1. Principles and Policies I: Macroeconomics
Chapter 9:Aggregate Demand, Aggregate Supply, and Modern Macroeconomics
Macroeconomics, Maclachlan /13/04

2. Chapter 9 Learning Objectives You should be able to …
Discuss the historical development of macroeconomics.
Explain the shape of the aggregate demand curve and what factors shift the curve.
Explain the shape of the short run aggregate supply curve and what factors shift the curve.
Explain the shape of the long-run aggregate supply curve.
Show the effects of shifts of the aggregate demand and aggregate supply curves on price level and output in both the short run and long run.
Discuss the limitations of the macro policy model.
Macroeconomics, Maclachlan /13/04

3. Macroeconomics, Maclachlan 10/13/04
Classical Model
Equilibrium in each market leads to equilibrium in the economy as a whole.
Fallacy of composition.
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4. Considering the whole as more than sum of the parts.
First major macroeconomist:
John Maynard Keynes
The General Theory of Employment, Interest and Money (1936)
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5. Macroeconomics, Maclachlan 10/13/04
In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. --John Maynard Keynes
Macroeconomics, Maclachlan /13/04

6. Macroeconomics, Maclachlan 10/13/04
The Paradox of Thrift
This paradox of thrift is important to the Keynesian story.
Paradox of thrift – an increase in savings can lead to a decrease in expenditures, decreasing output and causing a recession.
Macroeconomics, Maclachlan /13/04

7. The Aggregate Demand Curve
The aggregate demand (AD) curve shows how a change in the price level changes aggregate expenditures on all goods and services in an economy.
It shows the level of expenditures that would take place at every price level in the economy.
Macroeconomics, Maclachlan /13/04

8. The Slope of the AD Curve
The AD is a downward sloping curve.
Aggregate demand is composed of the sum of aggregate expenditures.
Expenditures = C + I + G +(X - M)
Macroeconomics, Maclachlan /13/04

9. The Slope of the AD Curve
The slope of the AD curve is determined by the wealth effect, the interest rate effect, the international effect, and the multiplier effect.
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10. Macroeconomics, Maclachlan 10/13/04
The Wealth Effect
Wealth effect – a fall in the price level will make the holders of money and other financial assets richer, so they buy more.
Most economists accept the logic of the wealth effect, however, they do not see the effect as strong.
Macroeconomics, Maclachlan /13/04

11. The Interest Rate Effect
Interest rate effect – the effect a lower price level has on investment expenditures through the effect that a change in the price level has on interest rates.
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12. The Interest Rate Effect
The interest rate effect works as follows:
a decrease in the price level 
increase of real cash 
banks have more money to lend 
interest rates fall 
investment expenditures increase
Macroeconomics, Maclachlan /13/04

13. The International Effect
International effect – as the price level falls (assuming exchange rates do not change), net exports will rise.
Macroeconomics, Maclachlan /13/04

14. The International Effect
The international effect works as follows:
a decrease in the price level in the U.S.
the fall in price of U.S. goods relative to foreign goods 
U.S. goods become more competitive internationally 
U.S. exports rise and U.S. imports fall
Macroeconomics, Maclachlan /13/04

15. Macroeconomics, Maclachlan 10/13/04
The Multiplier Effect
Initial changes in expenditures set in motion a process in the economy that amplifies the initial effects.
Multiplier effect – the amplification of initial changes in expenditures.
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16. Macroeconomics, Maclachlan 10/13/04
The AD Curve
Price
level
Real output
Aggregate demand P0 Y0
Wealth, interest rate, and international effects
Multiplier effect P1 Y1 Ye
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17. Macroeconomics, Maclachlan 10/13/04
Shifts in the AD Curve
Except for a change in the price level, anything that changes aggregate expenditures shifts the AD curve.
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18. Macroeconomics, Maclachlan 10/13/04
Shifts in the AD Curve
The main shift factors of aggregate demand are:
Foreign income.
Expectations about future output or prices.
Exchange rate fluctuations.
The distribution of income.
Government policies.
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19. Macroeconomics, Maclachlan 10/13/04
Fiscal Policy
Changing tax rates and/or government spending to influence aggregate demand.
Expansionary macro policy shifts the curve to the right.
Contractionary macro policy shifts it to the left.
Macroeconomics, Maclachlan /13/04

