© 2005 Thomson C hapter 19 Aggregate Demand and Aggregate Supply

© 2005 Thomson 2 Gottheil - Principles of Economics, 4e Economic Principles The phases of the business cycle Gross Domestic Product (GDP) The CPI and GDP deflator Nominal and real GDP Aggregate demand and aggregate supply

© 2005 Thomson 3 Gottheil - Principles of Economics, 4e Economic Principles Macroeconomic equilibrium Demand-pull and cost-push inflation

© 2005 Thomson 4 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Recession A phase in the business cycle in which the decline in the economy’s real GDP persists for at least a half-year. A recession is marked by relatively high unemployment.

© 2005 Thomson 5 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Depression Severe recession.

© 2005 Thomson 6 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Prosperity A phase in the business cycle marked by a relatively high level of real GDP, full employment, and inflation.

© 2005 Thomson 7 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Inflation An increase in the price level.

© 2005 Thomson 8 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Business cycle Alternating periods of growth and decline in an economy’s GDP.

© 2005 Thomson 9 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? No two business cycles are identical. The number of months in any given phase of the cycle varies from cycle to cycle. Business cycle

© 2005 Thomson 10 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Trough The bottom of a business cycle.

© 2005 Thomson 11 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? This is the time period when the economy’s unemployment rate is greatest and output declines to the cycle’s minimum level. Trough

© 2005 Thomson 12 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Recovery A phase in the business cycle, following a recession, in which real GDP increases and unemployment declines.

© 2005 Thomson 13 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Peak The top of a business cycle.

© 2005 Thomson 14 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? This is the time period when output reaches its maximum level, the labor force is fully employed, and increasing pressure on prices is likely to generate inflation. Peak

© 2005 Thomson 15 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Downturn A phase in the business cycle in which real GDP declines, inflation moderates, and unemployment emerges.

© 2005 Thomson 16 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Trend lines trace the economy’s output performance over the course of a business cycle, measured either from recession to recession or from prosperity to prosperity.

© 2005 Thomson 17 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Upward-sloping trend lines signify economic growth. The steeper the trend line, the higher the economy’s rate of growth. When no growth occurs, the trend line is horizontal.

© 2005 Thomson 18 Gottheil - Principles of Economics, 4e EXHIBIT 1THE BUSINESS CYCLE

© 2005 Thomson 19 Gottheil - Principles of Economics, 4e Exhibit 1: The Business Cycle What does the trend line in Exhibit 1 tell us about the economy’s output performance? The trend line shows that the economy is growing.

© 2005 Thomson 20 Gottheil - Principles of Economics, 4e Measuring the National Economy Total value of all final goods and services, measured in current market prices, produced in the economy during a year. Gross Domestic Product (GDP)

© 2005 Thomson 21 Gottheil - Principles of Economics, 4e Measuring the National Economy “Final goods and services” refers to everything produced that is not itself used to produce other goods and services. Gross Domestic Product (GDP)

© 2005 Thomson 22 Gottheil - Principles of Economics, 4e Measuring the National Economy “During a given year” refers to a specific calendar year. Gross Domestic Product (GDP)

© 2005 Thomson 23 Gottheil - Principles of Economics, 4e Measuring the National Economy “Produced in the economy” refers to any good or service produced in the United States, regardless of whether a US-owned or a foreign-owned company produced the good. Gross Domestic Product (GDP)

© 2005 Thomson 24 Gottheil - Principles of Economics, 4e Measuring the National Economy Conversely, goods produced by US-owned firms in foreign countries are not included in GDP. Gross Domestic Product (GDP)

© 2005 Thomson 25 Gottheil - Principles of Economics, 4e Measuring the National Economy To compare GDP across years, we must devise some way of eliminating the effect of inflation.

© 2005 Thomson 26 Gottheil - Principles of Economics, 4e Measuring the National Economy Nominal GDP GDP measured in terms of current market prices—that is, the price level at the time of measurement. (It is not adjusted for inflation.)

© 2005 Thomson 27 Gottheil - Principles of Economics, 4e Measuring the National Economy Real GDP GDP adjusted for changes in the price level.

© 2005 Thomson 28 Gottheil - Principles of Economics, 4e Measuring the National Economy Price indices are designed to remove the effect of price changes. The consumer price index and the GDP deflator are the two indices most commonly used.

© 2005 Thomson 29 Gottheil - Principles of Economics, 4e Measuring the National Economy Consumer Price Index (CPI) A measure comparing the prices of consumer goods and services that a household typically purchases to the prices of those goods and services purchased in a base year.

