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INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALLCHAPTER 17 / AGGREGATE DEMAND AND AGGREGATE SUPPLY
2005, South-Western/Thomson Learning
Aggregate Demand
and Aggregate Supply
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Figure 1: The Two-Way Relationship
Between Output and the Price Level
PriceLevel
RealGDP
Aggregate Demand Curve
Aggregate Supply Curve
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The Price Level and The Money Market
First effect of a change in the price level occurs inthe money market
Rise in the price increases the demand for moneyand shifts the money demand curve rightward
It makes purchases more expensive Drop in the price level
Makes purchases cheaper Decreases the demand for money Shifts the money demand curve leftward
Rise in the price level causes the interest rate torise and interest-sensitive spending to fall Equilibrium GDP decreases by a multiple of the decrease
in interest-sensitive spending
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The Price Level and Net Exports
The second effect of a higher price level
brings in the foreign sector
A rise in the price level causes
Net exports to drop and
Equilibrium GDP to decrease by a multiple of the
drop in net exports
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Deriving The Aggregate Demand (AD)
Curve
Figure 2 plots the price level on a vertical
axis and the economys real GDP on the
horizontal axis
If we continued to change the price level toother values we would find that each different
price level results in a different equilibrium
GDP The aggregate demand (AD) curve tells us
the equilibrium real GDP at any price level
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Figure 2: Deriving the Aggregate
Demand Curve
AD
140
100
PriceLevel
K
J
106 Real GDP($ Trillions)
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Movements Along The AD Curve
A variety of events can cause the price level to change, and move usalong the AD curve
Its important to understand what happens in the economy as we make sucha move
Opposite sequence of events will occurif the price level falls, moving us
rightward along the AD curve
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Shifts of The AD Curve
The distinction between movements along the AD curve andshifts of the curve itselfis very important Always keep the following rule in mind
When a change in the price level causes equilibrium GDP to change, wemove along the AD curve
Whenever anything other than the price level causes equilibrium GDP tochange, the AD curve itself shifts
What are these otherinfluences on GDP? Equilibrium GDP will change whenever there is a change in any of
the following Government spending Taxes Autonomous consumption spending Investment spending The money supply curve The money demand curve
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Changes in the Money Market
Changes that originate in the money market
will also shift the aggregate demand curve
An increase in the money supply shifts the
AD curve rightward
A decrease in the money supply shifts the AD
curve leftward
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Figure 4(a): Effects of Key Changes on
the Aggregate Demand Curve
(a)
Real GDP
Price Level
P3
Q3 Q1 Q2
AD
P1
P2
Price level movesus leftward along
the ADcurve
Price level movesus rightward alongthe ADcurve
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Figure 4(b): Effects of Key Changes on
the Aggregate Demand Curve
EntireADcurve shifts rightward if: a, IP, G, orNX increases
Net taxes decrease The money supply increases
AD2
AD1
(b)
Real GDP
Price Level
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Figure 4(c): Effects of Key Changes on
the Aggregate Demand Curve
AD2
decreasesEntireADcurve shifts leftward if: a, IP, G, orNXdecreases
Net taxes increase The money supply decreases
(c)
Real GDP
Price Level
AD1
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The Aggregate Supply Curve
On the one hand, changes in the price levelaffect output
On the other hand, changes in output affect the
pric
e level This relationshipsummarized by the aggregate
supply curveis the focus of this section
The effect ofchanges in output on the price
level is complex, involving a variety of forces
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Costs and Prices
Price level in economy results from pricing behaviorof millions ofindividual business firms In any given year, some of these firms will raise their
prices, and some will lower them
Often, all firms
in the e
conomy are affe
cted
by thesame macroeconomic event
Causing prices to rise or fall throughout the economy
To understand how macroeconomic events affectthe price level, we begin with a very simple
assumption A firm sets price ofits products as a markup overcost
per unit
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Costs and Prices
Percentage markup in any particularindustry will depend ondegree ofcompetition there
In macroeconomics, we are not concerned with how themarkup differs in different industries
But rather with average per
centage markup
in e
conomy Determined by competitive conditions
Competitive structure changes very slowly, so average percentagemarkup should be somewhat stable from year-to-year
But a stable markup does not necessarily mean a stableprice level, because unit costs can change
In short-run, price level rises when there is an economy-wideincrease in unit costs
Price level falls when there is an economy-wide decrease in unit costs
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GDP, Costs, and the Price Level
Why should a change in output affect unit costs and
price level?
