Mehdi Arzandeh, University of Manitoba PowerPoint Presentation by Mehdi Arzandeh, University of Manitoba

© 2016 McGraw‐Hill Education Limited Aggregate Demand and Aggregate Supply 12 LEARNING OBJECTIVES LO12.1 Define aggregate demand (AD) and explain how its downward slope is the result of the real-balances effect, the interest-rate effect, and the foreign-trade effect. LO12.2 Explain the factors that cause changes (shifts) in AD. LO12.3 Define aggregate supply (AS) and explain how it differs in the immediate short run, the short run, and the long run. LO12.4 Explain the factors that cause changes (shifts) in AS. LO12.5 Discuss how AD and AS determine an economy’s equilibrium price level and level of real GDP. LO12.6 Describe how the AD–AS model explains periods of demand–pull inflation, cost– push inflation, and recession. © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 12.1 Aggregate Demand Aggregate demand is a schedule or curve that shows the amounts of real output (real GDP) that buyers collectively desire to purchase at each possible price level LO1 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 FIGURE 12-1 The Aggregate Demand Curve Price level AD Real domestic output, GDP LO1 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 12.1 Aggregate Demand Slopes downward because of the following effects of a change in price level: Real-balances Effect Interest-rate Effect Foreign Trade Effect LO1 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 FIGURE 12-2 Changes in Aggregate Demand Price level This figure shows changes in aggregate demand. A change in one or more of the listed determinants of aggregate demand will shift the aggregate demand curve. The rightward shift from AD1 to AD2 represents an increase in aggregate demand; the leftward shift from AD1 to AD3 shows a decrease in aggregate demand. The vertical distances between AD1 and the dashed lines represent the initial changes in spending. Through the multiplier effect, that spending produces the full shifts of the curves. AD2 AD1 AD3 Real domestic output, GDP LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Changes in Aggregate Demand 12.2 Determinants of Aggregate Demand CONSUMER SPENDING Consumer wealth Household borrowing Consumer expectations Personal taxes LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Changes in Aggregate Demand 12.2 INVESTMENT SPENDING Real Interest Rates Expected Returns Expectations about future business conditions Technology Degree of excess capacity Business taxes LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Changes in Aggregate Demand 12.2 GOVERNMENT SPENDING Government spending increases, aggregate demand increases (as long as interest rates and tax rates do not change) e.g. More computers for government agencies Government spending decreases, aggregate demand decreases e.g. Less transportation projects LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Changes in Aggregate Demand 12.2 NET EXPORT SPENDING National income abroad Exchange rates Dollar depreciation Dollar appreciation LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 12.3 Aggregate Supply Aggregate supply is a schedule or curve showing the relationship between the price level of output and the amount of real domestic output that firms in the economy produce LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 12.3 Aggregate Supply Aggregate supply depends on three time horizons: The immediate short run The short run The long run LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 12.3 Aggregate Supply Aggregate Supply in the Immediate Short Run In the immediate short run, both input prices and output prices are fixed In the immediate short run, the aggregate supply curve is horizontal at an economy’s current price level With output prices fixed, firms collectively supply the level of output that is demanded at those prices LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 FIGURE 12-3 Aggregate Supply in the Immediate Short Run Immediate-short-run aggregate supply P1 ASISR Price level This figure illustrates aggregate supply in the immediate short run. In the immediate short run, the aggregate supply curve ASISR is horizontal at the economy’s current price level, P1. With output prices fixed, firms collectively supply the level of output that is demanded at those prices. GDPf Real domestic output, GDP LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 12.3 Aggregate Supply Aggregate Supply in the Short Run The short run begins after the immediate short run ends. The short run is a period of time during which output prices are flexible but input prices are either totally fixed or highly inflexible. LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 12.3 Aggregate Supply The upward-sloping aggregate supply curve AS indicates a direct (or positive) relationship between the price level and the amount of real output that firms will offer for sale The AS curve is relatively flat below the full-employment output It is relatively steep beyond the full-employment output LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 FIGURE 12-4 Short-Run Aggregate Supply Curve AS Aggregate supply (short run) Price level The figure shows the aggregate supply curve in the short run. The upsloping aggregate supply curve AS indicates a direct (or positive) relationship between the price level and the amount of real output that firms will offer for sale. The AS curve is relatively flat below the full-employment output because unemployed resources and unused capacity allow firms to respond to price-level rises with large increases in real output. It is relatively steep beyond the full-employment output because resource shortages and capacity limitations make it difficult to expand real output as the price level rises. AS slopes upward because with input prices fixed, rising prices increase real profits and declining prices result in decreases in real profits. GDPf Real domestic output, GDP LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 12.3 Aggregate Supply Aggregate Supply in the Long Run For the economy as a whole, it is the time horizon over which all output and input prices are fully flexible It begins after the short run ends Price-level changes do not affect firms’ profits and thus they create no incentive for firms to alter their output. LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 FIGURE 12-5 Aggregate Supply in the Long Run ASLR Price level Long-run aggregate supply This figure reflects aggregate supply in the long run. The long-run aggregate supply curve, ASLR, is vertical at the full-employment level of real GDP (Qf) because in the long run wages and other input prices rise and fall to match changes in the price level. So price-level changes do not affect firms’ profits and thus they create no incentive for firms to alter their output. In the long run, the economy will produce the full-employment output level no matter what the price level is because profits always adjust to give firms exactly the right profit incentive to produce exactly the full employment output level. GDPf Real domestic output, GDP LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Changes in Aggregate Supply 12.4 Determinants of Short-Run Aggregate Supply Input prices Domestic factor prices Price of imported resources Productivity Legal-institutional environment Business taxes and subsidies Government regulation LO4 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 FIGURE 12-6 Changes in Short-Run Aggregate Supply AS3 AS1 AS2 Price level This figure illustrates changes in aggregate supply. A change in one or more of the AS determinants listed on the next slide will shift the aggregate supply curve. The rightward shift of the aggregate supply curve from AS1 to AS2 represents an increase in aggregate supply; the leftward shift of the curve from AS1 to AS3 shows a decrease in aggregate supply. Real domestic output, GDP LO4 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Equilibrium in the AD-AS Model 12.5 Equilibrium occurs at the price level that equalizes the amount of real output demanded and supplied. At the intersection of AD and AS: Equilibrium price level Equilibrium real output LO5 © 2016 McGraw‐Hill Education Limited

