1. Chapter 17 Aggregate Demand and Aggregate Supply

2. Figure 1: The Two-Way Relationship Between Output and the Price Level
Real
GDP
Aggregate Demand Curve
Aggregate Supply Curve
Lieberman & Hall; Introduction to Economics, 2005

3. The Price Level and The Money Market
First effect of a change in the price level occurs in the money market
Rise in the price increases the demand for money and shifts the money demand curve rightward
It makes purchases more expensive
Drop in the price level
Makes purchases cheaper
Decreases the demand for money
Shifts the money demand curve leftward
Rise in the price level causes the interest rate to rise and interest-sensitive spending to fall
Equilibrium GDP decreases by a multiple of the decrease in interest-sensitive spending
Lieberman & Hall; Introduction to Economics, 2005

4. The Price Level and Net Exports
The second effect of a higher price level brings in the foreign sector
A rise in the price level causes
Net exports to drop and
Equilibrium GDP to decrease by a multiple of the drop in net exports
Lieberman & Hall; Introduction to Economics, 2005

5. Deriving The Aggregate Demand (AD) Curve
Figure 2 plots the price level on a vertical axis and the economy’s real GDP on the horizontal axis
If we continued to change the price level to other values we would find that each different price level results in a different equilibrium GDP
The aggregate demand (AD) curve tells us the equilibrium real GDP at any price level
Lieberman & Hall; Introduction to Economics, 2005

6. Figure 2: Deriving the Aggregate Demand Curve
Price
Level K
140 J
100 AD 6 10
Real GDP
($ Trillions)
Lieberman & Hall; Introduction to Economics, 2005

7. Movements Along The AD Curve
A variety of events can cause the price level to change, and move us along the AD curve
It’s important to understand what happens in the economy as we make such a move
Opposite sequence of events will occur if the price level falls, moving us rightward along the AD curve
Lieberman & Hall; Introduction to Economics, 2005

8. Shifts of The AD Curve
The distinction between movements along the AD curve and shifts of the curve itself is very important
Always keep the following rule in mind
When a change in the price level causes equilibrium GDP to change, we move along the AD curve
Whenever anything other than the price level causes equilibrium GDP to change, the AD curve itself shifts
What are these other influences on GDP?
Equilibrium GDP will change whenever there is a change in any of the following
Government spending
Taxes
Autonomous consumption spending
Investment spending
The money supply curve
The money demand curve
Lieberman & Hall; Introduction to Economics, 2005

9. Spending Shocks
Spending shocks initially affect the economy by changing total spending
And then changing output by a multiple of that original change in spending
The AD curve shifts rightward when government purchases, investment spending, autonomous consumption spending, or net exports increase, or when taxes decrease
The AD curve shifts leftward when government purchases, investment spending, autonomous consumption spending, or net exports decrease, or when taxes increase
Lieberman & Hall; Introduction to Economics, 2005

10. Figure 3: A Spending Shock Shifts the AD Curve
Price
Level
100 H E
AD1
AD2
Real GDP
($ Trillions) 10 15
Lieberman & Hall; Introduction to Economics, 2005

11. Changes in the Money Market
Changes that originate in the money market will also shift the aggregate demand curve
An increase in the money supply shifts the AD curve rightward
A decrease in the money supply shifts the AD curve leftward
Lieberman & Hall; Introduction to Economics, 2005

12. Figure 4(a): Effects of Key Changes on the Aggregate Demand Curve
Price Level
Price level ↑ moves us leftward along the AD curve P3
Price level ↓ moves us rightward along the AD curve P1 P2 AD Q3 Q1 Q2
Real GDP
Lieberman & Hall; Introduction to Economics, 2005

13. Figure 4(b): Effects of Key Changes on the Aggregate Demand Curve
Price Level
Entire AD curve shifts rightward if:
a, IP, G, or NX increases
Net taxes decrease
The money supply increases
AD2
AD1
Real GDP
Lieberman & Hall; Introduction to Economics, 2005

14. Figure 4(c): Effects of Key Changes on the Aggregate Demand Curve
Price Level
Entire AD curve shifts leftward if:
a, IP, G, or NX decreases
Net taxes increase
The money supply decreases
decreases
AD1
AD2
Real GDP
Lieberman & Hall; Introduction to Economics, 2005

15. The Aggregate Supply Curve
On the one hand, changes in the price level affect output
On the other hand, changes in output affect the price level
This relationship—summarized by the aggregate supply curve—is the focus of this section
The effect of changes in output on the price level is complex, involving a variety of forces
Lieberman & Hall; Introduction to Economics, 2005

