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Working With Basic Aggregate Demand/Supply Model
Chapter 10
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Aggregate Demand for Goods & Services
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Aggregate Demand for Goods & Services Aggregate demand curve:
-- indicates the various quantities of domestically produced goods & services that purchasers are willing to buy at different price levels .
The AD curve slopes downward to the right, indicating an inverse relationship between the amount of goods & services demanded and the price level.
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Goods & Services(real GDP)
Price level
AD
P 2
Y1 Y2
P 1A reduction in the price level will increase the quantity of goods &services demanded.
Aggregate Demand Curve
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Why Does the Aggregate Demand Curve Slope Downward The Wealth Effect: A lower price level
will increase the purchasing power of the fixed quantity of money.
The Interest Rate Effect: A lower price level will make the nominal interest rate appear lower which will stimulate additional purchases during the current period.
The Foreign Purchases Effect: Other things constant, a lower price level will make domestically produced goods less expensive relative to foreign goods.
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Factors that Shift Aggregate Demand
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Factors that Shift Aggregate Demand A decrease (increase) in Consumer Debt. An increase in the optimism (pessimism) of
businesses and consumers about future economic Expectations.
An increase (decrease) in Taxes. An increase (decrease) in Real Wealth.
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Goods & Services(real GDP)
Price level
AD0
Shifts in Aggregate Demand
AD1
AD2
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Aggregate Supply of Goods and Services
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Aggregate Supply of Goods & Services When considering the Aggregate Supply curve,
it is important to distinguish between the short-run and the long-run.
Short-run: -- time period during which some prices, particularly those in resource markets, are set by prior contracts
and agreements. Therefore, in the short-run, households and businesses are unable to adjust these prices when unexpected changes occur, including unexpected changes in the price level. Long-run: -- a time period of sufficient duration that people have the opportunity to modify their behavior in response to economic changes.
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Short-Run Aggregate Supply (SRAS)
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Short-Run Aggregate Supply (SRAS) SRAS indicates the various quantities of goods
& services that domestic firms will supply in response to changing demand conditions that alter the level of prices in the goods & services market.
SRAS curve slopes upward to the right. The upward slope reflects the fact that in the
short run an unanticipated increase in the price level will improve the profitability of firms and they will respond with an expansion in output.
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Goods & Services(real GDP)
Price level
SRAS (P100)
P 105
P 100
P 95
Y1 Y2 Y3
Short-Run Aggregate Supply Curve
An increase in the price level will increase the quantity supplied in
the short run.
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Shifts in Aggregate Supply
Factors that change SRAS: A decrease (increase) in resource prices
— that is, production costs such as wages, rent, and interest.
A reduction (increase) in the expected rate of inflation.
Favorable (unfavorable) supply shocks, such as good (bad) weather or a reduction (increase) in the world price of a key imported resource.
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Long-Run Aggregate Supply (LRAS)
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Long-Run Aggregate Supply (LRAS) LRAS indicates the relationship between the
price level and quantity of output after decision makers have had sufficient time to adjust their prior commitments where possible.
LRAS curve is vertical. LRAS is related to the economy's production
possibilities frontier. A higher price level does not loosen the constraints imposed by the economy's resource base, level of technology, and the efficiency of its institutional arrangements.
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Goods & Services(real GDP)
Price level
LRAS
YF
(full employment rate of output)
Long-Run Aggregate Supply Curve
Change in price level does not affect quantity supplied in the long run.
Potential GDP
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Anticipated and Unanticipated Changes
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Anticipated and Unanticipated Changes Anticipated changes are foreseen by
economic participants. Decision makers have time to adjust to
them before they occur. Unanticipated changes catch people by
surprise.
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Unanticipated Changes in Aggregate Demand
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Unanticipated Changes in Aggregate Demand Impact of unanticipated reductions in AD:
Weak demand and lower prices in the goods & services market will reduce profit margins. Many firms will incur losses.
Firms will reduce output, the rate of unemployment will rise above the natural rate, and output will temporarily fall short of the economy's long-run potential.
With time, long-term contracts will be modified.
Eventually, lower resource prices and a lower real interest rate will direct the economy back to long-run equilibrium, but this may be a lengthy and painful process.
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LRAS
Goods & Services(real GDP)
Price level
P 100
YF
SRAS1
AD1
Unanticipated Reduction in Aggregate Demand
The short-run impact of an unanticipated reduction in AD (shift from AD1 to AD2) will be a decline in output (decreases to Y2), and a lower price level (P95).
