Transcript Working With Our Basic Aggregate Demand / Supply Model

Chapter 10
Working With
Our Basic Aggregate
Demand/Supply Model
Slides to Accompany “Economics: Public and Private Choice 9th ed.”
James Gwartney, Richard Stroup, and Russell Sobel
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1. Anticipated and
Unanticipated Changes
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Anticipated and
Unanticipated Changes

Anticipated changes are foreseen by
economic participants.


Decision makers have time to adjust to
them before they occur.
Unanticipated changes catch people by
surprise.
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2. Factors that Shift
Aggregate Demand
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Factors that
Shift Aggregate Demand






An increase (decrease) in real wealth.
A decrease (increase) in the real rate of interest.
An increase in the optimism (pessimism) of
businesses and consumers about future
economic conditions.
An increase (decline) in the expected rate of
inflation.
Higher (lower) real incomes abroad.
A reduction (increase) in the exchange rate value
of the nation’s currency.
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Shifts in Aggregate Demand
Price
level
AD1
AD0
AD2
Goods & Services
(real GDP)


An increase in real wealth, such as would result from a stock market
boom, for example, will increase aggregate demand, shifting the
entire curve to the right (from AD0 to AD1).
In contrast, a reduction in real wealth decreases the demand for goods
& services, causing AD to shift to to the left (from AD0 to AD2).
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Questions for Thought:
1. Explain how and why each of the following
factors would influence current aggregate
demand in the United States:
(a) An increased fear of recession.
(b) An increased fear of inflation.
(c) The rapid growth of real income in
Canada and Western Europe.
(d) A reduction in the real interest rate.
(e) A higher price level (be careful).
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3. Unanticipated Changes
in Aggregate Demand
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Unanticipated Changes
in Aggregate Demand


In the short-run, output will deviate from full
employment capacity as prices in the goods &
services market deviate from the price level
that people expected.
Impact of unanticipated increases in AD:




Initially, the strong demand and higher price level
in the goods & services market will temporarily
improve profit margins.
Output will increase, the rate of unemployment
will drop below the natural rate, and output will
temporarily exceed the economy's long-run
potential.
With time, however, contracts will be modified
and resource prices will rise and return to their
competitive relation with product prices.
Once this happens, output will recede to the
economy's long-run potential.
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Unanticipated Increase
in Aggregate Demand
Price
level
LRAS
SRAS1
Short-run effects of an
unanticipated increase in AD
P105
P100
AD1
YF Y2

AD2
Goods & Services
(real GDP)
In response to an unanticipated increase in AD for goods & services
(shift from AD1 to AD2), prices will rise to P105 and output will
temporarily exceed full-employment capacity (increases to Y2).
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Unanticipated Increase
in Aggregate Demand
Price
level
LRAS
SRAS2
SRAS1
P110
Long-run effects of an
unanticipated increase in AD
P105
P100
AD1
YF Y2



AD2
Goods & Services
(real GDP)
With the passage of time, prices in resource markets, including the
labor market, will rise due to the strong demand. As a result, higher
costs reduce aggregate supply to SRAS2.
In the long-run, a new equilibrium at a higher price level (P110) and an
output consistent with the economy’s sustainable potential will occur.
Thus, the increase in demand will expand output only temporarily.
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Unanticipated Changes
in Aggregate Demand

Impact of unanticipated reductions in AD:




Weak demand and lower prices in the goods &
services market will reduce profit margins.
Many firms will incur losses.
Firms will reduce output, the rate of
unemployment will rise above the natural rate,
and output will temporarily fall short of the
economy's long-run potential.
With time, long-term contracts will be
modified.
Eventually, lower resource prices and a lower
real interest rate will direct the economy back
to long-run equilibrium, but this may be a
lengthy and painful process.
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Unanticipated Reduction
in Aggregate Demand
Price
level
LRAS
SRAS1
Short-run effects of an
unanticipated reduction in AD
P100
P95
AD2
Y2 YF