As total output increases
Greater amounts ofinputs may be needed to produce a unit ofoutput
Price of non-laborinputs rise
Nominal wage rate rises
A decrease in output affects unit costs through the
same three forces, but with opposite result
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The Short Run
All three of our reasons are important inexplaining why a change in output affectsprice level They operate within different time frames
Our third explanationchanges in nominalwage rateis a different story
For a year or more after a change in output,changes in average nominal wage are lessimportant than other forces that change unitcosts
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The Short Run
Some of the more important reasons why wages in
many industries respond so slowly to changes in
output
Many f
irms have un
ion
contra
cts that spe
cify wages forup to three years
Wages in many large corporations are set by slow-
moving bureaucracies
Wage changes in either direction can be costly to firms
Firms may benefit from developing reputations for paying
stable wages
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The Short Run
Nominal wage rate is fixed in short-run
We assume that changes in output have no
effect on nominal wage rate in short-run
Since we assume a constant nominal wagein short-run, a change in output will affect
unit costs through the other two factors
In short-run, a rise (fall) in real GDP, by causingunit costs to increase (decrease), will also cause
a rise (decrease) in price level
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Deriving the Aggregate Supply Curve
Figure 5 summarizes discussion about effect ofoutput on price level in short-run
Each time we change level of output, there will be anew price level in short-run
Giving us another point on the figure
If we connect all of these points, we obtain economysaggregate supply curve
Tells us price level consistent with firms unit costs and theirpercentage markup at any level of output over short-run
A more accurate name for AS curve would beshort-run-price-level-at-each-output-level curve
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Figure 5: The Aggregate Supply Curve
Price Level
Real GDP ($ Trillions)
130
100
80C
AS
13.5106
A
B
Starting at point A,anincrease in outputraises unit costs.
Firms raise prices,and the overall pricelevel rises.
Starting at point A, a decrease
in output lowers unit costs.Firms cut prices, and theoverall price level falls.
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Movements Along the AS Curve
When a change in output causes price level to
change, we move along economys AS curve
What happens in economy as we make such a
move?
As we move upward along AS curve, we can
represent what happens as follows
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Shifts of the AS Curve
Figure 5 assumed that a number ofimportant variablesremained unchanged Unit costs sometimes change for reasons other than a change in
output
In general, we distinguish between a movement along AS
curve, and a shift ofcurve itself, as follows When a change in real GDP causes the price level to change, wemove along AS curve
When anything other than a change in real GDP causes price level tochange, AS curve itself shifts
What can cause unit costs to change at any given level of
output? Changes in world oil prices
Changes in the weather
Technological change
Nominal wage, etc.
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Figure 7(a): Effects of Key Changes on
the Aggregate Supply Curve
(a)
Real GDP
Price Level
P3
Q2 Q1 Q3
P1
P2
AS
Real GDP movesus rightward alongthe AScurve
Real GDP movesus leftward alongthe AScurve
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Figure 7(b): Effects of Key Changes on
the Aggregate Supply Curve
Real GDP
Price Level
(b)
AS1
AS2
Entire AScurve shifts
upwardif un
it
costs forany reason besides an
increase in real GDP
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Figure 7(c): Effects of Key Changes on
the Aggregate Supply Curve
Real GDP
Price Level
(c)
AS1AS2
EntireAScurve shiftsdownward if unit costs for any reason besidesan decrease in real GDP
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Figure 8: Short-Run Macroeconomic
Equilibrium
Price Level
Real GDP ($ Trillions)
140
100
AS
106 14
E
B
AD
F
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What Happens When Things Change?
Our short-run equilibrium will change when eitherAD curve, AS curve, orboth, shift An event that causes AD curve to shift is called a
demand shock
An event that causes AS curve to shift is called a supplyshock
Earlier weve used phrase spending shock A change in spending by one or more sectors that
ultimately affe
cts ent
ire e
conomy Demand shocks and supply shocks are just two different
categories of spending shocks
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An Increase in Government Purchases
Shifts AD curve rightward
Can see how it affects economy in short-run
Process weve just des
cr
ibed
is not ent
irelyrealistic
Assumes that when government purchases rise,
first output increases, and then price level rises
In reality, output and price level tend to rise
together
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Figure 9: The Effect of a Demand
Shock
Price Level
Real GDP($ Trillions)
100
130
AS
10
12.5
13.5
E
J
H
AD1
AD2
115
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An Increase in Government Purchases
Can summarize impact of price-level changes
When government purchases increase, horizontal shift of AD curve
measures how much real GDP would increase if price level
remained constant
But because price level rises, real GDP rises by less than horizontalshift in AD curve
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An Decrease in Government Purchases
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An Increase in the Money Supply
Although monetary policy stimulates economy
through a different channel than fiscal policy
Once we arrive at AD and AS diagram, two look very
much alike
Can represent situation as follows
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An Example: The Great Depression
U.S. economy collapsed far more seriously during
1929 through 1933the onset of the Great
Depressionthan it did at any other time
What do we know about demand sho
cks that
caused Great Depression?
