Transcript 29.3 aggregate demand

CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
Provide a technical definition of recession and
describe the history of the U.S. business cycle.
2
Explain the influences on aggregate supply.
3
Explain the influences on aggregate demand.
4
Explain how fluctuations in aggregate demand and
aggregate supply create the business cycle.
29.1 DEFINITIONS AND FACTS
The business cycle is a periodic but irregular up-anddown movement in production and jobs.
A business cycle has two phases, expansion and
recession, and two turning point, a peak and a trough.
Dating Business-Cycle Turning Points
The task of identifying and dating business-cycle
phases and turning points is performed by a private
research organization, the National Bureau of Economic
Research (NBER).
29.1 DEFINITIONS AND FACTS
To date the business-cycle turning points, the NBER
needs a definition of recession.
Recession
A decrease in real GDP that lasts for at least two
quarters (six months) or a period of significant decline in
total output, income, employment, and trade, usually
lasting from six months to a year and marked by
widespread contractions in many sectors of the
economy.
29.1 DEFINITIONS AND FACTS
U.S. Business-Cycle History
The NBER has identified 32 complete cycles starting
from a trough in December 1854.
Over all 32 complete cycles:
• The average length of an expansion is 35 months
(almost 3 years), the average length of a recession
is 18 months.
• The average time from trough to trough is 53
months (almost 4 1 ⁄2 years).
29.1 DEFINITIONS AND FACTS
So over the 147 years since 1854, the U.S. economy
has been in:
• Recession for about one third of the time
• Expansion for about two thirds of the time.
The 147-year averages hide significant changes that
have occurred in the length of a cycle and the relative
length of the recession and expansion phases.
29.1 DEFINITIONS AND FACTS
Figure 29.1
summarizes U.S.
recession,
expansion, and cycle
length since 1854.
Recessions have
shortened.
Expansions have
lengthened, and
complete cycles have
lengthened.
29.1 DEFINITIONS AND FACTS
Recent Cycles
The current cycle began at a trough that followed a
recession that ran from July 1990 to March 1991.
The economy expanded from March 1991 until March
2001.
This expansion, which lasted for 120 months, is the
longest in U.S. history.
29.1 DEFINITIONS AND FACTS
Figure 29.2(a) shows the
recent cycles in real GDP.
Recessions began in
mid-1990 and in March
2001.
The longest expansion
in U.S. history ran from
March 1991 to March
2001.
29.1 DEFINITIONS AND FACTS
When real GDP decreased
in the recession (part a),
The unemployment rate
increased (part b).
And a little later, the inflation
rate decreased (part c).
As real GDP increased back
toward potential GDP, the
unemployment rate fell
toward the natural
unemployment rate and the
inflation rate fell.
29.2 AGGREGATE SUPPLY
Aggregate supply is the relationship between the
quantity of real GDP supplied and the price level when
all other influences on production plans remain the
same.
Other things remaining the same,
• When the price level rises, the quantity of real
GDP supplied increases.
• When the price level falls, the quantity of real GDP
supplied decreases.
29.2 AGGREGATE SUPPLY
Aggregate Supply Basics
The quantity of real GDP supplied (Y), depends on:
• The quantity of labor employed
• The quantities of capital and human capital and
the technologies they embody
• The quantities of land and natural resources used
• The amount of entrepreneurial talent available
29.2 AGGREGATE SUPPLY
At full employment:
• The real wage rate makes the quantity of labor
demanded equal to the quantity of labor supplied.
• Real GDP equals potential GDP.
Over the business cycle:
• The quantity of labor employed fluctuates.
• The quantity of real GDP supplied fluctuates
around potential GDP.
29.2 AGGREGATE SUPPLY
 Aggregate Supply and Potential GDP
Along the aggregate supply curve, the only influence
that on production plans that changes is the price level.
All the other influences on production plans remain
constant. Among these other influences are:
• The money wage rate
• The money prices of other resources
Along the potential GDP line, when the price level
changes the money wage rate changes to keep the real
wage rate at the full-employment level.
29.2 AGGREGATE SUPPLY
Figure 29.3 shows a
change in the quantity of
real GDP supplied.
Other things remaining the
same,
1. A fall in the price level
increases the quantity of
real GDP supplied.
2. A rise in the price level
increases the quantity of
real GDP supplied.
29.2 AGGREGATE SUPPLY
Why the AS Curve Slopes Upward
When the price level rises and the money wage rate is
constant, the real wage rate falls and employment
increases. The quantity of real GDP supplied increases.
When the price level falls and the money wage rate is
constant, the real wage rate rises and employment
decreases. The quantity of real GDP supplied
decreases.
29.2 AGGREGATE SUPPLY
 Changes in Aggregate Supply
Aggregate supply changes when any influence on
production plans other than the price level changes.
In particular, aggregate supply changes when:
• Potential GDP changes.
• The money wage rate changes.
• The money prices of other resources change.
29.2 AGGREGATE SUPPLY
Changes in Potential GDP
Anything that changes potential GDP shifts the potential
GDP line and shifts the aggregate supply curve.
29.2 AGGREGATE SUPPLY
Figure 29.4 shows an
increase in potential GDP.
Point C at the intersection of
the potential GDP line and
AS curve is an anchor point.
1. An increase in potential
GDP shifts the potential
GDP line rightward and ...
2. The aggregate supply curve
shifts rightward from AS0 to
AS1.
29.2 AGGREGATE SUPPLY
Changes in Money Wages and Other Resource
Prices
A change in the money wage rate or the money price of
another resource changes aggregate supply because it
changes firms’ costs.
