Aggregate demand (2)

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Exploring EconomicsExploring Economics33rdrd Edition Edition

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A Lecture PresentationA Lecture Presentation


Aggregate DemandAggregate Demandandand

Aggregate SupplyAggregate Supply

Chapter 21Chapter 21


21.1 The Determinants of21.1 The Determinants of Aggregate Demand Aggregate Demand

Aggregate Demand (AD)Aggregate Demand (AD) is the is the sum of the demand for all goods and sum of the demand for all goods and services in the economy. It can also services in the economy. It can also be seen as the quantity of real GDP be seen as the quantity of real GDP demanded at different price levels.demanded at different price levels. Aggregate Demand (Aggregate Demand (ADAD) = ) =

Consumption (Consumption (CC) + Investment () + Investment (II) + ) + Government purchases (Government purchases (GG) + ) + Net Exports (Net Exports (X X – – MM).).


Consumption (Consumption (CC))

Consumption is by far the largest Consumption is by far the largest component of component of ADAD, typically almost 70 , typically almost 70 percent of total economic activity, percent of total economic activity, measured by GDP. measured by GDP.

Understanding the determinants of Understanding the determinants of consumption is critical to an consumption is critical to an understanding of the forces leading to understanding of the forces leading to changes in aggregate demand, which in changes in aggregate demand, which in turn, change total output and income.turn, change total output and income.


The higher a nation’s income, the more it The higher a nation’s income, the more it spends on consumption. spends on consumption.

For individuals, consumption increases For individuals, consumption increases with after-tax, or with after-tax, or disposable incomedisposable income. .

Consumption is also influenced by other Consumption is also influenced by other factors.factors. the “lumpiness” of some goods’ purchases, the “lumpiness” of some goods’ purchases,

such as cars such as cars interest ratesinterest rates

At higher real interest rates, consumers save At higher real interest rates, consumers save more and consume less.more and consume less.


Looking at the economy as a whole, Looking at the economy as a whole, we have many groups of people with we have many groups of people with many different expectations (for many different expectations (for present versus lifetime incomes). present versus lifetime incomes).

So for the economy as a whole, So for the economy as a whole, consumption is closely related to consumption is closely related to current income.current income.


Households typically spend a large Households typically spend a large portion of their total disposable portion of their total disposable income, and save the rest.income, and save the rest.

Average propensity to consume Average propensity to consume (APC)(APC) the fraction of total disposable income the fraction of total disposable income

that households spend on that households spend on consumptionconsumption


Marginal propensity to consume Marginal propensity to consume (MPC)(MPC) the additional consumption that the additional consumption that

results from an additional dollar of results from an additional dollar of disposable incomedisposable income


Investment (Investment (II))

Because investment spending is an Because investment spending is an important component of aggregate important component of aggregate demand, which in turn is a demand, which in turn is a determinant of the level of GDP, determinant of the level of GDP, changes in investment spending are changes in investment spending are often responsible for changes in the often responsible for changes in the level of economic activity.level of economic activity.


Government Purchases (Government Purchases (GG))

Government purchases, another Government purchases, another component of aggregate demand, is component of aggregate demand, is spending by the federal, state, and spending by the federal, state, and local governments on the purchases local governments on the purchases of new goods and services produced.of new goods and services produced.


Net Exports (Net Exports (X – MX – M))

The interaction of the U.S. economy The interaction of the U.S. economy with the rest of the world is becoming with the rest of the world is becoming increasingly important.increasingly important.

International trade must be International trade must be incorporated into the framework, and incorporated into the framework, and models that include the effects of it models that include the effects of it are called are called open economyopen economy models. models.


Exports and imports can alter Exports and imports can alter aggregate demand.aggregate demand.

Exports minus imports is what we call Exports minus imports is what we call net exportsnet exports..

The impact of net exports on The impact of net exports on aggregate demand is similar to the aggregate demand is similar to the impact of government purchases on impact of government purchases on aggregate demand.aggregate demand.


21.2 The Aggregate Demand 21.2 The Aggregate Demand Curve Curve

The The aggregate demand curveaggregate demand curve reflects the total amounts of real reflects the total amounts of real goods and services that all groups goods and services that all groups together want to purchase in a given together want to purchase in a given time period. time period.

It indicates the quantities of real GDP It indicates the quantities of real GDP (RGDP) demanded at different price (RGDP) demanded at different price levels.levels.


ADAD is different than the demand is different than the demand curve presented in Chapter 4, which curve presented in Chapter 4, which looked at the relationship between looked at the relationship between the relative price of a good and the the relative price of a good and the quantity demanded.quantity demanded.


How is the Quantity of Real GDP How is the Quantity of Real GDP Demanded Affected by the Price Level?Demanded Affected by the Price Level?

The The ADAD curve slopes downward, curve slopes downward, which means that there is an inverse which means that there is an inverse (or opposite) relationship between the (or opposite) relationship between the price level and real gross domestic price level and real gross domestic product (RGDP) demanded.product (RGDP) demanded.


An increase in the price level causes An increase in the price level causes RGDP demanded to fall. RGDP demanded to fall.

