Chapter 14 Aggregate Demand and Supply Lecture Slides Survey of Economics Irvin B. Tucker © 2016 south-Western, a part of Cengage Learning

What will I learn in this chapter? How to use an aggregate demand and supply model to explain the business cycle © 2016 south-Western, a part of Cengage Learning

What is the aggregate demand curve (AD)? The curve shows the level of real GDP purchased by consumers, businesses, government, and foreigners (net exports) at different possible price levels during a time period, ceteris paribus © 2016 south-Western, a part of Cengage Learning

The vertical axis measures the average price of goods and services in the economy using the CPI The horizontal axis measures the value of final goods and services included in real GDP measured in base year dollars © 2016 south-Western, a part of Cengage Learning

Decrease in the real GDP demanded Increase in the real GDP demanded Increase in the price level Decrease in the price level © 2016 south-Western, a part of Cengage Learning

Exhibit 14-1 The Aggregate Demand Curve 400 300 A Price Level (CPI) B 200 100 AD 4 8 12 16 20 24 Real GDP 6 © 2016 south-Western, a part of Cengage Learning (trillions of dollars per year)

Why does the aggregate demand curve slope downward to the right? Real balances effect Interest-rate effect Net exports effect © 2016 south-Western, a part of Cengage Learning

What is the real balances effect? Consumers spend more on goods and services because lower prices make their dollars more valuable © 2016 south-Western, a part of Cengage Learning

What is the interest-rate effect? Assuming a fixed money supply, an increase in the price level increases borrowing demand and in turn higher interest rates, which discourages consumer spending. © 2016 south-Western, a part of Cengage Learning

What is the net exports effect? A higher domestic price level makes U.S. goods more expensive compared to foreign goods. As a result, exports (x) decrease and imports (m) increase, which decreases real GDP through the net exports component (x - m). © 2016 south-Western, a part of Cengage Learning

11 © 2016 south-Western, a part of Cengage Learning

What can cause a shift in the aggregate demand curve? Any of the components of GDP: Consumption ( ), investments (I), government spending (G), or net exports (X-M) can change and shift the AD curve C © 2016 south-Western, a part of Cengage Learning

Decrease in C,I, G, (X-M) Increase in C,I, G, (X-M) Increase in the aggregate demand curve Decrease in the aggregate demand curve Decrease in C,I, G, (X-M) Increase in C,I, G, (X-M) © 2016 south-Western, a part of Cengage Learning

Exhibit 14-3 An increase in the Aggregate Demand Curve 400 300 Price Level (CPI) A B 200 AD2 100 AD1 4 8 12 16 20 24 Real GDP 14 © 2016 south-Western, a part of Cengage Learning (trillions of dollars per year)

What is the aggregate supply curve (AS)? The curve that shows the level of real GDP produced at different price levels during a time period, ceteris paribus There are two opposing theories for the shape of the AS curve: (1) Keynesian view and (2) Classical view © 2016 south-Western, a part of Cengage Learning

Who is John Maynard Keynes? Keynes was a famous Cambridge University economist who wrote The General Theory of Employment, Interest, and Money published in 1936. © 2016 south-Western, a part of Cengage Learning

What is the Keynesian view of the AS curve? When there is a severe recession, Keynes argued that a horizontal (flat) supply curve exists because product prices and wages are fixed or rigid © 2016 south-Western, a part of Cengage Learning

Why did Keynes assume fixed product prices and wages? During a deep recession or depression, there are many idle resources in the economy © 2016 south-Western, a part of Cengage Learning

Why do idle resources cause fixed prices? Firms are willing to sell products at current prices because there are no shortages to put upward pressure on prices © 2016 south-Western, a part of Cengage Learning

Why do idle resources result in fixed wages? Unemployed workers willing to work for the prevailing wage diminish the power of employed workers to increase their wages Union contracts prevent business from lowering wage rates © 2016 south-Western, a part of Cengage Learning

According to Keynes, government spending must be used to increase aggregate demand and restore a depressed economy to full employment © 2016 south-Western, a part of Cengage Learning

Price level remains constant, while real GDP and employment rise Aggregate demand increases and the economy moves from E1 to E2 Government spending (G) increases © 2016 south-Western, a part of Cengage Learning

Exhibit 14-4 The Keynesian Horizontal Aggregate Supply Curve 400 300 E1 E2 Price Level (CPI) 200 AS AD2 100 AD1 Full employment 4 8 12 16 20 24 Real GDP © 2016 south-Western, a part of Cengage Learning (trillions of dollars per year) 23

What is the classical view of the aggregate supply curve? A vertical line at the full-employment real GDP © 2016 south-Western, a part of Cengage Learning

According to the classical economists, where does the economy normally operate? The economy normally operates at full- employment real GDP because markets will adjust in a short period of time without government intervention © 2016 south-Western, a part of Cengage Learning

Competition from unemployed workers reduces the wage rate Unlike Keynes, Classical economists believed in flexible prices and wages. A decrease in the AD curve creates a surplus of unsold goods. Firms cut prices and layoff workers. Competition from unemployed workers reduces the wage rate As prices fall, consumers increase their spending downward along the AD curve according to the real balances effect © 2016 south-Western, a part of Cengage Learning