20. Effect of a Shift Factor on the AD Curve
Price level
Real output
AD0
AD1
Initial effect
100
Multiplier
effect
200 P0
Change in total expenditures
300
Initial effect
Macroeconomics, Maclachlan /13/04

21. The Short-Run Aggregate Supply Curve
The short-run aggregate supply (SAS) curve specifies how a shift in the aggregate demand curve affects the price level and real output in the short run, other things constant.
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22. The Short-Run Aggregate Supply Curve
Real output
Price level
SAS
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23. The Slope of the SAS Curve
The SAS curve is upward-sloping.
The SAS curve reflects two different types of microeconomic markets in our economy.
Auction markets – markets represented by the supply/demand model.
Posted-price markets – prices are set by the producers and change only infrequently.
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24. Macroeconomics, Maclachlan 10/13/04
Shifts in the SAS Curve
The AS curve shifts when a shift factor changes – other things are not constant:
Changes in input prices.
Changes in expectations of inflation.
Productivity.
Excise and sales taxes.
Import prices.
Macroeconomics, Maclachlan /13/04

25. The Long-Run Aggregate Supply Curve
The LAS is vertical crossing output axis at POTENTIAL OUTPUT.
At potential output, a rise in the price level means that all prices, including input prices rise.
Macroeconomics, Maclachlan /13/04

26. The Long-Run Aggregate Supply Curve
Long-run aggregate supply (LAS)
Price level
Real output
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27. A Range for Potential Output and the LAS Curve
Real output C B
SAS A
Underutilized
resources
Overutilized
resources
Low-level potential output
High-level potential output
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28. Macroeconomics, Maclachlan 10/13/04
Shifts in the LAS Curve
The LAS curve will shift whenever there is a changes in:
Capital.
Available resources.
Growth-compatible institutions.
Technological development.
Entrepreneurship.
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29. Equilibrium in the Aggregate Economy
Changes in the SAS, AD, and LAS curves affect short-run and long-run equilibrium.
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30. Short-Run Equilibrium
Short-run equilibrium is where the AS and AD curves intersect.
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31. Short-Run Equilibrium: Shift in Aggregate Demand
Real output
Price level
SAS P1 F P0 E
AD1
AD0 Y0 Y1
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32. Short-Run Equilibrium: Shift in Aggregate Supply
Real output
Price level
SAS1 G P1
SAS0 E P0 AD Y1 Y0
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33. Macroeconomics, Maclachlan 10/13/04
Long-Run Equilibrium
Long-run equilibrium is where the AD and long-run aggregate supply curves intersect.
In the long run, output is fixed and the price level is variable.
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34. Long-Run Equilibrium: Shift in Aggregate Demand
Real output
Price level
AD1
LAS
AD0 H P1 P0 Y0 E
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35. Integrating the Short-Run and Long-Run Frameworks
The economy is in both short-run and long-run equilibrium when all three curves intersect in the same location.
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36. Integrating the Short-Run and Long-Run Frameworks
The ideal situation is for aggregate demand to grow at the same rate as aggregate supply and potential output.
Unemployment and growth are at their target rates with no inflation.
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37. Macroeconomics, Maclachlan 10/13/04
Long-Run Equilibrium AD
SAS YP
Real output
LAS P0 E
Price level
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38. Macroeconomics, Maclachlan 10/13/04
The Recessionary Gap
A recessionary gap is the amount by which equilibrium output is below potential output.
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39. Macroeconomics, Maclachlan 10/13/04
The Recessionary Gap
If the economy remains at this level for a long time, there would be an excess supply of factors of production.
Costs and wages would tend to fall.
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40. Macroeconomics, Maclachlan 10/13/04
The Recessionary Gap
As factor prices fall, the SAS curve will shift down to eliminate the recessionary gap.
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41. Macroeconomics, Maclachlan 10/13/04
The Recessionary Gap
Real output
Price level
LAS
SAS0 A P0 B
SAS1 P1 AD
Recessionary gap Y1 YP
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42. Macroeconomics, Maclachlan 10/13/04
The Inflationary Gap
The inflationary gap occurs when the economy is above potential that exists at the current price level.
Factor prices rise causing the SAS curve to shift up.
The price level rises, and the inflationary gap is eliminated.
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43. Macroeconomics, Maclachlan 10/13/04
The Inflationary Gap
LAS
SAS2 D
Price level P2 C
SAS0 P0 AD
Inflationary gap YP Y2
Real
output
(c)
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44. The Economy Beyond Potential
When the economy operates below its potential, firms can hire additional factors of production without increasing production costs.
Once the economy reaches its potential output, that is no longer possible.
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45. The Economy Beyond Potential
As firms compete for resources, costs rise beyond productivity increases.
The short-run AS curve shifts up and the price level rises.
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46. The Economy Beyond Potential
The economy will slow down by itself or the government will step in with a policy to contract output and eliminate the inflationary gap.
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47. Expansionary Fiscal Policy
Real output
Price level
LAS AS P1 P0 A
AD1
AD0 Y0 YP
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48. Contractionary Fiscal Policy
Real output
Price level
LAS B AS P2
AD0
AD2 YP Y2
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49. Some Additional Policy Examples
Unemployment is 12 percent and there is no inflation.
What policy would you recommend?
Use expansionary fiscal policy to shift the AD curve out to its potential income.
Macroeconomics, Maclachlan /13/04

