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Economics, Arab World Edition R. Glenn Hubbard, Anthony Patrick O’Brien, Ashraf Eid, Amany El Anshasy, © Pearson Education Chapter 20 Aggregate Demand and Aggregate Supply Analysis

The Fortunes of Aramex Follow the Business Cycle 20.1Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. 20.2Identify the determinants of aggregate supply and distinguish between a movement along the short- run aggregate supply curve and a shift of the curve. 20.3Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium. 20.4Use the dynamic aggregate demand and aggregate supply model to analyze macroeconomic conditions. APPENDIX Understand macroeconomic schools of thought. Learning Objectives The global economic environment plays a crucial role in the development of the air freight industry, which has witnessed a huge boom in recent years in the Arab world. © Pearson Education 20113

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand & Aggregate Demand Learning Objective 20.1 Aggregate demand and aggregate supply model A model that explains short-run fluctuations in real GDP and the price level. © Pearson Education A country’s aggregate demand (AD) refers to total demand for the goods and services produced in that country in a year. In all our references, aggregate demand is real aggregate demand for real GDP. Aggregate demand is sum of real consumption expenditure (C), investment (I), government purchases (G), and net exports (NX): AD = C + I + G + NX. Thus AD for Bahrain is the total amount of final goods and services produced in Bahrain that people, businesses, government, and foreigners would buy. Aggregate Demand

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand Learning Objective 20.1 Aggregate demand curve A curve that shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government. © Pearson Education 20115

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand Learning Objective 20.1 GDP has four components: consumption (C), investment (I), government purchases (G), and net exports (NX). If we let Y stand for GDP, we can write the following: Y = C + I + G + NX Why Is the Aggregate Demand Curve Downward Sloping? The Wealth Effect: How a Change in the Price Level Affects Consumption The impact of the price level on consumption is called the wealth effect. © Pearson Education 20116

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand Learning Objective 20.1 The impact of the price level on investment is known as the interest-rate effect. Why Is the Aggregate Demand Curve Downward Sloping? The International-Trade Effect: How a Change in the Price Level Affects Net Exports The impact of the price level on net exports is known as the international-trade effect. The Interest-Rate Effect: How a Change in the Price Level Affects Investment © Pearson Education 20117

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand Learning Objective 20.1 An important point to remember is that the aggregate demand curve tells us the relationship between the price level and the quantity of real GDP demanded, holding everything else constant. Shifts of the Aggregate Demand Curve versus Movements Along It © Pearson Education 20118

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand Learning Objective 20.1 Changes in government policies Changes in the expectations of households and firms Changes in foreign variables The Variables That Shift the Aggregate Demand Curve The variables that cause the aggregate demand curve to shift fall into three categories: © Pearson Education 20119

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand Learning Objective 20.1 Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives. The Variables That Shift the Aggregate Demand Curve Changes in Government Policies Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as high employment, price stability, and high rates of economic growth. © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand Learning Objective 20.1 If households become more optimistic about their future incomes, they are likely to increase their current consumption. The Variables That Shift the Aggregate Demand Curve Changes in the Expectations of Households and Firms If firms and households in other countries buy fewer U.S. goods or if firms and households in the United States buy more foreign goods, net exports will fall, and the aggregate demand curve will shift to the left. Changes in Foreign Variables © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Learning Objective 20.1 In a Global Economy, How Can You Tell the Imports from the Domestic Goods? Making the Connection While the Kushari dish or falafel sandwich are obviously made in Egypt, the Big Mac, the Cheesy Bites pizza, and the Zinger dinner box are not made in the US. © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Solved Problem 20-1 Movements along the Aggregate Demand Curve versus Shifts of the Aggregate Demand Curve Learning Objective 20.1 © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand Learning Objective 20.1 The Variables That Shift the Aggregate Demand Curve Table 20-1 Variables That Shift the Aggregate Demand Curve © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand Learning Objective 20.1 The Variables That Shift the Aggregate Demand Curve Table 20-1 Variables That Shift the Aggregate Demand Curve (continued) © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Supply Learning Objective 20.2 The long-run aggregate supply curve shows the relationship between the quantity of real GDP supplied and the price level in the long run when real GDP equals potential GDP. LRAS curve is shown in figure2. © Pearson Education Aggregate supply (AS) shows the total supply of all goods and services (or real GDP) produced in the economy per month or year. A country can supply more real GDP if its technology improves and has more factors of production such as labor and capital and other inputs (or resources). The Long-Run Aggregate Supply Curve

