Aggregate demand and aggregate supply model A model that explains short-run fluctuations in real GDP and the price level.

Aggregate Demand GDP has four components: consumption (C), investment (I), government purchases (G), and net exports (NX).

If we let Y stand for GDP, we can write the following:

Y = C + I + G + NX

The Wealth Effect: When our monetary wealth declines, we feel poorer and buy less.

Why Is the Aggregate Demand Curve Downward Sloping?

The Interest-Rate Effect: A higher interest rate discourages spending, investment spending in particular.

The International-Trade Effect (substitution of foreign stuff for our stuff): When our price level rises, foreigners buy less of our exports and we import more things from abroad.

When our price level rises, the real value of our monetary wealth declines. We feel poorer.

When our price level rises, real money balances (M/P) become scarcer and the interest rate rises.

The wealth effect refers to the fact that:a. When the price level falls, the real value of

household wealth rises, and so will consumption.b. When income rises, consumption rises.c. When the price level falls, the nominal value of

assets rises, while the real value of assets remains the same.

d. All of the above.

• Monetary policy Actions the Federal Reserve takes to manage the money supply and interest rates.

What Shifts the Aggregate Demand Curve?Changes in Government Policies intended to achieve macroeconomic objectives: high employment, price stability, steady economic growth.

• Fiscal policy Changes in federal taxes and purchases. Changes in Expectations of Households and Firms

• If households become more optimistic about their future incomes, they are likely to increase their current consumption.Changes in Foreign Variables

• If foreign economies expand, foreign firms and households will buy more U.S. goods.

• If the dollar depreciates, foreign firms and households will buy more U.S. goods and U.S. firms and households will buy fewer foreign goods.

Net exports will rise and the aggregate demand curve will shift to the right.

Movements along the Aggregate Demand Curve versus Shifts of the Aggregate Demand Curve

When price rises, less domestic output is demanded owing to the international-trade effect, the wealth effect and the interest rate effect.

When taxes increase or government spending decreases, when the money supply is reduced or when people lose confidence, aggregate demand shifts to the left

Variables That Shift the Aggregate Demand Curve

aggregate demand

Variables That Shift the Aggregate Demand Curve

Shifts the demand curve to the left

The Long-Run Aggregate Supply CurveLRAS reflects the economy’s output capacity at full employment of available resources using the best available technology.

LRAS shifts outward as capital accumulates, the labor force grows and as technology improves.

Which of the following factors does not cause the aggregate demand curve to shift?a. A change in the price level.b. A change in government policies.c. A change in the expectations of households and

firms.d. A change in foreign factors.

Aggregate demand and aggregate supply

Aggregate Supply

1 Contracts make some wages and prices “sticky.”

2 Firms are often slow to adjust wages.

3 Menu costs make some prices sticky.

The Short-Run Aggregate Supply Curve slopes upward

Why does the short-run aggregate supply curve slope upward?

Variables That Shift the Short-Run Aggregate Supply Curve

Expected Changes in the Future Price Level

Aggregate SupplyVariables That Shift the Short-Run Aggregate Supply CurveRecall: Supply Relation Reflects COSTS

Adjustments of Workers and Firms to Errors in Past Expectations about the Price Level: • Wage Adjustments

Unexpected Changes in the Price of an Important Natural Resource

Supply shock An unexpected event that changes costs causes the short-run aggregate supply curve to shift.

Variables That Shift the Short-Run Aggregate Supply Curve

Variables That Shift the Short-Run Aggregate Supply Curve

An increase in productivity results in:a. An increase in aggregate demand.b. An increase in short-run aggregate supply.c. A decrease in aggregate demand.d. A decrease in short-run aggregate supply.

Macroeconomic Equilibriumin the Long Run and the Short Run

Long-Run Macroeconomic Equilibrium

Macroeconomic Equilibriumin the Long Run and the Short Run

1 The economy has not been experiencing any inflation. The price level is currently 100, and workers and firms expect it to remain at 100 in the future.

2 The economy is not experiencing any long-run growth. Potential real GDP is $10.0 trillion and will remain at that level in the future.

Recessions, Expansions, and Supply Shocks

Because the full analysis of the aggregate demand and aggregate supply model can be complicated, we begin with a simplified case, using two assumptions:

Expansion...and restoration of full employmentThe Short-Run and Long- run Effects of an Increase in Aggregate Demand: • Prices rise along SRAS as

the economy expands• Costs increase as less

productive resources are used to produce more output

• Firms increase prices to cover higher costs

• Rising wages and prices shift SRAS inward

• Workers demand and get higher wages to offset higher prices

• Costs of production increase

• Firms increase prices to cover higher costs

How can government policies shift the aggregate demand curve to the right?a. By increasing personal income taxes.b. By increasing business taxes.c. By increasing government purchases.d. All of the above.