Real domestic output, GDP LO4.1 KEY GRAPH – The Equilibrium Price Level and Equilibrium Real GDP FIGURE 12-7 Real domestic output, GDP (billions of dollars) Price level (index numbers) Real Output Demanded (Billions) Price Level (Index Number) Real Output Supplied $506 108 $513 508 104 512 510 100 96 507 514 92 502 AS 100 92 a b AD This figure shows the equilibrium price level and equilibrium real GDP. The intersection of the aggregate demand curve and the aggregate supply curve determines the economy’s equilibrium price level. At the equilibrium price level of 100 (in index-value terms), the $510 billion of real output demanded matches the $510 billion of real output supplied. So the equilibrium GDP is $510 billion. 502 510 514 LO5 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 12.6 Changes in Equilibrium Increases in AD: Demand-Pull Inflation For any initial increase in aggregate demand, the resulting increase in real output will be smaller the greater is the increase in the price level Inflationary (positive) GDP gap Demand-pull inflation LO6 © 2016 McGraw‐Hill Education Limited

Real domestic output, GDP LO4.1 An Increase in Aggregate Demand that Causes Demand-Pull Inflation FIGURE 12-8 AS P2 Price level P1 This figure shows an increase in aggregate demand that causes demand-pull inflation. The increase in aggregate demand from AD1 to AD2 causes demand-pull inflation, shown as the rise in the price level from P1 to P2. It also causes an inflationary GDP gap of Q1 minus Qf. The rise in the price level reduces the size of the multiplier effect. If the price level had remained at P1, the increase in aggregate demand from AD1 to AD2 would increase output from Qf to Q2 and the multiplier would have been at full strength. But because of the increase in the price level, real output increases only from Qf to Q1 and the multiplier effect is reduced. AD2 AD1 GDPf GDP1 GDP2 Real domestic output, GDP LO6 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 12.6 Changes in Equilibrium Decreases in AD: Recession and Cyclical Unemployment Deflation, a decline in the price level, is a rarity in the Canadian economy Real output takes the full brunt of the decline in AD because product prices are “sticky” in the short run Recessionary (negative) GDP gap LO6 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 12.6 Changes in Equilibrium Reasons for downward price stickiness: fear of price wars menu costs wage contracts morale, effort, & productivity minimum wage LO6 © 2016 McGraw‐Hill Education Limited