© 2005 Thomson 30 Gottheil - Principles of Economics, 4e Measuring the National Economy Base year The reference year with which prices in other years are compared in a price index.

© 2005 Thomson 31 Gottheil - Principles of Economics, 4e Measuring the National Economy Price level A measure of prices in one year expressed in relation to prices in a base year.

© 2005 Thomson 32 Gottheil - Principles of Economics, 4e Measuring the National Economy Example: Suppose in 1998 (the base year) a basket of goods including such things as food, clothing, and fuel cost $350. The $350 converts to a price level index of 100, P = 100.

© 2005 Thomson 33 Gottheil - Principles of Economics, 4e Measuring the National Economy Example: Suppose in the next year, 1999, the same basket of goods cost $385. The 1999 CPI, measured against the 1998 base year of 100, is 110. P = ($385/$350) × 100 = 110.

© 2005 Thomson 34 Gottheil - Principles of Economics, 4e Measuring the National Economy Example: A 1999 P = 110 indicates that from 1998 to 1999 the cost of goods and services that consumers typically buy increased by 10 percent.

© 2005 Thomson 35 Gottheil - Principles of Economics, 4e Measuring the National Economy GDP deflator A measure comparing the prices of all goods and services produced in the economy during a given year to the prices of those goods and services purchased in a base year.

© 2005 Thomson 36 Gottheil - Principles of Economics, 4e Measuring the National Economy GDP deflator This price index includes not only consumer goods and services, but also producer goods, investment goods, exports and imports, and goods and services purchased by government.

© 2005 Thomson 37 Gottheil - Principles of Economics, 4e Measuring the National Economy GDP deflator This price index is used to convert nominal GDP to real GDP.

© 2005 Thomson 38 Gottheil - Principles of Economics, 4e Measuring the National Economy The formula to convert from nominal GDP to real GDP is: Real GDP = (nominal GDP × 100)/ GDP deflator.

© 2005 Thomson 39 Gottheil - Principles of Economics, 4e EXHIBIT 2CONVERTING NOMINAL GDP TO REAL GDP: 1995–2002 ($ BILLIONS, 1996 = 100) Source: U.S. Department of Commerce, Bureau of Economic Analysis.

© 2005 Thomson 40 Gottheil - Principles of Economics, 4e Exhibit 2: Converting Nominal GDP to Real GDP: What is the nominal difference between GDP in 1996 and 1997? The nominal difference = $8,318.4 billion - $7,813.2 billion = $505.2 billion.

© 2005 Thomson 41 Gottheil - Principles of Economics, 4e Exhibit 2: Converting Nominal GDP to Real GDP: What is the real difference between GDP in 1996 and 1997? Real GDP in 1996 is = ($7,813.2 billion × 100)/ = $7,813.2 billion.

© 2005 Thomson 42 Gottheil - Principles of Economics, 4e Exhibit 2: Converting Nominal GDP to Real GDP: What is the real difference between GDP in 1996 and 1997? Real GDP in 1997 = ($8,318.4 billion × 100)/ = $8,159.5 billion.

© 2005 Thomson 43 Gottheil - Principles of Economics, 4e Exhibit 2: Converting Nominal GDP to Real GDP: What is the real difference between GDP in 1996 and 1997? The real difference = $8,159.5 billion - $7,813.2 billion = $346.3 billion.

© 2005 Thomson 44 Gottheil - Principles of Economics, 4e Deriving Equilibrium GDP in the Aggregate Demand and Supply Model The aggregate demand and aggregate supply model is one model used to explain how GDP is determined.

© 2005 Thomson 45 Gottheil - Principles of Economics, 4e Deriving Equilibrium GDP in the Aggregate Demand and Supply Model Aggregate supply The total quantity of goods and services that firms in the economy are willing to supply at varying price levels.

© 2005 Thomson 46 Gottheil - Principles of Economics, 4e Deriving Equilibrium GDP in the Aggregate Demand and Supply Model There are three distinct segments of the aggregate supply curve: 1. Horizontal segment. Real GDP increases without affecting the economy’s price level.

