Chapter 13 We have seen how labor market equilibrium determines the quantity of labor employed, given a fixed amount of capital, other factors of production and the state of technology. Recall that the quantity of real GDP at full employment is potential GDP. Over the business cycle, real GDP fluctuates around potential GDP because the quantity of labor employed fluctuates around the full employment level. The aggregate supply-aggregate demand (AS-AD) model explains these fluctuations.

Aggregate supply All other things remaining constant, the higher the price level, the greater is the quantity of real GDP supplied; the lower the price level, the smaller is the quantity of real GDP supplied. The aggregate supply curve shows the quantities of real GDP supplied at each price level:

As we move along the AS curve, the only thing that can cause a change in the quantity of real GDP supplied is a change in the price level. E.g., if the price level increases from 115 to 130, real GDP increases from $9 trillion to $10 trillion. If the price level decreases from 115 to 100, real GDP decreases from $9 trillion to $8 trillion. When the price level is 115, the quantity of real GDP supplied is $9 trillion, which is potential GDP. Potential GDP is illustrated as a vertical line because it does not change when the price level changes. Potential GDP depends only on the economy’s ability to produce real output and on the full employment quantity of labor.

Why does the AS curve slope upward? If the price level increases, the real wage rate decreases. Recall that, for an individual employer, Real wage rate =Nominal wage rate Product price __________________________ An increase in the price level means that product prices rise and the real wage rate falls.

A fall in the real wage rate means that the firm’s cost of labor has decreased relative to the revenue an hour’s labor can produce, and therefore the firm’s profit increases. An increase in firms’ profits causes existing firms to increase their output rates and new firms to enter the industry and start producing. The quantity of real GDP supplied therefore increases. A decrease in the price level means falling product prices and rising real wage rates. Firms’ profits decrease. Firms respond by reducing their output rates and some firms exit the industry. The quantity of real GDP supplied therefore decreases.

Shifts of the AS curve A shift of the AS curve is called a change in aggregate supply. A change in any factor, other than the price level, that affects production causes a shift in AS. Shifts in AS can be either increases or decreases in AS. An increase in AS means an increase in the quantity of real GDP supplied at each price level. The AS curve shifts to the right. A decrease in AS means a decrease in the quantity of real GDP supplied at each price level. The AS curve shifts to the left:

The two main factors causing shifts of AS are: Changes in potential GDP Changes in the nominal wage rate or nominal prices of other resources A change in potential GDP: If potential GDP increases, the economy can produce more real GDP at full employment. But if the economy can produce more at full employment, it can also produce more at any level of employment. Therefore, if the potential GDP line shifts to the right, the entire AS curve also shifts to the right.

If potential GDP decreases, the economy produces less at full employment and at all other levels of employment. The shift to the left of the potential GDP line is matched by a shift to the left of the AS curve. In effect, the potential GDP line “anchors” the AS curve, so that shifts of the potential GDP line cause equal shifts of the AS curve:

Changes in the nominal wage rate or nominal prices of other resources: An increase in the nominal wage rate or the nominal price of another resource raises firms’ costs and therefore reduces the quantity of output that firms are willing to supply at each price level. The quantity of real GDP supplied at any given price level therefore decreases, and the AS curve shifts to the left.

A decrease in the nominal wage rate or the nominal price of another resource reduces firms’ costs and therefore increases the quantity of output that firms are willing to supply at each price level. The quantity of real GDP supplied at any given price level therefore increases, and the AS curve shifts to the right.

Aggregate demand The total quantity of real GDP demanded is the total expenditure of consumers, businesses, government and foreigners on final goods and services produced in the U.S. Y = C + I + G + NX All other things remaining constant, the higher the price level, the smaller is the quantity of real GDP demanded; the lower the price level, the greater is the quantity of real GDP demanded.

Why does the AD curve slope downward? The higher the price level, the lower the purchasing power of a given nominal amount of money. Therefore consumers and firms reduce their expenditures. The quantity of real GDP demanded decreases. As we move along the AD curve, the only thing that can cause a change in the quantity of real GDP demanded is a change in the price level.

