Transcript Economics: Principles, Applications, and Tools, 5th ed.

Aggregate Demand
and Aggregate Supply
PREPARED BY:
FERNANDO QUIJANO, YVONN QUIJANO,
KYLE THIEL & APARNA SUBRAMANIAN
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez
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14.1
STICKY PRICES AND THEIR MACROECONOMIC
CONSEQUENCES
• short run in macroeconomics
The period of time in which
prices do not change or do not
change very much.
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PRICE STICKINESS IN RETAIL CATALOGS
APPLYING THE CONCEPTS #1: What does the behavior of prices in retail catalogs 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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14.2 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.
 FIGURE 14.1
Aggregate Demand
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14.2 UNDERSTANDING AGGREGATE DEMAND
The Components of Aggregate Demand
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 effect
The increase in spending that occurs because the real
value of money increases when the price level falls.
THE INTEREST RATE EFFECT
THE INTERNATIONAL TRADE EFFECT
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14.2 UNDERSTANDING AGGREGATE DEMAND
Shifts in the Aggregate Demand Curve
Key factors that cause the shifts:
CHANGES IN THE SUPPLY OF MONEY
CHANGES IN TAXES
CHANGES IN GOVERNMENT SPENDING
ALL OTHER CHANGES IN DEMAND
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14.2 UNDERSTANDING AGGREGATE DEMAND
Shifts in the Aggregate Demand Curve
ALL OTHER CHANGES IN DEMAND
 FIGURE 14.2
Shifting Aggregate Demand
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14.2 UNDERSTANDING AGGREGATE DEMAND
How the Multiplier Makes the Shift Bigger
 FIGURE 14.3
The Multiplier
• 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
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14.2 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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Extra Application 4
RETAILERS REPORT MIXED FEBRUARY SALES
February retail sales results were mixed with 59 percent of the nation’s retailers missing
expectations and 41 percent exceeding expectations. The winners were the large
discount stores like Wal-Mart and Target with the specialty shops like The Gap and
Abercrombie and Fitch Co. losing ground. The Sharper Image Corporation experienced a
31 percent drop in same store sales.
• Some economists worry that consumer spending could slow since the overall savings
rate is negative.
• Consumers are spending more than they are making indicating additional borrowing
or dipping into savings.
Can consumers continue to spend?
If consumer spending continues to decline we will see a
permanent shift to the left in aggregate demand. If the
government or business sectors increase spending enough
to offset the consumer reduction there will be no change.
If the change is permanent we should see the price level
fall a little, ceteris paribus. If the Fed sees the same
pattern, it should signal the end of interest rate increases.
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14.2 UNDERSTANDING AGGREGATE DEMAND
How the Multiplier Makes the Shift Bigger
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14.3 UNDERSTANDING AGGREGATE SUPPLY
• aggregate supply curve (AS)
A curve that shows the relationship between the level of prices and
the quantity of output supplied.
The Long-Run Aggregate Supply Curve
• 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.
 FIGURE 14.4
Long-Run Aggregate Supply
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14.3 UNDERSTANDING AGGREGATE SUPPLY
The Long-Run Aggregate Supply Curve
DETERMINING OUTPUT AND THE PRICE LEVEL
 FIGURE 14.5
Aggregate Demand and the
Long-Run Aggregate Supply
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14.3 UNDERSTANDING AGGREGATE SUPPLY
The Short-Run Aggregate Supply Curve
• 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.
 FIGURE 14.6
Aggregate Demand and
Short-Run Aggregate Supply
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BUSINESS INVESTMENT, NET EXPORTS, AND THE 2001 RECESSION
APPLYING THE CONCEPTS #2: How can changes in demand cause a recession? In particular,
what factors do economists think caused the 2001 recession?
To determine what caused the 2001 recession and how it differed from past recessions,
economist Kevin Kliesen of the Federal Reserve Bank of St. Louis compared data for
recessions over time. Kliesen found that spending on consumer durables and new
residential housing production decreased.
However, during the 2001 recession spending on consumer durables and new housing
production both grew throughout the recession. Instead, business investment and net
exports dropped.
Investors and firms realized that the economic boom times of the late 1990s were over.
Net exports fell for two reasons:
• World economic growth slowed.
• The value of the dollar increased relative to foreign currencies, making U.S.
goods more expensive.
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14.3 UNDERSTANDING AGGREGATE SUPPLY
Supply Shocks
• supply shocks
External events that shift the aggregate supply curve.
 FIGURE 14.7
Supply Shock
• stagflation
A decrease in real output with increasing prices.
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HOW THE U.S. ECONOMY HAS COPED WITH OIL PRICE FLUCTUATIONS
APPLYING THE CONCEPTS #3: Do changes in oil prices always hurt the U.S. economy?
During the 1970s, the world economy was hit with unfavorable supply shocks
that raised prices and lowered output, including spikes in oil prices.
• Increases in oil prices shift the aggregate supply curve. However, they
also have an adverse effect on aggregate demand.
• Because the United States is a net importer of foreign oil, an increase
in oil prices is just like a tax that decreases the income of consumers.
• An increase in taxes will shift the aggregate demand curve to the left.
Between 1997 and 1998, the price of oil on the world market fell from $22 a
barrel to less than $13 a barrel. The result: gasoline prices were lower than
they had been in over 50 years.
In 2005, oil prices shot up to $60 a barrel.
• Reason: increased demand throughout the world, particularly in fastgrowing countries such as China and India.
• Result: the economy appeared to absorb these price increases
without too much difficulty. Price increases did not have adverse
effects on aggregate demand as in prior years.
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14.4 FROM THE SHORT RUN TO THE LONG RUN
 FIGURE 14.8
The Economy in the Short Run
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14.4 FROM THE SHORT RUN TO THE LONG RUN
 FIGURE 14.9
Adjusting to the Long Run
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