© 2005 Thomson 47 Gottheil - Principles of Economics, 4e Deriving Equilibrium GDP in the Aggregate Demand and Supply Model 2. Upward-sloping segment. A positive relationship between real GDP and price level. There are three distinct segments of the aggregate supply curve:

© 2005 Thomson 48 Gottheil - Principles of Economics, 4e Deriving Equilibrium GDP in the Aggregate Demand and Supply Model 3. Vertical segment. All resources are fully employed, so that real GDP cannot increase. There are three distinct segments of the aggregate supply curve:

© 2005 Thomson 49 Gottheil - Principles of Economics, 4e Deriving Equilibrium GDP in the Aggregate Demand and Supply Model Aggregate demand The total quantity of goods and services demanded by households, firms, foreigners, and government at varying price levels.

© 2005 Thomson 50 Gottheil - Principles of Economics, 4e Deriving Equilibrium GDP in the Aggregate Demand and Supply Model Increases in the price level affect people’s real wealth, their lending and borrowing activity, and the nation’s trade with other nations.

© 2005 Thomson 51 Gottheil - Principles of Economics, 4e Deriving Equilibrium GDP in the Aggregate Demand and Supply Model The quantity of goods and services demanded in the economy declines when price levels increase.

© 2005 Thomson 52 Gottheil - Principles of Economics, 4e EXHIBIT 3AGGREGATE SUPPLY AND AGGREGATE DEMAND

© 2005 Thomson 53 Gottheil - Principles of Economics, 4e Exhibit 3: Aggregate Supply and Aggregate Demand At what real GDP value is full- employment of resources realized in Exhibit 3? Full-employment real GDP is $9.5 trillion.

© 2005 Thomson 54 Gottheil - Principles of Economics, 4e Deriving Equilibrium GDP in the Aggregate Demand and Supply Model The aggregate demand curve shifts when there is a change in the quantity of goods and services demanded at a particular price level. Government spending, income levels, and expectations about the future are all factors that can cause the curve to shift.

© 2005 Thomson 55 Gottheil - Principles of Economics, 4e Deriving Equilibrium GDP in the Aggregate Demand and Supply Model The aggregate supply curve shifts due to factors such as changes in resource availability and resource prices.

© 2005 Thomson 56 Gottheil - Principles of Economics, 4e EXHIBIT 4SHIFTS IN AGGREGATE DEMAND AND AGGREGATE SUPPLY

© 2005 Thomson 57 Gottheil - Principles of Economics, 4e Exhibit 4: Shifts in Aggregate Demand and Aggregate Supply What might cause the aggregate demand curve in panel a of Exhibit 4 to shift to the right? Increases in government spending, increases in incomes, and optimistic expectations could all cause the aggregate demand curve to shift to the right.

© 2005 Thomson 58 Gottheil - Principles of Economics, 4e Macroeconomic Equilibrium Macroequilibrium The level of real GDP and the price level that equate the aggregate quantity demanded and the aggregate quantity supplied.

© 2005 Thomson 59 Gottheil - Principles of Economics, 4e EXHIBIT 5ACHIEVING MACROECONOMIC EQUILIBRIUM

© 2005 Thomson 60 Gottheil - Principles of Economics, 4e Exhibit 5: Achieving Macroeconomic Equilibrium 1. At what price level and real GDP is macroequilibrium achieved in Exhibit 5? Macroequilibrium is achieved at P = and real GDP = $ trillion.

© 2005 Thomson 61 Gottheil - Principles of Economics, 4e Exhibit 5: Achieving Macroeconomic Equilibrium 2. What happens when the price level increases to P = 110? At P = 110, the aggregate quantity demanded falls to $5 trillion and the aggregate quantity supplied increases to $9 trillion.

© 2005 Thomson 62 Gottheil - Principles of Economics, 4e Equilibrium, Inflation, and Unemployment The Depression of the 1930s produced one of the poorest GDP performance records in our economic history. Real GDP fell by 30 percent in the first four years of the decade.

© 2005 Thomson 63 Gottheil - Principles of Economics, 4e Time Line on Equilibrium, Inflation, and Unemployment The U.S. commitment to support England during World War II changed the pace and direction of our national economy significantly.

© 2005 Thomson 64 Gottheil - Principles of Economics, 4e Time Line on Equilibrium, Inflation, and Unemployment Government war-related spending shifted the aggregate demand curve to the right. With millions of men and women joining the armed forces, the size of the civilian labor pool declined and the aggregate supply curve shifted to the left.

© 2005 Thomson 65 Gottheil - Principles of Economics, 4e Time Line on Equilibrium, Inflation, and Unemployment The same basic shifts in aggregate demand and supply occurred during the Vietnam War. Unlike the poor economic condition prior to WWII, however, the economy was already relatively vigorous prior to the Vietnam war. Inflation resulted.

