Chapter 13: Aggregate Demand and Aggregate Supply

Jump to first page Aggregate Demand for Goods & Services

Jump to first page Aggregate Demand for Goods & Services n Aggregate demand curve: -- indicates the various quantities of domestically produced goods & services that purchasers are willing to buy at different price levels. n The AD curve slopes downward to the right, indicating an inverse relationship between the amount of goods & services demanded and the price level.

Jump to first page G oods & S ervices (real GDP) P rice level AD P 2 Y 1 Y 2 P 1 A reduction in the price level will increase the quantity of goods & services demanded. Aggregate Demand Curve

Jump to first page Why Does the Aggregate Demand Curve Slope Downward n The Wealth Effect: A lower price level will increase the purchasing power of the fixed quantity of money. n The Interest Rate Effect: A lower price level will make the nominal interest rate appear lower which will stimulate additional purchases during the current period. n The Foreign Purchases Effect: Other things constant, a lower price level will make domestically produced goods less expensive relative to foreign goods.

Jump to first page Factors that Shift Aggregate Demand

Jump to first page Factors that Shift Aggregate Demand n A change of businesses and consumers Expectations about the future n A change in Real Wealth.. n A change in Consumer Debt. n *A change in Taxes or Government Spending.

Jump to first page G oods & S ervices (real GDP) P rice level AD 0 Shifts in Aggregate Demand AD 1 2

Jump to first page Aggregate Supply of Goods and Services

Jump to first page Aggregate Supply of Goods & Services n When considering the Aggregate Supply curve, it is important to distinguish between the short-run and the long-run. n Short-run: -- time period during which some prices, particularly those in resource markets, are set by prior contracts and agreements. Therefore, in the short-run, households and businesses are unable to adjust these prices when unexpected changes occur, including unexpected changes in the price level. n Long-run: -- a time period of sufficient duration that people have the opportunity to modify their behavior in response to economic changes.

Jump to first page Short-Run Aggregate Supply (SRAS)

Jump to first page Short-Run Aggregate Supply (SRAS) n SRAS indicates the various quantities of goods & services that domestic firms will supply in response to changing demand conditions that alter the level of prices in the goods & services market. n SRAS curve slopes upward to the right. n The upward slope reflects the fact that in the short run an unanticipated increase in the price level will improve the profitability of firms and they will respond with an expansion in output.

Jump to first page G oods & S ervices (real GDP) P rice level SRAS (P 100 ) P 105 P 100 P 95 Y 1 Y 2 Y 3 Short-Run Aggregate Supply Curve An increase in the price level will increase the quantity supplied in the short run.

Jump to first page Shifts in Aggregate Supply Factors that change SRAS: n A change in resource costs such as wages, rent, and interest. n Unexpected supply shocks such as a change in weather or in the world price of a key imported resource. n *A change in Taxes or Government Spending

Jump to first page Shifts in Short Run Aggregate Supply G oods & S ervices (real GDP) P rice level SRAS 1 SRAS 2

Jump to first page Long-Run Aggregate Supply (LRAS)

Jump to first page Long-Run Aggregate Supply (LRAS) n LRAS indicates the relationship between the price level and quantity of output after decision makers have had sufficient time to adjust their prior commitments where possible. n LRAS curve is vertical. n LRAS is related to the economy's production possibilities frontier. A higher price level does not loosen the constraints imposed by the economy's resource base, level of technology, and the efficiency of its institutional arrangements.

Jump to first page G oods & S ervices (real GDP) P rice level LRAS Y F (full employment rate of output) Long-Run Aggregate Supply Curve Change in price level does not affect quantity supplied in the long run. Potential GDP

Jump to first page Shifts in Long Run Aggregate Supply n Factors that change LRAS: u A change in the supply of resources. u A change in technology and productivity. u Institutional changes that change the efficiency of resource use such as trade agreements.

Jump to first page G oods & S ervices (real GDP) P rice level LRAS 1 Y F,1 n Such factors as an increase in the stock of capital or an improvement in technology will expand the economy’s potential output and shift the LRAS to the right (note that SRAS will also shift to the right). n Such factors as a reduction in resource prices, favorable weather, or a temporary decrease in the world price of an important imported resource would shift SRAS to the right (note that LRAS will remain constant). Shifts in Long RunAggregate Supply LRAS 2 Y F,2

Jump to first page Anticipated and Unanticipated Changes

Jump to first page Anticipated and Unanticipated Changes n Anticipated changes are foreseen by economic participants. n Decision makers have time to adjust to them before they occur. n Unanticipated changes catch people by surprise.

