In this chapter you will learn:

About aggregate demand (AD) and the factors that cause it to change. About aggregate supply (AS) and the factors that cause it to change. How AD and AS determine an economy's equilibrium price level and level of real GDP. How the AD-AS model explains periods of demand-pull inflation, cost-push inflation, and

recession.

10.1 Real-Balances Effect

The real balances effect is also known as the Pigou effect, after its originator, Arthur C. Pigou. (1877-1959). Pigou was born on the Isle of Wight in England, and studied at Cambridge University. He eventually became the chair of political economy at Cambridge University, succeeding Alfred Marshall, who influenced Pigou greatly. Pigou was a welfare economist, meaning that he was concerned with how to maximize social well-being beyond the scope of the individual. He contributed to theories of income distribution, externalities, and price discrimination.

Photograph courtesy of: http 10.2 Efficiency Wage

The notion that higher wages promote greater productivity - efficiency wages - appears often in the history of economic thought. Although not credited with developing the term, Adam Smith (1723-1790) was one of the first to articulate the idea. Smith argued that there exists a positive relationship between wages and worker productivity. As Smith put it,

The liberal reward for labour, as it encourages the propagation, so it increases the industry of the common people. The wages of labour are the encouragement of industry, which like every other human quality, improves in proportion to the encouragement it receives. A plentiful subsistence increases the bodily strength of the labourer, and the comfortable hope of bettering his position, and of ending his days in ease and plenty, animates him to exert that strength to the utmost. Where wages are high, accordingly, we shall always find the workmen more active, diligent, and expeditious, than where they are low.

Keep in mind that Smith was writing during the time of the industrial revolution in Great Britain. At that time it was common to have wages that barely provided for physical subsistence, and often times fathers (the primary wage laborer), would forgo meals so that children could eat. Higher wages would allow workers, as Smith suggests, to increase bodily strength, and important dimension to productivity in late 18th century Britain. Modern efficiency wage theory focuses more on worker morale and labor turnover, and less on the physical needs of workers, a central issue in Smith's time.

Robert Owen (1771-1858), owner of the New Lanark spinning mills in Scotland, attempted to put the idea of efficiency wages into practice. Owen, who owned and ran the mills from 1800-1820, also established the model community of New Lanark. Operating during the industrial revolution, a period in which wages were pushed to subsistence, Owen paid his workers significantly more than the prevailing wages of the time, and his mills were both productive and profitable.

Several economists developed formal theories of efficiency wages. These theories are summarized by George Akerlof and Janet Yellen, eds., in their book, Efficiency Wage Models of the Labor Market (Cambridge: Cambridge University Press, 1986).

10.1 Graphing Exercise: Aggregate Demand – Aggregate Supply

The aggregate demand – aggregate supply (AD–AS) model is useful for analyzing changes in both real GDP and the price level. Changes in either aggregate demand, aggregate supply, or both can help to explain recession and unemployment, inflation, and economic growth. Our analysis in this exercise will focus on the short run effects of changes in aggregate supply and aggregate demand.

Exploration: How do changes in aggregate demand and supply affect the equilibrium price level and real GDP?

The graph shows the aggregate demand and aggregate supply curves for a hypothetical economy. The AD curve shows an inverse relationship between the aggregate price level and real GDP. This is because an increase in the price level: 1) reduces the real value of dollar-denominated assets, which reduces consumption expenditures (the real-balances effect); 2) increases the demand for money, which increases interest rates and thereby reduces investment expenditures (the interest-rate effect); and 3) makes domestically produced goods less attractive to foreigners, which reduces net exports (the foreign purchases effect).

The aggregate supply curve, on the other hand, reflects the costs of producing a given level of GDP. At very low levels of GDP, resources are unemployed and output may increase with little upward pressure on the price level. However, as real GDP approaches full employment, bottlenecks for some resources appear and costs begin to rise. The price level must rise sufficiently to cover these higher production costs.

The economy is initially at the full employment level of real GDP, labeled Q0, and the price level is stable at price level P. To use the graph, click and drag either the AD or AS labels to shift the aggregate demand or aggregate supply curve, respectively, to a new location. Clicking Reset will

restore the economy to full employment GDP and a stable price level. Click Update to establish the new equilibrium as a starting point for additional analysis.