Short-run effects of an unanticipated reduction in AD
P 95
Y2
AD2
Temporarily, profit margins decline, output falls, and unemployment rises below its natural rate.
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LRAS
Goods & Services(real GDP)
Price level
SRAS1
AD1
P 100
In the long-run, weak demand and excess supply in the resource market will lead to lower wage rates and resource prices resulting in an expansion in short-run aggregate supply to SRAS2.
In the long-run, a new equilibrium at a lower price level (P90) and an output consistent with the economy’s sustainable potential will result.
YF
AD2
P 95
P 90
Y2
Unanticipated Reduction in Aggregate Demand
This method of restoring equilibrium may be both long and painful.
SRAS2
YF
Long-run effects of an unanticipated reduction in AD
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Unanticipated Changes in Aggregate Demand
Impact of unanticipated increases in AD: Initially, the strong demand and higher price level
in the goods & services market will temporarily improve profit margins.
Output will increase, the rate of unemployment will drop below the natural rate, and output will temporarily exceed the economy's long-run potential.
With time, however, contracts will be modified and resource prices will rise and return to their competitive relation with product prices.
Once this happens, output will recede to the economy's long-run potential.
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LRAS
Goods & Services(real GDP)
Price level
P 100
YF
SRAS1
AD1
Unanticipated Increase in Aggregate Demand
In response to an unanticipated increase in AD for goods & services (shift from AD1 to AD2), prices will rise to P105 and output will temporarily exceed full-employment capacity (increases to Y2).
P 105
Y2
AD2
Short-run effects of an unanticipated increase in AD
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LRAS
Goods & Services(real GDP)
Price level
SRAS1
AD1
P 100
With the passage of time, prices in resource markets, including the labor market, will rise due to the strong demand. As a result, higher costs reduce aggregate supply to SRAS2.
In the long-run, a new equilibrium at a higher price level (P110) and an output consistent with the economy’s sustainable potential will occur.
YF
AD2
P 110
P 105
Y2
Unanticipated Increase in Aggregate Demand
Thus, the increase in demand will expand output only temporarily.
SRAS2
YF
Long-run effects of an unanticipated increase in AD
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Shifts in Long Run Aggregate Supply
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Shifts in Long Run Aggregate Supply
Factors that change LRAS: An increase (decrease) in the supply
of resources. An improvement (deterioration) in
technology and productivity. Institutional changes that increase
(reduce) the efficiency of resource use such as trade agreements.
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Impact of Changes in Aggregate Supply
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Impact of Changes in Aggregate Supply Economic growth and anticipated shifts in
long-run aggregate supply. Increases in LRAS will make it possible to
produce and sustain a larger rate of output. Both LRAS and SRAS will shift to the right
and output will increase. These changes generally take place slowly
and therefore they need not disrupt long-run equilibrium.
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Goods & Services(real GDP)
Price level
LRAS1
YF,1
Such factors as an increase in the stock of capital or an improvement in technology will expand the economy’s potential output and shift the LRAS to the right (note that SRAS will also shift to the right).
Such factors as a reduction in resource prices, favorable weather, or a temporary decrease in the world price of an important imported resource would shift SRAS to the right (note that LRAS will remain constant).
Shifts in Aggregate Supply
Goods & Services(real GDP)
Price level
SRAS1
LRAS2
YF,2
SRAS2
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LRAS1
Goods & Services(real GDP)
Price level
YF
AD
P 1
SRAS1
YF1
SRAS2
YF2
LRAS2
YF2
Here we illustrate the impact of economic growth due to capital formation or a technological advancement, for example.
Both LRAS and SRAS increase (to LRAS2 and SRAS2); the full employment output of the economy expands from YF1 to YF2.
P 2
Growth in Aggregate Supply
A sustainable, higher level of real output and real income is the result. If the money supply is held constant, a new long-run equilibrium will emerge at a larger output rate (YF2) and lower price level (P2).
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The Business Cycle -- Revisited
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The Business Cycle -- Revisited Recessions occur because prices in the
goods & services market are low relative to the costs of production and resource prices.
The two causes of recessions: unanticipated reductions in aggregate
demand, and, unfavorable supply shocks.
An unsustainable economic boom occurs when prices in the goods & services market are high relative to costs and resource prices.
The two causes of booms are: unanticipated increases in aggregate
demand, and, favorable supply shocks.
