Transcript Chapter 7 File

Chapter 7
Aggregate
Demand,
Aggregate
Supply, and the
Self-Correcting
Economy
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Review of Demand Shocks
• Consumption: Changes in consumer confidence, stock
market prices and housing prices can alter autonomous C
• Planned Investment: Changes in business optimism
and expectations of future profits can alter I
• Money Supply: Changes in the money supply affect the
interest rate, which affects interest-sensitive components of
autonomous C and I
• Exchange Rates: Changes in e can affect net exports
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Aggregate Demand
• The Aggregate Demand (AD) curve shows
the different combinations of the price level
and real output at which the money and
commodity markets are both in equilibrium.
• Recall: Any increase in C + I + G + NX will
cause the AD curve to shift to the right.
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Figure 7-1 Effect on Real Income
of Different Values of the Price
Level
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Figure 7-2 The Effect on the AD
Curve of a Doubling of the
Nominal Money Supply
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Figure 7-3 The Effect on the AD
Curve of a Decline in Planned
Autonomous Spending
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Aggregate Supply
• The Short-Run Aggregate Supply (SAS) curve
shows the amount of output that business firms
are willing to produce at different price levels,
holding constant the nominal wage rate.
– The SAS curve is upward sloping since an increase in
the price level will increase profits for firms assuming
wages and other input costs are fixed. This results in
firms increasing output at higher prices.
• The Long-Run Aggregate Supply (LAS) curve
shows the amount that business firms are willing
to produce when the nominal wage rate has fully
adjusted to any changes in the price level.
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Controversies Surrounding AS
• The three possible shapes of the AS curve has created
decades of controversy.
• The horizontal AS curve assumes prices are fixed but is
unrealistic because it cannot explain inflation.
• The vertical AS curve assumes prices are perfectly
flexible and is useful to analyze inflation, but cannot explain
unemployment.
• The positively sloped short-run AS curve assumes that
wages are fixed, so it cannot be applied to the long run, but
it helps to explain short-run fluctuations in output.
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7-8
Figure 7-4 Effect of a Rightward Shift
in the AD Curve with Three Alternative
Short-Run Aggregate Supply Curves
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7-9
Deriving the SAS Curve
• Assume that wages are fixed in the short run and that
prices are merely “sticky.”
• If prices rise, firms benefit because the real wage paid to
their workers falls.
• Thus, firms can increase output if the price level rises
because their profits increase!
– P  Y , which yields an upward-sloping SAS curve
• How steep is the SAS curve?
– If Labor Demand is relatively inelastic, SAS will be steeper!
– Why? If P  W/P  LD by a little  Y by a little
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7-10
Figure 7-5 The Labor Demand
Curve and the Short-Run
Aggregate Supply Curve
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7-11
Figure 7-6 The Short-Run Aggregate
Supply Curve for Two Different Values
of the Wage Rate, and W0 W1
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Determining the Equilibrium
W/P
• Recall: LD depends negatively on the real wage
• We will assume that LS increases with W/P
• What increases or shifts LS to the right?
– An increase in the working-age population
– A decrease in the availability of unemployment or
welfare benefits
• W/P is determined by the equality of LD and LS
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Figure 7-7 Determination of the
Equilibrium Real Wage Rate
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Figure 7-8 Effects on the Price Level and
Real Income of an Increase in Planned
Autonomous Spending from to AD1 to AD0
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The Quantity Theory of Money
• Classical economists believed that flexible prices were the
self-correcting forces that could stabilize real GDP.
• The “Quantity Equation” was a model developed by
classical economists:
•
MSV = PY
• The Quantity Theory of Money holds that:
– Actual output tends to grow steadily
– Velocity is determined by payment practices
– MS changes therefore affect the price level and have little effect on
output
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The Failure of Self-Correction
• The Keynesian Revolution started with publication of John Maynard
Keyne’s The General Theory in 1936 in response to failures of
classical economic ideas during The Great Depression.
• Monetary Impotence is the failure of real GDP to respond to an
increase in the real MS when either:
– The IS curve is vertical
– The LM curve is horizontal (i.e. Liquidity Trap)
•
Rigid Wages refers to the failure of the nominal wage rate to adjust by
the amount needed to maintain equilibrium in the labor market.
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Figure 7-9 Effect of a Decline in
Planned Spending When the Price
Level Is Perfectly Flexible
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7-18
Figure 7-10 The Lack of Effect of a
Drop in the Price Level When There Is
a Failure of Self-Correction
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Figure 7-11 Effect of a Decline in
Planned Spending When the
Nominal Rate Is Fixed at W0
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Stabilizing and Destabilizing
Effects of P
• Stabilizing Effects of P
– The Pigou or Real Balance Effect is the direct stimulus to AD
caused by an increase in the real money supply and does not
require a decline in the interest rate.
– The Keynes Effect is the stimulus to AD caused by a decline in the
interest rate.
• Destabilizing Effects of P
– The Expectations Effect is the decline in AD caused by the
postponement of purchases when consumers expect P.
– The Redistribution Effect is the decline in AD caused by the effect
of falling prices in redistributing income from high-spending debtors
to low-spending savers.
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What Caused the Great
Depression?
• Real investment fell by 74% from 1929 to 1933
• Sharp fall in consumption spending
• Fall in NX due to failure to devalue the USD until
1933 and protective tariffs
• Bank failures
• Tight monetary policy: Nominal MS fell by 25%
from 1929 to 1933
• No price decline from 1936 to 1940
– 26% decline from 1929 to 1933
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Table 7-1 Money, Output,
Unemployment, Prices, and Wages in
the Great Depression, 1929–41
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International Perspective: Why Was
the Great Depression Worse in the
United States than in Europe?
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Figure 7-12 The Price Level (P) and the
Ratio of Actual to Natural Real GDP (Y /YN)
During the Great Depression, 1929–41
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Chapter Equations
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Chapter Equations
Changes in Aggregate Demand
Changes in Real GDP 
Fixed Price Level
M sV  PY
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(7.1)
(7.2)
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