1 of 26 © 2014 Pearson Education, Inc. C H A P T E R O U T L I N E 12 The Determination of Aggregate Output, the Price Level, and the Interest Rate The Aggregate Supply (AS) Curve Aggregate Supply in the Short Run Shifts of the Short-Run Aggregate Supply Curve The Aggregate Demand (AD) Curve Planned Aggregate Expenditure and the Interest Rate The Behavior of the Fed Deriving the AD Curve The Final Equilibrium Other Reasons for a Downward-Sloping AD Curve The Long-Run AS Curve Potential GDP

2 of 26 © 2014 Pearson Education, Inc. aggregate supply The total supply of all goods and services in an economy. aggregate supply (AS) curve A graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level. Although it is called an aggregate supply curve, it is better thought of as a “price/output response” curve—a curve that traces out the price decisions and output decisions of all firms in the economy under different levels of aggregate demand. The Aggregate Supply (AS) Curve

3 of 26 © 2014 Pearson Education, Inc. In the short run, the aggregate supply curve (the price/output response curve) has a positive slope. At low levels of aggregate output, the curve is fairly flat. As the economy approaches capacity, the curve becomes nearly vertical. At capacity,, the curve is vertical.  FIGURE 12.1 The Short- Run Aggregate Supply Curve Aggregate Supply in the Short Run

4 of 26 © 2014 Pearson Education, Inc. Why an Upward Slope? Wages are a large fraction of total costs and wage changes lag behind price changes. This gives us an upward sloping short-run AS curve. Why the Particular Shape (flatter at the low output level but steeper otherwise)? Consider the vertical portion of the AS curve. At some level the overall economy is using all its capital and all the labor that wants to work at the market wage. At this level (), increased demand for output, and thereby, labor can be met only by increased prices. Neither wages nor prices are likely to be sticky. At low levels of output, the AS curve is flatter. Small price increases may be associated with relatively large output responses. We may observe relatively sticky wages upward at this point on the AS curve.

5 of 26 © 2014 Pearson Education, Inc.  FIGURE 12.2 Shifts of the Short-Run Aggregate Supply Curve

6 of 26 © 2014 Pearson Education, Inc. cost shock (or supply shock) A change in costs that shifts the short-run aggregate supply (AS) curve. For example: a change in the price of petroleum, a change in the wage rate. Shifts of the Short-Run Aggregate Supply Curve

7 of 26 © 2014 Pearson Education, Inc. The Aggregate Demand (AD) Curve We can use the fact that planned investment depends on the interest rate to consider how planned aggregate expenditure (AE) depends on the interest rate. Recall that planned aggregate expenditure is the sum of consumption, planned investment, and government purchases. That is, AE ≡ C + I + G Planned Aggregate Expenditure and the Interest Rate The aggregate demand (AD) curve is derived from the model of the goods market in Chapters 23 and 24 and from the behavior of the Fed. We begin with the goods market.

8 of 26 © 2014 Pearson Education, Inc. An increase in the interest rate from 3 percent to 6 percent lowers planned aggregate expenditure and thus reduces equilibrium output from Y 0 to Y 1.  FIGURE 12.3 The Effect of an Interest Rate Increase on Planned Aggregate Expenditure and Equilibrium Output

9 of 26 © 2014 Pearson Education, Inc. The effects of a change in the interest rate on the equilibrium level of output in the goods market include: A high interest rate (r) discourages planned investment (I). Planned investment is a part of planned aggregate expenditure (AE). Thus, when the interest rate rises, planned aggregate expenditure (AE) at every level of income falls. Finally, a decrease in planned aggregate expenditure lowers equilibrium output (income) (Y) by a multiple of the initial decrease in planned investment.

10 of 26 © 2014 Pearson Education, Inc. Using a convenient shorthand:

11 of 26 © 2014 Pearson Education, Inc. The higher price level leads to a lower level of demand for goods. high price  lower level of demand for goods The relationship between the price level and the aggregate demand is, apparently, negative. Deriving the AD Curve

12 of 26 © 2014 Pearson Education, Inc. The AD curve is derived from Figure Each point on the AD curve is an equilibrium point in Figure 12.7 for a given value of P. When P increases, the Fed raises the interest rate (the Fed rule in Figure 12.7 shifts to the left), which has a negative effect on planned investment and thus on Y. The AD curve reflects this negative relationship between P and Y.  FIGURE 12.8 The Aggregate Demand (AD) Curve

13 of 26 © 2014 Pearson Education, Inc.  FIGURE 12.9 Equilibrium Output and the Price Level The Final Equilibrium

14 of 26 © 2014 Pearson Education, Inc. real wealth effect The change in consumption brought about by a change in real wealth that results from a change in the price level. The AD curve slopes down in our analysis because the Fed raises the interest rate when P increases and because planned investment depends negatively on the interest rate. There is also a real wealth effect on consumption that contributes to a downward-sloping AD curve. Other Reasons for a Downward-Sloping AD Curve

15 of 26 © 2014 Pearson Education, Inc. When the AD curve shifts from AD 0 to AD 1, the equilibrium price level initially rises from P 0 to P 1 and output rises from Y 0 to Y 1. Wages respond in the longer run, shifting the AS curve from AS 0 to AS 1. If wages fully adjust, output will be back to Y 0. Y 0 is sometimes called potential GDP.  FIGURE The Long-Run Aggregate Supply Curve The Long-Run AS Curve

16 of 26 © 2014 Pearson Education, Inc. potential output, or potential GDP The level of aggregate output that can be sustained in the long run without inflation. Although different economists have different opinions on how to determine whether an economy is operating at or above potential output, there is general agreement that there is a maximum level of output (below the vertical portion of the short-run aggregate supply curve) that can be sustained without inflation. Potential GDP Short-Run Equilibrium Below Potential Output Recall that even the short-run AS curve becomes vertical at some particular level of output. The vertical portion of the short-run AS curve exists because there are physical limits to the amount that an economy can produce in any given time period.

17 of 26 © 2014 Pearson Education, Inc. With planned aggregate expenditure of AE 1 and aggregate demand of AD 1, equilibrium output is Y 1. A shift of planned aggregate expenditure to AE 2, corresponding to a shift of the AD curve to AD 2, causes output to rise but the price level to remain at P 1. If planned aggregate expenditure and aggregate demand exceed Y F, however, there is an inflationary gap and the price level rises to P 3. E C O N O M I C S I N P R A C T I C E The Simple “Keynesian” Aggregate Supply Curve THINKING PRACTICALLY 1.Why is the distance between AE 3 and AE 2 called an inflationary gap?

18 of 26 © 2014 Pearson Education, Inc. aggregate supply aggregate supply (AS) curve cost shock, or supply shock potential output, or potential GDP real wealth effect Equations: AE ≡ C + I + G Aggregate demand (AD) R E V I E W T E R M S A N D C O N C E P T S