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Supply Learning Objective 20.2 © Pearson Education long run, real GDP is the same for all price level. In the long run, the level of output or real GDP is determined by the amounts of capital and labor and by the available technology. Thus, it does not depend on the price level. As you know LRAS curve is vertical at potential real GDP (YP). Thus, as you see in figure 2 above, when potential real GDP increases LRAS supply curve shift to the rightward and when potential real GDP decreases LRAS supply curve shift to the leftward. Remember, change in potential GDP means shift in production possibilities frontier (PPF) and the PPF shifts when economic resources such as labor, capital and technology change. Thus, the same factors that shift PPF (or potential GDP) will also shift the LRAS curve. These factors are: 1. Change in the full-employment of labor 2. Change in the quantity of capital 3. Change (improvement) in technology

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Supply Learning Objective 20.2 © Pearson Education Short-run aggregate supply curve A curve that shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms. The three most common explanations as to why a short- run aggregate supply curve slopes upward include: Contracts make some wages and prices “sticky.” Firms are often slow to adjust wages. Menu costs make some prices sticky. Menu costs The costs to firms of changing prices.

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Supply Shifts of the Short-Run Aggregate Supply Curve versus Movements Along It It is important to remember the difference between a shift in a curve and a movement along a curve. Movement Along the SAS Curve Only changes in the price level cause movement along a SAS curve. For example, changes in price level from P0 to P1 would cause a movement from point A to point B along the SAS curve in.

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Supply Learning Objective 20.2 Variables That Shift the Short-Run Aggregate Supply Curve: 1. Expected Changes in the Future Price Level FIGURE 20.3 How Expectations of the Future Price Level Affect the Short-Run Aggregate Supply © Pearson Education Technological Change 3. Expected Changes in the Future Price Level

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Supply Learning Objective 20.2 Variables That Shift the Short-Run Aggregate Supply Curve Adjustments of Workers and Firms to Errors in Past Expectations about the Price Level Unexpected Changes in the Price of an Important Natural Resource Supply shock An unexpected event that causes the short-run aggregate supply curve to shift. © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Supply Learning Objective 20.2 Variables That Shift the Short-Run Aggregate Supply Curve Table 20-2 Variables That Shift the Short-Run Aggregate Supply Curve © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate Supply Learning Objective 20.2 Variables That Shift the Short-Run Aggregate Supply Curve Table 20-2 Variables That Shift the Short-Run Aggregate Supply Curve (continued) © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Macroeconomic Equilibrium in the Long Run and the Short Run Short-Run Macroeconomic equilibrium Short-Run Macroeconomic equilibrium occurs at the intersection of SRAS and AD curves as shown in figure.

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Macroeconomic Equilibrium in the Long Run and the Short Run Learning Objective 20.3 FIGURE 20.4 Long-Run Macroeconomic Equilibrium © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Macroeconomic Equilibrium in the Long Run and the Short Run Learning Objective The economy has not been experiencing any inflation. The price level is currently 100, and workers and firms expect it to remain at 100 in the future. 2 The economy is not experiencing any long-run growth. Potential real GDP is $10.0 trillion and will remain at that level in the future. Recessions, Expansions, and Supply Shocks Because the full analysis of the aggregate demand and aggregate supply model can be complicated, we begin with a simplified case, using two assumptions: © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Macroeconomic Equilibrium in the Long Run and the Short Run Learning Objective 20.3 Recessions, Expansions, and Supply Shocks The Short-Run and Long-Run Effects of a Decrease in Aggregate Demand © Pearson Education FIGURE 20.5 initially the economy at short run equilibrium A at the potential GDP, a decline in investment is going to shaft AD1 to AD2, new SRE at B, RGDP is below PGDP. This will result in declining profitability for many firms and layoffs some workers: the economy in recessions. Adjustment In the long-run: as the price level has fallen at B. workers & firms will adjust to the price level. Workers will accept lower wages, unemployment will make more workers willing to accept lower wages. Thus SRAS will shaft to right (SRAS1 To SRAS2) at point C (long –run Equilibrium). This is adjustment called automatic mechanism.

