prepared by brock williams chapter 14 aggregate demand and aggregate supply as we explained in...

Prepared By Brock Williams

Chapter 14

Aggregate Demand and

Aggregate Supply

As we explained in previous chapters, recessions occur

when output fails to grow and unemployment rises.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 14-2

Learning Objectives

1. Explain the role sticky wages and prices play in economic fluctuations.

2. List the determinants of aggregate demand3. Distinguish between the short run and long

run aggregate supply curves4. Describe the adjustment process back to

full employment


Fluctuations in the economy can be seen as failures in coordination.

Flexible and Sticky Prices

● short run in macroeconomicsThe period of time in which prices do not change or do not change very much.

How Demand Determines Output in the Short Run

• For most firms, the biggest cost of doing business is wages. If wages are sticky, firms’ overall costs will be sticky as well. This means that firms’ product prices will remain sticky, too.

• Sticky wages cause sticky prices and hamper the economy’s ability to bring demand and supply into balance in the short run.

14.1 STICKY PRICES AND THEIRMACROECONOMIC CONSEQUENCES


To analyze the behavior of retail prices, economist Anil Kashyap of the University of Chicago examined prices in consumer catalogs.

He looked at the prices of 12 selected goods from:

▪ L.L. Bean

▪ Recreational Equipment, Inc. (REI)

▪ The Orvis Company, Inc.

The goods included shoes, blankets, chamois shirts, binoculars, and a fishing rod and fly.

What did he find?

▪ Considerable price stickiness.

▪ When prices did change, he observed a mixture of both large and small changes.

▪ During periods of high inflation, prices tended to change more frequently.

MEASURING PRICE STICKINESS IN CONSUMER MARKETSAPPLYING THE CONCEPTS #1: What does the behavior of prices

in consumer markets demonstrate about how quickly prices adjust in the U.S. economy?

A P P L I C A T I O N 1


What Is the Aggregate Demand Curve?

● aggregate demand curve (AD)A curve that shows the relationship between the level of prices and the quantity of real GDP demanded.

14.2 UNDERSTANDING AGGREGATE DEMAND


The Components of Aggregate Demand

FIGURE 14.1Aggregate Demand

The aggregate demand curve plots the total demand for real GDP as a function of the price level.

The aggregate demand curve slopes downward, indicating that the quantity of aggregate demand increases as the price level in the economy falls.

14.2 UNDERSTANDING AGGREGATE DEMAND (cont.)


Why the Aggregate Demand Curve Slopes Downward

As the purchasing power of money changes, the aggregate demand curve is affected in three different ways:

THE WEALTH EFFECT

● wealth effectThe increase in spending that occurs because the real value of money increases when the price level falls.

R E A L - N O M I N A L P R I N C I P L E

What matters to people is the real value of money or income—its purchasing

power—not the face value of money or income.



Why the Aggregate Demand Curve Slopes Downward

THE INTEREST RATE EFFECT

THE INTERNATIONAL TRADE EFFECT

With a given supply of money in the economy, a lower price level will lead to lower interest rates.

With lower interest rates, both consumers and firms will find it cheaper to borrow money to make purchases.

As a consequence, the demand for goods in the economy (consumer durables purchased by households and investment goods purchased by firms) will increase.

In an open economy, a lower price level will mean that domestic goods (goods produced in the home country) become cheaper relative to foreign goods, so the demand for domestic goods will increase.



Shifts in the Aggregate Demand Curve

CHANGES IN TAXES

CHANGES IN GOVERNMENT SPENDING

CHANGES IN THE SUPPLY OF MONEY

An increase in the supply of money in the economy will increase aggregate demand and shift the aggregate demand curve to the right.

A decrease in taxes will increase aggregate demand and shift the aggregate demand curve to the right.

At any given price level, an increase in government spending will increase aggregate demand and shift the aggregate demand curve to the right.



Shifts in the Aggregate Demand Curve

ALL OTHER CHANGES IN DEMAND

FIGURE 14.2Shifting Aggregate Demand

Decreases in taxes, increases in government spending, and an increase in the supply of money all shift the aggregate demand curve to the right.

Higher taxes, lower government spending, and a lower supply of money shift the curve to the left.


TABLE 14.1Factors That Shift Aggregate Demand


How the Multiplier Makes the Shift Bigger

FIGURE 14.3The Multiplier

Initially, an increase in desired spending will shift the aggregate demand curve horizontally to the right from a to b.

The total shift from a to c will be larger. The ratio of the total shift to the initial shift is known as the multiplier.




● multiplierThe ratio of the total shift in aggregate demand to the initial shift in aggregate demand.

● consumption functionThe relationship between the level of income and consumer spending.

C = Ca + by




● autonomous consumption spendingThe part of consumption spending that does not depend on income.

● marginal propensity to consume (MPC)The fraction of additional income that is spent.

● marginal propensity to save (MPS)The fraction of additional income that is saved.





