1. Aggregate Supply and Demand

2. Macro View
Macroeconomics is the study of the aggregate economic behavior of the economy as a whole.

3. Macro Outcomes The basic macro outcomes include:
Output — The total volume of goods and services produced (real GDP).
Jobs — The levels of employment and unemployment.

4. Macro Outcomes The basic macro outcomes include:
Prices — The average price of goods and services.
Growth — The year-to-year expansion in production capacity.

5. Macro Outcomes The basic macro outcomes include:
International balances — The international value of the dollar, trade, and payment balances with other countries

6. Macro Determinants The determinants of macro performance include:
Internal market forces — Population growth, spending behavior, invention and innovation, and the like.

7. Macro Determinants The determinants of macro performance include:
External shocks — Wars, natural disasters, trade disruptions, and so on.

8. Macro Determinants The determinants of macro performance include:
Policy levers — Tax policy, government spending, changes in the availability of money, and regulation.

9. The Macro Economy MACRO ECONOMY DETERMINANTS OUTCOMES Jobs
Output
Jobs
Prices
Growth
International
balances
Policy levers
Internal market
forces
External shocks
MACRO
ECONOMY

10. Stable or Unstable
The central concern of macroeconomic theory is whether the internal forces of the marketplace will generate desired outcomes.

11. Classical Theory Prevalent theory prior to the 1930s.
The economy self-adjusts to deviations from its long-term growth.

12. Self Adjustment
The cornerstones of the Classical Theory are flexible wages and flexible prices.

13. Flexible Prices
Flexible prices virtually guarantee that all output could be sold.
No one would lose a job because of weak demand.

14. Flexible Wages
Flexible wages ensure that everyone who wants a job would have a job.

15. Say’s Law According to Say’s Law, supply creates its own demand.
Unsold goods will ultimately be sold when buyers and sellers find an acceptable price.

16. Say’s Law
In the labor market, some people will be unemployed, but can find new jobs if they are willing to accept lower wages.

17. Say’s Law
According to Classical economists, government intervention in a self-adjusting macro economy is unnecessary.

18. Inflation and Unemployment, 1900 – 1940
ANNUAL RATE OF INFLATION OR UNEMPLOYMENT (percent)
1900
1910
1920
1930
1940
– 8
– 4 4 8 12 16 20 24
Unemployment
Prices

19. The Keynesian Revolution
The Great Depression was a stunning blow to Classical economists.
John Maynard Keynes provided an alternative to the Classical Theory.

20. The Keynesian Revolution
Keynes argued that the Great Depression was not a unique event.
It would recur if reliance on the market to “self-adjust” continued.

21. No Self-Adjustment
Keynes asserted that the private economy was inherently unstable.
This instability requires government intervention.
Policy levers are necessary and effective.

22. The Aggregate Supply-Demand Model
Any influence on macro outcomes must be transmitted through supply or demand.

23. Aggregate Demand
Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

24. Real GDP (Output) Real GDP is the inflation-adjusted value of GDP.
It is the value of output in constant prices.

25. Price Level
The aggregate demand curve illustrates how the volume of purchases varies with average prices.
Purchases of real output increase as average prices fall.

26. Aggregate Demand Curve
The AD is downward sloping for three reasons:
Real balances effect
Foreign trade effect
Interest-rate effect

27. Real Balances Effect
The real value of money balances is measured by how many goods and services each dollar will buy.
As prices fall, money balances can purchase more goods.

28. Foreign Trade Effect
If domestic prices decline consumers demand more domestic output and fewer imports.

29. Interest-Rate Effect
At lower price levels, interest rates fall as consumers borrow less.
Lower interest rates stimulate borrowing and loan-financed purchases.

30. Aggregate Demand Higher prices Lower prices Aggregate demand
REAL OUTPUT (quantity per year)
PRICE LEVEL (average price)
Higher prices
Lower prices
Aggregate demand
Less output demanded
More output demanded

31. Aggregate Supply
The total quantity of output producers are willing and able to supply at alternative price levels in a given time-period, ceteris paribus.

32. Aggregate Supply The aggregate supply curve is upward-sloping.
We expect the rate of output to increases when price level rises.

33. Profit Margins
Producers’ short-run costs, like rent and negotiated wages, are relatively constant.
Higher product prices tend to widen their profit margins.
They will want to produce and sell more.

34. Costs
Production costs tend to increase as producers try to produce more.
They must acquire more resources and use existing plant and equipment more intensively.

35. Costs
The aggregate supply curve is relatively flat when capacity is underutilized.
It begins to slope upward as producers approach capacity.

36. Aggregate Supply Higher prices Aggregate supply More output supplied
PRICE LEVEL (average price)
REAL OUTPUT (quantity per year)
Higher prices
Aggregate supply
More output supplied

37. Macro Equilibrium
Aggregate supply and demand curves summarize the market activity of the whole (macro) economy.

38. Macro Equilibrium
Macro equilibrium – the combination of price level and real output that is compatible with both aggregate demand and aggregate supply.

39. Macro Equilibrium
It is the only price-output combination mutually compatible with both buyers’ and sellers’ intentions.

40. Macro Equilibrium Aggregate supply PRICE LEVEL (average price) E PE
Aggregate demand QE
REAL OUTPUT (quantity per year)

41. Disequilibrium
If the price level is higher than at equilibrium, buyers will want to buy less than producers want to produce and sell.

