Survey of Economics: Principles, Applications, and Tools SEVENTH EDITION Chapter 14 Aggregate Demand and Aggregate Supply

Learning Objectives 14.1 Explain the role sticky wages and prices play in economic fluctuations. 14.2 List the determinants of aggregate demand. 14.3 Distinguish between the short run and long run aggregate supply curves. 14.4 Explain how the short-run aggregate supply curve shifts over time. Slide 2 is list of textbook LO numbers and statements

14.1 STICKY PRICES AND THEIR MACROECONOMIC CONSEQUENCES Fluctuations in the economy can be seen as failures in coordination. Flexible and Sticky Prices For most firms, the biggest cost of doing business is wages. If wages are sticky, firms’ overall costs will be sticky as well. This means that firms’ product prices will remain sticky, too. Sticky wages cause sticky prices and hamper the economy’s ability to bring demand and supply into balance in the short run. How Demand Determines Output in the Short Run Short run in macroeconomics The period of time in which prices do not change or do not change very much.

APPLICATION 1 MEASURING PRICE STICKINESS IN CONSUMER MARKETS APPLYING THE CONCEPTS #1: What does the behavior of prices in consumer markets demonstrate about how quickly prices adjust in the U.S. economy? To analyze the behavior of retail prices, economist Anil Kashyap of the University of Chicago examined prices in consumer catalogs. He looked at the prices of 12 selected goods from: L.L. Bean Recreational Equipment, Inc. (REI) The Orvis Company, Inc. The goods included shoes, blankets, chamois shirts, binoculars, and a fishing rod and fly. What did he find? Considerable price stickiness. When prices did change, he observed a mixture of both large and small changes. During periods of high inflation, prices tended to change more frequently.

14.2 UNDERSTANDING AGGREGATE DEMAND (1 of 10) What Is the Aggregate Demand Curve? Aggregate demand curve (AD) A curve that shows the relationship between the level of prices and the quantity of real GDP demanded.

14.2 UNDERSTANDING AGGREGATE DEMAND (2 of 10) The Components of Aggregate Demand The aggregate demand curve plots the total demand for real GDP as a function of the price level. The aggregate demand curve slopes downward, indicating that the quantity of aggregate demand increases as the price level in the economy falls.

14.2 UNDERSTANDING AGGREGATE DEMAND (3 of 10) Why the Aggregate Demand Curve Slopes Downward REAL-NOMINAL PRINCIPLE What matters to people is the real value of money or income—its purchasing power—not the face value of money or income. As the purchasing power of money changes, the aggregate demand curve is affected in three different ways: THE WEALTH EFFECT Wealth effect The increase in spending that occurs because the real value of money increases when the price level falls.

14.2 UNDERSTANDING AGGREGATE DEMAND (4 of 10) Why the Aggregate Demand Curve Slopes Downward THE INTEREST RATE EFFECT With a given supply of money in the economy, a lower price level will lead to lower interest rates. With lower interest rates, both consumers and firms will find it cheaper to borrow money to make purchases. As a consequence, the demand for goods in the economy (consumer durables purchased by households and investment goods purchased by firms) will increase. THE INTERNATIONAL TRADE EFFECT In an open economy, a lower price level will mean that domestic goods (goods produced in the home country) become cheaper relative to foreign goods, so the demand for domestic goods will increase.

14.2 UNDERSTANDING AGGREGATE DEMAND (5 of 10) Shifts in the Aggregate Demand Curve CHANGES IN THE SUPPLY OF MONEY An increase in the supply of money in the economy will increase aggregate demand and shift the aggregate demand curve to the right. CHANGES IN TAXES A decrease in taxes will increase aggregate demand and shift the aggregate demand curve to the right. CHANGES IN GOVERNMENT SPENDING At any given price level, an increase in government spending will increase aggregate demand and shift the aggregate demand curve to the right.

14.2 UNDERSTANDING AGGREGATE DEMAND (6 of 10) Shifts in the Aggregate Demand Curve ALL OTHER CHANGES IN DEMAND Decreases in taxes, increases in government spending, and an increase in the supply of money all shift the aggregate demand curve to the right. Higher taxes, lower government spending, and a lower supply of money shift the curve to the left. TABLE 14.1 Factors That Shift Aggregate Demand Factors That Increase Aggregate Demand Factors That Decrease Aggregate Demand Decrease in taxes Increase in taxes Increase in government spending Decrease in government spending Increase in the money supply Decrease in the money supply

14.2 UNDERSTANDING AGGREGATE DEMAND (7 of 10) How the Multiplier Makes the Shift Bigger Initially, an increase in desired spending will shift the aggregate demand curve horizontally to the right from a to b. The total shift from a to c will be larger. The ratio of the total shift to the initial shift is known as the multiplier.

14.2 UNDERSTANDING AGGREGATE DEMAND (8 of 10) How the Multiplier Makes the Shift Bigger Multiplier The ratio of the total shift in aggregate demand to the initial shift in aggregate demand. Consumption function The relationship between the level of income and consumer spending. C = Ca + by

14.2 UNDERSTANDING AGGREGATE DEMAND (9 of 10) How the Multiplier Makes the Shift Bigger Autonomous consumption spending The part of consumption spending that does not depend on income. Marginal propensity to consume (MPC) The fraction of additional income that is spent.