Jump to first page Unanticipated Changes in Aggregate Demand

Jump to first page Unanticipated Changes in Aggregate Demand n Impact of unanticipated reductions in AD: n Weak demand and lower prices in the goods & services market will reduce profit margins. Many firms will incur losses. n Firms will reduce output, the rate of unemployment will rise above the natural rate, and output will temporarily fall short of the economy's long-run potential. n With time, long-term contracts will be modified. n Eventually, lower resource costs and a lower real interest rate will direct the economy back to long-run equilibrium, but this may be a lengthy and painful process.

Jump to first page LRAS G oods & S ervices (real GDP) P rice level P 100 Y F SRAS 1 AD 1 Unanticipated Reduction in Aggregate Demand n The short-run impact of an unanticipated reduction in AD (shift from AD 1 to AD 2 ) will be a decline in output (decreases to Y 2 ), and a lower price level (P 95 ). Short-run effects of an unanticipated reduction in AD P 95 Y 2 AD 2 n Temporarily, profit margins decline, output falls, and unemployment rises higher than the natural rate.

Jump to first page LRAS G oods & S ervices (real GDP) P rice level SRAS 1 AD 1 P 100 n In the long-run, weak demand and excess supply in the resource market will lead to lower wage rates and resource prices resulting in an expansion in short-run aggregate supply to SRAS 2. n In the long-run, a new equilibrium at a lower price level (P 90 ) and an output consistent with the economy’s sustainable potential will result. Y F AD 2 P 95 P 90 Y 2 Unanticipated Reduction in Aggregate Demand n This method of restoring equilibrium may be both long and painful. SRAS 2 Y F Long-run effects of an unanticipated reduction in AD

Jump to first page Unanticipated Changes in Aggregate Demand n Impact of unanticipated increases in AD: n Initially, the strong demand and higher price level in the goods & services market will temporarily improve profit margins. n Output will increase, the rate of unemployment will drop below the natural rate, and output will temporarily exceed the economy's long-run potential. n With time, however, contracts will be modified and resource prices will rise and return to their competitive relation with product prices. n Once this happens, output will recede to the economy's long-run potential.

Jump to first page LRAS G oods & S ervices (real GDP) P rice level P 100 Y F SRAS 1 AD 1 Unanticipated Increase in Aggregate Demand n In response to an unanticipated increase in AD for goods & services (shift from AD 1 to AD 2 ), prices will rise to P 105 and output will temporarily exceed full-employment capacity (increases to Y 2 ). P 105 Y 2 AD 2 Short-run effects of an unanticipated increase in AD

Jump to first page LRAS G oods & S ervices (real GDP) P rice level SRAS 1 AD 1 P 100 n With the passage of time, prices in resource markets, including the labor market, will rise due to the strong demand. As a result, higher costs reduce aggregate supply to SRAS 2. n In the long-run, a new equilibrium at a higher price level (P 110 ) and an output consistent with the economy’s sustainable potential will occur. Y F AD 2 P 110 P 105 Y 2 Unanticipated Increase in Aggregate Demand n Thus, the increase in demand will expand output only temporarily. SRAS 2 Y F Long-run effects of an unanticipated increase in AD

Jump to first page Impact of Changes in Aggregate Supply

Jump to first page Impact of Changes in Aggregate Supply n Economic growth and anticipated shifts in long-run aggregate supply. n Increases in LRAS will make it possible to produce and sustain a larger rate of output. n Both LRAS and SRAS will shift to the right and output will increase. n These changes generally take place slowly and therefore they need not disrupt long-run equilibrium.

Jump to first page LRAS 1 G oods & S ervices (real GDP) P rice level Y F AD P 1 SRAS 1 Y F1 SRAS 2 Y F2 LRAS 2 Y F2 n Here we illustrate the impact of economic growth due to capital formation or a technological advancement, for example. n Both LRAS and SRAS increase (to LRAS 2 and SRAS 2 ); the full employment output of the economy expands from Y F1 to Y F2. P 2 Growth in Aggregate Supply n A sustainable, higher level of real output and real income is the result. If the money supply is held constant, a new long-run equilibrium will emerge at a larger output rate (Y F2 ) and lower price level (P 2 ).

Jump to first page The Business Cycle -- Revisited

Jump to first page The Business Cycle -- Revisited n Recessions occur because prices in the goods & services market are low relative to the costs of production and resource prices. n The two causes of recessions: n unanticipated reductions in aggregate demand, and, n unfavorable supply shocks. n An unsustainable economic boom occurs when prices in the goods & services market are high relative to costs and resource prices. n The two causes of booms are: n unanticipated increases in aggregate demand, and, n favorable supply shocks.