1. Starting from full employment, what will be the impact on real GDP and the price level of an increase in desired consumption expenditures?See answer here

2. Suppose the economy is operating at full employment and prices are stable. All else equal, will an increase in wages and salaries increase the aggregate price level?See answer here

3. Starting from a full-employment, stable price equilibrium, suppose aggregate demand decreases. Which will result in a deeper recession—if the price level falls or if it remains the same?See answer here

4. The late 1990s were a period of dramatically rising stock values and rising labor productivity. Real GDP increased, yet prices remained relatively stable. How might this be explained by the AD–AS model?See answer here

Problem 10.1 - Productivity and costs

Problem:

Suppose an economy's relationship between its aggregate inputs and output can be represented by the following table, in which inputs and real GDP are expressed in billions:

Inputs Real GDP100 400105 420110 440115 460

a. What is the productivity level in this economy? b. Suppose each input costs $5. What is the per unit

production cost at each level of output? c. Suppose productivity increases by 10% with no change

in input prices. Calculate the new per unit production cost.

d. Alternatively, suppose input prices increase by 10% with no change in productivity. Calculate the new per unit production cost.

e. True or false: "An equal percentage increase in productivity and input prices will have no impact on per unit production costs."

Answer:

a. Productivity is measured as the ratio of total output to total inputs. In this example, productivity is 4. 4 = $400/100.

b. Production cost is measured as the price of each input times its price. Per unit production cost is this amount divided by total output, or real GDP. In this example, per unit production cost at each level of output is $1.25. $1.25 = ($5 x 100)/$400 = ($5 x 105)/$420 =($5 x 110)/$440 =($5 x 115)/$460.

c. The new productivity level is 4.4 = 1.1 x 4, a 10% increase over its previous level. This means that 100 billion units of inputs could produce 100 x 4.4 = $440 billion of real GDP. The new per unit production cost is ($5 x 100)/$440 = $1.14, a drop of 10%.

d. Inputs would now cost $5.50 = 1.1 x 5. Per unit production cost is ($5.50 x 100)/$400 = $1.375, an increase of 10% over its previous value of $1.25.

e. True. Per unit production cost is the ratio of total input cost to total output. If both numerator and denominator increase in proportion, the ratio is unchanged.

. Suppose that the aggregate demand and supply schedules for a hypothetical economy are as shown below:

a. Use these sets of data to graph the aggregate demand and aggregate supply curves. What is the equilibrium price level and the equilibrium level of real output in this hypothetical economy? Is the equilibrium real output also necessarily the full-employment real output? Explain.

b. Why will a price level of 150 not be an equilibrium price level in this economy? Why not 250? c. Suppose that buyers desire to purchase $200 billion of extra real output at each price level. Sketch in the

new aggregate demand curve as AD1. What factors might cause this change in aggregate demand? What is the new equilibrium price level and level of real output?

5. Suppose that a hypothetical economy has the following relationship between its real output and the input quantities necessary for producing that output:

a. What is productivity in this economy? b. What is the per-unit cost of production if the price of each input unit is $2? c. Assume that the input price increases from $2 to $3 with no accompanying change in productivity. What

is the new per-unit cost of production? In what direction would the $1 increase in input price push the economy's aggregate supply curve? What effect would this shift of aggregate supply have on the price level and the level of real output?

d. Suppose that the increase in input price does not occur but, instead, that productivity increases by 100 percent. What would be the new per-unit cost of production? What effect would this change in per-unit production cost have on the economy's aggregate supply curve? What effect would this shift of aggregate supply have on the price level and the level of real output?

6. What effects would each of the following have on aggregate demand or aggregate supply? In each case use a diagram to show the expected effects on the equilibrium price level and the level of real output. Assume all other

things remain constant.

a. A widespread fear of depression on the part of consumers. b. A $2 increase in the excise tax on a pack of cigarettes. c. A reduction in interest rates at each price level. d. A major increase in Federal spending for health care. e. The expectation of rapid inflation. f. The complete disintegration of OPEC, causing oil prices to fall by one-half. g. A 10 percent reduction in personal income tax rates. h. A sizable increase in labor productivity (with no change in nominal wages). i. A 12 percent increase in nominal wages (with no change in productivity). j. Depreciation in the international value of the dollar.

