ECONOMICS: Principles and Applications 3e HALL & LIEBERMAN © 2005 Thomson Business and Professional Publishing Slides by: John & Pamela Hall Aggregate Demand and Aggregate Supply

2 Figure 1: The Two-Way Relationship Between Output and the Price Level

3 The Aggregate Demand Curve First step in understanding how price level affects economy is an important fact –When price level rises, money demand curve shifts rightward Shift in money demand, and its impact on the economy, is illustrated in Figure 2 Imagine a rather substantial rise in price level—from 100 to 140 Compared with our initial position, this new equilibrium has the following characteristics –Money demand curve has shifted rightward –Interest rate is higher –Aggregate expenditure line has shifted downward –Equilibrium GDP is lower All of these changes are caused by a rise in price level A rise in price level causes a decrease in equilibrium GDP

4 Figure 2: Deriving the Aggregate Demand Curve

5 Deriving the Aggregate Demand Curve Panel (c) of Figure 2 shows a new curve –Shows negative relationship between price level and equilibrium GDP Call aggregate demand curve –Tells us equilibrium real GDP at any price level

6 Understanding the AD Curve AD curve is unlike any other curve you’ve encountered in this text –In all other cases, our curves have represented simple behavioral relationships But AD curve represents more than just a behavioral relationship between two variables –Each point on curve represents a short-run equilibrium in economy A better name for AD curve would be “equilibrium output at each price level” curve—not a very catchy name –AD curve gets its name because it resembles demand curve for an individual product –AD curve is not a demand curve at all, in spite of its name

7 Movements Along the AD Curve As you will see later in this chapter, a variety of events can cause price level to change, and move us along AD curve –Suppose price level rises, and we move from point E to point H along this curve –Following sequence of events occurs Opposite sequence of events will occur if price level falls, moving us rightward along AD curve

8 Shifts of the AD Curve When we move along AD curve in Figure 2, we assume that price level changes –But that other influences on equilibrium GDP are constant –Keep following rule in mind When a change in price level causes equilibrium GDP to change, we move along AD curve Whenever anything other than price level causes equilibrium GDP to change, AD curve itself shifts Equilibrium GDP will change whenever there is a change in any of the following –Government purchases –Taxes –Autonomous consumption spending –Investment spending –Net exports –Money supply

9 An Increase in Government Purchases Spending shocks initially affect economy by shifting aggregate expenditure line In Figure 3, we assume economy begins at a price level of 100 Let’s increase government purchases by $2 trillion and ask what happens if price level remains at 100 –An increase in government purchases shifts entire AD curve rightward AD curve shifts rightward when government purchases, investment spending, autonomous consumption spending, or net exports increase, or when taxes decrease Analysis also applies in the other direction –AD curve shifts leftward when government purchases, investment spending, autonomous consumption spending, or net exports decrease, or when taxes increase

10 Figure 3: A Spending Shock Shifts the AD Curve

11 Changes in the Money Supply Changes in money supply will also shift aggregate demand curve –Imagine that Fed conducts open market operations to increase money supply –AD curve shifts rightward A decrease in money supply would have the opposite effect

12 Shifts vs. Movements Along the AD Curve: A Summary Figure 4 summarizes how some events in economy cause a movement along AD curve, and other events shift AD curve Panels (b) and (c) of Figure 4 tell us how a variety of events affect AD curve, but not how they affect real GDP Where will price level end up? –First step in answering that question is to understand the other side of the relationship between GDP and price level

13 Figure 4: Effects of Key Changes on the Aggregate Demand Curve

14 Costs and Prices Price level in economy results from pricing behavior of millions of individual business firms –In any given year, some of these firms will raise their prices, and some will lower them But often, all firms in the economy are affected by the same macroeconomic event –Causing prices to rise or fall throughout the economy To understand how macroeconomic events affect the price level, we begin with a very simple assumption –A firm sets price of its products as a markup over cost per unit