AD1
Goods & Services
(real GDP)
The short-run impact of an unanticipated reduction in AD
(shift from AD1 to AD2) will be a decline in output (decreases
to Y2), and a lower price level (P95).
Temporarily, profit margins decline, output falls, and
unemployment rises below its natural rate.
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Unanticipated Reduction
in Aggregate Demand
Price
level
LRAS
SRAS1
SRAS2
P100
Long-run effects of an
unanticipated reduction in AD
P95
P90
AD2
Y2 YF



AD1
Goods & Services
(real GDP)
In the long-run, weak demand and excess supply in the resource
market will lead to lower wage rates and resource prices resulting
in an expansion in short-run aggregate supply to SRAS2.
In the long-run, a new equilibrium at a lower price level (P90) and an
output consistent with the economy’s sustainable potential will result.
This method of restoring equilibrium may be both long and painful.
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4. Shifts in
Aggregate Supply
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Shifts in Aggregate Supply
Factors that change LRAS:





An increase (decrease) in the supply of resources.
An improvement (deterioration) in technology and
productivity.
Institutional changes that increase (reduce) the
efficiency of resource use.
Factors that change SRAS:



A decrease (increase) in resource prices
— that is, production costs.
A reduction (increase) in the expected rate of
inflation.
Favorable (unfavorable) supply shocks, such as
good (bad) weather or a reduction (increase) in the
world price of a key imported resource.
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Questions for Thought:
1. Indicate how each of the following would
influence U.S. aggregate supply in the short run:
(a) An increase in real wage rates.
(b) A severe freeze that destroys half the
orange crop in Florida.
(c) An increase in the expected rate of
inflation in the future.
(d) An increase in the world price of oil,
a key import.
(e) Abundant rainfall during the growing
season of agricultural states.
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5. Impact of Changes in
Aggregate Supply
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Impact of Changes
in Aggregate Supply

Economic growth and anticipated shifts in
long-run aggregate supply.



Increases in LRAS will make it possible to
produce and sustain a larger rate of output.
Both LRAS and SRAS will shift to the right
and output will increase.
These changes generally take place slowly
and therefore they need not disrupt long-run
equilibrium.
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Shifts in Aggregate Supply
Price
Price
level
LRAS1
YF,1


level
LRAS2
YF,2
SRAS1 SRAS2
Goods & Services
Goods & Services
(real GDP)
(real GDP)
Such factors as an increase in the stock of capital or an improvement in
technology will expand the economy’s potential output and shift the
LRAS to the right (note that SRAS will also shift to the right).
Such factors as a reduction in resource prices, favorable weather, or a
temporary decrease in the world price of an important imported resource
would shift SRAS to the right (note that LRAS will remain constant).
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Growth in Aggregate Supply
Price
level
LRAS1 LRAS2
SRAS1
SRAS2
P1
P2
AD
YFF1 YF2



Goods & Services
(real GDP)
Here we illustrate the impact of economic growth due to capital
formation or a technological advancement, for example.
Both LRAS and SRAS increase (to LRAS2 and SRAS2); the full
employment output of the economy expands from YF1 to YF2.
A sustainable, higher level of real output and real income is the result.
If the money supply is held constant, a new long-run equilibrium will
emerge at a larger output rate (YF2) and lower price level (P2).
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Impact of Changes
in Aggregate Supply

The impact of changes in short-run aggregate
supply (SRAS):




SRAS shifts to the right – output will temporarily
exceed the economy's long-run potential.
Since the temporarily favorable supply conditions
cannot be counted on in the future, the economy’s
long-term production capacity will not be altered.
Recognizing that they will be unable to maintain
their current high level of income, individuals will
generally save a substantial portion of it for use at
a future time that is not nearly so prosperous.
The increased saving will reduce interest rates,
which encourages investment (capital formation).
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Unanticipated, Temporary Increase
in Aggregate Supply
Price
level
LRAS
SRAS1
SRAS2
P1
P2
AD
YF