Conversely, if there is a reduction in Conversely, if there is a reduction in the price level, the quantity of RGDP the price level, the quantity of RGDP demanded rises.demanded rises.



Why is the Aggregate Demand Why is the Aggregate Demand Curve Negatively Sloped?Curve Negatively Sloped?

Three complementary explanations Three complementary explanations exist for the negative slope of the exist for the negative slope of the aggregate demand curve: aggregate demand curve: the real wealth effectthe real wealth effect the interest rate effectthe interest rate effect the open economy effectthe open economy effect


The real wealth effect The real wealth effect The real (adjusted for inflation) value of any The real (adjusted for inflation) value of any

asset of fixed dollar value, like cash, falls as asset of fixed dollar value, like cash, falls as the price level increases. the price level increases.

People’s real wealth is reduced, reducing their People’s real wealth is reduced, reducing their planned purchases of goods and services, and planned purchases of goods and services, and lowering the quantity of RGDP demanded. lowering the quantity of RGDP demanded.

If the price level falls, people’s real wealth in If the price level falls, people’s real wealth in such forms will increase, increasing the such forms will increase, increasing the quantity of RGDP demanded. quantity of RGDP demanded.

The Real Wealth EffectThe Real Wealth Effect


The real wealth effect can be The real wealth effect can be summarized as: summarized as: A higher price level A higher price level �� reduced real reduced real

wealth wealth �� reduced purchasing power reduced purchasing power �� reduced RGDP demandedreduced RGDP demanded

A lower price level A lower price level �� increased real increased real wealth wealth �� greater purchasing power greater purchasing power �� increased RGDP demanded.increased RGDP demanded.


If the price level falls, households and If the price level falls, households and firms will need less money to conduct firms will need less money to conduct their daily activities. At a lower price their daily activities. At a lower price level, households and firms will shift level, households and firms will shift their “excess” money into bonds or their “excess” money into bonds or saving accounts increasing the supply saving accounts increasing the supply of funds to the loanable funds market of funds to the loanable funds market and interest rates would fall.and interest rates would fall.

The Interest Rate EffectThe Interest Rate Effect


As interest rates fall, households will As interest rates fall, households will borrow more and buy more goods borrow more and buy more goods and services, thus the quantity of and services, thus the quantity of RGDP demanded will increase. RGDP demanded will increase.


If the price level rises, households If the price level rises, households and firms will need to hold more and firms will need to hold more money to buy goods and services and money to buy goods and services and conduct their daily activities. conduct their daily activities. Households and firms will need to Households and firms will need to borrow money and this increased borrow money and this increased demand for loanable funds results in demand for loanable funds results in higher interest rates. higher interest rates.


At higher interest rates consumers At higher interest rates consumers may give up plans to buy new cars or may give up plans to buy new cars or houses and firms may delay houses and firms may delay investments in plant and equipment.investments in plant and equipment.

That is, as households and firms are That is, as households and firms are discouraged from borrowing RGDP discouraged from borrowing RGDP demanded decreases.demanded decreases.


Many goods and services are bought Many goods and services are bought and sold in global markets. and sold in global markets.

If the prices of goods and services in If the prices of goods and services in the domestic market rise relative to the domestic market rise relative to those in global markets due to a those in global markets due to a higher domestic price level, higher domestic price level, consumers and businesses will buy consumers and businesses will buy more from foreign producers and less more from foreign producers and less from domestic producers.from domestic producers.

The Open Economy EffectThe Open Economy Effect


Because real GDP is a measure of Because real GDP is a measure of domestic output, the reduction in the domestic output, the reduction in the willingness of consumers to buy from willingness of consumers to buy from domestic producers leads to a lower domestic producers leads to a lower level of real GDP demanded at the level of real GDP demanded at the higher domestic price level. higher domestic price level.

And if domestic prices of goods and And if domestic prices of goods and services fall relative to foreign prices, services fall relative to foreign prices, more domestic products will be bought, more domestic products will be bought, increasing RGDP demanded.increasing RGDP demanded.


The open economy effect can be The open economy effect can be summarized as:summarized as: An increased price level An increased price level �� decreases the decreases the

demand for domestic goods demand for domestic goods �� decreases decreases RGDP demanded.RGDP demanded.

A decreased price level A decreased price level �� increases the increases the demand for domestic goods demand for domestic goods �� increases increases RGDP demanded.RGDP demanded.


21.3 Shifts in the Aggregate 21.3 Shifts in the Aggregate Demand Curve Demand Curve

As in the supply and demand curves of As in the supply and demand curves of Chapter 4, there can be both shifts in Chapter 4, there can be both shifts in and movements along the and movements along the ADAD curve. curve.

The real wealth effect, the interest rate The real wealth effect, the interest rate effect, and the open (or foreign) economy effect, and the open (or foreign) economy effect result in the downward slope of the effect result in the downward slope of the AD curve (not a shift in AD).AD curve (not a shift in AD). Each of these factors generates a movement Each of these factors generates a movement

along the AD curve because the general price along the AD curve because the general price level changed.level changed.


