Aggregate Demand and Aggregate Supply Chapter 15 CHAPTER 1.

Aggregate Demand and Aggregate Supply

Chapter 15

CHAPTER

1

The Price Level

2

•Up to this point, we have not said much about prices and the price level (P)

• In this chapter we derive the: • Aggregate Demand curve which shows the relation between aggregate expenditure (AE) and the price level (P)

• Aggregate Supply curve shows the relation between aggregate production and the price level (P)

Derivation of Aggregate Demand (AD) Curve

• Start with money demand. An increase in the price level shifts the money demand curve rightward– increasing the equilibrium interest rate (if

the Fed does not increase the money supply)

– causing the aggregate expenditure line to shift downward

– resulting in a lower equilibrium level of GDP.

3

Deriving the Aggregate Demand Curve (a)

4

Interest

Rate

Money ($ billions)

M1d

9%

500

MS

6%A

M2d

B

As the price level, say the CPI, increases from 100 to 140, money demand increases and the interest rate rises.

Deriving the Aggregate Demand Curve (b, c)

5© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Real Aggregate

Expenditure

($ Trillions)

Real GDP ($ Trillions)

45°

10

AEr=6%E

AEr=9%

6

F

The rise in the interest rate causes real GDP to fall.

Price level

Real GDP ($ Trillions)106

On the AD curve, a higher price level is associated with a lower real GDP.

AD

K

H140

100

The Aggregate Demand Curve

• a curve indicating equilibrium GDP at each price level, with a constant money supply

• its NOT a demand curve at all!

• it is actually an “equilibrium-output-at-each-price-level” curve

6

The Aggregate Demand Curve• Movements along the AD curve

– a change in the price level causes equilibrium GDP to change

7

This inverse relationship between P and Y caused by the change in the interest rate is called the interest rate effect

The Aggregate Demand (AD) Curve

• Another reason for a downward-sloping aggregate demand curve is the Real Wealth Effect• This is the change in consumption

brought about by a change in real wealth that results from a change in the price level.

Nominal and Real Wealth

Nominal Wealth (W) = Assets – Liabilities

Real Wealth is the purchasing power of wealth =

Two things change real wealth: W or P

W

P

As P↓ => (W/P)↑ => C↑=> AE↑ => Y↑

C

Y

450

Y0 Y1

A

BAE0

AE1

As P ↑ =>(W/P) ↓ => C ↓ => AE ↓ => Y ↓ P and Y move in opposite directions. The AD curve Slopes downward to the right.

What shifts the AD curve ?

• Changes in any of the variables that shift the AE curve: – Government purchases (G)– Planned Investment spending (IP) – Autonomous consumption spending (a)– Taxes (T)– Net exports (NX)– The money supply (M)

11

The Aggregate Demand Curve

• AD curve shifts rightward when: – Government purchases (G) increase– Planned Investment spending (IP) increases– Autonomous consumption spending (a)

increases– Net exports increase– Net taxes decrease – Money supply increases

12

A Spending Change Shifts the AD Curve

13

Real Aggregate

Expenditure

($ Trillions)

Real GDP ($ Trillions)

45°

12.5

AE1

10

E

At any given price level, an increase in government purchases shifts the AE line upward, raising real GDP.

Get the multiplier effect we introduced in chapter 11.

Price level

Real GDP ($ Trillions)12.510

Since real GDP is higher at the given price level, the AD curve shifts rightward.

H to J is the multiplier effect we introduced in chapter 11

AD1

H100

AE2F

AD2

J

Change in Price Level Moves Along the AD Curve (a)


Price

Level

Real GDP

AD

P3

Price level ↑ moves us leftward along the AD curve

Q3

P1

P2

Q1 Q2

Price level ↓ moves us rightward along the AD curve

Effects of Key Changes on the Aggregate Demand Curve (b, c)


Price Level

Real GDP

AD1

Entire AD curve shifts rightward if:

• a, Ip, G, or NX increases

• Net taxes decrease

• The money supply increases

AD2

Price Level

Real GDP

AD1

Entire AD curve shifts leftward if:

• a, Ip, G, or NX decreases

• Net taxes increase

• The money supply decreases

AD2

The Aggregate Supply Curve

Assumptions:• Firms set the price of their products as a

markup over unit cost of production p = unit cost + mark-up

• Average percentage markup in the economy is determined by competitive conditions in the economy– so we treat the mark-up as stable (fixed)

from year to year• The competitive structure of the economy

changes very slowly16


• In general, changes in GDP affects unit costs of production– As total GDP(output) increases:

• greater amounts of inputs are needed to produce the greater output

• the prices for non-labor inputs rise • the price of labor, the nominal wage rate,

can also increase (but we make an assumption about this in the short-run!)

17

The Aggregate Supply Curve• We assume that in the short-run the

price of labor, nominal wages, are “fixed”, “sticky”– union contracts– can be costly to firms– reputation for paying stable wages– slow-moving bureaucracies

• THIS IS A KEY ASSUMPTION!!!– nominal wage rate is fixed in the short run– changes in output have no effect on the

nominal wage rate in the short run18


• In the short run, a change in output will affect non-labor costs of production– a rise in real GDP raises firms’ unit costs

• Input requirements increase: coal, oil lumber, copper,…….

• The prices of these non-labor inputs rise

– A decrease in real GDP lowers unit costs • Input requirements decrease• Prices of non-labor inputs fall

19


• Aggregate Supply (AS) curve– a curve indicating the price level

consistent with firms’ unit costs and markups for any level of output (Y) in the short run

– it is actually a “short-run-price-level-at-each-output-level” curve

– its upward sloping• Price level on the vertical axis• Total output on the horizontal axis

20



Price

Level

Real GDP

AS

130

Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises.

6

100

80

10 12.5

Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price level falls.

C

A

B

The Aggregate Supply Curve• Movements along the AS curve

– A change in real GDP causes the price level to change

Wages are sticky! Labor costs do not change in the short-run.

Another View of the Aggregate Supply Curve

• In the short run there must be a lag between changes in output prices and changes in input prices, otherwise the aggregate supply (price/output response) curve would be vertical.

• If input and output prices rise by the same percentage amount, no firm would find it advantageous to change its level of output.

Slope Matters!Shape of the Short-run Aggregate Supply Curve - Ordinary Conditions

Moderate Levels of :

Unemployment -

Unemployment Rate: 5 -10%

Some excess Capacity -

Ex. Cap Rate: 10-25%

AS exhibits a Positive Slope

Aggregate Supply Curve - Ordinary Conditions Implications

With the positive slope:

Change in output (Y) causes a moderate change in the price level (P)

Shape of the Short-run Aggregate Supply Curve - Slack Conditions

• 26 of 23

High Levels of:

• Unemployment -

Unemployment Rate > 10%

• Lot of excess Capacity - Ex Cap Rate > 25%

• AS is Almost Flat

Shape of the Short-run Aggregate Supply Curve - Slack Conditions - Implications

With a flat slope:

The economy can expand a lot with small increase in P because of the excess capacity.

Shape of the Short-run Aggregate Supply Curve - Tight Conditions

Low Levels of:

Unemployment -

Unemployment Rate < 3%

Little excess Capacity-

Ex Cap Rate < 10%

• AS is Very Steep

Shape of the Short-run Aggregate Supply Curve - Tight Conditions - Implication

• 29 of 23

AS

Large increase in P for a relatively small increase in GDP (Y).

The Aggregate Supply Curve is not a straight line

[--Slack-----] [--Ordinary--] [--Tight--]

Capacity

What Causes the Aggregate Supply Curve to Shift?• Increase in AS means the AS curve shifts downward:

– Lower world oil prices– Good weather – Technological change– Regulation– Lower nominal wages

• Decrease in AS means the AS curve shifts upward: – Higher world oil prices

– Bad weather – Technological change(negative?), stupid pills(?)– Regulation– Higher nominal wages

31

Shift of the Aggregate Supply Curve


Price

Level

Real GDP

AS1

140 When unit costs rise at any given real GDP—e.g., from an increase in world oil prices or bad weather for farm production—the AS curve shifts upward.

100

10

A

AS2

L

Effects of Key Changes on the Aggregate Supply Curve (a)


Price

Level

Real GDP

AS

Real GDP ↑ moves us rightward along the AS curve

Y3 Y1 Y2

Real GDP ↓ moves us leftward along the AS curveP3

P1

P2

Effects of Key Changes on the Aggregate Supply Curve (b, c)

34

Price Level

Real GDP

AS1

Entire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP

AS2

Price Level

Real GDP

AS1

Entire AS curve shifts downward if unit costs ↓ for any reason besides a decrease in real GDP

AS2

AD and AS: Short-Run Equilibrium

• Short-run macroeconomic equilibrium – a combination of price level and GDP

consistent with both the AD and AS curves

35

At point E, the price level of 100 is consistent with an output of $10 trillion along the AD curve. The output level of $10 trillion is consistent with a price level of 100 along the AS curve. At any other combination of price level and output, such as point F or point B, at least one condition for equilibrium will not be satisfied.

Short-Run Macroeconomic Equilibrium

36

Price

Level

Real GDP

AS

140

6

100

10 14

B

AD

E

F80

Excess Supply

Excess Demand

At point B, AS > AD. Excess Supply.P will fall from 140 to 100 and Y will fall from 14 to 10. As P and Y fall, the interest rate falls which means C and Ip increases causing AD to increase.

Movements along the curves!


37

Price

Level

Real GDP

AS

140

6

100

10 14

B

AD

E

F80

Excess Supply

Excess Demand

The is a lot more complicated than the basic AE model presented in chapters 10 and 11 where only Y fell as inventories increased.Here, Y, P , money demand, the interest rate(r) and AE all adjust.

At point F, AD > AS. Excess Demand.

P will increase from 80 to 100 and Y will increase from 6 to 10.

As P and Y increase, the interest rate rises which means C and Ip fall causing AD to decrease

Movements along the curves!


38

Price

Level

Real GDP

AS

140

6

100

10 14

B

AD

E

F80

Excess Supply

Excess Demand

The is a lot more complicated than the basic AE model presented in chapters 10 and 11 where only Y fell as inventories decreased. Here, Y, P , money demand, the interest rate(r) and AE all adjust.

What Happens When Things Change?• Demand shock

– this is any event that causes the AD curve to shift

– for example, a change in government purchases or a change in the money supply

• Supply shock – an event that causes the AS curve to shift– e.g., increase or decrease in world oil

price, regulation, nominal wages.

39

Point J illustrates where the economy would move if the price level remained constant; multiplier = (1/(1-MPC). But, as output increases, the price level rises. Thus, the economy moves along the AS curve from point E to point N.

The Effect of a Demand Shock: Increase G

40

Price

Level

Real GDP

$ Trillions

AS

110

10.0

100

11.5 12.5

AD1

E

AD2

N

J

Starting at point E, an increase in government purchases would shift the AD curve rightward to AD2

Relate back to the Keynesian 450 graph. Multiplier= (1/(1-MPC).

What Happens When Things Change?• Increase in government purchases

Crowding-out of interest-sensitive spending. Multiplier is less than (1/(1-MPC). Inflation and rising interest rates reduce the size of the multiplier.

The Effect of a Demand Shock• As P increases, money demand increases.

If the money supply is constant, the interest rate rises and crowds-out interest sensitive investment and consumer spending. Move up along the AD curve from point J to N.

• Crowding-out of interest-sensitive spending means the size of the multiplier is reduced.

• Inflation and the increase in the interest rate reduce the size of the multiplier.

What Happens When Things Change?• Decrease in government purchases

43

Crowding-in of interest-sensitive spending. Multiplier is larger than (1/(1-MPC). Falling prices and falling interest rates increase the size of the multiplier.

What Happens When Things Change?• Increase in money supply


To sum up the short-run -• A positive demand shock

– shifts the AD curve rightward– increases both real GDP and the price

level in the short run • A negative demand shock

– shifts the AD curve leftward– decreases both real GDP and the price

level in the short run

45

Demand Shocks: Adjusting to Long Run

• In the short run we treat the wage rate and labor costs as given

• In the long run– the wage rate will change– when output is above full employment

• Wage rate will rise, shifting the AS curve upward

– when output is below full employment• Wage rate will fall, shifting the AS curve

downward

46


• Self-correcting mechanism – the adjustment process where price and

wage changes return the economy to full-employment output in the long run

• If a demand shock pulls the economy away from full employment– changes in the wages and the price level

will eventually cause the economy to correct itself and return to full-employment output

47

Demand Shocks: Adjusting to Long Run• Positive demand shock

48NOTE: Y >YFE => U <Un

St point E, a positive demand shock would shift the aggregate demand curve to AD2, raising both output and the price level.

In the short-run the economy moves to point N, output is above the full-employment level, YFE.

Firms compete to hire scarce workers, driving up the wage rate. In the long-run the higher wage rate will shift the AS curve to AS2. The economy returns to full-employment output at point L in the long-run.

Long-Run Adjustment after a Positive Demand Shock

49

Price

Level

Real GDP

AS1

YFE

P1

AD1

EAD2

Y2

P2 N

AS2

L

P4


• Negative demand shock

50NOTE: Y <YFE => U >Un

Starting from point E, a negative demand shock shifts the AD curve to AD2, lowering GDP and the price level. In the short-run, output is below the full-employment level at point N. With unemployed labor available, wages and unit costs will fall, causing firms to lower their prices. The AS curve shifts downward until full employment is regained at point M, with a lower price level in the long-run.

Long-Run Adjustment after a Negative Demand Shock

51

Price

Level

Real GDP

AS1

YFE

P3 AD1

E

AD2

Y2

P2 N

AS2

P1

M

Demand shock : The self-correcting mechanism in the long-run• When output exceeds its full-employment

level– Wages will eventually rise– Causing a rise in the 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 the price level and a rise in

GDP until full employment is restored

52

Long-run Aggregate Supply Curve• Long-run aggregate supply curve

– A vertical line – Indicating all possible output and price-

level combinations at which the economy could end up in the long run

• The self-correcting mechanism– Shows us that, in the long run, the

economy will eventually behave as the classical model predicts

53

This figure illustrates a positive demand shock, but focuses on the long-run effects. The initial equilibrium is at point E, with output at full employment (YFE) and price level P1. After the positive demand shock and all the long-run adjustments to it, the economy ends up at point L with a higher price level (P4), but the same full-employment output level (YFE). The long-run AS curve—a vertical line—shows all possible combinations of price level and output for the economy, skipping over the short-run changes. The vertical, long-run AS curve shows that in the long run, demand shocks can affect the price level but not output.

The Long-Run AS Curve

54

Price

Level

Real GDP

AS1

YFE

P1

AD1

EAD2

Y2

P2 N

AS2

LP4

Long-Run AS Curve

Supply Shocks• Negative supply shock. In the short run

– the AS curve shifts upward• Decreasing output and increasing the price

level

– causes stagflation (falling output and rising prices)

• Positive supply shock. In the short run– the AS curve shifts downward

• Increasing output and decreasing the price level

55

A negative supply shock would shift the AS curve upward from AS1 to AS2.

In the short-run, equilibrium is at point R, the price level is higher and output (Y2) is below YFE.

Eventually, wages will fall, causing unit costs to fall, and the AS curve will shift back down to its original position.

The Effect of a Negative Supply Shock

56

Price

Level

Real GDP

AS1

P1

AD

E

Y2

P2

AS2

YFE

Long-Run AS Curve

R

A positive supply shock would shift the AS curve down from AS1 to AS2. In the short-run equilibrium at point R, the price level is lower and output is above YFE.

Eventually, wages will rise, causing unit costs to rise, and the AS curve will shift back up to its original position.

The Effect of a Positive Supply Shock

57

Price

Level

Real GDP

AS1

P1

AD

E

Y2

P2

AS2

YFE

Long-Run AS Curve

R

Supply Shocks• In the long run

– The economy self-corrects after a long-lasting supply shock

– When output differs from its full-employment level• The wage rate changes• AS curve shifts until full employment is

restored

58

The Story of Two Recessions• The recession of 1990-91

– a supply-shock recession– caused by a reduction in oil supply

• Price of oil doubled

• The recession of 2008-09– a powerful, negative demand shock

• Home prices – falling• Stock prices – plunged

59

An AD and AS Analysis of Two Recessions: 1990-91Recession

60

Price

Level

Real GDP

AS1990

YFE

AD1990

E

Y2

P2

AS1991

P1

R

1. In 1990, a supply shock

from higher oil prices shifted the AS curve leftward …

2. causing output to fall…

3. and the price level to rise

An AD and AS Analysis of Two Recessions: 2008-09 Recession

61

Price

Level

Real GDP

AS2007

YFE

AD2007

E

Y2

P2

P1

4. In 2008-09, a demand shock from several factors caused the AD curve to shift leftward …

5. causing output to fall…

6. and the price level to fall

AD2009

R

GDP and the Price Level in Two Recessions


More Real World Examples

The Aggregate Supply Curve is not a straight line

[--Slack-----] [--Ordinary--] [--Tight--]

CapacityAD1

AD2

AD3

AD4

P1

P2

P3

P4Expansionary policy is inflationary and has small impact on aggregate output (Y)

Expansionary policy is not inflationary and has relatively large impact on aggregate output (Y)

Aggregate Demand and Aggregate Supply Chapter 15 CHAPTER 1.

Documents

Transcript of Aggregate Demand and Aggregate Supply Chapter 15 CHAPTER 1.