16. Costs and Prices
Price level in economy results from pricing behavior of millions of individual business firms
In any given year, some of these firms will raise their prices, and some will lower them
Often, all firms in the economy are affected by the same macroeconomic event
Causing prices to rise or fall throughout the economy
To understand how macroeconomic events affect the price level, we begin with a very simple assumption
A firm sets price of its products as a markup over cost per unit
Lieberman & Hall; Introduction to Economics, 2005

17. Costs and Prices
Percentage markup in any particular industry will depend on degree of competition there
In macroeconomics, we are not concerned with how the markup differs in different industries
But rather with average percentage markup in economy
Determined by competitive conditions
Competitive structure changes very slowly, so average percentage markup should be somewhat stable from year-to-year
But a stable markup does not necessarily mean a stable price level, because unit costs can change
In short-run, price level rises when there is an economy-wide increase in unit costs
Price level falls when there is an economy-wide decrease in unit costs
Lieberman & Hall; Introduction to Economics, 2005

18. GDP, Costs, and the Price Level
Why should a change in output affect unit costs and price level?
As total output increases
Greater amounts of inputs may be needed to produce a unit of output
Price of non-labor inputs rise
Nominal wage rate rises
A decrease in output affects unit costs through the same three forces, but with opposite result
Lieberman & Hall; Introduction to Economics, 2005

19. The Short Run
All three of our reasons are important in explaining why a change in output affects price level
They operate within different time frames
Our third explanation—changes in nominal wage rate—is a different story
For a year or more after a change in output, changes in average nominal wage are less important than other forces that change unit costs
Lieberman & Hall; Introduction to Economics, 2005

20. The Short Run
Some of the more important reasons why wages in many industries respond so slowly to changes in output
Many firms have union contracts that specify wages for up to three years
Wages in many large corporations are set by slow-moving bureaucracies
Wage changes in either direction can be costly to firms
Firms may benefit from developing reputations for paying stable wages
Lieberman & Hall; Introduction to Economics, 2005

21. The Short Run Nominal wage rate is fixed in short-run
We assume that changes in output have no effect on nominal wage rate in short-run
Since we assume a constant nominal wage in short-run, a change in output will affect unit costs through the other two factors
In short-run, a rise (fall) in real GDP, by causing unit costs to increase (decrease), will also cause a rise (decrease) in price level
Lieberman & Hall; Introduction to Economics, 2005

22. Deriving the Aggregate Supply Curve
Figure 5 summarizes discussion about effect of output on price level in short-run
Each time we change level of output, there will be a new price level in short-run
Giving us another point on the figure
If we connect all of these points, we obtain economy’s aggregate supply curve
Tells us price level consistent with firms’ unit costs and their percentage markup at any level of output over short-run
A more accurate name for AS curve would be “short-run-price-level-at-each-output-level” curve
Lieberman & Hall; Introduction to Economics, 2005

23. Figure 5: The Aggregate Supply Curve
Price Level AS
Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises.
130 B
100 A 80 C
Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price level falls. 6 10
13.5
Real GDP ($ Trillions)
Lieberman & Hall; Introduction to Economics, 2005

24. Movements Along the AS Curve
When a change in output causes price level to change, we move along economy’s AS curve
What happens in economy as we make such a move?
As we move upward along AS curve, we can represent what happens as follows
Lieberman & Hall; Introduction to Economics, 2005

25. Shifts of the AS Curve
Figure 5 assumed that a number of important variables remained unchanged
Unit costs sometimes change for reasons other than a change in output
In general, we distinguish between a movement along AS curve, and a shift of curve itself, as follows
When a change in real GDP causes the price level to change, we move along AS curve
When anything other than a change in real GDP causes price level to change, AS curve itself shifts
What can cause unit costs to change at any given level of output?
Changes in world oil prices
Changes in the weather
Technological change
Nominal wage, etc.
Lieberman & Hall; Introduction to Economics, 2005

26. Figure 6: Shifts of the Aggregate Supply Curve
AS2
Price Level
AS1 L
140
When unit costs rise at any given real GDP, the AS curve shifts upward–e.g., an increase in world oil prices or bad weather for farm production.
100 A 10
Real GDP ($ Trillions)
Lieberman & Hall; Introduction to Economics, 2005

27. Figure 7(a): Effects of Key Changes on the Aggregate Supply Curve
Price Level AS
Real GDP ↑ moves us rightward along the AS curve P3
Real GDP ↓ moves us leftward along the AS curve P1 P2
Real GDP Q2 Q1 Q3
Lieberman & Hall; Introduction to Economics, 2005