Real domestic output, GDP LO4.1 A Decrease in Aggregate Demand that Causes a Recession FIGURE 12-9 AS b Price level P1 a P2 c This figure shows a decrease in aggregate demand that causes a recession. If the price level is downwardly inflexible at P1, a decline of aggregate demand from AD1 to AD2 will move the economy leftward from a to b along the horizontal broken-line segment and reduce real GDP from Qf to Q1. Idle production capacity, cyclical unemployment, and a recessionary GDP gap (of Q1 minus Qf) will result. If the price level were flexible downward, the decline in aggregate demand would move the economy depicted from a to c instead of from a to b. AD1 AD2 GDP1 GDP2 GDPf Real domestic output, GDP LO6 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 12.6 Changes in Equilibrium Decreases in AS: Cost-Push Inflation Effects of a leftward shift in AS are doubly bad output decreases price level increases LO6 © 2016 McGraw‐Hill Education Limited

Real domestic output, GDP LO4.1 A Decrease in Aggregate Supply that Causes a Cost-Push Inflation FIGURE 12-10 AS2 AS1 b P2 Price level a P1 This figure reflects a decrease in aggregate supply that causes cost-push inflation. A leftward shift of aggregate supply from AS1 to AS2 raises the price level from P1 to P2 and produces cost-push inflation. Real output declines and a recessionary GDP gap (of Q1 minus Qf) occurs. AD GDP1 GDPf Real domestic output, GDP LO6 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 12.6 Changes in Equilibrium Increases in AS: Full Employment with Price-Level Stability Increases in AD should normally lead to inflation In the late 1990s, productivity growth has shifted the long- run AS curve to the right Economy slowed down in 2001 due to a substantial fall in investment spending During 2002-2006 economy rebounded but followed by the recession of 2008-2009. LO6 © 2016 McGraw‐Hill Education Limited

Real domestic output, GDP LO4.1 Growth, Full Employment, and Relative Price Stability FIGURE 12-11 AS1 AS2 P3 b P2 c P1 a Price level This figure illustrates growth, full employment, and relative price stability. Normally, an increase in aggregate demand from AD1 to AD2 would move the economy from a to b along AS1. Real output would expand to Q2, and inflation would result (P1 to P3). But in the late 1990s, significant increases in productivity shifted the aggregate supply curve, as shown by AS1 to AS2. The economy moved from a to c rather than from a to b. It experienced strong economic growth (Q1 to Q3), full employment, and only very mild inflation (P1 to P2) before receding in March 2001. AD2 AD1 GDP1 GDP2 GDP3 Real domestic output, GDP LO6 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 Stimulus and the Great Recession in the American versus the Canadian Economy The LAST WORD Aggregate demand stimulus helped to prevent the 2008-2009 downturn from becoming another Great Depression. The US economy entered a recession in 2007, following the housing collapse. To stimulate aggregate demand The Federal Reserve lowered short-term interest rates The federal government used fiscal policy In the US, real GDP fell by 4.7% and unemployment rate rose from 4.6% to 10.1%. In Canada, GDP fell by 2.7% and unemployment rate rose from 6.1% to 8.7%. After the recession, GDP growth was higher and unemployment rate was lower for Canada. © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 Chapter Summary LO12.1 Define aggregate demand (AD) and explain how its downward slope is the result of the real-balances effect, the interest-rate effect, and the foreign-trade effect. LO12.2 Explain the factors that cause changes (shifts) in AD. LO12.3 Define aggregate supply (AS) and explain how it differs in the immediate short run, the short run, and the long run. LO12.4 Explain the factors that cause changes (shifts) in AS. LO12.5 Discuss how AD and AS determine an economy’s equilibrium price level and level of real GDP. LO12.6 Describe how the AD–AS model explains periods of demand– pull inflation, cost–push inflation, and recession. © 2016 McGraw‐Hill Education Limited