Chapter 11 Aggregate Demand and Supply

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-2 Introduction Economists and financial news media anticipate the latest measure of total output by the Bureau of Economic Analysis (BEA). How does the BEA attempt to gauge the economy’s performance? You will find out in this chapter.

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-3 Did You Know That... Decisions on how to categorize business expenses will affect the relative size of an increase or a decrease in economic activity? Statisticians measuring our national economic performance strive for consistency in constructing their measures across time?

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-4 The Simple Circular Flow Two observations 1. In every economic exchange, the seller receives exactly the same amount that the buyer spends. 2. Goods and services flow in one direction and money payments flow in the other.

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-5 The Simple Circular Flow (cont'd) Profits explained  Question  Why is profit a cost of production?  Answer  Profits are the return entrepreneurs receive for the risk they incur when organizing productive activities.

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-6 The Simple Circular Flow (cont'd) Final Goods and Services  Goods and services that are at their final stage of production and will not be transformed into yet other goods or services

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-7 Figure 8-1 The Circular Flow of Income and Product

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-8 The Simple Circular Flow (cont'd) Product Markets  Transactions in which households buy goods

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-9 The Simple Circular Flow (cont'd) Factor Markets  Transactions in which businesses buy resources

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Simple Circular Flow (cont'd) Total Income  Wages, rent, interest, profits

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Simple Circular Flow (cont'd) Question  Why must total income be identical to the dollar value of total output? Answer  Every transaction simultaneously involves an expenditure and a receipt.

Copyright © 2008 Pearson Addison Wesley. All rights reserved National Income Accounting  A measurement system used to estimate national income and its components Total Income  The yearly amount earned by the nation’s resources (factors of production)

Copyright © 2008 Pearson Addison Wesley. All rights reserved National Income Accounting (cont'd) Gross Domestic Product (GDP)  The total market value of all final goods and services produced by factors of production located within a nation’s borders

Copyright © 2008 Pearson Addison Wesley. All rights reserved National Income Accounting (cont'd) Observations  GDP measures the dollar value of final output.  GDP measures the dollar value of final goods and services produced per year by factors of production located within a nation’s borders.

Copyright © 2008 Pearson Addison Wesley. All rights reserved National Income Accounting (cont'd) Stress on final output  What is a final good?  Wheat?  Steel?  Oil?  Bread?  Automobile?  Gasoline?

Copyright © 2008 Pearson Addison Wesley. All rights reserved National Income Accounting (cont'd) Intermediate Goods  Goods used up entirely in the production of final goods Value Added  The dollar value of an industry’s sales minus the value of intermediate goods (for example, raw materials and parts) used in production

Copyright © 2008 Pearson Addison Wesley. All rights reserved Table 8-1 Sales Value and Value Added at Each Stage of Donut Production

Copyright © 2008 Pearson Addison Wesley. All rights reserved National Income Accounting (cont'd) Exclusion of financial transactions, transfer payments, and secondhand goods  Numerous transactions occur that have nothing to do with final goods and services being produced.

Copyright © 2008 Pearson Addison Wesley. All rights reserved National Income Accounting (cont'd) Exclusion of financial transactions  Securities  Stocks and bonds  Government transfer payments  Social Security  Unemployment compensation  Private transfer payments  Individual gifts  Corporate gifts

Copyright © 2008 Pearson Addison Wesley. All rights reserved National Income Accounting (cont'd) Transfer of secondhand goods excluded  Why not count the sale of a used computer, guitar, or snowboard as part of GDP? Other excluded transactions  Household production  Legal and illegal underground transactions

Copyright © 2008 Pearson Addison Wesley. All rights reserved National Income Accounting (cont'd) GDP’s limitations  Excludes non-market production  It is not necessarily a good measure of the well-being of a nation.