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Macroeconomic Equilibrium in the Long Run and the Short Run Learning Objective 20.3 Expansion FIGURE 20.6 The Short-Run and Long- Run Effects of an Increase in Aggregate Demand © Pearson Education initially the economy at equilibrium at A. an increase in investment → AD1 to AD2 at B. the RGDP rises and above PGDP the economy at SRE. But a rise in price level at B, workers & firms will adjust to the price level. In the long-run with lower level of unemployment Workers will push wages to higher level. So the SRAS will shaft from SRAS1 to SRAS2, the economy will be back to long-run equilibrium. This is an automatic mechanism.

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Macroeconomic Equilibrium in the Long Run and the Short Run Learning Objective 20.3 Stagflation A combination of inflation and recession, usually resulting from a supply shock. Supply Shock © Pearson Education Supply Shock: an increase in Oil prices, it will increase many firms’ costs and cause the SRAS to shift to left. And it will cause Stagflation. The recession caused by a supply shock increases unemployment and reduces output. As in figure 20.7-A The recession caused by a supply shock eventually leads to falling wages and prices, shafting SRAS back to its original position. As in figure 20.7-B

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Macroeconomic Equilibrium in the Long Run and the Short Run Learning Objective 20.3 FIGURE 20.7 The Short-Run and Long-Run Effects of a Supply Shock Supply Shocks © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis A Dynamic Aggregate Demand and Aggregate Supply Model Learning Objective 20.4 Potential real GDP increases continually, shifting the long-run aggregate supply curve to the right. During most years, the aggregate demand curve will be shifting to the right. Except during periods when workers and firms expect high rates of inflation, the short-run aggregate supply curve will be shifting to the right. We can create a dynamic aggregate demand and aggregate supply model by making three changes to the basic model. © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis A Dynamic Aggregate Demand and Aggregate Supply Model Learning Objective 20.0 FIGURE 20.8 A Dynamic Aggregate Demand and Aggregate Supply Model © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis A Dynamic Aggregate Demand and Aggregate Supply Model Learning Objective 20.4 FIGURE 20.9 Using Dynamic Aggregate Demand and Aggregate Supply to Understand Inflation What Is the Usual Cause of Inflation? © Pearson Education If AD shifts to the right by more than LRAS at B we will have inflation. The SRAS has shifted to the right by less than LRAS.

Chapter 20: Aggregate Demand and Aggregate Supply Analysis A Dynamic Aggregate Demand and Aggregate Supply Model Learning Objective 20.4 A decline in global aggregate demand and in the Arab world The Slow Recovery from the Recession of 2009 A decline in the world demand for oil led to a large drop in its prices Recessionary trends in the Arab world economies The recession of 2009 was caused The recession was caused by the financial crises that started in the US and expanded to the whole world by the end of © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis A Dynamic Aggregate Demand and Aggregate Supply Model Learning Objective 20.4 The Slow Recovery from the Recession of 2009 FIGURE Using Dynamic Aggregate Demand and Aggregate Supply to Understand the Recovery from the 2009 Recession © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Learning Objective 20.4 Saudi’s Slow Economic Recovery Making the Connection Following a stagnant and a difficult year in 2009, Saudi Arabia’s economic recovery in 2010 and 2011 seems to follow a gradual but steady path of an accelerating growth performance. © Pearson Education During a recession, businesses suffer from slower demand and less consumer spending. As a result, investment shrinks.

Chapter 20: Aggregate Demand and Aggregate Supply Analysis A Dynamic Aggregate Demand and Aggregate Supply Model Learning Objective 20.4 The More Rapid Recovery of 2010–2011 FIGURE Using Dynamic Aggregate Demand and Aggregate Supply to Understand the More Rapid Recovery of 2010–2011 © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Solved Problem 20-4 Showing the Oil Shock of 1974–1975 on a Dynamic Aggregate Demand and Aggregate Supply Graph Learning Objective 20.4 © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Learning Objective 24.4 Can FedEx and the US Economy Withstand High Oil Prices? Making the Connection FedEx’s trucks and jets have become more fuel efficient. © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis Aggregate demand and aggregate supply model Aggregate demand curve Fiscal policy Long-run aggregate supply curve Menu costs Monetary policy Short-run aggregate supply curve Stagflation Supply shock K e y T e r m s © Pearson Education

Chapter 20: Aggregate Demand and Aggregate Supply Analysis