Shifts Versus Movements Along Shifts Versus Movements Along the Aggregate Demand Curvethe Aggregate Demand Curve

The whole AD curve can shift to the The whole AD curve can shift to the right or left.right or left. If some non-price level determinant If some non-price level determinant

causes total spending to increase, then causes total spending to increase, then the the ADAD curve will shift to the right. curve will shift to the right.

If a non-price level determinant causes If a non-price level determinant causes the level of total spending to decline, the level of total spending to decline, then the then the ADAD curve will shift to the left. curve will shift to the left.



Aggregate Demand Curve ShiftersAggregate Demand Curve Shifters

Anything that changes the amount Anything that changes the amount of total spending in the economy of total spending in the economy (holding price levels constant) will (holding price levels constant) will impact the impact the ADAD curve. curve. An increase in any component of GDP An increase in any component of GDP

((CC, , II, , GG, and , and XX – – MM) can cause the ) can cause the ADAD curve to shift rightward. curve to shift rightward.

Conversely, decreases in Conversely, decreases in CC, , II, , GG, or , or X – X – MM will shift will shift ADAD leftward. leftward.


A whole host of changes could impact A whole host of changes could impact consumption patterns. consumption patterns. shift shift ADAD to the right to the right

an increase in consumer confidence, an increase in consumer confidence, an increase in wealth an increase in wealth a tax cut a tax cut an increase in population an increase in population

shift shift ADAD to the left to the left consumers expect a recession consumers expect a recession a tax increase a tax increase


Since consuming less is saving more, Since consuming less is saving more, an increase in savings, an increase in savings, ceteris ceteris paribus,paribus, would shift would shift ADAD to the left. to the left. Consumer debt may also be a reason Consumer debt may also be a reason why some consumers might put off why some consumers might put off additional spending.additional spending.


Increases in demand for investment goods, Increases in demand for investment goods, an important determinant of an important determinant of ADAD, occur for , occur for a variety of reasons.a variety of reasons. ADAD will shift to the right (business investment will shift to the right (business investment

increases) increases) business confidence increases business confidence increases real interest rates fall real interest rates fall business taxes reducedbusiness taxes reduced

ADAD will shift to the left will shift to the left real interest rates rise real interest rates rise business taxes risebusiness taxes rise


Government purchases is also part Government purchases is also part of total spending and therefore must of total spending and therefore must impact impact ADAD. .

An increase in government purchases, An increase in government purchases, other things equal, shifts other things equal, shifts ADAD to the to the right, while a reduction shifts right, while a reduction shifts ADAD to to the left.the left.


Global markets are also important Global markets are also important in a domestic economy.in a domestic economy.

If major trading partners are If major trading partners are experiencing economic slowdowns, experiencing economic slowdowns, then they will demand fewer U.S. then they will demand fewer U.S. imports.imports.

This causes net exports (This causes net exports (X X – – MM) to ) to fall, shifting fall, shifting ADAD to the left. to the left.


Alternatively, an economic boom in Alternatively, an economic boom in the economies of major trading the economies of major trading partners may lead to an increase in partners may lead to an increase in our exports to them, causing net our exports to them, causing net exports (exports (X X – – MM) to rise and ) to rise and ADAD to to increase. increase.


21.4 The Aggregate Supply 21.4 The Aggregate Supply Curve Curve

The The aggregate supply (AS) curveaggregate supply (AS) curve is the relationship between the total is the relationship between the total quantity of final goods and services quantity of final goods and services that suppliers are willing and able to that suppliers are willing and able to produce and the overall price level.produce and the overall price level.

The aggregate supply curve The aggregate supply curve represents how much RGDP suppliers represents how much RGDP suppliers will be willing to produce at different will be willing to produce at different price levels.price levels.


What is the Aggregate Supply What is the Aggregate Supply Curve?Curve?

In fact, there are two aggregate In fact, there are two aggregate supply curves:supply curves: Short-run aggregate supply (SRAS)Short-run aggregate supply (SRAS)

a period when output can change in response a period when output can change in response to supply and demand, but input prices have to supply and demand, but input prices have not yet been able to adjust not yet been able to adjust

for example, nominal wages are assumed to adjust for example, nominal wages are assumed to adjust slowly in the short runslowly in the short run

Long-run aggregate supply (LRAS)Long-run aggregate supply (LRAS) a period long enough for the prices of outputs a period long enough for the prices of outputs

and all inputs to fully adjust to changes in the and all inputs to fully adjust to changes in the economyeconomy


Why is the Short-Run Aggregate Why is the Short-Run Aggregate Supply Curve Positively Sloped?Supply Curve Positively Sloped?

In the short run, the aggregate In the short run, the aggregate supply curve is upward sloping. supply curve is upward sloping. At higher price levels, producers are At higher price levels, producers are

willing to supply more real output. willing to supply more real output. At lower price levels, they are willing At lower price levels, they are willing

to supply less real output. to supply less real output.



Why would producers be willing to Why would producers be willing to supply more output just because supply more output just because the price level increases? the price level increases?