28. Figure 7(b): Effects of Key Changes on the Aggregate Supply Curve
AS2
Price Level
AS1
Entire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP
Real GDP
Lieberman & Hall; Introduction to Economics, 2005

29. Figure 7(c): Effects of Key Changes on the Aggregate Supply Curve
Price Level
AS1
AS2
Entire AS curve shifts downward if unit costs ↓ for any reason besides an decrease in real GDP
Real GDP
Lieberman & Hall; Introduction to Economics, 2005

30. AD and AS Together: Short-Run Equilibrium
Where will the economy settle in short-run?
Where is our short-run macroeconomic equilibrium?
In equilibrium, economy must be at some point on AD curve
Short-run equilibrium requires economy be operating on its AS curve
Only when economy is at point E—on both curves—will we have reached a sustainable level of real GDP and the price level
Lieberman & Hall; Introduction to Economics, 2005

31. Figure 8: Short-Run Macroeconomic Equilibrium
Price Level AS B
140 E
100 F AD
Real GDP ($ Trillions) 6 10 14
Lieberman & Hall; Introduction to Economics, 2005

32. What Happens When Things Change?
Our short-run equilibrium will change when either AD curve, AS curve, or both, shift
An event that causes AD curve to shift is called a demand shock
An event that causes AS curve to shift is called a supply shock
In earlier chapters, we’ve used phrase spending shock
A change in spending by one or more sectors that ultimately affects entire economy
Demand shocks and supply shocks are just two different categories of spending shocks
Lieberman & Hall; Introduction to Economics, 2005

33. An Increase in Government Purchases
Shifts AD curve rightward
Can see how it affects economy in short-run
Process we’ve just described is not entirely realistic
Assumes that when government purchases rise, first output increases, and then price level rises
In reality, output and price level tend to rise together
Lieberman & Hall; Introduction to Economics, 2005

34. Figure 9: The Effect of a Demand Shock
Price Level AS
130 H
115 J
100 E
AD2
AD1 10
13.5
Real GDP($ Trillions)
12.5
Lieberman & Hall; Introduction to Economics, 2005

35. An Increase in Government Purchases
Can summarize impact of price-level changes
When government purchases increase, horizontal shift of AD curve measures how much real GDP would increase if price level remained constant
But because price level rises, real GDP rises by less than horizontal shift in AD curve
Lieberman & Hall; Introduction to Economics, 2005

36. An Decrease in Government Purchases
Lieberman & Hall; Introduction to Economics, 2005

37. An Increase in the Money Supply
Although monetary policy stimulates economy through a different channel than fiscal policy
Once we arrive at AD and AS diagram, two look very much alike
Can represent situation as follows
Lieberman & Hall; Introduction to Economics, 2005

38. Other Demand Shocks A positive demand shock—shifts AD curve rightward
Increases both real GDP and price level in short-run
A negative demand shock—shifts AD curve leftward
Decreases both real GDP and price level in short-run
Lieberman & Hall; Introduction to Economics, 2005

39. An Example: The Great Depression
U.S. economy collapsed far more seriously during 1929 through 1933—the onset of the Great Depression—than it did at any other time
What do we know about demand shocks that caused Great Depression?
Fall of 1929, bubble of optimism burst
Stock market crashed, and investment and consumption spending plummeted
Demand for products exported by United States fell
Fed reacted by cutting money supply sharply
Each of these events contributed to a leftward shift of AD curve
Causing both output and price level to fall
Lieberman & Hall; Introduction to Economics, 2005

40. Demand Shocks: Adjusting to the Long-Run
In Figure 9, point H shows new equilibrium after a positive demand shock in short-run—a year or so after the shock
But point H is not necessarily where economy will end up in long-run
In short-run, we treat wage rate as given
But in long-run, wage rate can change
When output is above full employment, wage rate will rise, shifting AS curve upward
When output is below full employment, wage rate will fall, shifting AS curve downward
Lieberman & Hall; Introduction to Economics, 2005

41. Demand Shocks: Adjusting to the Long Run
Increase in government purchases has no effect on equilibrium GDP in long-run
Economy returns to full employment, which is just where it started
This is why long-run adjustment process is often called economy’s self-correcting mechanism
If a demand shock pulls economy away from full employment
Change in wage rate and price level will eventually cause economy to correct itself and return to full-employment output
Lieberman & Hall; Introduction to Economics, 2005

42. Figure 10: The Long-Run Adjustment Process
Price Level
AS2
AS1 P4 K P3 J P2 H P1 E
AD2
AD1
YFE Y3 Y2
Real GDP
Lieberman & Hall; Introduction to Economics, 2005

