1. Prepared By Brock Williams Chapter 14 Aggregate Demand and Aggregate Supply As we explained in previous chapters, recessions occur when output fails to grow and unemployment rises.

2. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-2 Learning Objectives 1.Explain the role sticky wages and prices play in economic fluctuations. 2.List the determinants of aggregate demand 3.Distinguish between the short run and long run aggregate supply curves 4.Describe the adjustment process back to full employment

3. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-3 Fluctuations in the economy can be seen as failures in coordination. Flexible and Sticky Prices ● short run in macroeconomics The period of time in which prices do not change or do not change very much. How Demand Determines Output in the Short Run For most firms, the biggest cost of doing business is wages. If wages are sticky, firms’ overall costs will be sticky as well. This means that firms’ product prices will remain sticky, too. Sticky wages cause sticky prices and hamper the economy’s ability to bring demand and supply into balance in the short run. 14.1 STICKY PRICES AND THEIR MACROECONOMIC CONSEQUENCES

4. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-4 To analyze the behavior of retail prices, economist Anil Kashyap of the University of Chicago examined prices in consumer catalogs. He looked at the prices of 12 selected goods from: ▪ L.L. Bean ▪ Recreational Equipment, Inc. (REI) ▪ The Orvis Company, Inc. The goods included shoes, blankets, chamois shirts, binoculars, and a fishing rod and fly. What did he find? ▪ Considerable price stickiness. ▪ When prices did change, he observed a mixture of both large and small changes. ▪ During periods of high inflation, prices tended to change more frequently. MEASURING PRICE STICKINESS IN CONSUMER MARKETS APPLYING THE CONCEPTS #1: What does the behavior of prices in consumer markets demonstrate about how quickly prices adjust in the U.S. economy? A P P L I C A T I O N 1

5. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-5 What Is the Aggregate Demand Curve? ●aggregate demand curve (AD) A curve that shows the relationship between the level of prices and the quantity of real GDP demanded. 14.2 UNDERSTANDING AGGREGATE DEMAND

6. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-6 The Components of Aggregate Demand  FIGURE 14.1 Aggregate Demand The aggregate demand curve plots the total demand for real GDP as a function of the price level. The aggregate demand curve slopes downward, indicating that the quantity of aggregate demand increases as the price level in the economy falls. 14.2 UNDERSTANDING AGGREGATE DEMAND (cont.)

7. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-7 Why the Aggregate Demand Curve Slopes Downward As the purchasing power of money changes, the aggregate demand curve is affected in three different ways: THE WEALTH EFFECT ● wealth effect The increase in spending that occurs because the real value of money increases when the price level falls. R E A L - N O M I N A L P R I N C I P L E What matters to people is the real value of money or income—its purchasing power—not the face value of money or income. 14.2 UNDERSTANDING AGGREGATE DEMAND (cont.)

8. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-8 Why the Aggregate Demand Curve Slopes Downward THE INTEREST RATE EFFECT THE INTERNATIONAL TRADE EFFECT With a given supply of money in the economy, a lower price level will lead to lower interest rates. With lower interest rates, both consumers and firms will find it cheaper to borrow money to make purchases. As a consequence, the demand for goods in the economy (consumer durables purchased by households and investment goods purchased by firms) will increase. In an open economy, a lower price level will mean that domestic goods (goods produced in the home country) become cheaper relative to foreign goods, so the demand for domestic goods will increase. 14.2 UNDERSTANDING AGGREGATE DEMAND (cont.)

9. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-9 Shifts in the Aggregate Demand Curve CHANGES IN TAXES CHANGES IN GOVERNMENT SPENDING CHANGES IN THE SUPPLY OF MONEY An increase in the supply of money in the economy will increase aggregate demand and shift the aggregate demand curve to the right. A decrease in taxes will increase aggregate demand and shift the aggregate demand curve to the right. At any given price level, an increase in government spending will increase aggregate demand and shift the aggregate demand curve to the right. 14.2 UNDERSTANDING AGGREGATE DEMAND (cont.)

10. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-10 Shifts in the Aggregate Demand Curve ALL OTHER CHANGES IN DEMAND  FIGURE 14.2 Shifting Aggregate Demand Decreases in taxes, increases in government spending, and an increase in the supply of money all shift the aggregate demand curve to the right. Higher taxes, lower government spending, and a lower supply of money shift the curve to the left. 14.2 UNDERSTANDING AGGREGATE DEMAND (cont.)  TABLE 14.1 Factors That Shift Aggregate Demand

11. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-11 How the Multiplier Makes the Shift Bigger  FIGURE 14.3 The Multiplier Initially, an increase in desired spending will shift the aggregate demand curve horizontally to the right from a to b. The total shift from a to c will be larger. The ratio of the total shift to the initial shift is known as the multiplier. 14.2 UNDERSTANDING AGGREGATE DEMAND (cont.)

12. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-12 How the Multiplier Makes the Shift Bigger ● multiplier The ratio of the total shift in aggregate demand to the initial shift in aggregate demand. ● consumption function The relationship between the level of income and consumer spending. C = C a + by 14.2 UNDERSTANDING AGGREGATE DEMAND (cont.)

13. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-13 How the Multiplier Makes the Shift Bigger ● autonomous consumption spending The part of consumption spending that does not depend on income. ● marginal propensity to consume (MPC) The fraction of additional income that is spent. ● marginal propensity to save (MPS) The fraction of additional income that is saved. 14.2 UNDERSTANDING AGGREGATE DEMAND (cont.)

14. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-14 How the Multiplier Makes the Shift Bigger 14.2 UNDERSTANDING AGGREGATE DEMAND (cont.) ▼ TABLE 14.1 THE MULTIPLIER IN ACTION The initial $10 million increase in aggregate demand will, through all the rounds of spending, eventually lead to a $25 million increase.

15. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-15 The Long-Run Aggregate Supply Curve ● aggregate supply curve (AS) A curve that shows the relationship between the level of prices and the quantity of output supplied. ● long-run aggregate supply curve A vertical aggregate supply curve that represents the idea that in the long run, output is determined solely by the factors of production. 14.3 UNDERSTANDING AGGREGATE SUPPLY

16. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-16 The Long-Run Aggregate Supply Curve  FIGURE 14.4 Long-Run Aggregate Supply In the long run, the level of output, y p, is independent of the price level. 14.3 UNDERSTANDING AGGREGATE SUPPLY (cont.)

17. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-17 The Long-Run Aggregate Supply Curve  FIGURE 14.5 Aggregate Demand and the Long-Run Aggregate Supply Output and prices are determined at the intersection of AD and AS. An increase in aggregate demand leads to a higher price level. DETERMINING OUTPUT AND THE PRICE LEVEL 14.3 UNDERSTANDING AGGREGATE SUPPLY (cont.)

18. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-18 The Short-Run Aggregate Supply Curve ●short-run aggregate supply curve A relatively flat aggregate supply curve that represents the idea that prices do not change very much in the short run and that firms adjust production to meet demand. 14.3 UNDERSTANDING AGGREGATE SUPPLY (cont.)

19. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-19 The Short-Run Aggregate Supply Curve  FIGURE 14.6 Aggregate Demand and Short-Run Aggregate Supply With a short-run aggregate supply curve, shifts in aggregate demand lead to large changes in output but small changes in price. 14.3 UNDERSTANDING AGGREGATE SUPPLY (cont.)

20. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-20 The Short-Run Aggregate Supply Curve What factors determine the costs firms must incur to produce output? The key factors are Input prices (wages and materials) The state of technology Taxes, subsidies, or economic regulations 14.3 UNDERSTANDING AGGREGATE SUPPLY (cont.)

21. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-21 Economists have used the basic framework of aggregate demand and supply analysis to explain recessions. Recessions can occur either when there is a sharp decrease in demand or a decrease in aggregate supply. Economic historian Peter Temin looked at all recessions from 1893 to 1990 to determine their causes. He found, recessions were caused by many different factors. Sometimes, as in 1929, they were caused by shifts in aggregate demand from the private sector, as consumers cut back their spending. Other times, as in 1981, the government cut back on aggregate demand to reduce inflation. Supply shocks were the cause of the recessions in 1973 and 1979. The most severe shock hit the U.S. economy in 1931 and converted an economic downturn into the Great Depression. He believes that foreign monetary developments were the ultimate source of this shock to the U.S. economy. TWO APPROACHES TO DETERMINING THE CAUSES OF RECESSIONS APPLYING THE CONCEPTS #2: How can we determine what factors cause recessions? A P P L I C A T I O N 2

22. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-22 Supply Shocks ● supply shocks External events that shift the aggregate supply curve.  FIGURE 14.7 Supply Shock An adverse supply shock, such as an increase in the price of oil, will cause the AS curve to shift upward. The result will be higher prices and a lower level of output. ● stagflation A decrease in real output with increasing prices. 14.3 UNDERSTANDING AGGREGATE SUPPLY (cont.)

23. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-23 Economists have long believed that disruptions to oil supplies were the cause of supply shocks for the U.S. economy. But not all changes in oil prices are necessarily caused by supply disruptions. They may be caused by increases in world demand or the activities of speculators in the oil market. How important are actual supply disruptions? Economist Kilian examined this issue and found supply disruptions only explained a small fraction of the variability of oil prices. Speculation in oil markets may be one such factor. Speculators can be countries, firms, or individuals. If speculators believe prices are going to rise in the future, they will buy oil now or, if they own it, sell less into the market. Either action increases the current price of oil. Note that if speculators are on average correct in their assessments, they will smooth out the price of oil over time—raising it now and lowering it later. This can actually benefit the economy. While politicians often complain about speculators, in many cases they may be helping the economy. Of course, speculators can be wrong and make fluctuations in prices worse, but in this case at least some of them will lose money. OIL SUPPLY DISRUPTIONS, SPECULATION AND SUPPLY SHOCKS APPLYING THE CONCEPTS #3: Are oil price increases caused by true shocks to supply? A P P L I C A T I O N 3

24. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-24  FIGURE 14.8 The Economy in the Short Run In the short run, the economy produces at y 0, which exceeds potential output y p. 14.4 FROM THE SHORT RUN TO THE LONG RUN

25. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-25  FIGURE 14.9 Adjusting to the Long Run With output exceeding potential, the short-run AS curve shifts upward over time. The economy adjusts to the long-run equilibrium at a 1. 14.4 FROM THE SHORT RUN TO THE LONG RUN (cont.)

26. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-26 Looking Ahead The aggregate demand and aggregate supply model in this chapter provides an overview of how demand affects output and prices in both the short run and the long run. The next several chapters explore more closely how aggregate demand determines output in the short run. 14.4 FROM THE SHORT RUN TO THE LONG RUN (cont.)

27. Copyright ©2014 Pearson Education, Inc. All rights reserved.14-27 K E Y T E R M S aggregate demand curve (AD) aggregate supply curve (AS) autonomous consumption spending consumption function long-run aggregate supply curve marginal propensity to consume (MPC) marginal propensity to save (MPS) multiplier short-run aggregate supply curve short run in macroeconomics stagflation supply shocks wealth effect