Copyright © 2008 Pearson Addison Wesley. All rights reserved National Income Accounting (cont'd) GDP is a measure of the value of production in terms of market prices, and an indicator of economic activity. GDP is not a measure of a nation’s overall welfare.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Two Main Methods of Measuring GDP Expenditure Approach  Computing GDP by adding up the dollar value at current market prices of all final goods and services

Copyright © 2008 Pearson Addison Wesley. All rights reserved Two Main Methods of Measuring GDP (cont'd) Expenditure Approach

Copyright © 2008 Pearson Addison Wesley. All rights reserved Two Main Methods of Measuring GDP (cont'd) Income Approach  Measuring GDP by adding up all components of national income, including wages, interest, rent, and profits

Copyright © 2008 Pearson Addison Wesley. All rights reserved Two Main Methods of Measuring GDP (cont'd) Income Approach

Copyright © 2008 Pearson Addison Wesley. All rights reserved Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the expenditure approach  Consumption Expenditure (C)  Durable Consumer Goods  Life span of more than three years  Nondurable Consumer Goods  Goods that are used up in three years  Services  Mental or physical help

Copyright © 2008 Pearson Addison Wesley. All rights reserved Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the expenditure approach  Gross Private Domestic Investment (I)  The creation of capital goods, such as factories and machines, that can yield production and hence consumption in the future  Also included: changes in business inventories and repairs made to machines, buildings

Copyright © 2008 Pearson Addison Wesley. All rights reserved Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the expenditure approach  Gross Private Domestic Investment (I)  Producer Durables or Capital Goods  Life span of more than three years  Fixed Investment  Purchases by business of newly produced producer durables or capital goods  Inventory Investment  Changes in stocks of finished goods and goods in process, as well as changes in raw materials

Copyright © 2008 Pearson Addison Wesley. All rights reserved Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the expenditure approach  Government Expenditures (G)  State, local, and federal  Valued at cost

Copyright © 2008 Pearson Addison Wesley. All rights reserved Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the expenditure approach  Net Exports (Foreign Expenditures) Net exports (X) = Total exports – Total imports

Copyright © 2008 Pearson Addison Wesley. All rights reserved Two Main Methods of Measuring GDP (cont'd) Presenting the expenditure approach  Where  C=consumption expenditures  I=investment expenditures  G=government expenditures  X=net exports GDP = C + I + G + X

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 8-2 GDP and Its Components

Copyright © 2008 Pearson Addison Wesley. All rights reserved Deriving GDP by the Income Approach Gross Domestic Income (GDI)  The sum of all income—wages, interest, rent, and profits—paid to the four factors of production

Copyright © 2008 Pearson Addison Wesley. All rights reserved Two Main Methods of Measuring GDP (cont'd) Gross Domestic Income (GDI)  Wages: salaries and labor income  Rent: farms, houses, stores  Interest: savings accounts  Profits: sole proprietorships, partnerships, corporations

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2007 (in billions of 2007 dollars per year) Source: U.S. Department of Commerce. First quarter preliminary data annualized.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2007 (in billions of 2007 dollars per year)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Other Components of National Income Accounting National Income (NI)  The total of all factor payments to resource owners Personal Income (PI)  The amount of income that households actually receive before they pay personal income taxes

Copyright © 2008 Pearson Addison Wesley. All rights reserved Other Components of National Income Accounting (cont'd) Disposable Personal Income (DPI)  Personal income after personal income taxes have been paid

Copyright © 2008 Pearson Addison Wesley. All rights reserved Table 8-2 Going from GDP to Disposable Income, 2007

Copyright © 2008 Pearson Addison Wesley. All rights reserved Distinguishing Between Nominal and Real Values Nominal Values  Measurements in terms of the actual market prices at which goods are sold; expressed in current dollars, also called money values

Copyright © 2008 Pearson Addison Wesley. All rights reserved Distinguishing Between Nominal and Real Values (cont'd) Real Values  Measurements after adjustments have been made for changes in the average of prices between years; expressed in constant dollars Constant Dollars  Dollars expressed in terms of real purchasing power

Copyright © 2008 Pearson Addison Wesley. All rights reserved *Price level: measured by the GDP deflator Real GDP =  x 100 Nominal GDP Price level* Example: Correcting GDP for Price Index Changes Correcting GDP for price index changes  Nominal (current) dollars GDP  Real (constant) dollars GDP

Copyright © 2008 Pearson Addison Wesley. All rights reserved Table 8-3 Correcting GDP for Price Index Changes

Copyright © 2008 Pearson Addison Wesley. All rights reserved Per capita real GDP = Real GDP Population Distinguishing Between Nominal and Real Values (cont'd) Per capita GDP  Adjusting for population growth

