Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 46 Aggregate demand and aggregate supply model A model that explains short-run fluctuations in real GDP and the price level.

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 46 Aggregate Demand GDP has four components: consumption (C), investment (I), government purchases (G), and net exports (NX). If we let Y stand for GDP, we can write the following: Y = C + I + G + NX The Wealth Effect: When our monetary wealth declines, we feel poorer and buy less. Why Is the Aggregate Demand Curve Downward Sloping? The Interest-Rate Effect: A higher interest rate discourages spending, investment spending in particular. The International-Trade Effect (substitution of foreign stuff for our stuff): When our price level rises, foreigners buy less of our exports and we import more things from abroad. When our price level rises, the real value of our monetary wealth declines. We feel poorer. When our price level rises, real money balances (M/P) become scarcer and the interest rate rises.

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 46 Monetary policy Actions the Federal Reserve takes to manage the money supply and interest rates. What Shifts the Aggregate Demand Curve? Changes in Government Policies intended to achieve macroeconomic objectives: high employment, price stability, steady economic growth. Fiscal policy Changes in federal taxes and purchases. Changes in Expectations of Households and Firms If households become more optimistic about their future incomes, they are likely to increase their current consumption. Changes in Foreign Variables If foreign economies expand, foreign firms and households will buy more U.S. goods. If the dollar depreciates, foreign firms and households will buy more U.S. goods and U.S. firms and households will buy fewer foreign goods. Net exports will rise and the aggregate demand curve will shift to the right.

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 46 Movements along the Aggregate Demand Curve versus Shifts of the Aggregate Demand Curve When price rises, less domestic output is demanded owing to the international-trade effect, the wealth effect and the interest rate effect. When taxes increase or government spending decreases, when the money supply is reduced or when people lose confidence, aggregate demand shifts to the left

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 46 Variables That Shift the Aggregate Demand Curve

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 46 Variables That Shift the Aggregate Demand Curve

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 46 The Long-Run Aggregate Supply Curve LRAS reflects the economy’s output capacity at full employment of available resources using the best available technology. LRAS shifts outward as capital accumulates, the labor force grows and as technology improves.

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 46 Aggregate Supply 1 Contracts make some wages and prices “sticky.” 2 Firms are often slow to adjust wages. 3 Menu costs make some prices sticky. The Short-Run Aggregate Supply Curve Why does the short-run aggregate supply curve slope upward?

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 46 Variables That Shift the Short-Run Aggregate Supply Curve Expected Changes in the Future Price Level How Expectations of the Future Price Level Affect the Short-Run Aggregate Supply

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 46 Aggregate Supply Variables That Shift the Short-Run Aggregate Supply Curve Adjustments of Workers and Firms to Errors in Past Expectations about the Price Level Unexpected Changes in the Price of an Important Natural Resource Supply shock An unexpected event that causes the short-run aggregate supply curve to shift.

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 46 Variables That Shift the Short-Run Aggregate Supply Curve

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 46 Variables That Shift the Short-Run Aggregate Supply Curve Unexpected Changes in the Price of an Important Natural Resource

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 46 Macroeconomic Equilibrium in the Long Run and the Short Run Long-Run Macroeconomic Equilibrium

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 46 Macroeconomic Equilibrium in the Long Run and the Short Run 1 The economy has not been experiencing any inflation. The price level is currently 100, and workers and firms expect it to remain at 100 in the future. 2 The economy is not experiencing any long-run growth. Potential real GDP is $10.0 trillion and will remain at that level in the future. Recessions, Expansions, and Supply Shocks Because the full analysis of the aggregate demand and aggregate supply model can be complicated, we begin with a simplified case, using two assumptions:

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 46 Macroeconomic Equilibrium in the Long Run and the Short Run Recessions, Expansions, and Supply Shocks Recession The Short-Run and Long-Run Effects of a Decrease in Aggregate Demand

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 46 Macroeconomic Equilibrium in the Long Run and the Short Run Expansion FIGURE 12.6 The Short-Run and Long- run Effects of an Increase in Aggregate Demand