There are two possible explanations. There are two possible explanations. profit effect profit effect misperception effectmisperception effect


To many firms, input costs like wages To many firms, input costs like wages and rents are relatively constant in the and rents are relatively constant in the short run. short run.

The slow adjustments of input prices The slow adjustments of input prices are due to the longer-term input contracts are due to the longer-term input contracts that do not adjust quickly that do not adjust quickly to price changes. to price changes.

So when the price level rises, output prices So when the price level rises, output prices rise relative to input prices rise relative to input prices (costs), raising producers’ short-run (costs), raising producers’ short-run profit margins. profit margins.


These increased profit margins make it These increased profit margins make it in the producers’ self-interest to expand in the producers’ self-interest to expand their production and sales at higher price their production and sales at higher price levels. levels.

If the price level falls, output prices fall If the price level falls, output prices fall and producers’ profits tend to fall. and producers’ profits tend to fall.

When output prices fall, producers will find When output prices fall, producers will find it more difficult to cover their input costs, it more difficult to cover their input costs, and consequently, will reduce their level of and consequently, will reduce their level of output.output.


The second explanation of the upward-The second explanation of the upward-sloping short-run aggregate supply sloping short-run aggregate supply curve is that producers can be fooled by curve is that producers can be fooled by price changes in the short run. price changes in the short run.

If a producer sees the price of his output If a producer sees the price of his output rising and thinks that the rising and thinks that the relative pricerelative price of his output is rising (i.e., that his of his output is rising (i.e., that his product is becoming more valuable in product is becoming more valuable in real terms), he will supply more. real terms), he will supply more.


It might be that it was not just his goods It might be that it was not just his goods prices that were rising; the prices of many prices that were rising; the prices of many other goods and services could also be other goods and services could also be rising at the same time as a result of an rising at the same time as a result of an increase in the price level. increase in the price level.

The relative price of his output, then, was The relative price of his output, then, was not actually rising, although it appeared so not actually rising, although it appeared so in the short run. in the short run.

In this case, the producer was fooled into In this case, the producer was fooled into supplying more based on his short-run supplying more based on his short-run misperception of relative prices. misperception of relative prices.


Why is the Long-Run Aggregate Why is the Long-Run Aggregate Supply Curve Vertical?Supply Curve Vertical?

Along the short-run aggregate supply Along the short-run aggregate supply curve, we assume that wages and curve, we assume that wages and other input prices are constant.other input prices are constant.

This is not the case in the long run, This is not the case in the long run, which is a period long enough for the which is a period long enough for the price of all inputs to fully adjust to price of all inputs to fully adjust to changes in the economy. changes in the economy.


Along the long-run aggregate supply Along the long-run aggregate supply curve, we are looking at the curve, we are looking at the relationship between RGDP produced relationship between RGDP produced and the price level, once input prices and the price level, once input prices have been able to respond to changes have been able to respond to changes in output prices. in output prices.


Along the Along the LRASLRAS curve, two sets of curve, two sets of prices are changing the prices of prices are changing the prices of outputs and the price of inputs.outputs and the price of inputs.

Along the Along the LRASLRAS curve, a 10 percent curve, a 10 percent increase in the price of goods and increase in the price of goods and services is matched by a 10 percent services is matched by a 10 percent increase in the price of inputs.increase in the price of inputs.


The long-run aggregate supply curve The long-run aggregate supply curve is insensitive to the price level, is insensitive to the price level, reflecting the fact that the level of reflecting the fact that the level of RGDP producers are willing to supply RGDP producers are willing to supply is not affected by changes in the price is not affected by changes in the price level. level.


The vertical The vertical LRASLRAS curve will always curve will always be positioned at the natural rate of be positioned at the natural rate of output, where all resources are fully output, where all resources are fully employed. employed.

In the long run, firms will always In the long run, firms will always produce at the maximum sustainable produce at the maximum sustainable level allowed by their capital, labor, level allowed by their capital, labor, and technological inputs, regardless and technological inputs, regardless of the price level.of the price level.



The long-run equilibrium level is The long-run equilibrium level is where the economy will settle when where the economy will settle when undisturbed, and all resources are undisturbed, and all resources are fully employed. fully employed.


The economy will always be at the The economy will always be at the intersection of intersection of ASAS and and ADAD but that but that will not always be at the natural rate will not always be at the natural rate of output.of output.

Long-run equilibrium will only occur Long-run equilibrium will only occur where where ASAS and and ADAD intersect along the intersect along the long-run aggregate supply curve at long-run aggregate supply curve at the natural, or potential, rate of the natural, or potential, rate of output.output.


21.5 Shifts in the Aggregate21.5 Shifts in the Aggregate Supply Curve Supply Curve

The underlying determinant of shifts The underlying determinant of shifts in short-run aggregate supply is in short-run aggregate supply is production costs. production costs. Ceteris paribus,Ceteris paribus, lower production costs lower production costs

will motivate producers to produce more will motivate producers to produce more at any given price level, shifting at any given price level, shifting ASAS rightward.rightward.