43. Demand Shocks: Adjusting to the Long Run
For a positive demand shock that shifts AD curve rightward, self-correcting mechanism works like this
Lieberman & Hall; Introduction to Economics, 2005

44. Figure 11: Long-Run Adjustment After a Negative Demand Shock
Price Level
AS1
AS2 P1 E P2 N P3 M
AD1
AD2
Real GDP Y2
YFE
Lieberman & Hall; Introduction to Economics, 2005

45. Demand Shocks: Adjusting to the Long Run
Complete sequence of events after a negative demand shock looks like this
Lieberman & Hall; Introduction to Economics, 2005

46. Demand Shocks: Adjusting to the Long Run
Can summarize economy’s self-correcting mechanism as follows
Whenever a demand shock pulls economy away from full employment
Self-correcting mechanism will eventually bring it back
When output exceeds its full-employment level, wages will eventually rise
Causing a rise in price level and a drop in GDP until full employment is restored
When output is less than its full employment level wages will eventually fall
Causing a drop in price level and a rise in GDP until full employment is restored
Lieberman & Hall; Introduction to Economics, 2005

47. The Long-Run Aggregate Supply Curve
Self-correcting mechanism provides an important link between economy’s long-run and short-run behaviors
Long-run aggregate supply curve also illustrates another classical conclusion
An increase in government purchases causes complete crowding out
Rise in government purchases is precisely matched by a drop in consumption and investment spending
Leaving total output and total spending unchanged
Self-correcting mechanism shows that, in long-run, economy will eventually behave as classical model predicts
Notice the word eventually in the previous statement
This is why governments around the world are reluctant to rely on self-correcting mechanism alone to keep economy on track
Lieberman & Hall; Introduction to Economics, 2005

48. Figure 12: The Long-Run Aggregate Supply Curve
Long-Run AS Curve
Price Level K E M
AD2
AD1
AD3
Real GDP
YFE
Lieberman & Hall; Introduction to Economics, 2005

49. Some Important Provisos about the AS Curve
Upward-sloping aggregate supply curve we’ve presented in this chapter gives a realistic picture of how economy behaves after a demand shock
Story we have told about what happens as we move along AS curve is somewhat incomplete
Made assumption that prices are completely flexible—that they can change freely over short periods of time
In fact, however, some prices take time to adjust, just as wages take time to adjust
Assumed that wages are completely inflexible in short-run
But in some industries, wages respond quickly
More to process of recovering from a shock than adjustment of prices and wages
Lieberman & Hall; Introduction to Economics, 2005

50. Short-Run Effects of Supply Shocks
Figure 13 shows an example of a supply shock
An increase in world oil prices that shifts aggregate supply curve upward, from AS1 and AS2
Called negative supply shock, because of negative effect on output
In short-run a negative supply shock shifts AS curve upward, decreasing output and increasing price level
Notice sharp contrast between effects of negative supply shocks and negative demand shocks in short-run
Economists and journalists have coined term “stagflation” to describe a stagnating economy experiencing inflation
A negative supply shock causes stagflation in short-run
Examples of positive supply shocks include unusually good weather, a drop in oil prices, and a technological change that lowers unit costs
In addition, a positive supply shock can sometimes be caused by government policy
Lieberman & Hall; Introduction to Economics, 2005

51. Figure 13: The Effect of Supply Shocks
Long-Run
AS Curve
Price Level
AS2
AS1 R
AS3 P2 P1 E T P2 AD
Real GDP Y2
YFE Y3
Lieberman & Hall; Introduction to Economics, 2005

52. Long-Run Effects of Supply Shocks
What about effects of supply shocks in long-run?
In some cases, we need not concern ourselves with this question, because some supply shocks are temporary
In other cases, however, a supply shock can last for an extended period
In long-run, economy self-corrects after a supply shock, just as it does after a demand shock
When output differs from its full-employment level
Wage rate changes
AS curve shifts until full employment is restored
Lieberman & Hall; Introduction to Economics, 2005

53. Using the Theory: The Recession of 1990-91
Story of recession begins in mid-1990, when Iraq invaded Kuwait
During this conflict, Kuwait’s oil was taken off world market, as was Iraq’s
Reduction in oil supplies resulted in a rapid and substantial increase in price of oil
Lieberman & Hall; Introduction to Economics, 2005