7. Assume that (a) the price level is flexible upward but not downward and (b) the economy is currently operating at its full-employment output. Other things equal, how will each of the following affect the equilibrium price level and equilibrium level of real output in the short run?

a. An increase in aggregate demand. b. A decrease in aggregate supply, with no change in aggregate demand. c. Equal increases in aggregate demand and aggregate supply. d. A decrease in aggregate demand. e. An increase in aggregate demand that exceeds an increase in aggregate supply.

Aggregate Demand

Aggregate Demand Curve : A schedule that shows amounts of real output (real GDP) that buyers collectively desire to purchase at each possible price level. (Thus, price level and real domestic output are inversely related.)Rationale of downward slope of AD curve:

Real-balances effect (i.e. Wealth Effect): A change in the price level o A higher price level reduces the real value (purchasing power) of the public's accumulated savings

balances. In other words, the real value of assets with fixed money values (eg. savings accounts, bonds) diminishes. Keep in mind that wealth also includes physical assets such as houses and cars; as such, a fall in the value of housing will diminish the wealth of homeowners.

o Simply put, a lower price level makes you seem wealthier while a higher price level makes you seem less wealthy.

o The public is then more poor in real terms and will reduce spending. Higher prices mean less consumption. Interest-rate effect: A change in the interest-rate level o Assume that the supply of money in an economy is fixed. low price levels will cause interest rates to decrease and result in more consumer spending If the price level rises, consumers and businesses need more money to consume or invest.

Therefore, a higher price level increases demand for money An increase in money demand will drive up the price paid for its use - this is interest. Higher interest rates then reduces investment or consumption which require loans.

Foreign purchases effect (i.e. Net Export Effect):

When domestic price levels rise relatively to foreign products, foreigners buy fewer U.S. goods, and Americans buy more foreign goods. Thus, U.S. exports fall and U.S. imports rise

o The rise in the price level of U.S. goods reduces the quantity of U.S. goods demanded as net exports.

Difference between AD curve and microeconomics demand curve: No substitute effect, because you cannot substitute all goods. No income effect, because a lower price level actually means less nominal income for the resource

suppliers -- e.g. lower wages, rents, interests, profits.

*We study aggregate demand to see how fluctuations in C, I, G, and Xn affect the AD curve*

Determinants of Aggregate Demand / AD shifters Note: change in determinant that directly changes amount of real GDP

o multiplier effect produces greater change in AD than initiating change in spending o shift along the curve = changes in real GDP

Consumer spending: (C) o Consumer Wealth: Consumer wealth includes both financial assets and physical assets. A sharp

increase in the real value of consumer wealth prompts people to save less and buy more products, shifting the AD curve to the right. Also vise versa.

o Expectations: Expectation of future income rises, ppl tend to spend more of their current incomes. Thus current

consumption spending increases, and the AD curve shifts to the right. Also, a widely helped expectation of surging inflation in the near future may increase aggregate demand today because consumers will want to buy products before their price escalate.

o Household debt: Increased household debt enables consumers collectively to increase their consumption spending, which shifts the AD curve to the right.

o Taxes: A reduction in personal income tax rates raises take-home income and increases consumer purchases. Tax cuts shift the AD curve to the right.

Investment spending: (unstable) (I) o Real Interest Rates : An increase in real interest-rate will decrease investments aka shift aggregate demand curve to the

left. It identifies a change in the real interest rate resulting from a change in the nation's money supply.

An increase in the money supply lowers the interest rate, thereby increasing investment and aggregate demand and vice versa.

o Expected Returns : Expected future business condition: If firms think that the future is looking good, they will probably

invest more today to help boost up their profits. However, if they think the future is looking bleak, they will cut back on investment, thus shifting AD to the left.

Technology: New and better technology helps to shift AD to the right because they usually have a high expected rate of return.

For example, recent advances in microbiology have motivated pharmaceutical companies to establish new labs and production facilities because there is a greater demand for those capital goods.

Degree of excess capacity: When there's more excess capacity (unused capital), there will be less investment, meaning an inward shift of the AD curve. But once they realize that they have used up their capital, the expected returns on new investment rise, they will start investing more, meaning an outward shift of the AD curve.

Business taxes: An increase in business taxes will cut out more of the after-tax profits so investment and AD will decrease and shift left. Conversely, a decrease in taxes will shift the curve out.