Higher production costs will motivate Higher production costs will motivate producers to produce less at any given producers to produce less at any given price level, shifting price level, shifting ASAS leftward. leftward.


Shifting Short-Run and Long-Shifting Short-Run and Long-Run Supply CurvesRun Supply Curves

Any change in the quantity of any Any change in the quantity of any factor of production available capital, factor of production available capital, entrepreneurship, land, or labor can entrepreneurship, land, or labor can cause a shift in both the long-run and cause a shift in both the long-run and short-run aggregate supply curves.short-run aggregate supply curves. An increase in any of these factors can An increase in any of these factors can

shift both the shift both the LRASLRAS and and SRASSRAS curves to curves to the right.the right.

A decrease in any of these factors can A decrease in any of these factors can shift both the shift both the LRASLRAS and and SRASSRAS curves to curves to the left.the left.



Changes in the stock of capital will Changes in the stock of capital will alter the amount of goods and alter the amount of goods and services the economy can produce. services the economy can produce.

Investing in capital improves the Investing in capital improves the quantity and quality of the capital quantity and quality of the capital stock. stock.


More and better quality capital will More and better quality capital will lower the costs of production in the lower the costs of production in the short run, shifting the short-run short run, shifting the short-run aggregate supply curve rightward, aggregate supply curve rightward, and allow output to be permanently and allow output to be permanently greater than before, shifting the greater than before, shifting the LRASLRAS curve rightward, curve rightward, ceteris ceteris paribus.paribus.


Changes in human capital can also Changes in human capital can also alter the aggregate supply curve.alter the aggregate supply curve.

Investments in human capital may Investments in human capital may include educational or vocational include educational or vocational programs or on-the-job training. programs or on-the-job training.

All of these investments in human All of these investments in human capital would cause productivity to capital would cause productivity to rise. rise.


As a result, the short-run aggregate As a result, the short-run aggregate supply curve would shift to the right supply curve would shift to the right because a more skilled workforce will because a more skilled workforce will lower the costs of production, and the lower the costs of production, and the LRASLRAS curve would shift to the right curve would shift to the right because greater output is achievable because greater output is achievable on a permanent, or sustainable, on a permanent, or sustainable, basis, basis, ceteris paribus.ceteris paribus.


Through their inventive activity, Through their inventive activity, entrepreneurs lower costs and expand entrepreneurs lower costs and expand real output possibilities. real output possibilities.

If entrepreneurial activities lower the If entrepreneurial activities lower the costs of production and expand what costs of production and expand what can be produced with the resources can be produced with the resources available to the economy, then the available to the economy, then the short-run and long-run aggregate short-run and long-run aggregate supply curves both shift to the right.supply curves both shift to the right.


LandLand is an all-encompassing definition that is an all-encompassing definition that includes all natural resources.includes all natural resources. An increase in usable natural resources, such An increase in usable natural resources, such

as successful oil exploration, would lower the as successful oil exploration, would lower the costs of production and expand the economy’s costs of production and expand the economy’s sustainable rate of output, shifting both sustainable rate of output, shifting both SRASSRAS and and LRASLRAS to the right. to the right.

A decrease in the amount of natural resources A decrease in the amount of natural resources available would result in a leftward shift of available would result in a leftward shift of both both SRASSRAS and and LRASLRAS. (OPEC is the prime . (OPEC is the prime example.)example.)


The addition of workers to the labor The addition of workers to the labor force, force, ceteris paribus,ceteris paribus, can increase can increase aggregate supply.aggregate supply. women and baby boomers during the women and baby boomers during the

1960s. 1960s. It tends to depress wages and It tends to depress wages and

increase short-run aggregate supply, increase short-run aggregate supply, ceteris paribus. ceteris paribus.


An expanded labor force also increases An expanded labor force also increases the economy’s potential output, the economy’s potential output, increasing increasing LRASLRAS. Increases or decreases . Increases or decreases in labor productivity will also affect the in labor productivity will also affect the aggregate supply curve. aggregate supply curve.

Lower output per worker causes Lower output per worker causes production costs to rise and potential production costs to rise and potential real output to fall, resulting in a leftward real output to fall, resulting in a leftward shift in both shift in both SRASSRAS and and LRASLRAS. .


Increases in government regulations can Increases in government regulations can make it more costly for producers; this make it more costly for producers; this increase in production costs results in a increase in production costs results in a leftward shift of leftward shift of SRASSRAS, and the , and the reduction in society’s potential output reduction in society’s potential output would shift would shift LRASLRAS left as well. left as well.

A reduction in government regulations A reduction in government regulations on businesses would lower the costs of on businesses would lower the costs of production and expand potential real production and expand potential real output, causing both output, causing both SRASSRAS and and LRASLRAS to to shift to the right.shift to the right.


What Factors Shift Short-Run What Factors Shift Short-Run Aggregate Supply Only?Aggregate Supply Only?

Some factors shift Some factors shift SRASSRAS but do not but do not impact impact LRASLRAS..