42. Macro Disequilibrium PRICE LEVEL (average price)
REAL OUTPUT (quantity per year)
Aggregate supply P1 E PE
Aggregate demand D1 QE S1

43. Macro Failure
There are two potential problems with macro equilibrium — undesirability and instability.

44. Macro Failure
Undesirability — the price-output relationship at equilibrium may not satisfy our macroeconomic goals.

45. Macro Failure
Instability — even if designated macro equilibrium is optimal, it may be displaced by macro disturbances.

46. Undesirable Outcomes
Unemployment — the inability of labor-force participants to find jobs.
Inflation — an increase in the average level of prices of goods and services

47. An Undesired Equilibrium
PRICE LEVEL (average price)
REAL OUTPUT (quantity per year)
Aggregate demand
Aggregate supply
Unemployment arises when QE< QF E PE F P*
Equilibrium output
Full employment QE QF

48. Unstable Outcomes
Shifts in aggregate supply and aggregate demand can upset a full employment equilibrium.

49. Shifts in Aggregate Supply
A leftward shift of aggregate supply results in higher prices and less output.

50. Shifts in Aggregate Demand
A leftward shift of aggregate demand results in less output.

51. Recurrent Shifts
Business cycles are a result of recurrent shifts of the aggregate supply and demand curves.
Business cycles are alternating periods of economic growth and contraction.

52. Macro Disturbances (a) Supply shifts (b) Demand shifts AS1 AS0 AS0 AD0
PRICE LEVEL (average price)
REAL OUTPUT (quantity per year)
AS1
AS0
AS0
AD0 G P1 F F P* P* H P2
AD0
AD1 Q1 QF Q2 QF

53. Shift Factors
There are lots of reasons to expect aggregate supply and aggregate to shift.

54. Demand Shifts
The aggregate demand curve might shift as a result of changes in:
Consumer sentiment.
Taxes on consumer income.
Interest rates.

55. Supply Shifts Price or availability of raw materials.
Business tax changes.
Environmental and work place regulations.

56. Competing Theories of Short-Run Instability
Economists are not in complete agreement about how to achieve desired macro outcomes.

57. Competing Theories of Short-Run Instability
Macro controversies focus on the shape of aggregate supply and demand curves and the potential to shift them.

58. Demand-Side Theories
Keynesian Theory
Monetary Theories

59. Keynesian Theory
Keynes argues that if people demand a product, producers will supply it.
If aggregate spending isn't sufficient, some goods will remain unsold and some production capacity will be idled.

60. Keynesian Theory
Keynesian theory urges increased government spending or tax cuts as mechanisms for increasing aggregate demand.

61. Monetary Theories
Monetary theories focus on the control of money and interest rates as mechanisms for shifting the aggregate demand curve.

62. Monetary Theories
Money and credit affect the ability and willingness of people to buy goods and services.

63. Monetary Theories
If right amount of money is not available, aggregate demand may be too small.
High interest rates decrease aggregate demand.

64. Supply-Side Theories
A decline in aggregate supply causes output and employment to fall.
The focus of supply-side theories is to get more output by shifting the AS curve to the right.

65. Eclectic Explanations
Shifts in both supply and demand curves may occur.

66. Origins of a Recession: Demand Shifts
REAL OUTPUT (quantity per year)
PRICE LEVEL (average price)
AS0 E0 E1
AD0
AD1 Q1 QF

67. Origins of a Recession: Supply Shifts
REAL OUTPUT (quantity per year)
PRICE LEVEL (average price)
AS1
AS0 E2 E0
AD0 Q2 QF

68. Origins of a Recession: Supply and Demand Shifts
REAL OUTPUT (quantity per year)
PRICE LEVEL (average price)
AS1
AS0 E3 E0
AD0
AD1 Q3 QF

69. Policy Options The government has three policy options:
Shift the aggregate demand curve.
Shift the aggregate supply curve.
Do nothing.

70. Fiscal Policy
Fiscal policy is the use of government taxes and spending to alter macro-economic outcomes.
Fiscal policy is conducted by Congress and the President.

71. Monetary Policy
Monetary policy is the use of money and credit controls to influence macro-economic activity.
The Federal Reserve is regulatory body that controls supply of money.

72. Supply-Side Policy
Supply-side policies seek to increase the ability and willingness to produce goods and services.

73. Supply-Side Policy
Supply-side policies include cutting tax rates, deregulation, and other production enhancing mechanisms.

74. The Changing Choice of Policy Levers
A do nothing approach prevailed until the Great Depression.
The Great Depression spurred a desire for a more active government role.

75. The Changing Choice of Policy Levers: 1960s
Fiscal policy dominated the economic debate in the 1960s.
The promise of fiscal policy was tarnished by its failure to control inflation in the late 1960s.

76. The Changing Choice of Policy Levers: 1970s
Monetary policy dominated macro policy in the 1970s.
The heavy reliance on monetary policy ended with a recession in the late 1970s.

77. The Changing Choice of Policy Levers: 1980s
Supply-side policies prevailed in 1980’s with Ronald Reagan.

78. The Changing Choice of Policy Levers: 1990s
The George H. Bush administration pursued a less activist approach in the early 1990s.
Bill Clinton pursued a contractionary fiscal policy in the mid-1990s.
This fiscal policy retreat cleared the way for a reemergence of monetary policy.

79. Current Policy
The fiscal restraint of the late 1990's helped the federal budget move from deficits to surpluses.

80. Current Policy
In 2001, 2002, and 2003 Congress cut taxes in an attempt to deal with a recession.

81. Aggregate Supply and Demand
End of Chapter 11