Government spending: (G) o When the government spends more, the AD curve shifts to the right, as long as the interest rates

and tax collections do not change o A decrease of government spending, such as fewer projects in transportation, will shift the AD curve

to the left. Net export spending: (Xn) o A rise in net exports (higher exports relative to imports) shift the aggregate demand curve to the

right. o

National income abroad: Rising national income abroad encourages foreigners to buy more products. Net exports of the U.S. thus rise and aggregate demand curve shift to the right.

Exchange rates: change in the dollar's exchange rate. The price of foreign currencies in terms of the U.S. dollar-- may affect U.S. exports and therefore aggregate demand. If the U.S. dollar depreciates in terms of the euro, the new higher value euros enables consumers to obtain more dollars with each euro--> exports rise, imports fall --> AD shifts out.

Aggregate Supply

Aggregate Supply: The schedule or curve showing the level of real domestic output that firms will produce at each level.

Aggregate Supply in the long-run: Long Run: A period in which nominal wages (resource

prices) match changes in the price level.This occurs because enough time has passed for firms to adjust to any changes in price level.

Long Run Aggregate Supply is only possible with flexible labor markets

Ceterus paribus (other things equal), Aggregate Supply in the long run is vertical at the economy's full-employment (including the natural rate of unemployment) output because resources and capital are at full capacity; thus, if one company attempts to attract workers through increasing wages, employees from other firms will come, not new workers.

Therefore the curve is perfectly inelastic, vertical curve shown.

Because real profit does not change, the firm will not alter its production. Real GDP will remain at full-employment level.

Shifters: o change in laboro technology o productivity (education, more machines) o open up trade with other nations

Aggregate Supply in the short-run: Short Run: A period in which nominal wages (resource

prices) do not match changes in price level. This occurs

because firms have not had enough time to adjust to changes in price level. During this period, the prices of the factors of production do not change, especially the price of labor (wage rate) is fixed.

There's a positive/direct relationship between the price level and the total output and so, the SRAS curve slopes upward because to produce more output, firms are likely to face higher costs of production, which increases the price levels.

At outputs below the Qf level, the slope of the aggregate supply curve is relatively flat: -- large amounts of unused resources, can be put back to work with a little upward pressure on per-unit production costs

At outputs above the Qf level, the slope of the aggregate supply curve is relatively steep.-majority of resources is already employed, so adding more reduces the efficiency of workers, capital, and total output rises less rapidly than total input cost. In other words, when the output level exceeds Qf, the price level rises more rapidly over the same amount of increased output.

Can having three distinct segments: o Horizontal -unemployment & high excess capacity. o Upsloping - increase in real output = increase in price level; full-employment near, producer costs

rise. o Vertical - full-employment w/ Natural Rate of Unemployment (NRU), full capacity is assumed, and

increase output = increase in resource and product prices. With full employment this production equals the economies potential output.

Changes in Aggregate Supply: Determinants of Aggregate Supply Input prices: Input or resource prices (domestic or imported) o Domestic Resource Prices: Wages and Salaries Labor supply ↑ → wage ↓→ aggregate supply ↑ (curve shifts right) Labor supply ↓→ wage ↑→aggregate supply ↓(curve shifts left) Rents and Capital Investments: Price of machinery ↓because prices of steel ↓→ per unit production cost ↓→ aggregate supply

↑(curve shifts right) Land resources ↑due to irrigation or technological innovations → per unit production cost

↓→aggregate supply ↑(curve shifts right)

o Prices of Imported Resources: o

A decrease in the price of imported resources increases U.S. aggregate supply (curve shifts right). An increase in the price of imported resources reduces U.S. aggregate supply (curve shifts left). Exchange rates also play a role: If dollar appreciates, domestic produces face a lower dollar price of foreign resources. increase in imports shift AS to the right.o Market Power: A change in the ability to set prices above competitive levels. OPEC's fluctuation market power. increase in power = increase in oil prices which reduced U.S. Aggregate supply dramatically leftward

anddrove up per-unit production costs. decrease in power = decrease in oil prices which increased U.S Aggregate supply Productivity: o Measure of the relationship between a nation's level of real output and the amount of resources used

to produce that output.

o Productivity = total output/total input. o An increase in productivity enables the economy to obtain more real output from its limited

resources. It does this by reducing the per-unit cost of output.

per-unit production cost= total input cost/ total output.o By reducing the per-unit production cost, an increase in productivity shifts the aggregate supply

curve to the right. o higher productivity --> lower per-unit cost --> AS curve shifts out. o The main source of productivity advance is improved production technology, better-educated

workforce, improved forms of business enterprises, and the reallocation of labor resources from lower to higher productivity uses.