54. Using the Theory: The Recession of 2001
Story of 2001 recession was quite different
This time, there was no spike in oil prices and no other significant supply shock to plague economy
Rather, there was a demand shock, and a Federal Reserve policy during the year before the recession that might have made it a bit worse
During late 1990s, Fed had become concerned that investment boom and consumer optimism were shifting AD curve rightward too rapidly
Creating a danger that we would overshoot potential GDP and set off higher inflation
Fed responded by tightening money supply and raising interest rate
Effects of this policy may have continued into early 2001, exacerbating decrease in investment that was occurring for other reasons
In this way, rate hikes themselves may have contributed to a further leftward shift of AD curve
Lieberman & Hall; Introduction to Economics, 2005

55. Figure 14(a): An AD and AS analysis of Two Recessions
1. In 1990, a supply shock from higher oil prices shifted the AS curve leftward . . .
(a)
Price Level
Real GDP
AS1991
AS1990 R P2
2. causing output to fall . . . P1 E
AD1990
3. and the price level to rise. Y2
YFE
Lieberman & Hall; Introduction to Economics, 2005

56. Figure 14(b): An AD and AS analysis of Two Recessions
4. In 2001, a demand shock from several factors caused the AD curve to shift leftward . . .
(b)
Price Level
Real GDP
AS2000
5. causing output to fall . . . P2 E R P1
AD2000
6. and the price level to fall.
AD2001 Y2
YFE
Lieberman & Hall; Introduction to Economics, 2005

57. Figure 15(a/b): GDP and the Price Level in Two Recessions
The Recession
(a)
(b)
Year and Quarter
1989:3
1990:2
1991:1
6.75
6.72
6.66
6.60
6.69
6.63
Real GDP ($ Trillions)
CPI
140
135
130
125
120
1989:3
1990:2
1991:1
Year and Quarter
Lieberman & Hall; Introduction to Economics, 2005

58. Figure 15(c/d): GDP and the Price Level in Two Recessions
The 2001 Recession
(c)
(d)
9.35
CPI
178
9.30
176
9.25
Real GDP ($ Trillions)
9.20
174
9.15
172
9.10
2000:1
2001:1
Year and Quarter
2000:1
2001:1
Year and Quarter
Lieberman & Hall; Introduction to Economics, 2005

59. Using the Theory: Jobless Expansions
After a recession, economy enters expansion phase of business cycle
Employment usually grows rapidly during this period as well
But in our two most recent recessions, economy experienced abnormal, prolonged periods during which employment did not grow at all
Figure 16 illustrates behavior of employment during our two most recent recession
Called trough of recession
Vertical axis shows an employment index—employment divided by employment at the trough
Blue line shows that employment falls during the contraction phase of average cycle
Rises rapidly during the first year of the expansion phase
But red and pink lines show what happened in first year of our most recent expansions—during 1992 and 2002
In both cases, employment drifted slightly downward, telling us that total number of jobs decreased during year
Lieberman & Hall; Introduction to Economics, 2005

60. Figure 16: The Average Expansion Versus Two Recent Jobless Expansions
Employment
Index
(Trough = 1)
1.04
1.03
After Average Recession
1.02
After 2001 Recession
1.01
1.00
After 1991 Recession
0.99 -6 -4 -2 +2 +4 +6 +8
+10
+12
Months Before and After the Trough
Lieberman & Hall; Introduction to Economics, 2005

61. Explaining Jobless Expansions
Since story is similar for both of these expansions, let’s focus on period from late 2001 to late 2002—the first year of expansion after our most recent recession
Using equation for economic growth
Real GDP = productivity x average hours x (emp/pop) x population
But equation can be used in different ways
Now we’re using equation to account for deviations in employment away from full employment in short-run
For this purpose, we’ll need to make some adjustments to equation
Real GDP = productivity x average hours x employment
Lieberman & Hall; Introduction to Economics, 2005

62. Explaining Jobless Expansions
Let’s convert equation to percentage changes
%Δ real GDP = %Δ productivity + %Δ employment
Finally, rearranging
%Δ employment (-0.3%) = %Δ real GDP (2.9%) - %Δ productivity (3.2%)
Numbers in parentheses show actual percentage changes for each of these variables during 2002
Lieberman & Hall; Introduction to Economics, 2005

63. Explaining Jobless Expansions
Why didn’t real GDP growth keep up with productivity?
Because growth in real GDP was unusually low
Productivity grew at about the same rate as average expansion, in spite of the low growth in output
Throughout period, firms were reluctant to hire full-time, permanent workers
Created uncertainty about strength and duration of expansion
Instead, business expanded output by hiring part-time and temporary workers
Why would this boost productivity?
Enabled firms to adjust their workforce more easily to fluctuations in production
Phrase “jobless expansion” refers to just part of expansion phase
Eventually, employment catches up—even to higher levels of output made possible by productivity growth
Lieberman & Hall; Introduction to Economics, 2005