Transcript Chapter 9

Chapter 9
Aggregate
Demand and
Aggregate Supply
As we explained in previous
chapters, recessions occur
when output fails to grow and
unemployment rises.
Prepared By Brock Williams
Learning Objectives
1. Explain the role sticky wages and prices
play in economic fluctuations.
2. List the determinants of aggregate demand
3. Distinguish between the short run and long
run aggregate supply curves
4. Describe the adjustment process back to
full employment
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9.1 STICKY PRICES AND THEIR
MACROECONOMIC CONSEQUENCES
Fluctuations in the economy can be seen as failures in coordination.
●stickiness
The resistance of some variable (prices,
wages, costs) to change
Flexible and Sticky Prices
• 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.
How Demand Determines Output in the Short Run
●short run in macroeconomics
The period of time in which
prices do not change or do not
change very much.
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APPLICATION
1
MEASURING PRICE STICKINESS IN CONSUMER MARKETS
APPLYING THE CONCEPTS #1: What does the behavior of prices
in consumer markets demonstrate about how quickly prices adjust
in the U.S. economy?
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.
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9.2 UNDERSTANDING AGGREGATE
DEMAND
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.
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9.2 UNDERSTANDING AGGREGATE
DEMAND
The Components of Aggregate Demand
 FIGURE 9.1
Aggregate 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.
Y=C+I+G+NX
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9.2 UNDERSTANDING AGGREGATE
DEMAND
Why the Aggregate Demand Curve Slopes Downward
REAL-NOMINAL PRINCIPLE
What matters to people is the real value of money or income—its purchasing
power—not the face value of money or income.
As the purchasing power of money changes, the aggregate demand curve is
affected in three different ways:
THE WEALTH EFFECT
The increase in spending that occurs because the real value of money
increases when the price level falls.
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9.2 UNDERSTANDING AGGREGATE
DEMAND
Why the Aggregate Demand Curve Slopes Downward
THE INTEREST RATE 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.
THE INTERNATIONAL TRADE EFFECT
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.
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9.2 UNDERSTANDING AGGREGATE
DEMAND
Shifts in the Aggregate Demand Curve
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.
CHANGES IN TAXES
A decrease in taxes will increase aggregate demand and shift the aggregate
demand curve to the right.
CHANGES IN GOVERNMENT SPENDING
At any given price level, an increase in government spending will increase
aggregate demand and shift the aggregate demand curve to the right.
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9.2 UNDERSTANDING AGGREGATE
DEMAND
Shifts in the Aggregate Demand Curve
 FIGURE 9.2
Shifting 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.
ALL OTHER CHANGES IN DEMAND
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9.2 UNDERSTANDING AGGREGATE
DEMAND
How the Multiplier Makes the Shift Bigger
 FIGURE 9.3
The 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.
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9.2 UNDERSTANDING AGGREGATE
DEMAND
How the Multiplier Makes the Shift Bigger
●multiplier
The ratio of the total shift in
aggregate demand to the initial shift
in aggregate demand.
●consumption function
The relationship between the level
of income and consumer spending.
C = Ca + by
where: Ca = autonomous consumption
b = marginal propensity to consume
y = level of income
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9.2 UNDERSTANDING AGGREGATE
DEMAND
How the Multiplier Makes the Shift Bigger
●autonomous consumption spending
The 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.
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9.2 UNDERSTANDING AGGREGATE
DEMAND
How the Multiplier Makes the Shift Bigger
multiplier 
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1
(1  MPC)
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9.3 UNDERSTANDING AGGREGATE
SUPPLY
●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 curve
A vertical aggregate supply curve that
represents the idea that in the long run,
output is determined solely by the
factors of production.
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9.3 UNDERSTANDING AGGREGATE
SUPPLY
The Long-Run Aggregate Supply Curve
 FIGURE 9.4
Long-Run Aggregate Supply
In the long run, the level of
output, yp, is independent of the
price level.
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9.3 UNDERSTANDING AGGREGATE
SUPPLY
The Long-Run Aggregate Supply Curve
DETERMINING OUTPUT AND THE PRICE LEVEL
 FIGURE 9.5
Aggregate 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.
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9.3 UNDERSTANDING AGGREGATE
SUPPLY
●short-run aggregate supply curve
A 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.
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9.3 UNDERSTANDING AGGREGATE
SUPPLY
The Short-Run Aggregate Supply Curve
 FIGURE 9.6
Aggregate 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.
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9.3 UNDERSTANDING AGGREGATE
SUPPLY
The Short-Run Aggregate Supply Curve
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
All cause a shift in the short-run aggregate supply curve
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9-20
APPLICATION
2
TWO APPROACHES TO DETERMINING THE CAUSES OF
RECESSIONS
APPLYING THE CONCEPTS #2: How can we determine what
factors cause recessions?
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.
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9.3 UNDERSTANDING AGGREGATE
SUPPLY
Supply Shocks
●supply shocks
External events that shift the aggregate supply curve.
 FIGURE 9.7
Supply 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.
●stagflation
A decrease in real output with increasing prices.
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9.4 FROM THE SHORT RUN TO THE
LONG RUN
 FIGURE 9.8
The Economy in the
Short Run
In the short run, the
economy produces at y0,
which exceeds potential
output yp.
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9.4 FROM THE SHORT RUN TO THE
LONG RUN
 FIGURE 9.9
Adjusting 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.
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9.4 FROM THE SHORT RUN TO THE
LONG RUN
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.
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KEY TERMS
aggregate demand curve (AD)
multiplier
aggregate supply curve (AS)
short-run aggregate supply curve
autonomous consumption spending
short run in macroeconomics
consumption function
stagflation
long-run aggregate supply curve
supply shocks
marginal propensity to consume (MPC)
wealth effect
marginal propensity to save (MPS)
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Questions?
Homework
Ch9, pp 202-204
1.4, 2.7, 3.5, 4.3,
4.4
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