Copyright © 2008 Pearson Addison Wesley. All rights reserved Source: U.S. Department of Commerce Figure 8-4 Nominal and Real GDP

Copyright © 2008 Pearson Addison Wesley. All rights reserved Table 8-4 Comparing GDP Internationally

Copyright © 2008 Pearson Addison Wesley. All rights reserved Issues and Applications: The Art of Estimating GDP Often Requires Touch-Ups The Bureau of Economic Analysis gives an advance estimate of quarterly GDP. The estimate receives considerable attention from the news media. Nevertheless, the estimate is updated at least two times. How different is the final result?

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 8-5 Effects of Revisions in GDP Estimates on Measured GDP Growth Rates

Copyright © 2008 Pearson Addison Wesley. All rights reserved Did You Know That... The price of a bottle of Coca-Cola remained unchanged at 5 cents from 1886–1959? Prices of final goods and services have not always adjusted immediately in response to changes in aggregate demand? The classical model and the Keynesian approach help in understanding variations in real GDP and the price level?

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Classical Model The classical model was the first attempt to explain  Determinants of the price level  National levels of real GDP  Employment  Consumption  Saving  Investment

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Classical Model (cont'd) Classical economists—Adam Smith, J.B. Say, David Ricardo, John Stuart Mill, Thomas Malthus, A.C. Pigou, and others—wrote from the 1770s to the 1930s. They assumed wages and prices were flexible, and that competitive markets existed throughout the economy.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Classical Model (cont'd) Say’s Law  A dictum of economist J.B. Say that supply creates its own demand  Producing goods and services generates the means and the willingness to purchase other goods and services.  Supply creates its own demand; hence it follows that desired expenditures will equal actual expenditures.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 11-1 Say’s Law and the Circular Flow

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Classical Model (cont'd) Assumptions of the classical model  Pure competition exists.  Wages and prices are flexible.  People are motivated by self-interest.  People cannot be fooled by money illusion.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Classical Model (cont'd) Money Illusion  Reacting to changes in money prices rather than relative prices  If a worker whose wages double when the price level also doubles thinks he or she is better off, that worker is suffering from money illusion.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Classical Model (cont'd) Consequences of the assumptions  If the role of government in the economy is minimal,  If pure competition prevails, and all prices and wages are flexible,  If people are self-interested, and do not experience money illusion,  Then problems in the macroeconomy will be temporary and the market will correct itself.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Classical Model (cont'd) Equilibrium in the credit market  When income is saved, it is not reflected in product demand.  It is a type of leakage from the circular flow of income and output, because saving withdraws funds from the income stream.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Classical Model (cont'd) Equilibrium in the credit market  Classical economists contended each dollar saved would be matched by business investment.  Leakages would thus equal injections.  At equilibrium, the price of credit—the interest rate—ensures that the amount of credit demanded equals the amount supplied.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 11-2 Equating Desired Saving and Investment in the Classical Model

Copyright © 2008 Pearson Addison Wesley. All rights reserved Equating Desired Saving and Investment in the Classical Model Summary  Changes in saving and investment create a surplus or shortage in the short run.  In the long run, this is offset by changes in the interest rate.  This interest rate adjustment returns the market to equilibrium where S = I.

Copyright © 2008 Pearson Addison Wesley. All rights reserved International Example: A Global Credit Market Awash in Saving In the 2000s, the U.S. credit market received substantial inflows of saving from abroad. The result has been a rightward shift in the U.S. saving supply curve, contributing to generally lower equilibrium interest rates. What would happen to U.S. interest rates if foreign residents decided to shift their saving to other nations?