Fall of1929, bubble of optimism burst
Stock market crashed, and investment and consumption
spending plummeted
Demand for products exported by United States fell
Fed reacted by cutting money supply sharply
Each of these events contributed to a leftward shift of AD curve Causing both output and price level to fall
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Demand Shocks: Adjusting to the
Long-Run In Figure 9, point H shows new equilibrium after a
positive demand shock in short-runa year or soafter the shock But point H is not necessarily where economy will end up
in long-run In short-run, we treat wage rate as given
But in long-run, wage rate can change
When output is above full employment, wage rate will
rise, sh
ift
ing AS
curve upward
When output is below full employment, wage rate will fall,shifting AS curve downward
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Demand Shocks: Adjusting to the Long
Run Increase in government purchases has no effect on
equilibrium GDP in long-run
Economy returns to full employment, which is just where
it started
This is why long-run adjustment process is often called
economys self-correcting mechanism
If a demand shock pulls economy away from full
employment
Change in wage rate and price level will eventually cause
economy to correct itself and return to full-employment
output
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Figure 10: The Long-Run Adjustment
Process
Price Level
Real GDP
P2
P3
P4
P1
YFEY3 Y2
H
E
AS2
AS1
AD2
AD1
J
K
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Demand Shocks: Adjusting to the Long
Run For a positive demand shock that shifts AD curve
rightward, self-correcting mechanism works like
this
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Figure 11: Long-Run Adjustment After
a Negative Demand Shock
Price Level
Real GDP
P2
AS1
P1
P3
YFEY2
AS2
AD2
AD1
E
M
N
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Demand Shocks: Adjusting to the Long
Run Complete sequence of events after a negative
demand shock looks like this
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Demand Shocks: Adjusting to the Long
Run Can summarize economys self-correcting
mechanism as follows Whenever a demand shock pulls economy away from full
employment
Self-correcting mechanism will eventually bring it back When output exceeds its full-employment level, wages
will eventually rise Causing a rise in price level and a drop in GDP until full
employment is restored
When output is less than its full employment level wageswill eventually fall Causing a drop in price level and a rise in GDP until full
employment is restored
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The Long-Run Aggregate Supply Curve
Self-correcting mechanism provides an important link
between economys long-run and short-run behaviors
Long-run aggregate supply curve also illustrates another
classical conclusion
An increase in government purchases causes complete crowding out Rise in government purchases is precisely matched by a drop in
consumption and investment spending
Leaving total output and total spending unchanged
Self-correcting mechanism shows that, in long-run,
economy will eventually behave as classical model predicts Notice the word eventually in the previous statement
This is why governments around the world are reluctant to rely on
self-correcting mechanism alone to keep economy on track
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Figure 12: The Long-Run Aggregate
Supply Curve
Price Level
Real GDPYFE
E
M
AD1
AD3
K
Long-RunASCurve
AD2
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Short-Run Effects of Supply Shocks
Figure 13 shows an example of a supply shock An increase in world oil prices that shifts aggregate supply curve
upward, from AS1 and AS2 Called negative supply shock, because of negative effect on output
In short-run a negative supply shock shifts AS curve upward, decreasingoutput and increasing price level
Notice sharp contrast between effects of negative supplyshocks and negative demand shocks in short-run Economists and journalists have coined term stagflation to describe
a stagnating economy experiencing inflation A negative supply shock causes stagflation in short-run
Examples of positive supply sho
cks
in
clude unusually goodweather, a drop in oil prices, and a technological change
that lowers unit costs In addition, a positive supply shock can sometimes be caused by
government policy
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Figure 13: The Effect of Supply Shocks
Price Level
Real GDP
P2
P1
YFEY2
E
AS2
AS1
AD
R
Long-RunASCurve
AS3
T
P2
Y3
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Long-Run Effects of Supply Shocks
What about effects of supply shocks in long-run?