The economy moves to a level of full employment Unemployment causes a decrease in prices Aggregate demand decreases at full employment © 2016 south-Western, a part of Cengage Learning

Exhibit 14-5 The Classical Aggregate Supply Curve 400 Surplus E1 300 E' Price Level (CPI) E2 200 AD1 100 AD2 Full employment 4 8 12 16 20 24 Real GDP (trillions of dollars per year) 28 © 2016 south-Western, a part of Cengage Learning

Why is the AS curve upward-sloping in the intermediate range? Bottlenecks (obstacles to output flows) develop because firms can not fill orders and raise their prices Labor shortages make wage increase demands difficult to reject Production costs rise as firms use less skilled labor and machinery to fill orders © 2016 south-Western, a part of Cengage Learning

Exhibit 14-6 Three Ranges of the Aggregate Supply Curve AS Classical Range Price Level (CPI) Intermediate Range Full employment Keynesian Range YK YF 30 Real GDP © 2016 south-Western, a part of Cengage Learning

How is macro equilibrium determined? Equilibrium occurs where the aggregate demand curve equals the aggregate supply curve © 2016 south-Western, a part of Cengage Learning

Exhibit 14-7 The Aggregate Demand and Aggregate Supply Model AS 500 400 300 Price level (CPI) E 200 100 AD - GDP gap Full employment 0 4 12 20 24 8 16 Real GDP © 2016 south-Western, a part of Cengage Learning (trillions of dollars per year)

How do increases in the AD curve affect the price level and real GDP? Along the Keynesian range, real GDP increases while the price level remains constant Along the intermediate range, both real GDP and the price level increase Along the classical range, the price level rises while real GDP remains at the full- employment level © 2016 south-Western, a part of Cengage Learning

Exhibit 14-8 Effects of Increases in Aggregate Demand 400 E4 300 AD5 E3 Price Level (CPI) E1 E2 AD4 200 AD3 AD2 100 AD1 Full employment 4 8 12 16 20 Real GDP 34 © 2016 south-Western, a part of Cengage Learning (trillions of dollars per year)

Exhibit 14-9 Effect of Decreases in Aggregate Demand During the Recession of 2008-2009 (actual data) Price level (CPI) 219 E2 E3 212 AD1 AD3 AD2 Q3 2008 Q2 2009 Q4 2008 14.3 14.6 14.9 15.5 Real GDP © 2016 south-Western, a part of Cengage Learning (trillions of dollars per year)

What are some examples of factors that would cause a rightward shift in the AS curve? Lower labor costs Lower oil prices Lower taxes Reduced government regulations © 2016 south-Western, a part of Cengage Learning

Exhibit 14-10 A Rightward Shift in the Aggregate Supply Curve 250 AS1 AS2 200 E1 175 E2 150 Price Level (CPI) 100 AD 50 Full employment 4 8 10 12 16 20 Real GDP 37 © 2016 south-Western, a part of Cengage Learning (trillions of dollars per year)

What are the two types of inflation? Cost push Demand pull © 2016 south-Western, a part of Cengage Learning

What is cost-push inflation? A rise in the general price level resulting from an increase in the cost of production that causes the AS curve to shift leftward © 2016 south-Western, a part of Cengage Learning

Nonprice-Level Determinants of Aggregate Supply Exhibit 14.11 Summary of the Nonprice – Level Determinants of Aggregate Demand and Aggregate Supply Nonprice-Level Determinants of Aggregate Demand (total spending) Nonprice-Level Determinants of Aggregate Supply 1. Consumption (c) 1. Resource prices (domestic and imported) 2. Investment (I) 2. Taxes 3. Government spending (G) 3. Technological change 4. Net exports (X – M) 4. Subsidies 5. Regulation © 2016 south-Western, a part of Cengage Learning

Exhibit 14-12(a) Cost - Push Inflation AS74 AS73 E2 49.3 Price Level (CPI) E1 44.4 AD Full employment 5,390 5,418 Real GDP 41 © 2016 south-Western, a part of Cengage Learning (billions of dollars per year)

High unemployment and rapid inflation exist simultaneously What is stagflation? High unemployment and rapid inflation exist simultaneously © 2016 south-Western, a part of Cengage Learning

What is demand-pull inflation? A rise in the general price level resulting from an excess of total spending caused by a rightward shift in the AD curve. © 2016 south-Western, a part of Cengage Learning

Exhibit 14-12(b) Demand- Pull Inflation AS Price Level (CPI) E2 32.4 AD66 31.5 E1 AD65 Full Employment 3,973 4,235 Real GDP © 2016 south-Western, a part of Cengage Learning (billions of dollars per year) 44

What determines the business cycle? Shifts in the aggregate demand and aggregate supply curves © 2016 south-Western, a part of Cengage Learning

What happens when both curves increase? That depends on how much each increases © 2016 south-Western, a part of Cengage Learning

Increase in price level Increase in aggregate demand and supply Increase in real GDP Increase in aggregate demand and supply © 2016 south-Western, a part of Cengage Learning

Exhibit 14-13 Rightward Shift in Aggregate Demand and Supply Curves AS95 AS00 Price Level (CPI) E2 172 E1 152 AD00 AD95 10,164 12,565 Real GDP 48 © 2016 south-Western, a part of Cengage Learning (billions of dollars per year)

END