15 Costs and Prices Percentage markup in any particular industry will depend on degree of competition there In macroeconomics, we are not concerned with how the markup differs in different industries –But rather with average percentage markup in economy Determined by competitive conditions Competitive structure changes very slowly, so average percentage markup should be somewhat stable from year-to-year But a stable markup does not necessarily mean a stable price level, because unit costs can change –In short-run, price level rises when there is an economy-wide increase in unit costs Price level falls when there is an economy-wide decrease in unit costs

16 GDP, Costs, and the Price Level Why should a change in output affect unit costs and price level? –As total output increases Greater amounts of inputs may be needed to produce a unit of output Price of non-labor inputs rise Nominal wage rate rises A decrease in output affects unit costs through the same three forces, but with opposite result

17 The Short Run All three of our reasons are important in explaining why a change in output affects price level –However, they operate within different time frames But our third explanation—changes in nominal wage rate—is a different story For a year or more after a change in output, changes in average nominal wage are less important than other forces that change unit costs Some of the more important reasons why wages in many industries respond so slowly to changes in output –Many firms have union contracts that specify wages for up to three years –Wages in many large corporations are set by slow-moving bureaucracies –Wage changes in either direction can be costly to firms –Firms may benefit from developing reputations for paying stable wages

18 The Short Run Nominal wage rate is fixed in short-run –We assume that changes in output have no effect on nominal wage rate in short-run Since we assume a constant nominal wage in short-run, a change in output will affect unit costs through the other two factors –In short-run, a rise (fall) in real GDP, by causing unit costs to increase (decrease), will also cause a rise (decrease) in price level

19 Deriving the Aggregate Supply Curve Figure 5 summarizes discussion about effect of output on price level in short-run Each time we change level of output, there will be a new price level in short-run –Giving us another point on the figure –If we connect all of these points, we obtain economy’s aggregate supply curve Tells us price level consistent with firms’ unit costs and their percentage markup at any level of output over short-run A more accurate name for AS curve would be “short-run-price-level-at-each-output-level” curve

20 Figure 5: The Aggregate Supply Curve

21 Movements Along the AS Curve When a change in output causes price level to change, we move along economy’s AS curve –What happens in economy as we make such a move? –As we move upward along AS curve, we can represent what happens as follows

22 Shifts of the AS Curve Figure 5 assumed that a number of important variables remained unchanged –But in real world, unit costs sometimes change for reasons other than a change in output In general, we distinguish between a movement along AS curve, and a shift of curve itself, as follows –When a change in real GDP causes the price level to change, we move along AS curve When anything other than a change in real GDP causes price level to change, AS curve itself shifts What can cause unit costs to change at any given level of output? –Changes in world oil prices –Changes in the weather –Technological change –Nominal wage, etc.

23 Figure 6: Shifts of the Aggregate Supply Curve Price Level Real GDP ($ Trillions) 100 AS 1 10 A AS L

24 Figure 7: Effects of Key Changes on the Aggregate Supply Curve

25 AD and AS Together: Short-Run Equilibrium Where will the economy settle in short-run? –Where is our short-run macroeconomic equilibrium? We know that in equilibrium, economy must be at some point on AD curve Short-run equilibrium requires economy be operating on its AS curve Only when economy is at point E—on both curves—will we have reached a sustainable level of real GDP and the price level

26 Figure 8: Short-Run Macroeconomic Equilibrium

27 What Happens When Things Change? Now that we know how short-run equilibrium is determined, and armed with our knowledge of AD and AS curves, we are ready to put model through its paces Our short-run equilibrium will change when either AD curve, AS curve, or both, shift –An event that causes AD curve to shift is called a demand shock –An event that causes AS curve to shift is called a supply shock In earlier chapters, we’ve used phrase spending shock –A change in spending by one or more sectors that ultimately affects entire economy –Demand shocks and supply shocks are just two different categories of spending shocks

28 An Increase in Government Purchases Shifts AD curve rightward –Can see how it affects economy in short-run Process we’ve just described is not entirely realistic –Assumes that when government purchases rise, first output increases, and then price level rises –In reality, output and price level tend to rise together