In some cases, we need not concern ourselves with this
question, because some supply shocks are temporary
In othercases, however, a supply shock can last
for an extended period
In long-run, economy self-corrects after a supply
shock, just as it does after a demand shock
When output differs from its full-employment level Wage rate changes
AS curve shifts until full employment is restored
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Using the Theory: The Recession of
1990-91
Story of1990-91 recession begins in mid-
1990, when Iraq invaded Kuwait
During this conflict, Kuwaits oil was taken off
world market, as was Iraqs Reduction in oil supplies resulted in a rapid and
substantial increase in price of oil
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Using the Theory: The Recession of
2001
Story of2001 recession was quite different This time, there was no spike in oil prices and no other significant
supply shock to plague economy
Rather, there was a demand shock, and a Federal Reserve policyduring the yearbefore the recession that might have made it a bitworse
During late 1990s, Fed had become concerned thatinvestment boom and consumer optimism were shifting ADcurve rightward too rapidly Creating a danger that we would overshoot potential GDP and set off
higherinflation
Fed responded by tightening money supply and raising interest rate
Effects of this policy may have continued into early 2001,exacerbating decrease in investment that was occurring for otherreasons
In this way, rate hikes themselves may have contributed to a furtherleftward shift of AD curve
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Figure 14(a): An AD and AS analysis
of Two Recessions
P2
AS199
0
P1
YFEY2
Price Level
Real GDP
AD1990
E
R
(a)
AS1991
1. In 1990, a supply shock fromhigher oil prices shifted theAScurve leftward ...
2. causing outputto fall ...
3. and the pricelevel to rise.
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Figure 14(b): An AD and AS analysis
of Two Recessions
YFEY2
AS2000
AD2000
AD2001
ER
(b)4. In 2001, a demand shock from
several factors caused the ADcurve to shift leftward ...
5. causing outputto fall ...
Price Level
Real GDP
P2
P1
6. and the pricelevel to fall.
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Figure 15(a/b): GDP and the Price
Level in Two Recessions
The 1990-91 Recession
(b)(a)
140
135
130
120
125
CPI
1989:3 1990:2 1991:1
Year and QuarterYear and Quarter
1989:3 1990:2 1991:1
6.75
6.
72
6.66
6.60
6.69
6.63
R
ealGDP
($Trillions)
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Figure 15(c/d): GDP and the Price
Level in Two Recessions
(d)
178
176
174
172
2000:1 2001:1
9.35
9.30
9.20
9.10
9.25
9.15
(c)
Year and Quarter
R
ealGDP
($Trillions)
2000:1 2001:1
Year and Quarter
CPI
The 2001 Recession
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Using the Theory: Jobless Expansions
After a recession, economy enters expansion phase ofbusiness cycle Employment usually grows rapidly during this period as well
But in our two most recent recessions, economy experienced abnormal,prolonged periods during which employment did not grow at all
Figure 16illustrates behavior of employment during our two most recentrecession
Called trough of recession Vertical axis shows an employment indexemployment divided by
employment at the trough
Blue line shows that employment falls during the contraction phase ofaverage cycle Rises rapidly during the first year of the expansion phase
But red and pink lines show what happened in first year of our mostrecent expansionsduring 1992 and 2002 In both cases, employment drifted slightly downward, telling us that total
number of jobs decreased during year
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Figure 16: The Average Expansion
Versus Two Recent Jobless Expansions
EmploymentIndex
(Trough = 1)
-6 -4 -2 0 +2 +4 +6
Months Before and After the Trough
+8
0.99
1.00
1.01
1.02
1.03
1.04
+10 +12
After Average
Rec
essi
on
After2001Recession
After1991Recession
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Explaining Jobless Expansions
Since story is similar forboth of these expansions,lets focus on period from late 2001 to late 2002the first year of expansion after our most recentrecession Using equation for economic growth
Real GDP = productivity x average hours x (emp/pop) xpopulation
But equation can be used in different ways Now were using equation to account for deviations in
employment away from full employment in short-run
For this purpose, well need to make someadjustments to equation Real GDP = productivity x average hours x employment
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Explaining Jobless Expansions
Lets convert equation to percentagechanges
% real GDP = % productivity + %employment
Finally, rearranging
% employment (-0.3%) = % real GDP (2.9%) -% productivity (3.2%)
Numbers in parentheses show actualpercentage changes for each of thesevariables during 2002
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Explaining Jobless Expansions
Why didnt real GDP growth keep up with productivity? Because growth in real GDP was unusually low
Productivity grew at about the same rate as average expansion, inspite of the low growth in output
Throughout period, firms were reluctant to hire full-time, permanentworkers
Created uncertainty about strength and duration of expansion Instead, business expanded output by hiring part-time and temporary
workers
Why would this boost productivity? Enabled firms to adjust their workforce more easily to fluctuations in
production
Phrase jobless expansion refers to just part of expansionphase Eventually, employment catches upeven to higher levels of output
made possible by productivity growth