1. 1 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis CHAPTER 12 Aggregate Demand and Aggregate Supply Analysis Fernando Quijano Prepared by:

2. 2 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand Aggregate demand and aggregate supply model A model that explains short-run fluctuations in real GDP and the price level. FIGURE 12-1 Aggregate Demand and Aggregate Supply Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. 12.1 LEARNING OBJECTIVE

3. 3 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand Aggregate demand (AD) curve A curve that shows the relationship between the price level (P) and the quantity of real GDP (Y) demanded by households, firms, and the government. Short-run aggregate supply (SRAS) curve A curve that shows the relationship in the short-run between the price level (P) and the quantity of real GDP (Y) supplied by firms. Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. 12.1 LEARNING OBJECTIVE

4. 4 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis 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 Why does the AD curve slope downward? Reason # 1: The Wealth Effect How a Change in the Price Level Affects Consumption The impact of the price level on consumption is called the wealth effect. Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. 12.1 LEARNING OBJECTIVE

5. 5 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand The impact of the price level on investment is known as the interest-rate effect. Reason # 3: The International-Trade Effect How a Change in the Price Level Affects Net Exports The impact of the price level on net exports is known as the international-trade effect. Reason # 2: The Interest-Rate Effect How a Change in the Price Level Affects Investment Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. 12.1 LEARNING OBJECTIVE

6. 6 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand An important point to remember is that the aggregate demand curve tells us the relationship between the price level and the quantity of real GDP demanded, holding everything else constant. A “shift” of the aggregate demand curve vs a “movement along” Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. 12.1 LEARNING OBJECTIVE

7. 7 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand 1. changes in government policies 2. changes in the expectations of households and firms 3. changes in foreign variables Variables That Shift the AD Curve The variables that cause the aggregate demand curve to shift fall into three categories: Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. 12.1 LEARNING OBJECTIVE

8. 8 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand Monetary policy The actions the Federal Reserve takes to manipulate the money supply or the interest rate to pursue macroeconomic policy objectives. Changes in Government Policies Fiscal policy Changes in federal taxes or purchases that are intended to achieve macroeconomic policy objectives. Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. 12.1 LEARNING OBJECTIVE

9. 9 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Aggregate Demand If households become more optimistic about their future incomes, they are likely to increase their current consumption. Changes in the Expectations of Households and Firms If firms and households in other countries buy fewer U.S. goods or if firms and households in the United States buy more foreign goods, net exports will fall, and the aggregate demand curve will shift to the left. Changes in Foreign Variables Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. 12.1 LEARNING OBJECTIVE

10. 10 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Solved Problem 12-1 Movements along the Aggregate Demand Curve versus Shifts of the Aggregate Demand Curve Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve. 12.1 LEARNING OBJECTIVE

11. 11 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Aggregate Supply Long-run aggregate supply (LRAS) curve A curve that shows the relationship in the long-run between the price level (P) and the quantity of real GDP supplied (Y). Identify the determinants of aggregate supply and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve. 12.2 LEARNING OBJECTIVE

12. 12 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Aggregate Supply The Long-Run Aggregate Supply Curve FIGURE 12-2 The LRAS Curve Identify the determinants of aggregate supply and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve. 12.2 LEARNING OBJECTIVE

13. 13 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis 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 The three most common explanations as to why the Keynesian short-run aggregate supply curve slopes upward include: Menu costs The costs to firms of changing prices. Identify the determinants of aggregate supply and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve. 12.2 LEARNING OBJECTIVE

14. 14 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Aggregate Supply 1. increases in the labor force and in the capital stock (K) 2. positive or negative technological change 3. expected changes in the future price level Identify the determinants of aggregate supply and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve. 12.2 LEARNING OBJECTIVE Variables That Shift the SRAS Curve 5. workers and firms adjusting to errors in their past expectations about the price level 4. unexpected changes in the price of a natural resource Supply shock An unexpected event that causes the short-run aggregate supply curve to shift.