29 Figure 9: The Effect of a Demand Shock Price Level Real GDP ($ Trillions) AS 10 E AD 1 H J AD 2

30 An Increase in Government Purchases Can summarize impact of price-level changes –When government purchases increase, horizontal shift of AD curve measures how much real GDP would increase if price level remained constant But because price level rises, real GDP rises by less than horizontal shift in AD curve

31 An Decrease in Government Purchases

32 An Increase in the Money Supply Although monetary policy stimulates economy through a different channel than fiscal policy –Once we arrive at AD and AS diagram, two look very much alike –Can represent situation as follows

33 Other Demand Shocks A positive demand shock—shifts AD curve rightward –Increases both real GDP and price level in short-run A negative demand shock—shifts AD curve leftward –Decreases both real GDP and price level in short-run

34 An Example: The Great Depression U.S. economy collapsed far more seriously during 1929 through 1933—the onset of the Great Depression—than it did at any other time What do we know about demand shocks that caused Great Depression? –Fall of 1929, bubble of optimism burst –Stock market crashed, and investment and consumption spending plummeted –Demand for products exported by United States fell –Fed reacted by cutting money supply sharply Each of these events contributed to a leftward shift of AD curve –Causing both output and price level to fall

35 Demand Shocks: Adjusting to the Long-Run In Figure 9, point H shows new equilibrium after a positive demand shock in short-run—a year or so after the shock –But point H is not necessarily where economy will end up in long-run In short-run, we treat wage rate as given –But in long-run, wage rate can change –When output is above full employment, wage rate will rise, shifting AS curve upward –When output is below full employment, wage rate will fall, shifting AS curve downward

36 Demand Shocks: Adjusting to the Long Run Increase in government purchases has no effect on equilibrium GDP in long-run –Economy returns to full employment, which is just where it started –This is why long-run adjustment process is often called economy’s self-correcting mechanism If a demand shock pulls economy away from full employment –Change in wage rate and price level will eventually cause economy to correct itself and return to full- employment output

37 Figure 10: The Long-Run Adjustment Process Price Level Long-Run AS Curve Real GDP P 1 Y FE E AS 1 AD Y 2 P H AS 2 P 4 K Y 3 P 3 J

38 Demand Shocks: Adjusting to the Long Run For a positive demand shock that shifts AD curve rightward, self-correcting mechanism works like this

39 Figure 11: Long-Run Adjustment After A Negative Demand Shock

40 Demand Shocks: Adjusting to the Long Run Complete sequence of events after a negative demand shock looks like this

41 Demand Shocks: Adjusting to the Long Run Can summarize economy’s self-correcting mechanism as follows –Whenever a demand shock pulls economy away from full employment Self-correcting mechanism will eventually bring it back –When output exceeds its full-employment level, wages will eventually rise Causing a rise in price level and a drop in GDP until full employment is restored –When output is less than its full employment level wages will eventually fall Causing a drop in price level and a rise in GDP until full employment is restored

42 The Long-Run Aggregate Supply Curve Self-correcting mechanism provides an important link between economy’s long-run and short-run behaviors Long-run aggregate supply curve also illustrates another classical conclusion –An increase in government purchases causes complete crowding out Rise in government purchases is precisely matched by a drop in consumption and investment spending –Leaving total output and total spending unchanged Self-correcting mechanism shows that, in long-run, economy will eventually behave as classical model predicts But notice the word eventually in the previous statement –This is why governments around the world are reluctant to rely on self-correcting mechanism alone to keep economy on track

43 Figure 12: The Long-Run Adjustment Process

44 Short-Run Effects of Supply Shocks Figure 13 shows an example of a supply shock –An increase in world oil prices that shifts aggregate supply curve upward, from AS 1 and AS 2 –Called negative supply shock, because of negative effect on output In short-run a negative supply shock shifts AS curve upward, decreasing output and increasing price level Notice sharp contrast between effects of negative supply shocks and negative demand shocks in short-run –Economists and journalists have coined term “stagflation” to describe a stagnating economy experiencing inflation A negative supply shock causes stagflation in short-run Examples of positive supply shocks include unusually good weather, a drop in oil prices, and a technological change that lowers unit costs –In addition, a positive supply shock can sometimes be caused by government policy