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Classical Model (cont'd) Question  Would unemployment be a problem in the classical model? Answer  No, classical economists assumed wages would always adjust to the full employment level.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 11-3 Equilibrium in the Labor Market

Copyright © 2008 Pearson Addison Wesley. All rights reserved Table 11-1 The Relationship Between Employment and Real GDP

Copyright © 2008 Pearson Addison Wesley. All rights reserved Classical Theory, Vertical Aggregate Supply, and the Price Level In the classical model, long-term unemployment is impossible. Say’s law, coupled with flexible interest rates, prices, and wages would tend to keep workers fully employed. The LRAS curve is vertical. A change in aggregate demand will cause a change in the price level.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 11-4 Classical Theory and Increases in Aggregate Demand Classical theorists believed that Say’s law, flexible interest rates, prices, and wages would always lead to full employment at real GDP of $12 trillion

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 11-5 Effect of a Decrease in Aggregate Demand in the Classical Model

Copyright © 2008 Pearson Addison Wesley. All rights reserved Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve The classical economists’ world was one of fully utilized resources. In the 1930s, Europe and the United States entered a period of economic decline that could not be explained by the classical model John Maynard Keynes developed an explanation that has become known as the Keynesian model.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve (cont'd) Keynes and his followers argued  Prices, including wages (the price of labor) are inflexible, or “sticky”, downward  An increase in aggregate demand, AD, will not raise the price level  A decrease in AD will not cause firms to lower the price level

Copyright © 2008 Pearson Addison Wesley. All rights reserved Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve (cont'd) Keynesian Short-Run Aggregate Supply Curve  The horizontal portion of the aggregate supply curve in which there is excessive unemployment and unused capacity in the economy

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 11-6 Demand-Determined Equilibrium Real GDP at Less Than Full Employment Keynes assumed prices will not fall when aggregate demand falls

Copyright © 2008 Pearson Addison Wesley. All rights reserved Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve (cont'd) Real GDP and the price level, 1934–1940  Keynes argued that in a depressed economy, increased aggregate spending can increase output without raising prices.  Data showing the U.S. recovery from the Great Depression seem to bear this out.  In such circumstances, real GDP is demand driven.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 11-7 Real GDP and the Price Level, 1934–1940

Copyright © 2008 Pearson Addison Wesley. All rights reserved Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve (cont'd) The Keynesian model  Equilibrium GDP is demand-determined.  The Keynesian short-run aggregate supply schedule shows sources of price rigidities.  Union and long-term contracts explain inflexibility of nominal wage rates.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Example: Bringing Keynesian Short-Run Aggregate Supply Back to Life New Keynesians contend the SRAS curve is essentially flat. Based on research, they contend SRAS is horizontal because firms adjust their prices about once a year. If the SRAS schedule were really horizontal, how could the price level ever increase?

Copyright © 2008 Pearson Addison Wesley. All rights reserved Output Determination Using Aggregate Demand and Aggregate Supply: Fixed versus Changing Price Levels in the Short Run The underlying assumption of the simplified Keynesian model is that the relevant range of the short-run aggregate supply schedule (SRAS) is horizontal.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Output Determination Using Aggregate Demand and Aggregate Supply: Fixed versus Changing Price Levels in the Short Run (cont'd) The price level has drifted upward in recent decades. Prices are not totally sticky. Modern Keynesian analysis recognizes some—but not complete—price adjustment takes place in the short run.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Output Determination Using Aggregate Demand and Aggregate Supply: Fixed versus Changing Price Levels in the Short Run (cont'd) Short-Run Aggregate Supply Curve  Relationship between total planned economywide production and the price level in the short run, all other things held constant  If prices adjust incompletely in the short run, the curve is positively sloped.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 11-8 Real GDP Determination with Fixed versus Flexible Prices

Copyright © 2008 Pearson Addison Wesley. All rights reserved Output Determination Using Aggregate Demand and Aggregate Supply: Fixed versus Changing Price Levels in the Short Run (cont'd) In modern Keynesian short run, when the price level rises partially, real GDP can be expanded beyond the level consistent with its long-run growth path.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Output Determination Using Aggregate Demand and Aggregate Supply: Fixed versus Changing Price Levels in the Short Run (cont'd) All these adjustments cause real GDP to rise as the price level increases  Firms use workers more intensively, (getting workers to work harder)  Existing capital equipment used more intensively, (use machines longer)  If wage rates held constant, a higher price level leads to increased profits, which leads to lower unemployment as firms hire more

Copyright © 2008 Pearson Addison Wesley. All rights reserved Shifts in the Aggregate Supply Curve Just as non-price-level factors can cause a shift in the aggregate demand curve, there are non-price-level factors that can cause a shift in the aggregate supply curve.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Shifts in the Aggregate Supply Curve (cont'd) Shifts in both the short- and long-run aggregate supply Shifts in SRAS only