50. Expansionary Fiscal Policy
Real output
Price level
LAS
SAS B P1 P0 A
AD1
AD0 Y0 YP
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51. Some Additional Policy Examples
Unemployment is at its target rate and it is likely that consumer expenditures will rise.
What policy would you recommend?
Use contractionary fiscal policy to shift the AD curve inward to counteract the expected increase in AD.
Macroeconomics, Maclachlan /13/04

52. Contractionary Fiscal Policy
Real output
Price level
LAS B
SAS P1
AD0
AD2 YP Y1
Macroeconomics, Maclachlan /13/04

53. Some Additional Policy Examples
What would have happened if the government didn’t institute a contractionary fiscal policy?
There would be an inflationary gap which would increase factor prices.
The SAS curve would shift up until it intersects the AD curve at YP.
Macroeconomics, Maclachlan /13/04

54. Economy Above Potential
Real output
Price level
LAS
SAS1 E P1 D
SAS0 P0 C
AD1
AD0 YP Y1
Macroeconomics, Maclachlan /13/04

55. The Problem of Implementing Fiscal Policy
There is no guarantee that government will do what the economy needs to be done.
Implementing government spending and tax changes is a slow legislative process.
Government spending and tax decisions are made for political rather than for economic reasons.
Macroeconomics, Maclachlan /13/04

56. The Problem of Estimating Potential Output
One way of estimating potential output is to estimate the target rate of unemployment.
Target rate of unemployment – the rate below which inflation began to accelerate in the past.
Target rate is not constant. It’s hard to tell what’s structural and what’s cyclical.
Macroeconomics, Maclachlan /13/04

57. The Problem of Estimating Potential Output
Another way to determine potential output is to add the normal growth factor (3%) the economy’s previous level.
Estimating the economy’s potential from past growth rates is complicated by potentially dramatic changes in regulations, technology, and expectations.
Macroeconomics, Maclachlan /13/04

58. Macroeconomics, Maclachlan 10/13/04
Problem 9-3
Explain what will likely happen to the slope or position of the AD curve in the following circumstances.
The exchange rate changes from fixed to flexible.
When the price level changes the exchange rate will change so the international effect won’t be as strong. The curve will get steeper.
Macroeconomics, Maclachlan /13/04

59. Macroeconomics, Maclachlan 10/13/04
9-3 cont.
b) A fall in the price level doesn’t make people feel richer.
The wealth effect will be weaker & curve will be steeper.
c) A fall in the price level creates expectations of a further falling price level.
The curve shifts downward.
d) Income is redistributed from rich people to poor people.
Since poor people consume a greater percentage of their income, the curve shifts to the right.
e) Autonomous exports increase by 20.
Curve shifts to the right.
f) Government spending decreases by 10.
Curve shifts to the left.
Macroeconomics, Maclachlan /13/04

60. Macroeconomics, Maclachlan 10/13/04
Problem 9-5
Congratulations! You have been appointed an economic policy adviser to the United States. You are told that the economy is significantly below potential output, and that the following will happen next year: World income will fall significantly; and the price of oil will rise significantly. (The United States is an oil importer.)
What will happen to the price level and real output?
What policy might you suggest to the government?
Macroeconomics, Maclachlan /13/04