Chapter 9- Aggregate Supply, Aggregate Demand Is the market economy of U.S. stable? How do we know? What can keep the economy stable? Government or Private Enterprise?

Real GDP Growth

Now you know why Market is skiddish

Two Basic Questions?  U.S. economy is in a slump  What can be done to get out and jump- start economic engine for growth? Answer: Government can enter and stimulate AD Leave economy alone- it will adjust by itself. Government can stimulate AS

3 Theories on moving business cycle 1. Keynesian Theory 2. Supply-Side Theory 3. Monetary Theory

Aggregate Demand and Supply The forces of supply and demand are at work in the macro economy. The macro model shows how the macro economy works, and it consists of aggregate demand (AD) and aggregate supply (AS). 8-6

Aggregate Demand Aggregate demand (AD): the total quantity of output (real GDP) demanded at alternative price levels in a given time period, ceteris paribus. The collective behavior of all buyers in the marketplace. It comprises all goods and services. AD slopes downward; people will buy more goods and services at lower price levels, and vice versa. 8-7

Aggregate Demand (AD) Why does AD slope downward? Real balances effect (Wealth effect) : the cash you hold is worth more when the price level falls, so you can buy more. Foreign trade effect: lower price levels in the United States convince customers to buy more American goods and fewer foreign goods. Interest rate effect: lower interest rates promote more borrowing and more spending. 8-8

Effect on AD Why an Increase in Price Level Reduces Quantity of Real GDP Demanded Why a Decrease in Price Level Raises Quantity of Real GDP Demanded Wealth When P rises, consumers are poorer in real terms. This primarily decreases the demand for consumption goods. When P falls, consumers are wealthier in real terms. This primarily increases the demand for consumption goods. Interest Rate When P rises, individuals save less, which increases the equilibrium interest rate. Higher interest rates reduce the quantity demanded of investment goods. When P falls, individuals can afford to save more, which decreases the equilibrium interest rate. Lower interest rates increase the quantity demanded of investment goods. International Trade When P rises in the United States, all else equal, goods and services produced elsewhere are less expensive. Imports rise and exports fall so that net exports fall. When P falls in the United States, all else equal, goods and services produced elsewhere are more expensive. Imports fall and exports rise so net exports fall.

Aggregate Supply Aggregate supply (AS): the total quantity of output (real GDP) producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus. The collective behavior of all suppliers (sellers) in the marketplace. It comprises all goods and services. AS slopes upward; suppliers will bring more goods and services to market at higher price levels, and vice versa. 8-10

Aggregate Supply (AS) Why does AS slope upward? Profit effect: if there is no change in the cost of operating a business, rising prices will improve profits, and suppliers will bring more products to the market. Cost effect: cost increases make producing products more expensive. Producers will be willing to supply more only if prices also rise to cover those added costs. At high rates of output (near productive capacity), costs rise steeply and AS steepens sharply. 8-11

Aggregate Demand and Supply 8-12

Macro Equilibrium AS and AD summarize the market activity of the macro economy. Macro equilibrium: the combination of price level and real output that is compatible with both AD and AS. Where AD and AS intersect. … at P E and Q E. 8-13

Results of Shifts in AD and AS A shift in either AD or AS can cause the economy to: go into recession, recover from a recession, cause the economy to stagnate, or cause the economy to overheat. Business cycles likely result from recurrent shifts of AS and AD. 8-14

Short-Run Instability: Theories Classical economists believe the economy will self-regulate and gravitate toward full employment. Keynes and his followers do not believe this. They believe the economy might get worse without government intervention. In addition, there are controversies about the shape of AS and AD and the potential to shift these curves. 8-15

Keynesian Theory This is a demand-side theory. A recession originates with a deficiency of spending. AD is too far to the left. Policy: increase government spending to shift AD back to the right. Inflation originates with an excess in spending. AD is too far to the right. Policy: increase taxes to shift AD back to the left. 8-16

Monetary Theory This is also a demand-side theory. Emphasizes the role of money in financing AD. “Tight” money might cause AD to shift too far to the left. Policy: increase money supply and lower interest rates to shift AD back to the right. “Easy” money might cause AD to shift too far to the right. Policy: decrease money supply and raise interest rates to shift AD back to the left. 8-17

ASSUMPTION for Aggregate demand IS: If Price level is decreasing, so are incomes. Economy moves down its AD curve Moves to lower price level *remember circular flow model- (when consumers pay lower prices for goods and services – Less nominal income flows to resource suppliers.

Shifts of Aggregate Demand Curve shifts right or left according to stimuli. These shifts come from any or all components of GDP (C, I, G, X-M)

DETERMINANTS OF AGGREGATE DEMAND Change in Consumer Spending Consumer Wealth (people’s houses fell in value) Consumer Expectations (expect higher prices) Interest rate ( interest sensitive durables) Taxes Think in aggregate terms

Changes in Investment Spending  Real Interest Rates ( rates high- not much I taking place)  Expected Future Sales ( health of economy- confidence is big)  Business Taxes ( higher taxes less profit)

Government Spending This will be discussed further, but anytime government spends, it has an affect on GDP. Infrastructure – Health Care Supplies for military Education Etc.

Net Export Spending  National Income Abroad- (when foreign nations do well, their incomes are higher- can buy more U.S. goods and services. – U.S. exports rise)  Exchange Rates- Price of one nation’s currency in terms of another. Dollar vs Euro  Our currency appreciates if it takes more foreign $ to buy it.. (depreciates if it takes more of ours to buy theirs.) $1.00 to $1.25 Euro.  Depreciation of nation’s currency makes foreign goods more expensive (but attracts foreigners to buy our goods.) Our exports rise. *this is why the Fed has not worried about our low dollar valuation.