Y2
Goods & Services
(real GDP)
Here we illustrate an unanticipated, but temporary, increase in aggregate
supply, such as may result from a bumper crop caused by good weather.
The increase in aggregate supply (shift to SRAS2) would lead to a lower
price level (P95) and an increase in current GDP to Y2.
Since the favorable supply conditions cannot be counted on in the future,
the economy’s long-run aggregate supply will not increase.
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Growth in Aggregate Supply
Loanable Funds
Market
Real Interest
Rate
S1
S2
r1
r2
D
Q1 Q2



Quantity of
Loanable Funds
Predictably, decision makers will save a large proportion of their
temporary higher real income, spreading the benefits into the future.
Thus, the supply of loanable funds will increase (from S1 to S2).
The real interest rate will fall to r2, encouraging expenditures on
interest-sensitive capital goods and consumer durables.
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Impact of Changes
in Aggregate Supply

The impact of unanticipated reductions in
short-run aggregate supply (SRAS):



If an unfavorable supply shock is expected to
be temporary, long-run aggregate supply will
be unaffected.
Households will reduce their current saving
level (and dip into past savings) to maintain a
current consumption level more consistent with
their longer-term perceived opportunities.
The reduction in saving will lead to higher real
interest rates and retard current investment.
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Reduction in Resources: A Supply Shock
Resource
Market
Price
Level
S2
S1
Pr2
Pr1
D
Q2 Q1


Quantity of
Resources
Suppose there is an unanticipated reduction in the supply
of resources, perhaps as the result of a crop failure or a
sharp increase in the world price of a major imported
resource, such as oil.
Resource prices would rise from P1 to P2.
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Effects of Adverse Supply Shock
Price
LRAS
level
SRAS2 (Pr2)
SRAS1 (Pr1)
P110
B
P100
A
AD
Y2




YF
Goods & Services
(real GDP)
The higher resource prices shift the SRAS curve to the left; in the
short-run, the price level rises to P110 and output falls to Y2.
What happens in the long-run depends on whether the reduction in
the supply of resources is temporary or permanent.
If temporary, resource prices fall in the future, permitting the economy
to return to its original equilibrium (A).
If permanent, the productive potential of the economy will shrink
(LRAS shifts to the left) and (B) will become the long-run equilibrium.
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6. The Business Cycle
-- Revisited
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The Business Cycle
-- Revisited


Recessions occur because prices in the
goods & services market are low relative to
the costs of production and resource prices.
The two causes of recessions:




unanticipated reductions in aggregate
demand, and,
unfavorable supply shocks.
An unsustainable economic boom occurs
when prices in the goods & services market
are high relative to costs and resource prices.
The two causes of booms are:


unanticipated increases in aggregate
demand, and,
favorable supply shocks.
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Expansions, Recessions, and the
Rate of Unemployment
• Here we illustrate the periods
of expansion and contraction
(recession) since 1960.
• Note how the reductions in
real GDP (shaded periods) in
the top graph are associated
with increases in the rate of
unemployment well above the
natural rate (bottom graph).
• The AD/AS model indicates
that recessions are caused by
unanticipated reductions in AD
that are likely to accompany
abrupt reductions in the
inflation rate and/or adverse
supply shocks that might occur,
for example, when there is a
large increase in the price of a
key imported resource, such as
crude oil.
Expansion
Real GDP
Expansion
(billions of 1987 $)
6,000
1990
Recession
Real
GDP
4,000
1982
Recession
1980
Recession
1974–75
Recession
2,000
1970
Recession
1960
Recession
0 1960
1965
1970
1975
1980
1985
1990
1995
2000
Percentage of the
Labor Force Unemployed
Actual rate
of unemployment
10
8
6
Natural rate of
unemployment
4
(estimated range)
2
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
Source: Derived from computerized data supplied by FAME Economics.
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7. Does the Market Have
a Self-Corrective
Mechanism That Will
Keep it on Track?
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Does the Market Have a
Self-Corrective Mechanism
That Will Keep it on Track?