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2000
10
8
6
4
2
01960 1965 1970 1975 1980 1985 1990 1995
6,000
4,000
2,000
0 1960 1965 1970 1975 1980 1985 1990 1995 2000
Percentage of the
Labor Force Unemployed
Real GDP(billions of 1987 $)
Source: Derived from computerized data supplied by FAME Economics.
Actual rate of unemployment
Natural rate of unemployment(estimated range)
Expansion
RealGDP
1960 Recession
1970 Recession
1974–75 Recession
1982 Recession
1990 Recession
1980 Recession
Expansion
• Here we illustrate the periods of expansion and contraction (recession) since 1960.
• Note how the reductions in real GDP (shaded periods) in the top graph are associated with increases in the rate of unemployment well above the natural rate (bottom graph).• The AD/AS model indicates that recessions are caused by unanticipated reductions in AD that are likely to accompany abrupt reductions in the inflation rate and/or adverse supply shocks that might occur, for example, when there is a large increase in the price of a key imported resource, such as crude oil.
Expansions, Recessions, and the Rate of Unemployment
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Does the Market Have a Self-Corrective Mechanism That Will Keep it on Track?
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Does the Market Have a Self-Corrective Mechanism That Will Keep it on Track? There are three reasons to believe that it does:
Consumption demand is relatively stable over the business cycle.
Changes in real interest rates will help to stabilize aggregate demand and redirect economic fluctuations.
Interest rates will tend to fall during a recession and rise during and economic boom.
Changes in real resource prices will redirect economic fluctuations.
Real resource price will tend to fall during a recession and rise during an economic expansion.
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Price level
LRAS
YF
Goods & Services (real GDP)
When aggregate output is less than the economy’s full employment potential (YF), weak demand for investment leads to lower real interest rates, while slack employment in resource markets will place downward pressure on wages and other resource prices (Pr).
Changes in Real Interest Rates and Resource Prices Over the Business Cycle
rReal interest rates fall
(because of weak demand for investment)
rReal interest rates rise
(because of strongdemand for investment)
PrReal resource prices fall(because of weak demand and high unemployment) Pr
Real resource prices rise(because of strong demand
and low unemployment)
Unemployment greater
than Natural Rate
Unemployment less
than Natural Rate
Conversely, when output exceeds YF, strong demand for capital goods and tight labor market conditions will result in rising real interest rates and resource prices (Pr).
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Goods & Services(real GDP)
Price level
SRAS1
AD1
P 100
Y1
LRAS
YF
P 105
P 95
SRAS2
YF
AD2
Lower resource prices increase SRAS
Lower real interest rates increase AD
The Economy’s Self Corrective Mechanism
If output is temporarily less than capacity, lower interest rates (reflecting the weak demand for investment funds) will stimulate aggregate demand (shifting AD from AD1 to AD2). In addition, lower resource prices will reduce production prices (because of weak demand and abnormally high unemployment) and thereby stimulate SRAS (shifting SRAS to SRAS2).
This output will move the economy toward full-employment capacity. However, this self-correction process may take some time.
YF
In the short-run, outputmay exceed or fall
short of the economy’s full-employment
capacity (YF).
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Price level
Goods & Services(real GDP)
SRAS1
AD1
P 100
Y1
LRAS
YF
P 95
If output is temporarily greater than the economy’s potential, higher real interest rates and resource prices will lead to a lower but sustainable rate of output.
YF
P 105
The Economy’s Self Corrective Mechanism
SRAS2
AD2
Higher interest rates will reduce AD (from AD1 to AD2). At the same time, higher resource prices will increase production
costs and therefore reduce SRAS (from SRAS1 to SRAS2). These forces direct output toward full-employment potential (YF).
In the short-run, outputmay exceed or fall
short of the economy’s full-employment
capacity (YF).
YF
Higher resource prices reduce SRAS
Higher real interest rates reduce AD
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The Great Debate: -- How rapidly does
the self-corrective mechanism work?
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The Great Debate: -- How rapidly does the self-corrective mechanism work? Many economists believe that the self-
corrective mechanism works slowly. If this is the case, then market economies will
still experience prolonged periods of abnormally high unemployment and below-capacity output.
Others believe that the self-corrective mechanism works fairly rapidly if it is not disrupted by perverse monetary and fiscal policy.
This is an important and continuing debate that we will return to and analyze in more detail as we proceed.
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EndChapter 10
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