Chapter 13: Aggregate Demand and Aggregate Supply

Chapter 13:Aggregate Demand and

Aggregate Supply

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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 change of businesses and consumers

Expectations about the future A change in Real Wealth. . A change in Consumer Debt. *A change in Taxes or Government Spending.

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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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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 change in resource costs such as wages,

rent, and interest. Unexpected supply shocks such as a change

in weather or in the world price of a key imported resource.

*A change in Taxes or Government Spending

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Shifts in Short Run Aggregate Supply


Price level

SRAS1 SRAS2

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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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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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Shifts in Long Run Aggregate Supply

Factors that change LRAS: A change in the supply of resources. A change in technology and

productivity. Institutional changes that change the

efficiency of resource use such as trade agreements.

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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 Long RunAggregate Supply

LRAS2

YF,2

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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 costs 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


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 higher than the natural rate.

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LRAS


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


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


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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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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LRAS1


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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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


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 13

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Chapter 13: Aggregate Demand and Aggregate Supply