Aggregate Demandand Aggregate Supply O’Sullivan Sheffrin Perez © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 2 of 22 1 What does the behavior of prices in retail catalogs demonstrate about how quickly prices adjust in the U.S. economy? Price Stickiness in Retail Catalogs 2 How can changes in demand cause a recession? In particular, what factors do economists think caused the 2001 recession? Business Investment, Net Exports, and the 2001 Recession 3 Do changes in oil prices always hurt the U.S. economy? How the U.S. Economy Has Coped with Oil Price Fluctuations

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 3 of 22 STICKY PRICES AND THEIR MACROECONOMIC CONSEQUENCES 9.1 short run in macroeconomics The period of time in which prices do not change or do not change very much.

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 4 of 22 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. PRICE STICKINESS IN RETAIL CATALOGS APPLYING THE CONCEPTS #1: What does the behavior of prices in retail catalogs demonstrate about how quickly prices adjust in the U.S. economy?

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 5 of 22 UNDERSTANDING AGGREGATE DEMAND 9.2 aggregate demand curve (AD) A curve that shows the relationship between the level of prices and the quantity of real GDP demanded. What Is the Aggregate Demand Curve?  FIGURE 9.1 Aggregate Demand

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 6 of 22 UNDERSTANDING AGGREGATE DEMAND 9.2 The Components of Aggregate Demand Why the Aggregate Demand Curve Slopes Downward As the purchasing power of money changes, the aggregate demand curve is affected in three different ways: THE WEALTH EFFECT THE INTEREST RATE EFFECT THE INTERNATIONAL TRADE EFFECT wealth effect The increase in spending that occurs because the real value of money increases when the price level falls.

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 7 of 22 UNDERSTANDING AGGREGATE DEMAND 9.2 Shifts in the Aggregate Demand Curve Key factors that cause the shifts: CHANGES IN THE SUPPLY OF MONEY CHANGES IN TAXES CHANGES IN GOVERNMENT SPENDING ALL OTHER CHANGES IN DEMAND

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 8 of 22 UNDERSTANDING AGGREGATE DEMAND 9.2 Shifts in the Aggregate Demand Curve - Remember Shift Happens ALL OTHER CHANGES IN DEMAND  FIGURE 9.2 Shifting Aggregate Demand

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 9 of 22 UNDERSTANDING AGGREGATE DEMAND 9.2 How the Multiplier Makes the Shift Bigger  FIGURE 9.3 The Multiplier 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 = C a + by

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 10 of 22 UNDERSTANDING AGGREGATE DEMAND 9.2 How the Multiplier Makes the Shift Bigger autonomous consumption spending The part of consumption spending that does not depend on income. marginal propensity to save (MPS) The fraction of additional income that is saved. marginal propensity to consume (MPC) The fraction of additional income that is spent.

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 11 of 22 RETAILERS REPORT MIXED FEBRUARY SALES Some economists worry that consumer spending could slow since the overall savings rate is negative. Consumers are spending more than they are making indicating additional borrowing or dipping into savings. Can consumers continue to spend? February retail sales results were mixed with 59 percent of the nation’s retailers missing expectations and 41 percent exceeding expectations. The winners were the large discount stores like Wal-Mart and Target with the specialty shops like The Gap and Abercrombie and Fitch Co. losing ground. The Sharper Image Corporation experienced a 31 percent drop in same store sales. If consumer spending continues to decline we will see a permanent shift to the left in aggregate demand. If the government or business sectors increase spending enough to offset the consumer reduction there will be no change. If the change is permanent we should see the price level fall a little, ceteris paribus. If the Fed sees the same pattern, it should signal the end of interest rate increases. Extra Application 4