Recession...and textbook restoration of full employment

The Short-Run and Long-Run Effects of a Decrease in Aggregate Demand:• Declining wages

and prices shift SRAS outward

Why does the short run aggregate supply curve slope upward?a. Because profits rise when the prices of the goods

and services firms sell rise more rapidly than the prices they pay for inputs.

b. Because an increase in market price results in an increase in quantity supplied, as stated by the law of supply.

c. Because, as the number of workers, machinery, equipment, and technological change increase, quantity supplied increases.

d. All of the above.

Does It Matter What Causes a Decline in Aggregate Demand?

The collapse in spending on housing added to the severity of the 2007–2009 recession.

Spending on residential construction has declined prior to every recession since 1955

It’s the financial crisis and deleveraging by households, businesses, governments, and foreigners that make the current downturn so ugly.• Deleveraging: Cutting back spending in effort to reduce debt.

Which Components of Aggregate Demand Changed the Most during the 2007–2009 Recession?

Which Components of Aggregate Demand Changed the Most during the 2007–2009 Recession?

The following graphs illustrate the components of aggregate demand that showed the largest movements relative to potential GDP during the 2007-2009 recession, which is represented by the red bar.

Which Components of Aggregate Demand Changed the Most during the 2007–2009 Recession?

Macroeconomic Equilibriumin the Long Run and the Short Run

Supply Shock

The Short-Run and Long-Run Effects of a Supply Shock

Stagflation..in short run

Stagflation: falling output and rising prices at the same time

Which of the following statements is true?a. In the long run, increases in the price level

result in an increase in real GDP.b. In the long run, increases in the price level

result in a decrease in real GDP.c. In the long run, increases in the price level

do not affect real GDP.d. In the long run, increases in the price level

may increase or decrease real GDP.

A Dynamic Aggregate Demand and Aggregate Supply Model

• Potential real GDP increases continually, shifting the long-run aggregate supply curve to the right.

• During most years, the aggregate demand curve will be shifting to the right.

• Except during periods when workers and firms expect high rates of inflation, the short-run aggregate supply curve will be shifting to the right as productivity increases.

We can create a dynamic aggregate demand and aggregate supply model by making three changes to the basic model...but we won’t

Realistically,

Macroeconomic Schools of Thought

Keynesian revolution The name given to the widespread acceptance during the 1930s and 1940s of John Maynard Keynes’s macroeconomic model and activist policy prescriptions...and use of demand management tools during the post-WWII “Golden Age.”

1 The monetarist model

2 The new classical model

3 The real business cycle model

Alternative schools of thought use models that differ significantly from the standard aggregate demand and aggregate supply model. We can briefly consider each of three major alternative models that caution against Keynesian, activist policies:

Macroeconomic Schools of Thought

The Monetarist Model

Monetary growth rule A plan for increasing the quantity of money at a steady, predictable rate that does not respond to changes in economic conditions.

• Steady monetary growth can serve as an automatic stabilizer.

Monetarism The macroeconomic theories of Milton Friedman and his followers; particularly the idea that the quantity of money should be increased at a constant rate.

• Unintended consequences of Keynesian intervention will only make matters worse...So don’t mess with the economy!

The monetarist model—also known as the neo-Quantity Theory of Money model—was developed beginning in the 1940s by Milton Friedman, an economist at the University of Chicago who was awarded the Nobel Prize in Economics in 1976.

Macroeconomic Schools of Thought

The New Classical Model

New classical macroeconomics The macroeconomic theories of Robert Lucas and others, particularly the idea that workers and firms have rational expectations.

• People anticipate what government will do to try to hype the economy ... and will act in ways that makes demand management polices ineffective.

• So don’t mess with the economy!!

The new classical model was developed in the mid-1970s by a group of economists including Nobel laureate Robert Lucas of the University of Chicago, Thomas Sargent of New York University, and Robert Barro of Harvard University.

Macroeconomic Schools of Thought

The Real Business Cycle Model

Real business cycle model A macroeconomic model that focuses on real, rather than monetary, causes of the business cycle.

• Instability is from the supply-side.

• So don’t mess with Keynesian demand-side policies!!!

Beginning in the 1980s, some economists, including Nobel laureates Finn Kydland of Carnegie Mellon University and Edward Prescott of Arizona State University, argued that Lucas was correct in assuming that workers and firms formed their expectations rationally and that wages and prices adjust quickly to supply and demand but wrong about the source of fluctuations in real GDP.

Karl Marx: Capitalism’s Severest Critic… or most perceptive analyst?

Karl Marx predicted that a final economic crisis would lead to the collapse of the market system.

Aggregate demand and aggregate supply modelAggregate demand curveFiscal policyLong-run aggregate supply curveMenu costsMonetary policy

Short-run aggregate supply curveStagflationSupply shock

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