14.2 UNDERSTANDING AGGREGATE DEMAND (10 of 10) How the Multiplier Makes the Shift Bigger TABLE 14.2 THE MULTIPLIER IN ACTION The initial $10 million increase in aggregate demand will, through all the rounds of spending, eventually lead to a $25 million increase. Round of Spending Increase in Aggregate Demand (millions) Increase in GDP and Income (millions) Increase in Consumption (millions) 1 $10.00 $6.00 2 6.00 3.60 3 2.16 4 1.30 . Total $25.00 $15.00

APPLICATION 2 TWO APPROACHES TO DETERMINING THE CAUSES OF RECESSIONS APPLYING THE CONCEPTS #2: How can we determine what factors cause recessions? Economists have used the basic framework of aggregate demand and supply analysis to explain recessions. Recessions can occur either when there is a sharp decrease in demand or a decrease in aggregate supply. Economic historian Peter Temin looked at all recessions from 1893 to 1990 to determine their causes. He found, recessions were caused by many different factors. Sometimes, as in 1929, they were caused by shifts in aggregate demand from the private sector, as consumers cut back their spending. Other times, as in 1981, the government cut back on aggregate demand to reduce inflation. Supply shocks were the cause of the recessions in 1973 and 1979. The most severe shock hit the U.S. economy in 1931 and converted an economic downturn into the Great Depression. He believes that foreign monetary developments were the ultimate source of this shock to the U.S. economy.

14.3 UNDERSTANDING AGGREGATE SUPPLY (1 of 7) Aggregate supply curve (AS) A curve that shows the relationship between the level of prices and the quantity of output supplied. The Long-Run Aggregate Supply Curve Long-run aggregate supply curve A vertical aggregate supply curve that represents the idea that in the long run, output is determined solely by the factors of production.

14.3 UNDERSTANDING AGGREGATE SUPPLY (2 of 7) The Long-Run Aggregate Supply Curve In the long run, the level of output, yp, is independent of the price level.

14.3 UNDERSTANDING AGGREGATE SUPPLY (3 of 7) The Long-Run Aggregate Supply Curve DETERMINING OUTPUT AND THE PRICE LEVEL Output and prices are determined at the intersection of AD and AS. An increase in aggregate demand leads to a higher price level.

14.3 UNDERSTANDING AGGREGATE SUPPLY (4 of 7) The Short-Run Aggregate Supply Curve Short-run aggregate supply curve A relatively flat aggregate supply curve that represents the idea that prices do not change very much in the short run and that firms adjust production to meet demand.

14.3 UNDERSTANDING AGGREGATE SUPPLY (5 of 7) The Short-Run Aggregate Supply Curve With a short-run aggregate supply curve, shifts in aggregate demand lead to large changes in output but small changes in price.

14.3 UNDERSTANDING AGGREGATE SUPPLY (6 of 7) The Short-Run Aggregate Supply Curve What factors determine the costs firms must incur to produce output? The key factors are Input prices (wages and materials) The state of technology Taxes, subsidies, or economic regulations

14.3 UNDERSTANDING AGGREGATE SUPPLY (7 of 7) Supply Shocks Supply shocks External events that shift the aggregate supply curve. An adverse supply shock, such as an increase in the price of oil, will cause the AS curve to shift upward. The result will be higher prices and a lower level of output. Stagflation A decrease in real output with increasing prices.

APPLICATION 3 OIL PRICE DECLINES AND THE U.S. ECONOMY APPLYING THE CONCEPTS #3: Do declines in oil prices always help the U.S. Economy? Economists have generally believed that falling oil prices will benefit the U.S. economy and lead to higher economic growth. Falling oil prices should lead to falling gasoline and heating oil prices and put more money in the pockets of consumers that will lead to increases in aggregate demand. Since fuel is an input into production, lower oil prices may also increase aggregate supply. But the decrease in oil prices in 2014 and 2015 have had only a modest effect on economic growth. Consumers appeared to have used the extra money to reduce overall debt instead of other consumption. Lower oil prices reduce the incentive for firms to produce energy and invest in new capital and equipment.

14.4 FROM THE SHORT RUN TO THE LONG RUN (1 of 3) In the short run, the economy produces at y0, which exceeds potential output yp.

14.4 FROM THE SHORT RUN TO THE LONG RUN (2 of 3) With output exceeding potential, the short-run AS curve shifts upward over time. The economy adjusts to the long-run equilibrium at a1.

14.4 FROM THE SHORT RUN TO THE LONG RUN (3 of 3) Looking Ahead The aggregate demand and aggregate supply model in this chapter provides an overview of how demand affects output and prices in both the short run and the long run. The next several chapters explore more closely how aggregate demand determines output in the short run.

KEY TERMS Aggregate demand curve (AD) Aggregate supply curve (AS) Autonomous consumption spending Consumption function Long-run aggregate supply curve Marginal propensity to consume (MPC) Marginal propensity to save (MPS) Multiplier Short-run aggregate supply curve Short run in macroeconomics Stagflation Supply shocks Wealth effect