45 Figure 13: The Effect of a Supply Shock

46 Long-Run Effects of Supply Shocks What about effects of supply shocks in long-run? –In some cases, we need not concern ourselves with this question, because some supply shocks are temporary In other cases, however, a supply shock can last for an extended period In long-run, economy self-corrects after a supply shock, just as it does after a demand shock –When output differs from its full-employment level Wage rate changes AS curve shifts until full employment is restored

47 Some Important Provisos About the AS Curve Upward-sloping aggregate supply curve we’ve presented in this chapter gives a realistic picture of how economy behaves after a demand shock However, the story we have told about what happens as we move along AS curve is somewhat incomplete –Made assumption that prices are completely flexible—that they can change freely over short periods of time In fact, however, some prices take time to adjust, just as wages take time to adjust –Assumed that wages are completely inflexible in short-run But in some industries, wages respond quickly –More to process of recovering from a shock than adjustment of prices and wages

48 Using the Theory: The Recession of Story of recession begins in mid- 1990, when Iraq invaded Kuwait –During this conflict, Kuwait’s oil was taken off world market, as was Iraq’s –Reduction in oil supplies resulted in a rapid and substantial increase in price of oil

49 Using the Theory: The Recession of 2001 Story of 2001 recession was quite different –This time, there was no spike in oil prices and no other significant supply shock to plague economy –Rather, there was a demand shock, and a Federal reserve policy during the year before the recession that might have made it a bit worse During late 1990s, Fed had become concerned that investment boom and consumer optimism were shifting AD curve rightward too rapidly –Creating a danger that we would overshoot potential GDP and set off higher inflation –Fed responded by tightening money supply and raising interest rate –Effects of this policy may have continued into early 2001, exacerbating decrease in investment that was occurring for other reasons In this way, rate hikes themselves may have contributed to a further leftward shift of AD curve

50 Figure 14: An AD and AS analysis of Two Recessions

51 Figure 15: GDP and the Price Level in Two Recessions

52 Using the Theory: Jobless Expansions After a recession, economy enters expansion phase of business cycle –Employment usually grows rapidly during this period as well But in our two most recent recessions, economy experienced abnormal, prolonged periods during which employment did not grow at all Figure 16 illustrates behavior of employment during our two most recent recession –Called trough of recession Vertical axis shows an employment index—employment divided by employment at the trough Blue line shows that employment falls during the contraction phase of average cycle –Rises rapidly during the first year of the expansion phase But red and pink lines show what happened in first year of our most recent expansions—during 1992 and 2002 –In both cases, employment drifted slightly downward, telling us that total number of jobs decreased during year

53 Figure 16: The Average Expansion Versus Two Recent Jobless Expansions

54 Explaining Jobless Expansions Since story is similar for both of these expansions, let’s focus on period from late 2001 to late 2002— the first year of expansion after our most recent recession –Using equation for economic growth Real GDP = productivity x average hours x (emp / pop) x population But equation can be used in different ways –Now we’re using equation to account for deviations in employment away from full employment in short-run For this purpose, we’ll need to make some adjustments to equation –Real GDP = productivity x average hours x employment

55 Explaining Jobless Expansions Let’s convert equation to percentage changes –%Δ real GDP = %Δ productivity + %Δ employment Finally, rearranging –%Δ employment (-0.3%) = %Δ real GDP (2.9%) - %Δ productivity (3.2%) Numbers in parentheses show actual percentage changes for each of these variables during 2002

56 Explaining Jobless Expansions Why didn’t real GDP growth keep up with productivity? –Because growth in real GDP was unusually low –Productivity grew at about the same rate as average expansion, in spite of the low growth in output –Throughout period, firms were reluctant to hire full-time, permanent workers Created uncertainty about strength and duration of expansion Instead, business expanded output by hiring part-time and temporary workers Why would this boost productivity? –Enabled firms to adjust their workforce more easily to fluctuations in production Phrase “jobless expansion” refers to just part of expansion phase –Eventually, employment catches up—even to higher levels of output made possible by productivity growth