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 11-9 Shifts in Both Short- and Long-Run Aggregate Supply

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure Shifts in SRAS Only

Copyright © 2008 Pearson Addison Wesley. All rights reserved Table 11-2 Determinants of Aggregate Supply

Copyright © 2008 Pearson Addison Wesley. All rights reserved Consequences of Changes in Aggregate Demand Aggregate Demand Shock  Any event that causes the aggregate demand curve to shift inward or outward Aggregate Supply Shock  Any event that causes the aggregate supply curve to shift inward or outward

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure The Short-Run Effects of Stable Aggregate Supply and a Decrease in Aggregate Demand: The Recessionary Gap

Copyright © 2008 Pearson Addison Wesley. All rights reserved Consequences of Changes in Aggregate Demand (cont'd) Recessionary Gap  The gap that exists whenever equilibrium real GDP per year is less than full- employment real GDP as shown by the position of the LRAS curve

Copyright © 2008 Pearson Addison Wesley. All rights reserved Consequences of Changes in Aggregate Demand (cont'd) Inflationary Gap  The gap that exists whenever equilibrium real GDP per year is greater than full- employment real GDP as shown by the position of the LRAS curve

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure The Effects of Stable Aggregate Supply with an Increase in Aggregate Demand: The Inflationary Gap

Copyright © 2008 Pearson Addison Wesley. All rights reserved Explaining Short-Run Variations in Inflation In a growing economy, the explanation for persistent inflation is that aggregate demand rises over time at a faster pace than the full-employment level of real GDP. Short-run variations in inflation, however, can arise as a result of both demand and supply factors.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Explaining Short-Run Variations in Inflation (cont'd) Demand-Pull Inflation  Inflation caused by increases in aggregate demand not matched by increases in aggregate supply Cost-Push Inflation  Inflation caused by decreases in short-run aggregate supply

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure Cost-Push Inflation

Copyright © 2008 Pearson Addison Wesley. All rights reserved International Policy Example: Can Iran’s Vicious Cycle of Supply Shocks be Smoothed? Iran, located at the boundary between two plates of the earth’s crust, has experienced hundreds of earthquakes since The economic effects in each case were predictable: fewer resources meant the aggregate supply curve shifted leftward.

Copyright © 2008 Pearson Addison Wesley. All rights reserved International Policy Example: Can Iran’s Vicious Cycle of Supply Shocks be Smoothed? (cont'd) How might the establishment and enforcement of building codes promote long-term Iranian growth as well as help shield the nation from recurring aggregate supply shocks?

Copyright © 2008 Pearson Addison Wesley. All rights reserved Aggregate Demand and Supply in an Open Economy The open economy is one of the reasons why aggregate demand slopes downward.  When the domestic price level rises, U.S. residents want to buy cheaper-priced foreign goods.  The opposite occurs when the U.S. domestic price level falls.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Aggregate Demand and Supply in an Open Economy (cont'd) Currently, the foreign sector of the U.S. economy constitutes over 14% of all economic activities.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure The Two Effects of a Weaker Dollar, Panel (a) Decrease in the value of the dollar raises the cost of imported inputs. SRAS decreases. With AD constant, the price level rises. GDP decreases.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure The Two Effects of a Weaker Dollar, Panel (b) Decrease in the value of the dollar makes net exports rise. AD increases. With SRAS constant, the price level rises with GDP.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Issues and Applications: Oil Prices Still Matter, But Not As Much As Before Oil prices still matter, but not as much as before. Whoops!—Oil prices must be adjusted for inflation. Reduced sensitivity of aggregate supply to oil price changes.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure Inflation-Adjusted Oil Prices and Oil’s Role in Producing Real GDP, Panel (a)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure Inflation-Adjusted Oil Prices and Oil’s Role in Producing Real GDP, Panel (b)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives The four assumptions of the classical model are 1. Pure competition prevails 2. Wages and prices are flexible 3. People are motivated by self-interest 4. No money illusion

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Key Terms and Concepts aggregate demand aggregate demand curve aggregate supply aggregate supply curve cash balance circular flow of income exports imports net exports open economy effect real-balance effect