© 2005 Thomson 66 Gottheil - Principles of Economics, 4e Time Line on Equilibrium, Inflation, and Unemployment Demand-pull inflation Inflation caused primarily by an increase in aggregate demand.

© 2005 Thomson 67 Gottheil - Principles of Economics, 4e Equilibrium, Inflation, and Unemployment Stagflation A period of stagnating real GDP, rapid inflation, and relatively high levels of unemployment.

© 2005 Thomson 68 Gottheil - Principles of Economics, 4e Time Line on Equilibrium, Inflation, and Unemployment The oil price increases imposed by OPEC during the 1970s caused the cost of producing nearly everything in the economy to increase. The aggregate supply curve shifted to the left. GDP declined while the price level increased.

© 2005 Thomson 69 Gottheil - Principles of Economics, 4e Time Line on Equilibrium, Inflation, and Unemployment Cost-push inflation Inflation caused primarily by a decrease in aggregate supply.

© 2005 Thomson 70 Gottheil - Principles of Economics, 4e EXHIBIT 6AGGREGATE DEMAND AND AGGREGATE SUPPLY DURING THE DEPRESSION AND WAR PERIOD AND THE OIL PRICE INCREASES

© 2005 Thomson 71 Gottheil - Principles of Economics, 4e Exhibit 6: Aggregate Demand and Aggregate Supply During the Depression and War Period and the Oil Price Increases The aggregate supply curve shifts to the left after OPEC. How does macroeconomic equilibrium change before and after OPEC in panel b of Exhibit 6?

© 2005 Thomson 72 Gottheil - Principles of Economics, 4e Exhibit 6: Aggregate Demand and Aggregate Supply During the Depression and War Period and the Oil Price Increases How does macroeconomic equilibrium change before and after OPEC in panel b of Exhibit 6? A new equilibrium is obtained at a lower level of real GDP and at a higher price level.

© 2005 Thomson 73 Gottheil - Principles of Economics, 4e Time Line on Equilibrium, Inflation, and Unemployment During the second half of the 1980s, the economy was performing about as well as it ever had in the last quarter century. Tax reforms, ready credit, leveraged buyouts, a commercial real estate boom, and optimistic expectations contributed to the already strong aggregate demand.

© 2005 Thomson 74 Gottheil - Principles of Economics, 4e Time Line on Equilibrium, Inflation, and Unemployment Leveraged buyout A primarily debt-financed purchase of all the stock or assets of a company.

© 2005 Thomson 75 Gottheil - Principles of Economics, 4e Time Line on Equilibrium, Inflation, and Unemployment The recession of was caused by an inward shift in aggregate demand. Reduced federal revenue sharing with states, downsized government budgets, cuts in demand for military goods, and high levels of debt acquired during the 1980s are all to blame.

© 2005 Thomson 76 Gottheil - Principles of Economics, 4e The Longest Prosperity Phase: Economists attribute the boom to supply-side factors: A rise in the nation’s productivity caused by the diffusion of computer technology throughout the economy. The absence of rising inflation.

© 2005 Thomson 77 Gottheil - Principles of Economics, 4e The Recession and 9/11 The buying spree left consumers without the means to keep the spree alive. Terrorist attacks created a heightened sense of economic uncertainty.

© 2005 Thomson 78 Gottheil - Principles of Economics, 4e Can We Avoid Unemployment and Inflation? Although the desired macroequilibrium outcome would occur at a real GDP level consistent with full employment and no inflation, this level is not always achieved.

© 2005 Thomson 79 Gottheil - Principles of Economics, 4e Can We Avoid Unemployment and Inflation? Some economists believe government should act in ways to help shift macroequilibrium to this position.

© 2005 Thomson 80 Gottheil - Principles of Economics, 4e Can We Avoid Unemployment and Inflation? Increasing or decreasing government spending and income taxes are two methods government can use to attempt to shift the aggregate demand curve.

© 2005 Thomson 81 Gottheil - Principles of Economics, 4e EXHIBIT 7OBTAINING FULL-EMPLOYMENT GDP WITHOUT INFLATION

© 2005 Thomson 82 Gottheil - Principles of Economics, 4e Exhibit 7: Obtaining Full-Employment GDP Without Inflation How might government shift the aggregate demand curve from AD to AD′ in Exhibit 7? Government could increase spending and reduce income taxes in order to shift the demand curve to the right.