Jump to first page ,000 4,000 2, P ercentage of the L abor F orce U nemployed R eal GDP (billions of 1987 $) Source: Derived from computerized data supplied by FAME Economics. Actual rate of unemployment Natural rate of unemployment (estimated range) Expansion Real GDP 1960 Recession 1970 Recession 1974–75 Recession 1982 Recession 1990 Recession 1980 Recession Expansion Here we illustrate the periods of expansion and contraction (recession) since Note how the reductions in real GDP (shaded periods) in the top graph are associated with increases in the rate of unemployment well above the natural rate (bottom graph). The AD/AS model indicates that recessions are caused by unanticipated reductions in AD that are likely to accompany abrupt reductions in the inflation rate and/or adverse supply shocks that might occur, for example, when there is a large increase in the price of a key imported resource, such as crude oil. Expansions, Recessions, and the Rate of Unemployment

Jump to first page Does the Market Have a Self-Corrective Mechanism That Will Keep it on Track?

Jump to first page Does the Market Have a Self-Corrective Mechanism That Will Keep it on Track? n There are three reasons to believe that it does: n Consumption demand is relatively stable over the business cycle. n Changes in real interest rates will help to stabilize aggregate demand and redirect economic fluctuations. n Interest rates will tend to fall during a recession and rise during and economic boom. n Changes in real resource prices will redirect economic fluctuations. n Real resource price will tend to fall during a recession and rise during an economic expansion.

Jump to first page P rice level LRAS Y F G oods & S ervices (real GDP) n When aggregate output is less than the economy’s full employment potential (Y F ), weak demand for investment leads to lower real interest rates, while slack employment in resource markets will place downward pressure on wages and other resource prices (P r ). Changes in Real Interest Rates and Resource Prices Over the Business Cycle r Real interest rates fall (because of weak demand for investment) r Real interest rates rise (because of strong demand for investment) P r Real resource prices fall (because of weak demand and high unemployment) P r Real resource prices rise (because of strong demand and low unemployment) U nemployment greater than N atural R ate U nemployment less than N atural R ate n Conversely, when output exceeds Y F, strong demand for capital goods and tight labor market conditions will result in rising real interest rates and resource prices (P r ).

Jump to first page G oods & S ervices (real GDP) P rice level SRAS 1 AD 1 P 100 Y 1 LRAS Y F P 105 P 95 SRAS 2 Y F AD 2 Lower resource prices increase SRAS Lower real interest rates increase AD The Economy’s Self Corrective Mechanism n If output is temporarily less than capacity, lower interest rates (reflecting the weak demand for investment funds) will stimulate aggregate demand (shifting AD from AD 1 to AD 2 ). n In addition, lower resource prices will reduce production prices (because of weak demand and abnormally high unemployment) and thereby stimulate SRAS (shifting SRAS to SRAS 2 ). n This output will move the economy toward full-employment capacity. However, this self-correction process may take some time. Y F In the short-run, output may exceed or fall short of the economy’s full-employment capacity (Y F ).

Jump to first page P rice level G oods & S ervices (real GDP) SRAS 1 AD 1 P 100 Y 1 LRAS Y F P 95 n If output is temporarily greater than the economy’s potential, higher real interest rates and resource prices will lead to a lower but sustainable rate of output. Y F P 105 The Economy’s Self Corrective Mechanism SRAS 2 AD 2 n Higher interest rates will reduce AD (from AD 1 to AD 2 ). n At the same time, higher resource prices will increase production costs and therefore reduce SRAS (from SRAS 1 to SRAS 2 ). n These forces direct output toward full-employment potential (Y F ). In the short-run, output may exceed or fall short of the economy’s full-employment capacity (Y F ). Y F Higher resource prices reduce SRAS Higher real interest rates reduce AD

Jump to first page The Great Debate: -- How rapidly does the self-corrective mechanism work?

Jump to first page The Great Debate: -- How rapidly does the self-corrective mechanism work? n Many economists believe that the self- corrective mechanism works slowly. n If this is the case, then market economies will still experience prolonged periods of abnormally high unemployment and below-capacity output. n Others believe that the self-corrective mechanism works fairly rapidly if it is not disrupted by perverse monetary and fiscal policy. n This is an important and continuing debate that we will return to and analyze in more detail as we proceed.

Jump to first page End Chapter 13