Also, the higher the price level in the U.S., holding prices in other countries constant, the lower is spending by foreigners and U.S. residents on U.S.- produced goods and the higher is spending on foreign-produced goods. Net exports from the U.S. decrease. Therefore the quantity of domestically produced real GDP demanded decreases. The lower the price level, the greater the purchasing power of money, and therefore expenditure increases. Also, lower domestic prices relative to foreign prices cause net export expenditure to increase. For both of these reasons, the quantity of real GDP demanded increases.

Shifts of the AD curve A shift of the AD curve is called a change in aggregate demand. A change in any factor, other than the price level, that affects expenditure plans causes a shift in AD. Shifts in AD can be either increases or decreases in AD. An increase in AD means an increase in the quantity of real GDP demanded at each price level. The AD curve shifts to the right. A decrease in AD means a decrease in the quantity of real GDP demanded at each price level. The AD curve shifts to the left:

The main factors causing shifts of AD are: Expectations Fiscal and monetary policy Changes in the world economy Expectations: An increase in expected future income increases current consumption expenditure at any given level of prices. AD increases. An increase in expected future inflation causes an increase in current consumption expenditure at any given level of current prices, as households purchase more goods and services in anticipation of their prices rising in the future. AD increases.

An increase in expected future profit causes firms to increase current investment expenditure at any given level of prices. AD increases. Fiscal and monetary policy: An increase in government expenditure or a cut in net taxes causes an increase in total expenditure at any given level of prices. AD increases. A cut in interest rates or an increase in the money supply causes an increase in expenditure at any given level of prices. AD increases.

The world economy: If the U.S. dollar rises in value relative to foreign currencies, foreign-produced goods become relatively cheaper than U.S.-produced goods. Expenditure on U.S.-produced goods (by both foreigners and U.S. residents) decreases, and AD in the U.S. therefore decreases. An increase in income in foreign countries causes an increase in foreigners’ expenditure, including their expenditure on U.S. exports, and therefore an increase in AD in the U.S.

The AD multiplier When AD increases, the increase in expenditure causes an increase in income. This increase in income causes a further round of increased consumption expenditure, and therefore a further increase in AD. For example, suppose there is initially an increase in investment expenditure, ΔI:

The initial AD curve shifts out from AD 0 to AD 0 +ΔI. The extra investment spending causes an increase in income which causes a further round of consumption increases, etc., and AD increases further to AD 1. AD 1 now describes aggregate spending plans at each price level.

Macroeconomic equilibrium Macroeconomic equilibrium occurs where the quantity of real GDP supplied is equal to the quantity of real GDP demanded, i.e., at the intersection of the AS and AD curves. Why is this an equilibrium?

Equilibrium occurs at a price level of 115, where the quantity of real GDP supplied = the quantity of real GDP demanded = $9 trillion. If the price level is above 115, say, 130, the quantity of real GDP supplied is $10 trillion at point A. But the quantity of real GDP demanded is less than $10 trillion. Firms are unable to sell all of their output. Therefore, there is an unplanned increase in firms’ inventories. Firms respond by reducing production and cutting prices. The combination of a decrease in output and a decrease in prices means a movement down along the AS curve from point A toward point E.

If the price level is below 115, say, 100, the quantity of real GDP supplied is $8 trillion at point B. But the quantity of real GDP demanded is more than $8 trillion. There is an unplanned decrease in firms’ inventories as firms are unable to meet all of their customers’ demands. Firms respond by increasing production and raising prices. The combination of an increase in output and an increase in prices means a movement up along the AS curve from point B toward point E. Macroeconomic equilibrium can occur at full employment, above full employment, or below full employment:

Fluctuations in AD cause fluctuations in real GDP around potential GDP. At point E, AD 0 intersects AS at potential GDP. Equilibrium real GDP = Potential GDP Equilibrium real GDP is $9 trillion. This is a full employment equilibrium. Now, if AD increases to AD 1, firms’ inventories decrease and firms respond by increasing production and raising prices to meet the higher demand. Equilibrium real GDP increases to $10 trillion at point A. Equilibrium real GDP now exceeds potential GDP. This is an above-full employment equilibrium.

