Aggregate Supply and Aggregate Macroeconomics CHAPTER 27 Aggregate Supply and Aggregate Demand

Aggregate Supply The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output. It is upward sloping.

Shifts of the Short-Run Aggregate Supply Curve An increase in short-run aggregate supply: the short-run aggregate supply curve shifts rightward from SRAS1 to SRAS2,and the quantity of aggregate output supplied at any given aggregate price level rises.

Shifts of the Short-Run Aggregate Supply Curve Changes in commodity prices, nominal wages productivity Expectations lead to changes in producers’ profits and shift the short-run aggregate supply curve.

Long-Run Aggregate Supply Curve The long-run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible. Let’s make this easy: Think of Long –run aggregate supply as POTENTIAL output.

Long-Run Aggregate Supply Curve The long-run aggregate supply curve shows the quantity of aggregate output supplied when all prices, including nominal wages, are flexible. It is vertical at potential output, YP , because in the long run an increase in the aggregate price level has no effect on the quantity of aggregate output supplied.

Economic Growth Shifts the LRAS Curve Rightward

From the Short Run to the Long Run Leftward Shift of the Short-run Aggregate Supply Curve The initial short-run aggregate supply curve is SRAS1. At the aggregate price level, P1, the quantity of aggregate output supplied, Y1, exceeds potential output, YP. Eventually, low unemployment will cause nominal wages to rise, leading to a leftward shift of the short-run aggregate supply curve from SRAS1 to SRAS2.

From the Short Run to the Long Run Rightward Shift of the Short-run Aggregate Supply Curve At the aggregate price level, P1, the quantity of aggregate output supplied is less than potential output. This reflects the fact that the short-run aggregate supply curve has shifted to the right, due to both the short-run adjustment process in the economy and to a rightward shift of the long-run aggregate supply curve.

Shifts of the Short-Run Aggregate Supply Curve A decrease in short-run aggregate supply: the short-run aggregate supply curve shifts leftward from SRAS1 to SRAS2, and the quantity of aggregate output supplied at any given aggregate price level falls.

The Short-Run Aggregate Supply Curve Three-segment AS curve Classical Keynesian Intermediate range

Aggregate Demand The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, and the government.

The Aggregate Demand Curve The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded. The curve is downward-sloping due to the wealth effect of a change in the aggregate price level and the interest rate effect of a change in the aggregate price level. Here, the total quantity of goods and services demanded at an aggregate price level of 8.9, the actual number for 1933, is $636 billion in 2000 dollars, the actual quantity of aggregate output demanded in 1933. According to our hypothetical curve, however, if the aggregate price level had been only 5.0, the quantity of aggregate output demanded would have been $950 billion.

Why Is the Aggregate Demand Curve Downward-Sloping? The wealth effect of a change in the aggregate price level— higher prices reduce consumer spending. The interest rate effect of a change in aggregate the price level—a higher aggregate price level (inflation) leads to a rise in interest rates. Investment spending and consumer spending fall. The opposite is true also: lower interest rates will increase AD The net exports effect – Lower price level = more US exports. AD and GDP increase

Shifts of the Aggregate Demand Curve The aggregate demand curve shifts because of Changes in expectations Changes in wealth or interest rates Changes in tax policy or money supply Changes in C, G, I, X, or M Policy makers can use fiscal policy and monetary policy to shift the aggregate demand curve.

Shifts of the Aggregate Demand Curve – Rightward Shift The effect of events that increase the quantity of aggregate output demanded at any given aggregate price level, such as improvements in business and consumer expectations or increased government spending. Such changes shift the aggregate demand curve to the right, from AD1 to AD2.

Shifts of the Aggregate Demand Curve – Leftward Shift The effect of events that decrease the quantity of aggregate output demanded at any given price level, such as a fall in wealth caused by a stock market decline. This shifts the aggregate demand curve leftward from AD1 to AD2.

The Multiplier The size of the multiplier is based on the marginal propensity to consume. As disposable increases, people only have two choices: Spend or save. An autonomous change in aggregate spending leads to a chain reaction, in which the change in real GDP is equal to the multiplier times the initial change in aggregate spending.

The Multiplier Effect Simplified Spending Multiplier = 1 MPS

Total Increase in GDP from $50 Billion Rise in GDP Suppose that MPC = 0.6: each $1 in additional disposable income causes a $0.60 rise in consumer spending. In that case, a $50 billion increase in investment spending raises real GDP by $50 billion. The second-round increase in consumer spending raises GDP by another 0.6 × $50 billion, or $30 billion. The third-round increase in consumer spending raises GDP by another 0.6 × $30 billion, or $18 billion. The table above shows the successive stages of increase, where “. . . ” means the process goes on an infinite number of times. In the end, GDP rises by $125 billion as a consequence of the initial $50 billion rise in investment spending.

The Multiplier A change in expectations that leads to a rise in investment spending shifts the AD curve to the right for two reasons. Holding the aggregate price level constant, there is an initial increase in GDP from the rise in I. Then there are subsequent increases in GDP as rising disposable income leads to higher consumer spending. Panel (a) shows how the rise in GDP at a given aggregate price level takes place. Panel (b) shows how this shifts the AD curve.