The most important of these factors The most important of these factors are changes in input prices and are changes in input prices and natural disasters.natural disasters. The price of factors, or inputs, that go The price of factors, or inputs, that go

into producing outputs will affect only into producing outputs will affect only SRASSRAS if they don’t reflect permanent if they don’t reflect permanent changes in the suppliers of some factors changes in the suppliers of some factors of production.of production.



If wages increase without a If wages increase without a corresponding increase in labor corresponding increase in labor productivity, then it will become more productivity, then it will become more costly for suppliers to produce goods costly for suppliers to produce goods and services at every price level, and services at every price level, causing causing SRASSRAS to shift to the left. to shift to the left.

LRASLRAS will not shift because with the will not shift because with the same supply of labor as before, same supply of labor as before, potential output does not change. potential output does not change.


If the price of steel rises, automobile If the price of steel rises, automobile producers will find it more expensive producers will find it more expensive to do business because their to do business because their production costs will rise, again production costs will rise, again resulting in a leftward shift in resulting in a leftward shift in SRASSRAS..

The The LRASLRAS will not shift as long as the will not shift as long as the capacity to make steel has not been capacity to make steel has not been reduced.reduced.



It is supply and demand in factor It is supply and demand in factor markets (like capital, land, and labor) markets (like capital, land, and labor) that cause input prices to change. that cause input prices to change.

The reason that changes in input The reason that changes in input prices only affect prices only affect SRASSRAS and not and not LRASLRAS, , unless they reflect permanent changes unless they reflect permanent changes in the supplies of those inputs, lies in in the supplies of those inputs, lies in our definition of long-run aggregate our definition of long-run aggregate supply. supply.


The The LRASLRAS curve is vertical at the curve is vertical at the natural level of real output, natural level of real output, determined by the supplies of the determined by the supplies of the various factors of production. various factors of production.

A fall in input prices, which shifts A fall in input prices, which shifts SRASSRAS right, only shifts right, only shifts LRASLRAS right if potential right if potential output has risen, and this only occurs output has risen, and this only occurs if the supply of those inputs is if the supply of those inputs is increased.increased.


Adverse supply shocks, such as natural Adverse supply shocks, such as natural disasters, can increase the costs of disasters, can increase the costs of production. production.

They could cause They could cause SRASSRAS to shift to the to shift to the left, left, ceteris paribus.ceteris paribus.

However, once the temporary effects However, once the temporary effects of these disasters have been felt, no of these disasters have been felt, no appreciable change in the economy’s appreciable change in the economy’s productive capacity has occurred, so productive capacity has occurred, so LRASLRAS doesn’t shift as a result. doesn’t shift as a result.



21.6 Macroeconomic21.6 Macroeconomic Equilibrium Equilibrium

The short-run equilibrium level of real The short-run equilibrium level of real output and the price level are output and the price level are determined by the intersection of the determined by the intersection of the aggregate demand curve and the aggregate demand curve and the short-run aggregate supply curve.short-run aggregate supply curve.

When this equilibrium occurs at the When this equilibrium occurs at the potential output level, on the long-run potential output level, on the long-run aggregate supply curve, the economy aggregate supply curve, the economy is operating at full employment.is operating at full employment.


RGDP


Determining Macroeconomic Determining Macroeconomic EquilibriumEquilibrium

Only a short-run equilibrium that is at Only a short-run equilibrium that is at potential output is also a long-run potential output is also a long-run equilibrium. equilibrium.

Short-run equilibrium can change when Short-run equilibrium can change when the aggregate demand curve shifts or the aggregate demand curve shifts or the short-run aggregate supply curve shifts the short-run aggregate supply curve shifts

rightward or leftward, rightward or leftward, but the long-run equilibrium level of RGDP but the long-run equilibrium level of RGDP

only changes when the only changes when the LRASLRAS curve shifts. curve shifts.


Sometimes, these supply or demand Sometimes, these supply or demand changes are anticipated; at other changes are anticipated; at other times, however, the shifts occur times, however, the shifts occur unexpectedly. Economists call these unexpectedly. Economists call these unexpected shifts unexpected shifts shocksshocks..


Recessionary and Recessionary and Expansionary GapsExpansionary Gaps

Short-run equilibrium can occur at Short-run equilibrium can occur at less than the potential output of less than the potential output of the economy, resulting in a the economy, resulting in a recessionary gaprecessionary gap..

Or it can temporarily occur beyond Or it can temporarily occur beyond potential output, resulting in an potential output, resulting in an expansionary gapexpansionary gap..



Demand-Pull InflationDemand-Pull Inflation

Demand-pull inflationDemand-pull inflation occurs when occurs when the price level rises as a result of an the price level rises as a result of an increase in aggregate demand.increase in aggregate demand.

The increase in The increase in ADAD causes an increase causes an increase in the price level and an increase in in the price level and an increase in real output, illustrated by a real output, illustrated by a movement up along the SRAS curve. movement up along the SRAS curve.

This causes an expansionary gap.This causes an expansionary gap.