If AD now decreases to AD 2, firms’ inventories increase and firms respond by cutting production and lowering prices in order to sell all of their output. Equilibrium real GDP decreases to $8 trillion at point B. Equilibrium real GDP is now less than potential GDP. This is a below-full employment equilibrium. The business cycle Fluctuations in AD can cause business cycle fluctuations in real GDP. When AD increases from AD 0 to AD 1, equilibrium real GDP increases from full employment, at $9 trillion, to $10 trillion, which is a business cycle expansion.

If AD now decreases back to AD 0, equilibrium real GDP decreases again to $9 trillion, the full employment level. If AD decreases further to AD 2, equilibrium real GDP decreases to $8 trillion and the economy is in a recession, with equilibrium real GDP below full employment. If AD increases again to AD 0, equilibrium real GDP increases back to the full employment level of $9 trillion. The causes of these AD fluctuations are any of the factors we have discussed: changes in expectations, fiscal or monetary policy, or global economic conditions.

AS fluctuations Recall that AS can shift either because of a change in potential GDP or because of a change in the nominal price of labor or some other major resource. Potential GDP grows during periods of rapid technological change and capital accumulation. A good example of a change in the price of a major resource is a change in the price of crude oil. Oil is used as an input in the production of many goods and services because oil is used to produce electrical power and fuel for transportation.

Assume that the economy is initially in equilibrium at full employment, i.e., equilibrium real GDP = potential GDP. Now, oil prices rise. Firms face higher transportation and energy costs and therefore reduce production. AS decreases from AS 0 to AS 1 :

Equilibrium real GDP decreases below potential GDP and the price level rises. The economy is in a recession because real GDP is below full employment. But there is also inflation. A combination of recession and inflation is called stagflation, and occurred in the U.S. and the global economy in the mid-1970s and early 1980s. Starting from the same full employment equilibrium, if oil prices fall, firms’ transportation and energy costs decrease and firms increase production. AS increases from AS 0 to AS 2 :

Equilibrium real GDP increases above potential GDP and the price level falls. The economy is in an above- full employment equilibrium. In the mid-1980s, an economic expansion coincided with slowing inflation. Adjustment to full employment When a shift in AD moves the economy to an equilibrium that is above or below full employment, automatic forces operate to bring the economy back to full employment in the long run. AD increases from AD 0 to AD 1. Equilibrium real GDP increases above potential GDP. There is now an inflationary gap. This is a gap between actual GDP and full employment GDP that causes prices to rise:

The increase in the price level reduces the purchasing power of workers’ wages, while firms’ profits have increased. Workers demand higher wages to compensate them for higher prices, and other input suppliers likewise demand higher prices for their inputs. Firms agree to these demands because they want to maintain their output and employment in the face of strong demand for their products. As nominal wage rates and nominal prices of other inputs rise, AS decreases. The AS curve shifts from AS 0 to AS 1 and equilibrium real GDP decreases back to potential GDP. Full employment equilibrium is restored:

A decrease in AD from AD 0 to AD 2 causes equilibrium real GDP to decrease below potential GDP. There is now a deflationary gap. This is a gap between actual GDP and full employment GDP that causes prices to fall:

The economy is now in recession at an equilibrium level of real GDP that is below full employment, and the price level has fallen. Those workers who are still employed see the purchasing power of their wages rise due to the drop in prices. Firms’ profits decrease and, due to the surplus of unemployed labor, nominal wages fall. As firms reduce output, they purchase fewer inputs, and therefore nominal input prices fall too. As nominal wage rates and nominal prices of other inputs fall, AS increases. The AS curve shifts from AS 0 to AS 2 and equilibrium real GDP increases back to potential GDP. Full employment equilibrium is again restored: