Chapter 11:Chapter 11:Aggregate SupplyAggregate Supplyand Demandand Demand

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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A Macro ViewA Macro View

oMacroeconomics is the study of the aggregate economic behavior, of the economy as a whole.

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Macro OutcomesMacro Outcomes

oThe basic macro outcomes include:oOutput–the total volume of goods and

services produced (real GDP).

oJobs–the levels of employment and unemployment.

oPrices–the average prices of goods and services.

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Macro OutcomesMacro Outcomes

oThe basic macro outcomes include:oGrowth–the year-to-year expansion in

production capacity.

oInternational balances–the international value of the dollar; trade and payment balances with other countries.

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Macro DeterminantsMacro Determinants

oThe determinants of macro performance include:oInternal market forces–population growth,

spending behavior, invention and innovation, and the like.

oExternal shocks–wars, natural disasters, terrorist attacks, trade disruptions, and so on.

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Macro DeterminantsMacro Determinants

oThe determinants of macro performance include:oPolicy levers–tax policy, government

spending, changes in interest rates and the availability of money, trade policy, immigration policy, and regulation.

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The Macro EconomyThe Macro Economy

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Stable or Unstable?Stable or Unstable?

oThe central concern of macroeconomic theory is whether the internal forces of the marketplace will generate desired outcomes.

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Classical Theory and Self-AdjustmentClassical Theory and Self-Adjustment

oThis was the prevalent theory prior to the 1930s.

oAccording to the classical view, the economy self-adjusts to deviations from its long-term growth trend.

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Flexible Prices and WagesFlexible Prices and Wages

oThe cornerstones of the Classical Theory were flexible wages and flexible prices.

oFlexible prices virtually guarantee that all output could be sold.

oNo one would lose a job because of weak consumer demand.

oFlexible wages would ensure that everyone who wants a job would have a job.

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Say’s LawSay’s Law

oAccording to Say’s Law, “supply creates its own demand.”

oUnsold goods will ultimately be sold when buyers and sellers find an acceptable price.

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Say’s LawSay’s Law

oIn the labor market, some people will be unemployed, but can find new jobs if they are willing to accept lower wages.

oAccording to Classical economists, government intervention in the (self-adjusting) macro economy is unnecessary.

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The Keynesian RevolutionThe Keynesian Revolution

oThe Great Depression was a stunning blow to Classical economists.

oJohn Maynard Keynes provided an alternative to the Classical Theory.

oKeynes argued that the Great Depression was not a unique event.

oIt would recur if reliance on the market to “self-adjust” continued.

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No Self-AdjustmentNo Self-Adjustment

oKeynes asserted that the private economy was inherently unstable.

oThe inherent instability of the marketplace required government intervention.

oPolicy levers were both effective and necessary.

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The Aggregate Supply-Demand Model: The Aggregate Supply-Demand Model: Aggregate DemandAggregate Demand

oAny influence on macro outcomes must be transmitted through supply or demand.

oAggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

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Real GDP (Output)Real GDP (Output)

oReal GDP is the inflation-adjusted value of GDP or the value of output in constant prices.

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Price LevelPrice Level

oThe aggregate demand curve illustrates how the volume of purchases varies with average prices: oWith a given (constant) level of income,

people will buy more goods and services at lower prices.

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The Aggregate Demand CurveThe Aggregate Demand Curve

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The Aggregate Demand Curve’s SlopeThe Aggregate Demand Curve’s Slope

oThe Aggregate Demand curve is downward sloping for three reasons:oReal balances effect

oForeign trade effect

oInterest-rate effect

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Real Balances EffectReal Balances Effect

oThe real value of money is measured by how many goods and services each dollar will buy.

oAs prices fall, money can purchase more goods and services.

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Foreign Trade EffectForeign Trade Effect

oIf domestic prices decline, consumers demand more domestic output and fewer imports.

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Interest-Rate EffectInterest-Rate Effect

oAt lower price levels, interest rates fall as consumers borrow less.

oLower interest rates stimulate more borrowing and loan-financed purchases.

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Aggregate SupplyAggregate Supply

oAggregate supply is the total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus.

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The Aggregate Supply Curve’s SlopeThe Aggregate Supply Curve’s Slope

oThe aggregatesupply curveis upward-sloping.

oWe expect therate of output toincrease whenthe price levelrises.

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Profit MarginsProfit Margins

oProducers’ short-run costs, like rent and negotiated wages, are relatively constant.

oHigher product prices tend to widen their profit margins, so producers will want to produce and sell more goods.

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CostsCosts

oProduction costs tend to increase as producers try to produce more.oThey must acquire more resources and use

existing plant and equipment more intensively.

oThe aggregate supply curve is relatively flat when capacity is underutilized.

oIt begins to slope upward as producers approach capacity.

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The Macro EquilibriumThe Macro Equilibrium

oAggregate supply and demand curves summarize the market activity of the whole (macro) economy.

oMacro equilibrium–the unique combination of price level and real output that is compatible with both aggregate demand and aggregate supply.

oIt is the only price-output combination mutually compatible with both buyers’ and sellers’ intentions.

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The Macro EquilibriumThe Macro Equilibrium

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The Macro DisequilibriumThe Macro Disequilibrium

oIf the price level is higher than at equilibrium, buyers will want to buy less than producers want to produce and sell.

oThis is a disequilibrium situation, in which the intentions of buyers and sellers are incompatible.

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Macro Failure Macro Failure

oThere are two potential problems with macro equilibrium–undesirability and instability.

oUndesirability–the price-output relationship at equilibrium may not satisfy our macroeconomic goals.

oInstability–even if the designated macro equilibrium is optimal, it may be displaced by macro disturbances.

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Undesirable OutcomesUndesirable Outcomes

oFull-employment GDP–the rate of real output (GDP) produced at full employment

oUnemployment–the inability of labor-force participants to find jobs.

oInflation–an increase in the average level of prices of goods and services.

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An Undesired EquilibriumAn Undesired Equilibrium

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Unstable OutcomesUnstable Outcomes

oShifts in aggregate supply and aggregate demand can upset a full employment equilibrium.

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Shifts of AS and ADShifts of AS and AD

oA leftward shift of the aggregate supply curve results in higher price levels and less output.

oA leftward shift of the aggregate demand curve results in lower price levels and less output.

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Recurrent ShiftsRecurrent Shifts

oBusiness cycles result from recurrent shifts of the aggregate supply and demand curves:oBusiness cycles are alternating periods of

economic growth and contraction.

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Shift Factors: Demand ShiftsShift Factors: Demand Shifts

oThe aggregate demand curve might shift as a result of changes in:oConsumer sentiment.

oTaxes on consumer income.

oInterest rates.

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Shift Factors: Supply ShiftsShift Factors: Supply Shifts

oThe aggregate supply curve might shift as a result of changes in:oThe price or availability of raw materials.

oBusiness tax changes.

oEnvironmental or workplace regulations.

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Competing Theories of Short-Run InstabilityCompeting Theories of Short-Run Instability

oEconomists are not in complete agreement about how to achieve desired macro outcomes.

oMacro controversies focus on the shape of the aggregate supply and aggregate demand curves and the potential to shift them.

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Demand-Side TheoriesDemand-Side Theories

oKeynesian Theory

oMonetary Theories

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Keynesian TheoryKeynesian Theory

oKeynes argued that if people demand a product, producers will supply it.

oIf aggregate spending isn't sufficient, some goods will remain unsold and some production capacity will be idled.

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Keynesian TheoryKeynesian Theory

oKeynesian theory urges increased government spending or tax cuts as mechanisms for increasing (shifting) aggregate demand.

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Monetary TheoriesMonetary Theories

oMonetary theories focus on the control of money and interest rates as mechanisms for shifting the aggregate demand curve.

oMoney and credit affect the ability and willingness of people to buy goods and services.

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Monetary TheoriesMonetary Theories

oIf the right amount of money is not available, aggregate demand may be too small.

oHigh interest rates decrease aggregate demand.

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Supply-Side TheoriesSupply-Side Theories

oA decline in aggregate supply causes output and employment to decline.

oThe focus of supply-side theory is to get more output by shifting the AS curve to the right.

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Eclectic ExplanationsEclectic Explanations

oShifts in both supply and demand curves may occur.

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Policy OptionsPolicy Options

oEssentially, the government has three policy options:oShift the aggregate demand curve.

oShift the aggregate supply curve.

oDo nothing.

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Fiscal PolicyFiscal Policy

oFiscal policy is the use of government taxes and spending to alter macro-economic outcomes.oFiscal policy is conducted by Congress and

the President.

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Monetary PolicyMonetary Policy

oMonetary policy is the use of money and credit controls to influence macro-economic activity.oThe Federal Reserve is the regulatory body

that controls the supply of money.

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Supply-Side PolicySupply-Side Policy

oSupply-side policy is the use of tax rates, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services.

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The Changing Choice of Policy LeversThe Changing Choice of Policy Levers

oThe “do nothing” approach prevailed until the Great Depression.

oThe Great Depression spurred a desire for a more active government role.

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The Changing Choice of Policy Levers: 1960sThe Changing Choice of Policy Levers: 1960s

oFiscal policy dominated the economic debate in the 1960s.

oThe promise of fiscal policy was tarnished by its failure to control inflation in the late 1960s.

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The Changing Choice of Policy Levers: 1970sThe Changing Choice of Policy Levers: 1970s

oMonetary policy dominated macro policy in the 1970s.

oThe heavy reliance on monetary policy ended with a recession in the late 1970s.

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The Changing Choice of Policy Levers: 1980sThe Changing Choice of Policy Levers: 1980s

oSupply-side policies prevailed in the 1980s with President Ronald Reagan.

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The Changing Choice of Policy Levers: 1990sThe Changing Choice of Policy Levers: 1990s

oThe George H. Bush administration pursued a less activist approach in the early 1990s.

oBill Clinton pursued a contractionary fiscal policy in the mid-1990s.

oThis fiscal policy retreat cleared the way for the reemergence of monetary policy.

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The Changing Choice of Policy Levers: 2005The Changing Choice of Policy Levers: 2005

oThe fiscal restraint of the late 1990s helped the federal budget move from deficits to surpluses.

oIn 2001, ‘02, and ‘03, Congress cut taxes in an attempt to deal with a recession.

oThis fiscal stimulus shifted the AD curve to the right.

oThe Fed started lowering interest rates in 2007 to prevent the economy from slowing down.

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Aggregate Supply Aggregate Supply and Demandand Demand

End of Chapter 11End of Chapter 11

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