The increase in output as a result of The increase in output as a result of the increase in the price level is a the increase in the price level is a result of its effect on producers result of its effect on producers profits; firms have an incentive to profits; firms have an incentive to increase real output when the prices increase real output when the prices of the goods they are selling are of the goods they are selling are rising faster than the costs of the rising faster than the costs of the inputs they use in production.inputs they use in production.



The short-run result of an increase The short-run result of an increase in in ADAD is a level of RGDP beyond full is a level of RGDP beyond full employment.employment.

The potential output is an The potential output is an expansionary gap. expansionary gap.


It seems peculiar that the economy It seems peculiar that the economy can operate beyond its potential, but can operate beyond its potential, but this is possible, temporarily, as firmsthis is possible, temporarily, as firms encourage workers to work overtimeencourage workers to work overtime extend the hours of part time workersextend the hours of part time workers hire recently retired employeeshire recently retired employees reduce frictional unemployment through reduce frictional unemployment through

more extensive searches for employeesmore extensive searches for employees


Short-run real output beyond potential Short-run real output beyond potential output (and employment beyond full output (and employment beyond full employment) cannot be sustained in the employment) cannot be sustained in the long run.long run.

In the expansionary gap situation, In the expansionary gap situation, because the price level is now higher, because the price level is now higher, workers (and other input suppliers) workers (and other input suppliers) become disgruntled with real wages that become disgruntled with real wages that have not yet adjusted to the new price have not yet adjusted to the new price level. level.


Recall that along the Recall that along the SRASSRAS curve, wages curve, wages and other input prices are assumed to be and other input prices are assumed to be constant. Therefore, workers and input constant. Therefore, workers and input suppliers purchasing power falls as output suppliers purchasing power falls as output prices rise. prices rise.

(If prices have risen, but wages have not (If prices have risen, but wages have not risen as much, real wages have fallen.) risen as much, real wages have fallen.) Because real (adjusted for inflation) Because real (adjusted for inflation) wages have fallen, workers and other wages have fallen, workers and other suppliers demand higher prices in order suppliers demand higher prices in order to supply their inputs.to supply their inputs.


As input prices respond to the higher As input prices respond to the higher level of output prices, the level of output prices, the SRASSRAS curve curve shifts to the left. shifts to the left.

Suppliers will continually seek higher Suppliers will continually seek higher prices for their inputs until they reach prices for their inputs until they reach the new, long-run equilibrium. the new, long-run equilibrium.

At that point, input suppliers At that point, input suppliers purchasing power is restored at full purchasing power is restored at full employment equilibrium.employment equilibrium.


Cost-Push InflationCost-Push Inflation

The only long-run difference from the The only long-run difference from the initial equilibrium is the new, higher initial equilibrium is the new, higher price level.price level.

The 1970s and early 1980s witnessed The 1970s and early 1980s witnessed a phenomenon known as a phenomenon known as stagflationstagflation, where lower growth and , where lower growth and higher prices occurred together. higher prices occurred together.


Some economists believe that this Some economists believe that this was caused by a leftward shift in the was caused by a leftward shift in the aggregate supply curve.aggregate supply curve.

If aggregate demand did not change If aggregate demand did not change significantly and the price level significantly and the price level increased, then the inflation was increased, then the inflation was caused by supply-side forces, not caused by supply-side forces, not demand. This is called demand. This is called cost-push cost-push inflationinflation..


RGDP


The primary culprits responsible for the The primary culprits responsible for the leftward shift in leftward shift in SRASSRAS in the 1970s were in the 1970s were oil price increases. oil price increases.

An increase in input prices can cause the An increase in input prices can cause the SRASSRAS curve to shift to the left, and this curve to shift to the left, and this spelled big trouble for the U.S. economy:spelled big trouble for the U.S. economy: higher price levelshigher price levels lower outputlower output higher rates of unemploymenthigher rates of unemployment


Starting with the economy initially at Starting with the economy initially at full employment equilibrium, suppose full employment equilibrium, suppose there is a sudden increase in input there is a sudden increase in input prices, such as the increase in the prices, such as the increase in the price of oil. price of oil.


This increase would shift the This increase would shift the SRASSRAS curve curve to the left. to the left.

As a result, the price level rises and real As a result, the price level rises and real output falls below potential output. output falls below potential output.

Now firms may demand fewer workers as Now firms may demand fewer workers as a result of the higher input costs that a result of the higher input costs that cannot be passed on to the consumers. cannot be passed on to the consumers.

The result is higher prices, lower real The result is higher prices, lower real output, more unemployment, and a output, more unemployment, and a recessionary gap.recessionary gap.


As far as energy prices are concerned, the As far as energy prices are concerned, the 1980s witnessed falling oil prices as OPEC 1980s witnessed falling oil prices as OPEC lost some of its clout, and many non-OPEC lost some of its clout, and many non-OPEC oil producers increased production. oil producers increased production.

The net result was a rightward shift in The net result was a rightward shift in the the SRASSRAS curve. curve.

Holding Holding AD AD constant, this rightward shift in constant, this rightward shift in SRASSRAS would lead to lower prices, greater would lead to lower prices, greater output, and lower rates of unemployment.output, and lower rates of unemployment.