▼ TABLE 14.1 THE MULTIPLIER IN ACTIONThe initial $10 million increase in aggregate demand will, through all the rounds of spending, eventually lead to a $25 million increase.


The Long-Run Aggregate Supply Curve

● aggregate supply curve (AS)A curve that shows the relationship between the level of prices and the quantity of output supplied.

● long-run aggregate supply curveA vertical aggregate supply curve that represents the idea that in the long run, output is determined solely by the factors of production.

14.3 UNDERSTANDING AGGREGATE SUPPLY



FIGURE 14.4Long-Run Aggregate Supply

In the long run, the level of output, yp, is independent of the

price level.

14.3 UNDERSTANDING AGGREGATE SUPPLY (cont.)



FIGURE 14.5Aggregate Demand and the Long-Run Aggregate Supply

Output and prices are determined at the intersection of AD and AS.

An increase in aggregate demand leads to a higher price level.

DETERMINING OUTPUT AND THE PRICE LEVEL



The Short-Run Aggregate Supply Curve

● short-run aggregate supply curveA relatively flat aggregate supply curve that represents the idea that prices do not change very much in the short run and that firms adjust production to meet demand.




FIGURE 14.6Aggregate Demand and Short-Run Aggregate Supply

With a short-run aggregate supply curve, shifts in aggregate demand lead to large changes in output but small changes in price.




What factors determine the costs firms must incur to produce output? The key factors are

• Input prices (wages and materials)

• The state of technology

• Taxes, subsidies, or economic regulations



Economists have used the basic framework of aggregate demand and supply analysis to explain recessions. Recessions can occur either when there is a sharp decrease in demand or a decrease in aggregate supply.

Economic historian Peter Temin looked at all recessions from 1893 to 1990 to determine their causes. He found, recessions were caused by many different factors.

• Sometimes, as in 1929, they were caused by shifts in aggregate demand from the private sector, as consumers cut back their spending.

• Other times, as in 1981, the government cut back on aggregate demand to reduce inflation.

• Supply shocks were the cause of the recessions in 1973 and 1979.

• The most severe shock hit the U.S. economy in 1931 and converted an economic downturn into the Great Depression. He believes that foreign monetary developments were the ultimate source of this shock to the U.S. economy.

TWO APPROACHES TO DETERMINING THE CAUSES OF RECESSIONS

APPLYING THE CONCEPTS #2: How can we determine what factors cause recessions?



Supply Shocks

● supply shocksExternal events that shift the aggregate supply curve.

FIGURE 14.7Supply Shock

An adverse supply shock, such as an increase in the price of oil, will cause the AS curve to shift upward.

The result will be higher prices and a lower level of output.

● stagflationA decrease in real output with increasing prices.



• Economists have long believed that disruptions to oil supplies were the cause of supply shocks for the U.S. economy. But not all changes in oil prices are necessarily caused by supply disruptions. They may be caused by increases in world demand or the activities of speculators in the oil market.

• How important are actual supply disruptions? Economist Kilian examined this issue and found supply disruptions only explained a small fraction of the variability of oil prices.

• Speculation in oil markets may be one such factor. Speculators can be countries, firms, or individuals. If speculators believe prices are going to rise in the future, they will buy oil now or, if they own it, sell less into the market. Either action increases the current price of oil. Note that if speculators are on average correct in their assessments, they will smooth out the price of oil over time—raising it now and lowering it later. This can actually benefit the economy.

• While politicians often complain about speculators, in many cases they may be helping the economy. Of course, speculators can be wrong and make fluctuations in prices worse, but in this case at least some of them will lose money.

OIL SUPPLY DISRUPTIONS, SPECULATION AND SUPPLY SHOCKS APPLYING THE CONCEPTS #3: Are oil price increases caused by true

shocks to supply?



FIGURE 14.8The Economy in the Short Run

In the short run, the economy produces at y0,

which exceeds potential output yp.

14.4 FROM THE SHORT RUN TO THE LONG RUN


FIGURE 14.9Adjusting to the Long Run

With output exceeding potential, the short-run AS curve shifts upward over time.

The economy adjusts to the long-run equilibrium at a1.

14.4 FROM THE SHORT RUN TO THE LONG RUN (cont.)


Looking Ahead

• The aggregate demand and aggregate supply model in this chapter provides an overview of how demand affects output and prices in both the short run and the long run.

• The next several chapters explore more closely how aggregate demand determines output in the short run.

14.4 FROM THE SHORT RUN TO THE LONG RUN (cont.)


K E Y T E R M S

aggregate demand curve (AD)

aggregate supply curve (AS)

autonomous consumption spending

consumption function

long-run aggregate supply curve

marginal propensity to consume (MPC)

marginal propensity to save (MPS)

multiplier

short-run aggregate supply curve

short run in macroeconomics

stagflation

supply shocks

wealth effect

prepared by brock williams chapter 14 aggregate demand and aggregate supply as we explained in...

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