1. © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney Prepared by: Fernando & Yvonn Quijano

2. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 2 of 44 In the late 1970s and early 1980s, energy price increases arising from events in the Middle East led to recession and inflation here at home. What you will learn in this chapter: ➤ How the aggregate supply curve illustrates the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy ➤ Why the aggregate supply curve is different in the short run compared to the long run ➤ How the aggregate demand curve illustrates the relationship between the aggregate price level and the quantity of aggregate output demanded in the economy ➤ The importance of the multiplier, which determines the total change in aggregate output arising from a shift of the aggregate demand curve ➤ How the AS–AD model is used to analyze economic fluctuations ➤ How monetary policy and fiscal policy can stabilize the economy

3. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 3 of 44 Aggregate Supply The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied.

4. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 4 of 44 Aggregate Supply The nominal wage is the dollar amount of the wage paid. The Short-Run Aggregate Supply Curve (16-1)Profit per unit output = Price per unit output – Production cost per unit output The short-run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied that exists in the short run, the time period when many production costs can be taken as fixed.

5. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 5 of 44 Aggregate Supply The Short-Run Aggregate Supply Curve

6. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 6 of 44 Aggregate Supply Shifts of the Short-Run Aggregate Supply Curve

7. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 7 of 44 Aggregate Supply Shifts of the Short-Run Aggregate Supply Curve Changes in Commodity Prices The following are important factors that affect producers’ profit per unit and so can lead to shifts of the short-run aggregate supply curve: Changes in Nominal Wages Changes in Productivity

8. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 8 of 44 Aggregate Supply The Long-Run Aggregate Supply Curve The long-run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible.

9. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 9 of 44 Aggregate Supply The Long-Run Aggregate Supply Curve

10. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 10 of 44 Aggregate Supply The Long-Run Aggregate Supply Curve Potential output is the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible.

11. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 11 of 44 Aggregate Supply

12. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 12 of 44 Aggregate Supply From the Short Run to the Long Run

13. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 13 of 44 economics in action Prices and Output During the Great Depression

14. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 14 of 44 Aggregate Demand The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, the government, and the rest of the world.

15. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 15 of 44 Aggregate Demand

16. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 16 of 44 Aggregate Demand Why Is the Aggregate Demand Curve Downward Sloping? (16-2)GDP = C + I + G + X – IM The Wealth Effect The wealth effect of a change in the aggregate price level is the effect on consumer spending caused by the effect of a change in the aggregate price level on the purchasing power of consumers’ assets.

17. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 17 of 44 Aggregate Demand Why Is the Aggregate Demand Curve Downward Sloping? The Interest Rate Effect The interest rate is the price, calculated as a percentage of the amount borrowed, charged by the lender to a borrower for the use of the lender’s savings for one year. The interest rate effect of a change in the aggregate price level is the effect on consumer spending and investment spending caused by the effect of a change in the aggregate price level on the purchasing power of consumers’ and firms’ money holdings.

18. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 18 of 44 Aggregate Demand Shifts of the Aggregate Demand Curve

19. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 19 of 44 Aggregate Demand Shifts of the Aggregate Demand Curve Changes in Expectations A number of factors can shift the aggregate demand curve. Among the most important factors are: Changes in Wealth Changes in the Stock of Physical Capital

20. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 20 of 44 Aggregate Demand Government Policies and Aggregate Demand Fiscal Policy One of the key insights of macroeconomics is that the government can have a powerful influence on aggregate demand and that, in some circumstances, this influence can be used to improve economic performance. The two main ways the government can influence the aggregate demand curve are through: Monetary Policy

21. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 21 of 44 The Multiplier

22. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 22 of 44 The Multiplier The marginal propensity to consume, or MPC, is the increase in consumer spending when disposable income rises by $1. (16-3)

23. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 23 of 44 The Multiplier The marginal propensity to save, or MPS, is the increase in household savings when disposable income rises by $1. (16-4) Total increase in real GDP from $50 billion rise in I = $50 billion ×

24. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 24 of 44 The Multiplier TABLE 16-1 Rounds of Increases of Real GDP Increase in real GDP (billions of dollars) Total increase in real GDP (billions of dollars) First round$50 Second round30 80 Third round1898 Fourth round10.8108.8 …… … Final round0125

25. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 25 of 44 The Multiplier

26. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 26 of 44 The Multiplier An autonomous change in aggregate spending is an initial change in the desired level of spending by firms, households, and government at a given level of real GDP. The multiplier is the ratio of the total change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change. (16-5)(16-6)

27. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 27 of 44 The AS–AD Model In the AS–AD model, the aggregate supply curve and the aggregate demand curve are used together to analyze economic fluctuations.

28. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 28 of 44 The AS–AD Model Short-Run Macroeconomic Equilibrium

29. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 29 of 44 The AS–AD Model Short-Run Macroeconomic Equilibrium The economy is in short-run macroeconomic equilibrium when the quantity of aggregate output supplied is equal to the quantity demanded. The short-run equilibrium aggregate price level is the aggregate price level in the short-run macroeconomic equilibrium. Short-run equilibrium aggregate output is the quantity of aggregate output produced in the short-run macroeconomic equilibrium.

30. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 30 of 44 The AS–AD Model Shifts of the SRAS Curve An event that shifts the short-run aggregate supply curve is a supply shock.

31. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 31 of 44 The AS–AD Model Shifts of the SRAS Curve

32. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 32 of 44 The AS–AD Model Shifts of the SRAS Curve Stagflation is the combination of inflation and falling aggregate output.

33. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 33 of 44 The AS–AD Model Shifts of Aggregate Demand: Short-Run Effects An event that shifts the aggregate demand curve is a demand shock.

34. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 34 of 44 The AS–AD Model Shifts of Aggregate Demand: Short-Run Effects

35. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 35 of 44 The AS–AD Model Long-Run Macroeconomic Equilibrium

36. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 36 of 44 The AS–AD Model Long-Run Macroeconomic Equilibrium The economy is in long-run macroeconomic equilibrium when the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve.

37. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 37 of 44 The AS–AD Model Long-Run Macroeconomic Equilibrium

38. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 38 of 44 The AS–AD Model Long-Run Macroeconomic Equilibrium There is a recessionary gap when aggregate output is below potential output.

39. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 39 of 44 The AS–AD Model Long-Run Macroeconomic Equilibrium

40. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 40 of 44 The AS–AD Model Long-Run Macroeconomic Equilibrium There is an inflationary gap when aggregate output is above potential output. In the long run the economy is self- correcting: shocks to aggregate demand affect aggregate output in the short run but not the long run.

41. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 41 of 44 economics in action Supply Shocks versus Demand Shocks in Practice

42. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 42 of 44 Macroeconomic Policy Policy in the Face of Demand Shocks Some policy measures to increase aggregate demand, especially those that increase budget deficits, may have long-term costs in terms of lower long-run growth. Furthermore, in the real world policy makers aren’t perfectly informed, and the effects of their policies aren’t perfectly predictable. This creates the danger that stabilization policy will do more harm than good. Despite these qualifications, most economists believe that a good case can be made for using macroeconomic policy to offset major negative shocks to the AD curve.

43. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 43 of 44 Macroeconomic Policy Responding to Supply Shocks In contrast to the aggregate demand curve, there are no easy policies that shift the short-run aggregate supply curve. Economically advanced nations suffering from the supply shocks of the 1970s chose to stabilize prices.

44. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 44 of 44 Aggregate supply curve Nominal wage Short-run aggregate supply curve Long-run aggregate supply curve Potential output Aggregate demand curve Wealth effect of a change in the aggregate price level Interest rate effect of a change in the aggregate price level Marginal propensity to consume (MPC) Marginal propensity to save (MPS) Autonomous change in aggregate spending Multiplier AS–AD model Short-run macroeconomic equilibrium Short-run equilibrium aggregate price level Short-run equilibrium aggregate output Supply shock Stagflation Demand shock Long-run macroeconomic equilibrium Recessionary gap Inflationary gap Self-correcting K E Y T E R M S