Factors That Change Aggregate Demand & Consumption/Interest Rates Interest Rate ↑ → C ↓ → AD ↓ Interest Rate ↓ → C ↑ → AD ↑

Factors That Change Aggregate Demand & Investment/ Interest Rates Interest rates ↑ → I ↓ → AD ↓ Interest rates ↓ → I ↑ → AD ↑

Factors That Change Aggregate Demand & Investment/ Business Taxes Business taxes ↑ → I ↓ → AD ↓ Business taxes ↓ → I ↑ → AD ↑

Long-Run Equilibrium and the Price Level For the economy as a whole, long-run equilibrium occurs at the price level where the aggregate demand curve (AD) crosses the long-run aggregate supply curve (LRAS).

Figure 10-5 Long-Run Economywide Equilibrium

OK… One more time….. Component parts of GDP? C + I + G + (X-M) = GDP Long-Run Aggregate Supply Curve (LRAS) A vertical line representing the real output of goods and services after full adjustment has occurred It represents the real GDP of the economy under conditions of full employment; the economy is on its production possibilities curve

The Production Possibilities and the Economy’s Long-Run Aggregate Supply Curve

Output Growth and the Long-Run Aggregate Supply Curve (cont'd)  LRAS is vertical Input prices fully adjust to changes in output prices Suppliers have no incentive to increase output Unemployment is at the natural rate Determined by endowments and technology (or existing resources)

Output Growth and the Long-Run Aggregate Supply Curve (cont'd)  Growth is shown by outward shifts of either the production possibilities curve or the LRAS curve caused by Growth of population and the labor-force participation rate Capital accumulation Improvements in technology

What does Long Run Equilibrium Mean?  Economy is a full employment  Any additional production would be difficult to achieve.  Economy operating at natural rate of unemployment (anyone wanting job=have it.)  Equate the LRAS curve with bowed line on PPC.  To extend either would be to discover new resources – R&D

Full Employment  The condition that exists when the unemployment rate is equal to the natural unemployment rate.  Full productive capacity has been  Reached.

Image Cylinder= Economy… Businesses, factories, economy not working at full capacity

Full Employment AS AD LRAS

SRAS (short run aggregate supply)  Period where adjustment occurs.  As the output increases that puts upward pressure on price.  Movement on the curve denotes the relationship between price level and real output.

SRAS………….Shift  Shift in the curve denotes determinates that affect more or less real output production at various price levels.  Determinants: Change in input prices (steel, plastic, wool change in resource availability ) Change in productivity (+ = Shift right; - = Shift left) (more for less is the object) Change in legal environment (contracts, taxes, subsidies)

AD and SRAS

 Non-governmental actions that shift AS  Shift AS left: Raw materials cost rise Wages rise faster than productivity Worker productivity decreases Obsolescence Wars Natural disasters

Fiscal Policy  Governmental actions that shift AD  Shift AD right: Govt spending increases Taxes decreases Money Supply increases  Shift AD left: G decreases T increases MS decreases

Three States of the Economy. This applies to Classical and Keynesian 1. Real GDP is less than Natural Real GDP (recessionary gap) 2. Real GDP is more than Natural Real GDP (inflationary gap) 3. Real GDP is equal to Natural Real GDP. What is Natural Real GDP? Real GDP that is produced at the natural unemployment rate. (which we agree around 5%)

BOTH THEORIES CLASSICAL AND KEYNESIAN DO AGREE…… TWO THINGS WE CAN DO WITH DISPOSABLE INCOME- SPEND OR SAVE! We all know that consumption is 2/3 (or more) of GDP

When are you coming home, mom?

 The following slides are to assist you with understanding of the graphs.

Equilibrium States of the Economy During the time an economy moves from one equilibrium to another, it is said to be in disequilibrium.

Supply-Side Theory A shift in AS to the left causes output and employment to decrease and inflation to increase. – This problem cannot be corrected by shifting AD. Shift AD right and unemployment falls but inflation worsens. Shift AD left and inflation is reduced but unemployment rises. – Policy: devise ways to shift AS back to the right.

LRAS G oods & S ervices (real GDP) P rice level P 100 Y F SRAS 1 AD 1 Unanticipated Increase in Aggregate Demand  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

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  Here we illustrate the impact of economic growth due to capital formation or a technological advancement, for example.  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  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 ).

LRAS G oods & S ervices (real GDP) P rice level AD Y F P 100 SRAS 1 (P r 1 ) A P 110 Y 2  The higher resource prices shift the SRAS curve to the left; in the short-run, the price level rises to P 110 and output falls to Y 2.  What happens in the long-run depends on whether the reduction in the supply of resources is temporary or permanent. Effects of Adverse Supply Shock  If temporary, resource prices fall in the future, permitting the economy to return to its original equilibrium (A).  If permanent, the productive potential of the economy will shrink (LRAS shifts to the left) and (B) will become the long-run equilibrium. SRAS 2 (P r 2 ) B

Price Level Real Domestic Output, GDP Q P AS AD 1 INCREASES IN AD: DEMAND-PULL INFLATION P2P2 P1P1 AD 2 QfQf Q1Q1 Q2Q2

Price Level Real Domestic Output, GDP Q P AS 1 AD 1 DECREASES IN AS: COST-PUSH INFLATION P2P2 QfQf Q1Q1 a b AS 2 P1P1