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 46 Macroeconomic Equilibrium in the Long Run and the Short Run Learning Objective 12.3 Recessions, Expansions, and Supply Shocks Stagflation A combination of inflation and recession, usually resulting from a supply shock. Supply Shock

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 46 Macroeconomic Equilibrium in the Long Run and the Short Run Supply Shock The Short-Run and Long-Run Effects of a Supply Shock  Stagflation

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 46 A Dynamic Aggregate Demand and Aggregate Supply Model Potential real GDP increases continually, shifting the long-run aggregate supply curve to the right. During most years, the aggregate demand curve will be shifting to the right. Except during periods when workers and firms expect high rates of inflation, the short-run aggregate supply curve will be shifting to the right as productivity increases. We can create a dynamic aggregate demand and aggregate supply model by making three changes to the basic model.

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 46 A Dynamic Aggregate Demand and Aggregate Supply Model Learning Objective 12.4 FIGURE 12.8 A Dynamic Aggregate Demand and Aggregate Supply Model

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 46 A Dynamic Aggregate Demand and Aggregate Supply Model The Usual Cause of Inflation: AD increases by more than AS

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 22 of 46 A Dynamic Aggregate Demand and Aggregate Supply Model Learning Objective 12.4 The end of the stock market “bubble.” The Slow Recovery from the Recession of 2001 Excessive investment in information technology. The terrorist attacks of September 11, The corporate accounting scandals. The recession of 2001 was caused by a decline in aggregate demand. Several factors contributed to this decline:

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 23 of 46 The Slow Recovery from the Recession of 2001 Aggregate demand increased slowly following the dot.com bust and 9/11

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 24 of 46 The More Rapid Recovery of 2003–2004

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 25 of 46 Aggregate demand and aggregate supply model Aggregate demand curve Fiscal policy Long-run aggregate supply curve Menu costs Monetary policy Short-run aggregate supply curve Stagflation Supply shock K e y T e r m s

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 26 of 46 Macroeconomic Schools of Thought Keynesian revolution The name given to the widespread acceptance during the 1930s and 1940s of John Maynard Keynes’s macroeconomic model and activist policy prescriptions. 1 The monetarist model 2 The new classical model 3 The real business cycle model These alternative schools of thought use models that differ significantly from the standard aggregate demand and aggregate supply model. We can briefly consider each of the three major alternative models:

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 27 of 46 Macroeconomic Schools of Thought The Monetarist Model Monetary growth rule A plan for increasing the quantity of money at a fixed rate that does not respond to changes in economic conditions. Monetarism The macroeconomic theories of Milton Friedman and his followers; particularly the idea that the quantity of money should be increased at a constant rate. The monetarist model—also known as the neo-Quantity Theory of Money model—was developed beginning in the 1940s by Milton Friedman, an economist at the University of Chicago who was awarded the Nobel Prize in Economics in 1976.

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 28 of 46 Macroeconomic Schools of Thought The New Classical Model New classical macroeconomics The macroeconomic theories of Robert Lucas and others, particularly the idea that workers and firms have rational expectations. The new classical model was developed in the mid-1970s by a group of economists including Nobel laureate Robert Lucas of the University of Chicago, Thomas Sargent of New York University, and Robert Barro of Harvard University.

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 29 of 46 Macroeconomic Schools of Thought The Real Business Cycle Model Real business cycle model A macroeconomic model that focuses on real, rather than monetary, causes of the business cycle. Beginning in the 1980s, some economists, including Nobel laureates Finn Kydland of Carnegie Mellon University and Edward Prescott of Arizona State University, argued that Lucas was correct in assuming that workers and firms formed their expectations rationally and that wages and prices adjust quickly to supply and demand but wrong about the source of fluctuations in real GDP.

Chapter 12: Aggregate Demand and Aggregate Supply Analysis © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 30 of 46 Karl Marx: Capitalism’s Severest Critic … or most perceptive analyst? Making the Connection Karl Marx predicted that a final economic crisis would lead to the collapse of the market system.