What Helped the U.S. Recover What Helped the U.S. Recover in the 1980s?in the 1980s?


A Decrease in Aggregate A Decrease in Aggregate Demand and RecessionsDemand and Recessions

Just as cost-push inflation can cause Just as cost-push inflation can cause a recession, so can a decrease in a recession, so can a decrease in ADAD. .

A fall in A fall in ADAD would reduce real output would reduce real output and the price level, and increase and the price level, and increase unemployment in the short run—a unemployment in the short run—a recessionary gap.recessionary gap.



Adjusting to a Recessionary Adjusting to a Recessionary GapGap

Many recoveries from recessions occur Many recoveries from recessions occur because of increases in aggregate because of increases in aggregate demand that take the economy back to demand that take the economy back to potential output.potential output.

It is possible that the economy would It is possible that the economy would self-correctself-correct through declining wages through declining wages and prices. and prices.

In a recession, unemployed workers In a recession, unemployed workers and other input suppliers will bid and other input suppliers will bid down wages and prices.down wages and prices.


The resulting reduction in production The resulting reduction in production costs shifts the short-run aggregate costs shifts the short-run aggregate supply curve to the right. supply curve to the right.

Eventually, the economy returns to Eventually, the economy returns to a long-run equilibrium at potential a long-run equilibrium at potential output and a lower price level.output and a lower price level.



Slow Adjustments to a Slow Adjustments to a Recessionary GapRecessionary Gap

Many economists believe that wages Many economists believe that wages and prices may be very slow to and prices may be very slow to adjust, especially downward.adjust, especially downward.

This downward This downward wage and price wage and price inflexibilityinflexibility may lead to prolonged may lead to prolonged periods of a recessionary gap.periods of a recessionary gap.


What Causes Wages and What Causes Wages and Prices to be Sticky Downward?Prices to be Sticky Downward?

Wages and prices may be sticky Wages and prices may be sticky downward because of downward because of long-term labor contractslong-term labor contracts a legal minimum wagea legal minimum wage employers paying efficiency wagesemployers paying efficiency wages menu costsmenu costs


If the economy is currently in an If the economy is currently in an expansionary gap, with output expansionary gap, with output greater than potential output, the greater than potential output, the price level is higher than workers price level is higher than workers anticipated, and workers’ and input anticipated, and workers’ and input suppliers’ purchasing power has suppliers’ purchasing power has fallen. fallen.

Adjusting to an Expansionary GapAdjusting to an Expansionary Gap


Consequently, workers and other Consequently, workers and other suppliers demand higher prices to be suppliers demand higher prices to be willing to supply their inputs, shifting willing to supply their inputs, shifting the short-run aggregate supply to the the short-run aggregate supply to the left, until they reach the long-run left, until they reach the long-run equilibrium at potential output. Input equilibrium at potential output. Input suppliers’ purchasing power is suppliers’ purchasing power is restored at a higher price level.restored at a higher price level.


RGDP


How Precise is the Aggregate How Precise is the Aggregate Supply and Demand Model?Supply and Demand Model?

In this chapter, we have been shifting In this chapter, we have been shifting the the ASAS and and ADAD curves around as if we curves around as if we knew exactly what we were doing. knew exactly what we were doing.

But it is very important to mention But it is very important to mention that the that the ADAD//ASAS model is a crude tool. model is a crude tool.


In the supply and demand curves In the supply and demand curves covered in Chapter 4, we saw how covered in Chapter 4, we saw how this simple tool is very rich in this simple tool is very rich in explanatory power. explanatory power.

But even supply and demand analysis But even supply and demand analysis does not always provide precise does not always provide precise estimates of the shifts or of the exact estimates of the shifts or of the exact price and output changes that price and output changes that accompany those shifts.accompany those shifts.


However, while supply and demand However, while supply and demand analysis is not always perfect, it does analysis is not always perfect, it does provide a framework to predict the provide a framework to predict the direction that certain important direction that certain important variables will change under different variables will change under different circumstances. circumstances.

The same is true in the The same is true in the ADAD//ASAS model, model, but it is less precise because of the but it is less precise because of the complexities and interrelationships that complexities and interrelationships that exist in the macroeconomy. exist in the macroeconomy.


The slopes of the The slopes of the ADAD and and ASAS curves, curves, the magnitudes of the shifts, and the the magnitudes of the shifts, and the interrelationship of the variables are interrelationship of the variables are to some extent a mystery. to some extent a mystery. For example, if a reduction in aggregate For example, if a reduction in aggregate

demand leads to lower real GDP and, as demand leads to lower real GDP and, as a result, there are fewer workers that are a result, there are fewer workers that are willing to look for work, it impacts the willing to look for work, it impacts the ASAS curve. curve.


There are other examples of the There are other examples of the interdependence of the interdependence of the ADAD and and ASAS curves that make this analysis not curves that make this analysis not completely satisfactory. completely satisfactory. Nevertheless, the framework still Nevertheless, the framework still provides some important insights into provides some important insights into the workings of the macroeconomy.the workings of the macroeconomy.

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