Legal-institutional environment: o Business taxes and subsidies Business taxes ↑, per-unit production costs ↑, supply↓ Subsidy ↑, per-unit production costs ↓, supply ↑o Government regulations – regulation ↑, per-unit production costs ↑, supply ↓

Equilibrium and Changes in Equilibrium

The intersection of the aggregate demand curve AD and the aggregate supply curve AS establishes the economy's equilibrium price level and equilibrium real output.

Increases in AD: demand-pull inflation: Is as though, the higher demand is "pulling" prices up so much so that inflation exists. This inflation occurs when demand for goods and services exceeds existing supplies; thus the price

level is being pulled up by the increase in aggregate demand. Assume that economy is operating at full-employment output, but businesses and the government

want to increase their spending (AD curve to the right). Consumers are becoming more wealthy and they demand more products, but the supply sector

cannot catch up with the rapidly growing demand, therefore the price levels are brought up There is a positive GDP gap, where actual GDP > potential GDP. o Ex: U.S. during Vietnam war in the 1960s, where large government spending on the war shifted the

economy's AD curve to the right, producing great inflation. Rise of price level reduces size of multiplier effect: For any initial increase in aggregate demand,

resulting increase in real output will be smaller the greater the increase in price level

Decreases in AD: recession and cyclical unemployment: Deflation (i.e. price level decreases) is rare in the economy, but it is still possible. However,

deflation is NOT a good thing despite its "inflation" counterpart. Price levels should be STABLE, not decreasing.

Recessions caused by a negative GDP gap are usually unaccompanied by a price level decrease; thus the term "GDP gap but no deflation", also called disinflation, constituting a recession and creating cyclical unemployment.

Reasons why the price level tends to be inflexible in a downward direction during declines in aggregate demand in the United States:

o Fear of price wars: big firms fear that if they lower their prices, competitors will lower theirs and even make deeper price cuts so the initial price cut would set off a price war- successively deeper price cuts. Each firm would eventually end up with far less profit or higher losses than would be the case if each had simply maintained its original prices. To avoid this, firms would reduce production and lay off workers instead of making the initial price cut

o Menu costs: costs of 'printing new menus' when price is reduced by the firm; prices of estimating the magnitude anbd duration of the shift in demand to determine whether to lower prices, of repricing inventory items, printing/mailing new catalogs, communicating new prices to customers

o Wage contracts: difficult to profit from cuts of product prices without cutting wage rates; wages are usually inflexible downward b/c many laborers are under contracts prohibiting wage cuts

o Morale, effort, and productivity: Efficiency wages : wages that elicit max. work effort and minimize labor costs per unit of output if the higher labor costs resulting from reduced productivity exceed the cost savings from lower

wage, then wage cuts will increase rather than reduce labor costs per unit of outputo Minimum wage: a legal floor under the wages of the least skilled workers; firms paying minimum

wage cannot reduce the wage rate when AD declines

Decreases in AS: cost-push inflation: Is as though diminishing supply of g/s are "pushing" inflation higher. Costs ↑ → AS ↓ → PL ↑ = inflation

- "Double" negative effects – inflation and recession (y ↓) When a resource causes the cost of production for a wide variety of goods, this causes a decrease

in aggregate supply and there is cost-push inflation (rising price levels). Ex: Terrorist attack on oil facilities drives up oil prices by 300%. A decrease in AS is doubly bad because: o there is cost-push inflation o recession and negative GDP gap oo Stagflation - Period with decreasing output(AD and AS shifts left), rising price levels (inflation), and

increasing unemployment. Out put has decrease but Price level increase. This is experienced during an economic recession, such as the current state of the U.S. economy as the graph illustrates.

Increases in AS: full-employment with price-level stability: Normally, a shift of the aggregate demand curve to the right will result in expansion of output and

inflation. However, if the aggregate supply curve also shifts to the right, the economy will experience strong economic growth, full employment, and only very mild inflation.

The aggregate supply curve will shift to the right when larger than usual increases in productivity (ex: burst of new technology).

Expanding output beyond the full-employment level will lead to higher inflation.