Transcript increase in short-run aggregate supply

Chapter 10 homework
• Numbers 4, 7, 11, 12 and 18
Chapter 11
From Short-Run
to Long-Run
Equilibrium: The
Model in Action
Changing Aggregate Demand
and Short-Run Aggregate Supply
• Basic changes in aggregate demand or
short-run aggregate supply can explain four
basic macroeconomic outcomes in the
short run:

Increasing aggregate demand
• Growing economy with a higher price level

Decreasing aggregate demand
• Recession with lower price levels

Increasing short-run aggregate supply
• Growing economy with a lower price level

Decreasing short-run aggregate supply
• Recession with a higher price level
Changing Aggregate Demand
• Growing economy with a rising price level.

increase in aggregate demand

Business cycle expansion:
• Demand-Side Inflation
• AD shifts to the right increasing prices
• Example: U.S. recovery of the late 1990s.

US consumers were optimistic, stock prices and
home prices were rising (people felt wealthy), CPI
increased by about 10%, unemployment fell from 6
to 4%
Figure 11.1(a) Impact of Changing Aggregate
Demand on Short-Run Equilibrium
Changing Aggregate Demand
• Recession with a falling price level.

decrease in aggregate demand

Example: The Great Depression of the 1930s
• Consumption collapsed, taxes went up and government
spending was cut (to balance budget), trade wars reduced
exports
• GDP fell by 27%, unemployment reached 24%, price
levels fell by 25%
• This situation is relatively rare today as
governments have tools to prevent a decline
in aggregate demand.
Figure 11.1(b) Impact of Changing Aggregate
Demand on Short-Run Equilibrium
Changing Short-Run Aggregate Supply
• Growing economy with a falling price
level.

increase in short-run aggregate supply

Example: Hong Kong, Mali, Libya, Bahrain
and Oman all experienced lower prices and
higher real GDP for at least one year from
2001 to 2004.
• Most often results from new investment,
which increases productivity.
Figure 11.2(a) Impact of Changing Short-Run
Aggregate Supply on Short-Run Equilibrium
Changing Short-Run Aggregate Supply
• Recession with a rising price level.

decrease in short-run aggregate supply

Usual pattern of recessions in the United
States over the past 30 years.
• Sometimes called stagflation, or supply-side
inflation
• Can be caused by increases in business
taxes, declining productivity, pessimistic
expectations and higher energy prices.
Figure 11.2(b) Impact of Changing Short-Run
Aggregate Supply on Short-Run Equilibrium
Can we do it?
• Number 2

From 1948 to 1949, the US price level fell
from 24.1 to 23.8 while real GDP fell from
$1.64 trillion to $1.63 trillion. Graph this
situation using a change in either aggregate
demand alone or short-run aggregate supply
alone. What economic phenomenon does
this illustrate?
Answer???
This is a demand-side or spending recession, as prices and GDP
both fall from a reduction in aggregate demand.
The Long-Run Model of Aggregate
Demand and Aggregate Supply
• Illustrates a self-adjusting mechanism that can
move the macroeconomy to the full employment
level of real GDP.

Based on the classical school of economic thought
The Classical School
of Economic Thought
• Developed as the English economy was
entering in the Industrial Revolution.

The first Classical economists wrote during the
period from 1776 to 1850.
• Typified by Adam Smith in The Wealth of
Nations (1776), classical economists believed
the economy achieves full employment
equilibrium in the long run.
• Old…but some economists still believe in it
The Basic Beliefs of the Classical School
• Usually we are at or very close to the full
employment level of real GDP.
• The economy will tend to generate and
maintain full employment without government
intervention.

Laissez faire
• Let do, let go, let pass
• Any deviations will tend be minor, temporary,
and self-correcting.
Basis for the Long-Run Model
• The long-run belief in full employment
depends on three observations regarding
the nature of the macro-economy:

Say’s Law

The loanable funds market

Price and wage flexibility
Say’s Law
• The belief the supply creates its
own demand

The act of supplying goods to an economy
generates enough income to buy all those
same goods and services.
The Loanable Funds Market
• Say’s law is too simple
• It ignores saving.

If households save a portion of their incomes,
then some of the goods produced in the
economy would not be purchased. As a
result:
• Inventories would accumulate.
• Firms would cut back on production.
• Unemployment would increase.
The Loanable Funds Market (cont’d)
• The loanable funds market converts saving
into spending by bringing “savers” and
“borrowers” together
• Savers are the suppliers of loanable funds.

Seek the highest possible interest rate.
• Borrowers are demanders of loanable funds.

Seek the lowest possible interest rate.
The Loanable Funds Market (cont’d)
• Establishes the equilibrium interest rate

Quantity of funds savers want to save is
exactly equal to the quantity of funds that
borrowers demand.
Figure 11.3(a)
Operation of the Loanable Funds Market
Figure 11.3(b)
Operation of the Loanable Funds Market
Price and Wage Flexibility
• Wages and prices are fully and freely
flexible.

They are equally likely to go up or down.
• This flexibility is crucial to the economy’s
long-run self-adjustment process.
Price and Wage Flexibility (cont’d)
• Suppose that the quantity of aggregate
demand is less than the quantity of
aggregate supply:

Inventories increase.

Some producers cut the price of their
product.

Workers will accept cuts in wages or benefits
in order to keep their jobs.
Life Lessons
• Givebacks and flexible wages:


Worker’s wages generally do not decrease.
Only rarely do workers in a struggling
industry voluntarily accept pay cuts.
• Airline industry
• In recent years, companies have been asking
workers to give up some of their benefits to
maintain competitiveness.