Tax multiplier = MPC = MPC 1-MPC MPS Less than the spending multiplier because some of the 1st round of spending is saved, not spent.

The AS–AD Model The AS-AD model uses the aggregate supply curve and the aggregate demand curve together to analyze economic fluctuations.

The AS–AD Model The AS–AD model combines the short-run aggregate supply curve and the aggregate demand curve. Their point of intersection, ESR , is the point of short-run macroeconomic equilibrium where the quantity of aggregate output demanded is equal to the quantity of aggregate output supplied. PE is the short-run equilibrium aggregate price level, and YE is the short-run equilibrium level of aggregate output.

Short-Run Macroeconomic Equilibrium The economy is in short-run macroeconomic equilibrium when the quantity of aggregate output supplied is equal to the quantity demanded. The short-run equilibrium aggregate price level is the aggregate price level in the short-run macroeconomic equilibrium. Short-run equilibrium aggregate output is the quantity of aggregate output produced in the short-run macroeconomic equilibrium.

Shifts of the SRAS Curve A supply shock shifts the short-run aggregate supply curve, moving the aggregate price level and aggregate output in opposite directions. Panel (a) shows a negative supply shock, which shifts the short-run aggregate supply curve leftward, causing stagflation—lower aggregate output and a higher aggregate price level. Here the short-run aggregate supply curve shifts from SRAS1 to SRAS2 , and the economy moves from E1 to E2. The aggregate price level rises from P1 to P2 , and aggregate output falls from Y1 to Y2. Stagflation is the combination of inflation and falling aggregate output.

Shifts of the SRAS Curve Panel (b) shows a positive supply shock, which shifts the short-run aggregate supply curve rightward, generating higher aggregate output and a lower aggregate price level. The short-run aggregate supply curve shifts from SRAS1 to SRAS2 , and the economy moves from E1 to E2. The aggregate price level falls from P1 to P2 , and aggregate output rises from Y1 to Y2. An event that shifts the short-run aggregate supply curve is a supply shock.

Shifts of Aggregate Demand: Short-Run Effects A demand shock shifts the aggregate demand curve, moving the aggregate price level and aggregate output in the same direction. In panel (a) a negative demand shock shifts the aggregate demand curve leftward from AD1 to AD2, reducing the aggregate price level from P1 to P2 and aggregate output from Y1 to Y2.

Shifts of Aggregate Demand: Short-Run Effects A demand shock shifts the aggregate demand curve, moving the aggregate price level and aggregate output in the same direction. In panel (b) a positive demand shock shifts the aggregate demand curve rightward, increasing the aggregate price level from P1 to P2 and aggregate output from Y1 to Y2.

Long-Run Macroeconomic Equilibrium The economy is in long-run macroeconomic equilibrium when the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve.

Long-Run Macroeconomic Equilibrium Here the point of short-run macroeconomic equilibrium also lies on the long-run aggregate supply curve, LRAS. As a result, actual aggregate output is equal to potential output. The economy is in long-run macroeconomic equilibrium at ELR.

The Short-Run / Long run Equilibrium LRAS SR / LR Equilibrium point

Short-Run Versus Long-Run Effects of a Negative Demand Shock In the long run the economy is self-correcting: demand shocks have only temporary effects on aggregate output. Starting at E1, a negative demand shock shifts AD1 leftward to AD2. In the short run the economy moves to E2 and a recessionary gap arises: the aggregate price level declines from P1 to P2, aggregate output declines from Y1 to Y2, and unemployment rises. But in the long run nominal wages fall in response to high unemployment, and SRAS1 shifts rightward to SRAS2: aggregate output rises from Y2 to Y1, and the aggregate price level declines again, from P2 to P3. Long-run macroeconomic equilibrium is eventually restored at E3. Recessionary gap

Short-Run Versus Long-Run Effects of a Positive Demand Shock Starting at E1 a positive demand shock shifts AD1 rightward to AD2, and the economy moves to E2 in the short run. This results in an inflationary gap as aggregate output rises from Y1 to Y2, the aggregate price level rises from P1 to P2, and unemployment falls to a low level. In the long run, SRAS1 shifts leftward to SRAS2 as nominal wages rise in response to low unemployment. Aggregate output falls back to Y1, the aggregate price level rises again to P3, and the economy returns to long-run macroeconomic equilibrium at E3. Inflationary gap

Self-correcting Mechanism In the long run the economy is self correcting: shocks to aggregate demand do not affect aggregate output in the long run.

Negative Supply Shocks Negative supply shocks pose a policy dilemma: a policy that stabilizes aggregate output by increasing aggregate demand will lead to inflation, but a policy that stabilizes prices by reducing aggregate demand will decrease output.

Macroeconomic Policy The high cost—in terms of unemployment—of a recessionary gap and the future adverse consequences of an inflationary gap  Active stabilization policy, using fiscal or monetary policy to offset demand shocks: Fiscal policy affects aggregate demand directly through government purchases and indirectly through changes in taxes or government transfers that affect consumer spending. Monetary policy affects aggregate demand indirectly through changes in the interest rate that affect consumer and investment spending. There can be drawbacks, however, because such deficit and erroneous predictions can increase economic policies that may contribute to a long-term rise in the budget instability.

The End of Chapter 27