15. 15 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Aggregate Supply Most important: Expected changes in the future price level! FIGURE 12-3 How Expectations of the Future Price Level Affect the SRAS curve Identify the determinants of aggregate supply and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve. 12.2 LEARNING OBJECTIVE

16. 16 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Macroeconomic Equilibrium in the Long-Run and the Short-Run FIGURE 12-4 Long-Run Macroeconomic Equilibrium A “long-run equilibrium” is also called a “general” equilibrium because all markets are simultaneously in equilibrium. Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium. 12.3 LEARNING OBJECTIVE

17. 17 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis 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 $14.0 trillion and will remain at that level in the future. The simple (static) AD-LRAS-SRAS model Because the full analysis of the aggregate demand and aggregate supply model can be complicated, we begin with a simplified case, using two assumptions: Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium. 12.3 LEARNING OBJECTIVE

18. 18 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Macroeconomic Equilibrium in the Long-Run and the Short-Run FIGURE 12-5 The SR and LR equilibria from a decrease in aggregate demand Example: A negative AD shock in the simple (static) model Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium. 12.3 LEARNING OBJECTIVE The simple (static) AD-LRAS-SRAS model

19. 19 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Macroeconomic Equilibrium in the Long-Run and the Short-Run FIGURE 12-6 The SR and LR equilibria from an increase in aggregate demand Example: A positive AD shock in the simple (static) model Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium. 12.3 LEARNING OBJECTIVE The simple (static) AD-LRAS-SRAS model

20. 20 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Macroeconomic Equilibrium in the Long-Run and the Short-Run FIGURE 12-7 The SR and LR equilibria from a decrease in aggregate supply Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium. 12.3 LEARNING OBJECTIVE The simple (static) AD-LRAS-SRAS model Example: A negative supply shock in the simple (static) model

21. 21 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Macroeconomic Equilibrium in the Long-Run and the Short-Run Stagflation A combination of inflation and recession, usually resulting from a supply shock. Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium. 12.3 LEARNING OBJECTIVE Why are negative supply shocks so dangerous to an economy?

22. 22 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis How Long Does It Take to Return to Potential GDP? A View from the Obama Administration Making the Connection Christina Romer, the chair of the Council of Economic Advisers in the Obama Administration, provided an estimate of how long the economy would take to return to potential GDP. The difficulty in predicting how much aggregate demand and aggregate supply will shift means that economists often have difficulty correctly predicting the beginning and end of recessions. Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium. 12.3 LEARNING OBJECTIVE

23. 23 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis A Dynamic Aggregate Demand and Aggregate Supply Model 1. Potential real GDP increases continually, shifting the LRAS curve to the right. 2. During most years, the AD curve shifts to the right. 3. Except during periods when workers and firms expect high rates of inflation, the SRAS curve shifts to the right. We can create a dynamic aggregate demand and aggregate supply model by making three changes to our simple (static) model. Use the dynamic aggregate demand and aggregate supply model to analyze macroeconomic conditions. 12.4 LEARNING OBJECTIVE The complete (dynamic) AD-LRAS-SRAS model

24. 24 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis A Dynamic Aggregate Demand and Aggregate Supply Model FIGURE 12-8 Use the dynamic aggregate demand and aggregate supply model to analyze macroeconomic conditions. 12.4 LEARNING OBJECTIVE The complete (dynamic) AD-LRAS-SRAS model

25. 25 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis A Dynamic Aggregate Demand and Aggregate Supply Model FIGURE 12-9 Using dynamic AD-LRAS- SRAS to understand inflation Use the dynamic aggregate demand and aggregate supply model to analyze macroeconomic conditions. 12.4 LEARNING OBJECTIVE The complete (dynamic) AD-LRAS-SRAS model Example: An overheating economy where AD grows faster than LRAS

26. 26 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis A Dynamic Aggregate Demand and Aggregate Supply Model the bursting of the housing bubble The Great Recession of 2007-2009 the Financial Crisis of 2008 the rapid increase in oil prices during 2008 The Great Recession began in December 2007,with the end of the economic expansion that had begun in November 2001. Several factors contributed to bring on the recession: Use the dynamic aggregate demand and aggregate supply model to analyze macroeconomic conditions. 12.4 LEARNING OBJECTIVE

27. 27 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis A Dynamic Aggregate Demand and Aggregate Supply Model FIGURE 12-10 The Beginning of the Great Recession of 2007–2009 Use the dynamic aggregate demand and aggregate supply model to analyze macroeconomic conditions. 12.4 LEARNING OBJECTIVE The Great Recession in the dynamic AD-LRAS-SRAS model Example: The economy grows too slowly because LRAS grew faster than AD (plus there is a negative shock to SRAS)

28. 28 of 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Demand and Aggregate Supply Analysis Aggregate demand and aggregate supply model Aggregate demand (AD) curve Fiscal policy Long-run aggregate supply (LRAS) curve Menu costs Monetary policy Short-run aggregate supply (SRAS) curve Stagflation Supply shock KEY TERMS