When Things Change? 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


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


Figure 9: The Effect of a Demand Shock

Price Level

Real GDP($ Trillions)

100

130

AS

1012.5

13.5

EJ

H

AD1

AD2

115


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


An Decrease in Government Purchases


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


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


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


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


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


Figure 10: The Long-Run Adjustment Process

Price Level

Real GDP

P2

P3

P4

P1

YFE Y3 Y2

H

E

AS2

AS1

AD2

AD1

JK



For a positive demand shock that shifts AD curve rightward, self-correcting mechanism works like this


Figure 11: Long-Run Adjustment After a Negative Demand Shock

Price Level

Real GDP

P2

AS1

P1

P3

YFEY2

AS2

AD2

AD1

E

MN



Complete sequence of events after a negative demand shock looks like this



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


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

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 Supply Curve

Price Level

Real GDPYFE

E

MAD1

AD3

K

Long-Run AS Curve

AD2


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

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


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


Figure 13: The Effect of Supply Shocks

Price Level

Real GDP

P2

P1

YFEY2

E

AS2

AS1

AD

R

Long-RunAS Curve

AS3

TP2

Y3


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 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


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


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 from higher oil prices shifted the AS curve leftward . . .

2. causing output to fall . . .

3. and the price level to rise.


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 AD curve to shift leftward . . .

5. causing output to fall . . .

Price Level

Real GDP

P2

P1

6. and the price level to fall.


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 Quarter1989:3 1990:2 1991:1

6.75

6.72

6.66

6.60

6.69

6.63

Rea

l GD

P ($

Tril

lions

)


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

Rea

l GD

P ($

Tril

lions

)

2000:1 2001:1Year and Quarter

CPI

The 2001 Recession


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


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

+80.99

1.00

1.01

1.02

1.03

1.04

+10 +12

After Average Recession

After 2001 Recession

After 1991 Recession


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


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


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

Documents

Chapter 17 Aggregate Demand and Aggregate Supply