Transcript Principles of Economics Third Edition by Fred Gottheil

Chapter 4
Aggregate Demand and
Aggregate Supply
© 2005 Thomson
Economic Principles
The phases of the business cycle
Gross Domestic Product (GDP)
The CPI and GDP deflator
Nominal and real GDP
Aggregate demand and aggregate supply
Macroeconomic equilibrium
Demand-pull and cost-push inflation
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Why Recession? Why Prosperity?
• Recession
•A phase in the business cycle in which the
decline in the economy’s real GDP persists
for at least a half-year. A recession is
marked by relatively high unemployment.
•Depression
•Severe recession.
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Why Recession? Why Prosperity?
Prosperity
• A phase in the business cycle marked by
a relatively high level of real GDP, full
employment, and inflation.
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Why Recession? Why Prosperity?
Business cycle
• Alternating periods of growth and decline
in an economy’s GDP.
•No two business cycles are identical. The
number of months in any given phase of
the cycle varies from cycle to cycle.
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Why Recession? Why Prosperity?
Trough
• The bottom of a business cycle.
• This is the time period when the
economy’s unemployment rate is greatest
and output declines to the cycle’s minimum
level.
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Why Recession? Why Prosperity?
Recovery
• A phase in the business cycle, following a
recession, in which real GDP increases and
unemployment declines.
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Why Recession? Why Prosperity?
Peak
• The top of a business cycle.
• This is the time period when output
reaches its maximum level, the labor force is
fully employed, and increasing pressure on
prices is likely to generate inflation.
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Why Recession? Why Prosperity?
Downturn
• A phase in the business cycle in which
real GDP declines, inflation moderates,
and unemployment emerges.
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EXHIBIT 1
THE BUSINESS CYCLE
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Measuring the National Economy
Gross Domestic Product (GDP)
• Total value of all final goods and services,
measured in current market prices,
produced in the economy during a year.
• Final goods and services refers to everything produced
that is not itself used to produce other goods and services
•During a given year refers to a specific calendar year.
•Produced in the economy refers to any good or service
produced in the United States, regardless of whether a
US-owned or a foreign-owned company is producing.
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Measuring the
National Economy
To compare GDP across years, we
must devise some way of
eliminating the effect of inflation.
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Measuring the National Economy
Nominal GDP
• GDP measured in terms of current market
prices—that is, the price level at the time of
measurement. (It is not adjusted for
inflation.)
•Real GDP
•GDP adjusted for changes in the price level.
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Measuring the
National Economy
• Price indices are designed to
remove the effect of price changes.
• The consumer price index and
the GDP deflator are the two
indices most commonly used.
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Measuring the
National Economy
Consumer Price Index (CPI)
• A measure comparing the prices of
consumer goods and services that a
household typically purchases to the prices
of those goods and services purchased in a
base year.
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Measuring the
National Economy
Price level
• A measure of prices in one year expressed
in relation to prices in a base year.
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Measuring the
National Economy
Example: Suppose in 1998 (the base year) a
basket of goods including such things as food,
clothing, and fuel cost $350. The $350 converts to
a price level index of 100, P = 100.
Suppose in the next year, 1999, the same basket
of goods cost $385.
The 1999 CPI, measured against the 1998 base
year of 100, is 110. P = ($385/$350) × 100 = 110.
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Measuring the
National Economy
Example: A 1999 P = 110 indicates
that from 1998 to 1999 the cost of
goods and services that consumers
typically buy increased by 10
percent.
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Measuring the
National Economy
GDP deflator
• A measure comparing the prices of all goods and
services produced in the economy during a given year to
the prices of those goods and services purchased in a
base year.
•This price index includes not only consumer goods and
services, but also producer goods, investment goods,
exports and imports, and goods and services purchased
by government.
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EXHIBIT 2
CONVERTING NOMINAL GDP TO REAL GDP:
1995–2002 ($ BILLIONS, 1996 = 100)
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
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Deriving Equilibrium GDP in the
Aggregate Demand and Supply Model
The aggregate demand and
aggregate supply model is one
model used to explain how GDP is
determined.
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Deriving Equilibrium GDP in the
Aggregate Demand and Supply Model
Aggregate supply
• The total quantity of goods and services
that firms in the economy are willing to
supply at varying price levels.
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Deriving Equilibrium GDP in the
Aggregate Demand and Supply Model
There are three distinct segments
of the aggregate supply curve:
1. Horizontal segment. Real GDP increases without
affecting the economy’s price level.
2. Upward-sloping segment. A positive relationship
between real GDP and price level.
3. Vertical segment. All resources are fully employed, so
that real GDP cannot increase.