There are three reasons to believe that it does:


Consumption demand is relatively stable
over the business cycle.
Changes in real interest rates will help to
stabilize aggregate demand and redirect
economic fluctuations.


Interest rates will tend to fall during a
recession and rise during and economic boom.
Changes in real resource prices will redirect
economic fluctuations.

Real resource price will tend to fall during a
recession and rise during an economic expansion.
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Changes in Real Interest Rates and
Resource Prices Over the Business Cycle
Price
LRAS
level
r
Pr
Real interest rates fall
r
(because of weak
demand for investment)
Real resource prices fall
Pr
(because of weak demand
and high unemployment)
Real interest rates rise
(because of strong
demand for investment)
Real resource prices rise
(because of strong demand
and low unemployment)
Goods & Services
Unemployment greater
than Natural Rate


YF
Unemployment less
than Natural Rate
(real GDP)
When aggregate output is less than the economy’s full employment
potential (YF), weak demand for investment leads to lower real interest
rates, while slack employment in resource markets will place
downward pressure on wages and other resource prices (Pr).
Conversely, when output exceeds YF, strong demand for capital goods
and tight labor market conditions will result in rising real interest rates
and resource prices (Pr).
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The Economy’s Self Corrective Mechanism
Price
level
LRAS
In the short-run, output
may exceed or fall
short of the economy’s
full-employment
capacity (YF).
SRAS2
SRAS1
P105
P100
P95
Higher real interest
rates reduce AD
AD2
YF Y1




Higher resource
prices reduce SRAS
AD1
Goods & Services
(real GDP)
If output is temporarily greater than the economy’s potential,
higher real interest rates and resource prices will lead to a lower
but sustainable rate of output.
Higher interest rates will reduce AD (from AD1 to AD2).
At the same time, higher resource prices will increase production
costs and therefore reduce SRAS (from SRAS1 to SRAS2).
These forces direct output toward full-employment potential (YF).
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The Economy’s Self Corrective Mechanism
Price
level
LRAS
SRAS1
Lower resource
prices increase SRAS
SRAS2
In the short-run, output
may exceed or fall
short of the economy’s
full-employment
capacity (YF).
P105
P100
Lower real interest
rates increase AD
P95
AD1
Y1 YF



AD2
Goods & Services
(real GDP)
If output is temporarily less than capacity, lower interest rates
(reflecting the weak demand for investment funds) will stimulate
aggregate demand (shifting AD from AD1 to AD2).
In addition, lower resource prices will reduce production prices
(because of weak demand and abnormally high unemployment)
and thereby stimulate SRAS (shifting SRAS to SRAS2).
This output will move the economy toward full-employment
capacity. However, this self-correction process may take some time.
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8. The Great Debate:
-- How rapidly does
the self-corrective
mechanism work?
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The Great Debate:
-- How rapidly does the
self-corrective mechanism work?

Many economists believe that the selfcorrective mechanism works slowly.



If this is the case, then market economies will
still experience prolonged periods of abnormally
high unemployment and below-capacity output.
Others believe that the self-corrective
mechanism works fairly rapidly if it is not
disrupted by perverse monetary and fiscal policy.
This is an important and continuing debate that
we will return to and analyze in more detail as
we proceed.
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Questions for Thought:
1. Suppose consumers and investors suddenly become
more pessimistic about the future and therefore
decide to reduce their consumption and investment
spending. How will a market economy adjust to this
increase in pessimism? What will happen to the real
rate of interest?
2. Suppose that an unexpectedly rapid growth in real
income abroad leads to a sharp increase in the demand
for U.S. exports. What impact will this change have on
the price level, output, and employment in the short
run? In the long run?
3. When current output is less than full employment
capacity, explain how the self-corrective mechanism
will direct output toward the economy’s long-run
potential. Can you think of any reason why this
mechanism might not work? Discuss.
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End
Chapter 10
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