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 12 of 22 GLOBAL WARMING VS. ECONOMIC GROWTH Robert Samuelson maintains that there are no economically feasible and/or politically acceptable ways to cut greenhouse gases. Samuelson states that it would require all countries, rich and poor alike, to pledge to reduce emissions and actually follow through on those pledges. According to Nicholas Stern, the former chief economist for the World Bank, global warming will ultimately result in a global depression with output falling more than 20 percent. Additionally, many of the planet’s coastal cities will be under water. Stern advocates massive government intervention in order to curb greenhouse gas emissions and prevent the environmental disaster. Samuelson also maintains that the subsequent economic slowdown associated with curbing emissions might be worse than the unknown impact of global warming. Note that the imposition of a tax on emissions would shift the AD curve to the left. A tax reduction would have the opposite impact and increase AD. Extra Application 5

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 13 of 22 UNDERSTANDING AGGREGATE DEMAND 9.2 How the Multiplier Makes the Shift Bigger

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 14 of 22 UNDERSTANDING AGGREGATE SUPPLY 9.3 aggregate supply curve (AS) A curve that shows the relationship between the level of prices and the quantity of output supplied. 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. The Long-Run Aggregate Supply Curve  FIGURE 9.4 Long-Run Aggregate Supply

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 15 of 22 UNDERSTANDING AGGREGATE SUPPLY 9.3 DETERMINING OUTPUT AND THE PRICE LEVEL The Long-Run Aggregate Supply Curve  FIGURE 9.5 Aggregate Demand and the Long-Run Aggregate Supply

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 16 of 22 UNDERSTANDING AGGREGATE SUPPLY 9.3 The Short-Run Aggregate Supply Curve  FIGURE 9.6 Aggregate Demand and Short-Run Aggregate Supply 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.

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 17 of 22 BUSINESS INVESTMENT, NET EXPORTS, AND THE 2001 RECESSION APPLYING THE CONCEPTS #2: How can changes in demand cause a recession? In particular, what factors do economists think caused the 2001 recession? To determine what caused the 2001 recession and how it differed from past recessions, economist Kevin Kliesen of the Federal Reserve Bank of St. Louis compared data for recessions over time. Kliesen found that spending on consumer durables and new residential housing production decreased. However, during the 2001 recession spending on consumer durables and new housing production both grew throughout the recession. Instead, business investment and net exports dropped. Investors and firms realized that the economic boom times of the late 1990s were over. Net exports fell for two reasons: World economic growth slowed. The value of the dollar increased relative to foreign currencies, making U.S. goods more expensive.

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 18 of 22 UNDERSTANDING AGGREGATE SUPPLY 9.3 Supply Shocks  FIGURE 9.7 Supply Shock supply shocks External events that shift the aggregate supply curve. stagflation A decrease in real output with increasing prices.

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 19 of 22 HOW THE U.S. ECONOMY HAS COPED WITH OIL PRICE FLUCTUATIONS APPLYING THE CONCEPTS #3: Do changes in oil prices always hurt the U.S. economy? During the 1970s, the world economy was hit with unfavorable supply shocks that raised prices and lowered output, including spikes in oil prices. Increases in oil prices shift the aggregate supply curve. However, they also have an adverse effect on aggregate demand. Because the United States is a net importer of foreign oil, an increase in oil prices is just like a tax that decreases the income of consumers. An increase in taxes will shift the aggregate demand curve to the left. Between 1997 and 1998, the price of oil on the world market fell from $22 a barrel to less than $13 a barrel. The result: gasoline prices were lower than they had been in over 50 years. In 2005, oil prices shot up to $60 a barrel. Reason: increased demand throughout the world, particularly in fast- growing countries such as China and India. Result: the economy appeared to absorb these price increases without too much difficulty. Price increases did not have adverse effects on aggregate demand as in prior years.

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 20 of 22 FROM THE SHORT RUN TO THE LONG RUN 9.4  FIGURE 9.8 The Economy in the Short Run

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 21 of 22 FROM THE SHORT RUN TO THE LONG RUN 9.4  FIGURE 9.9 Adjusting to the Long Run Looking Ahead

chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 22 of 22 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