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Deriving Equilibrium GDP in the
Aggregate Demand and Supply Model
Aggregate demand
• The total quantity of goods and services
demanded by households, firms, foreigners,
and government at varying price levels.
•Increases in the price level affect people’s real wealth,
their lending and borrowing activity, and the nation’s
trade with other nations.
•The quantity of goods and services demanded in the
economy declines when price levels increase.
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EXHIBIT 3
AGGREGATE SUPPLY AND AGGREGATE
DEMAND
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Deriving Equilibrium GDP in the
Aggregate Demand and Supply Model
• The aggregate demand curve shifts
when there is a change in the quantity of
goods and services demanded at a
particular price level.
• Government spending, income levels,
and expectations about the future are all
factors that can cause the curve to shift.
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Deriving Equilibrium GDP in the
Aggregate Demand and Supply Model
The aggregate supply curve shifts
due to factors such as changes in
resource availability and resource
prices.
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EXHIBIT 4
SHIFTS IN AGGREGATE DEMAND AND
AGGREGATE SUPPLY
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Exhibit 4: Shifts in Aggregate Demand
and Aggregate Supply
What might cause the aggregate
demand curve in panel a of
Exhibit 4 to shift to the right?
• Increases in government spending,
increases in incomes, and optimistic
expectations could all cause the aggregate
demand curve to shift to the right.
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Macroeconomic Equilibrium
Macroequilibrium
• The level of real GDP and the price level that
equate the aggregate quantity demanded and
the aggregate quantity supplied.
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Exhibit 5: Achieving
Macroeconomic Equilibrium
1. At what price level and real GDP
is macroequilibrium achieved in
Exhibit 5?
• Macroequilibrium is achieved at P = 101.95
and real GDP = $8.1595 trillion.
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Exhibit 5: Achieving
Macroeconomic Equilibrium
2. What happens when the price
level increases to P = 110?
• At P = 110, the aggregate quantity
demanded falls to $5 trillion and the
aggregate quantity supplied increases
to $9 trillion.
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Time Line on Equilibrium,
Inflation, and Unemployment
The U.S. commitment to support
England during World War II
changed the pace and direction of
our national economy
significantly.
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Time Line on Equilibrium,
Inflation, and Unemployment
Demand-pull inflation
• Inflation caused primarily by an increase
in aggregate demand (such as during wars
when government spending increases).
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Equilibrium, Inflation, and
Unemployment
Stagflation
• A period of stagnating real GDP, rapid
inflation, and relatively high levels of
unemployment (oil crisis in the 1970s).
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Time Line on Equilibrium,
Inflation, and Unemployment
Cost-push inflation
• Inflation caused primarily by a decrease
in aggregate supply.
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Time Line on Equilibrium,
Inflation, and Unemployment
• During the second half of the 1980s,
the economy was performing about as
well as it ever had in the last quarter
century.
• Tax reforms, ready credit, leveraged
buyouts, a commercial real estate boom,
and optimistic expectations contributed
to the already strong aggregate demand.
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Time Line on Equilibrium,
Inflation, and Unemployment
The recession of 1990-91 was caused
by an inward shift in aggregate
demand. Reduced federal revenue
sharing with states, downsized
government budgets, cuts in
demand for military goods, and
high levels of debt acquired during
the 1980s are all to blame.
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The Longest Prosperity Phase:
1992-2000 (Clinton years)
Economists attribute the boom to
supply-side factors:
• A rise in the nation’s productivity caused
by the diffusion of computer technology
throughout the economy.
• The absence of rising inflation.
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The 2001-02 Recession and 9/11
• The 1992-2000 buying spree left
consumers without the means to
keep the spree alive.
• Terrorist attacks created a
heightened sense of economic
uncertainty.
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Can We Avoid Unemployment
and Inflation?
Although the desired
macroequilibrium outcome would
occur at a real GDP level consistent
with full employment and no
inflation, this level is not always
achieved.
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Can We Avoid Unemployment
and Inflation?
Some economists believe
government should act in ways to
help shift macroequilibrium to this
position.
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Can We Avoid Unemployment
and Inflation?
Increasing or decreasing
government spending and income
taxes are two methods government
can use to attempt to shift the
aggregate demand curve.
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EXHIBIT 7 OBTAINING FULL-EMPLOYMENT GDP
WITHOUT INFLATION
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Exhibit 7: Obtaining Full-Employment
GDP Without Inflation
How might government shift the
aggregate demand curve from AD
to AD′ in Exhibit 7?
• Government could increase spending and
reduce income taxes in order to shift the
demand curve to the right.
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