The higher the money wage rate, the higher are firms’
costs and the smaller is the quantity that firms are
willing to supply at each price level.
So an increase in the money wage rate decreases
aggregate supply.
29.2 AGGREGATE SUPPLY
Figure 29.5 shows the
effect of a change in the
money wage rate.
A rise in the money wage rate
decreases aggregate supply
and the aggregate supply
curve shifts leftward from AS0
to AS2.
A rise in the money wage rate
does not change potential
GDP.
29.3 AGGREGATE DEMAND
Aggregate demand is the relationship between the
quantity of real GDP demanded and the price level
when all other influences on expenditure plans remain
the same.
Other things remaining the same,
• When the price level rises, the quantity of
real GDP supplied increases.
• When the price level falls, the quantity of
real GDP supplied decreases.
29.3 AGGREGATE DEMAND
Aggregate Demand Basics
The quantity of real GDP demanded is the total amount
of final goods and services produced in the United
States that people, businesses, governments, and
foreigners plan to buy.
This quantity is the sum of the real consumption
expenditure (C), investment (I), government purchases
(G), and exports (X) minus imports (M).
That is,
Y=C+I+G+X–M
29.3 AGGREGATE DEMAND
Figure 29.6 shows a
change in the quantity of
real GDP demanded.
Other things remaining the
same,
1. A rise in the price level
decreases the quantity of
real GDP demanded.
2. A fall in the price level
increases the quantity of
real GDP demanded.
29.3 AGGREGATE DEMAND
Aggregate Demand and the AD Curve
The price level influences the quantity of real GDP
demanded because a change in the price level brings
changes in:
• The buying power of money
• The real interest rate
• The real prices of exports and imports
29.3 AGGREGATE DEMAND
The Buying Power of Money
A rise in the price level lowers the buying power of
money and decreases the quantity of real GDP
demanded.
For example, if the price level rises and other things
remain the same, a given quantity of money will less
goods and services, so people cut their spending.
So the quantity of real GDP demanded decreases.
29.3 AGGREGATE DEMAND
The Real Interest Rate
When the price level rises, the real interest rate rises.
An increase in the price level increases the amount of
money that people want to hold—increases the demand
for money.
When the demand for money increases, the nominal
interest rate rises.
In the short run, the inflation rate doesn’t change, so a
rise in the nominal interest rate brings a rise in the real
interest rate.
29.3 AGGREGATE DEMAND
Faced with a higher real interest rate, businesses and
people delay plans to buy new capital and consumer
durable goods and cut back on spending.
So the quantity of real GDP demanded decreases.
29.3 AGGREGATE DEMAND
The Real Prices of Exports and Imports
When the U.S. price level rises and other things remain
the same, the prices in other countries do not change.
So a rise in the U.S. price level makes U.S.-made
goods and services more expensive relative to foreignmade goods and services.
This change in real prices encourages people to spend
less on U.S.-made items and more on foreign-made
items.
29.3 AGGREGATE DEMAND
In the long run, when the price level changes by more in
one country than in other countries, the exchange rate
changes.
The exchange rate neutralizes the price level change,
so this international price effect on buying plans is a
short-run effect only.
But the short-run effect is powerful.
29.3 AGGREGATE DEMAND
Changes in Aggregate Demand
A change in any factor that influences expenditure plans
other than the price level brings a change in aggregate
demand.
• When aggregate demand increases, the aggregate
demand curve shifts rightward.
• When aggregate demand decreases, the
aggregate demand curve shifts leftward.
29.3 AGGREGATE DEMAND
The factors that change aggregate demand are:
• Expectations about the future
• Monetary policy and fiscal policy
• The state of the world economy
29.3 AGGREGATE DEMAND
Expectations
An increase in expected future income increases the
amount of consumption goods that people plan to buy
today and increases aggregate demand.
An increase in expected future inflation increases
aggregate demand today because people decide to buy
more goods and services before their prices rise.
An increase in expected future profit increases the
investment that firms plan to undertake today and
increases aggregate demand.
29.3 AGGREGATE DEMAND
Fiscal Policy and Monetary Policy
Government can influence aggregate demand by setting and changing taxes, transfer payments, and
government purchases of goods and services.
The Federal Reserve can influence aggregate demand
by changing the quantity of money and the interest rate.
29.3 AGGREGATE DEMAND
A tax cut or an increase in either transfer payments or
government purchases increases aggregate demand.
A cut in the interest rate or an increase in the quantity
of money increases aggregate demand.
29.3 AGGREGATE DEMAND
The World Economy
The foreign exchange arte and foreign income influence
aggregate demand.
Other things remaining the same, a rise in the foreign
exchange rate decreases aggregate demand.
An increase in foreign income increases U.S. exports
and increases U.S. aggregate demand.
29.3 AGGREGATE DEMAND
Figure 29.7 shows changes
in aggregate demand.
1. Aggregate demand increases if
• Expected future income,
inflation, or profits increase.
• Fiscal policy or monetary
policy increase planned
expenditure.
• The exchange rate falls or
foreign income increases.
29.3 AGGREGATE DEMAND
2. Aggregate demand decreases
if:
• Expected future income,
inflation, or profits decrease.
• Fiscal policy or monetary
policy decrease planned
expenditure.
• The exchange rate rises or
foreign income decreases.
29.3 AGGREGATE DEMAND
The Aggregate Demand Multiplier
The aggregate demand multiplier is an effect that
magnifies changes in expenditure plans and brings
potentially large fluctuations in aggregate demand.
When any influence on aggregate demand changes
expenditure plans:
• The change in expenditure changes income.
• And the change in income induces a change in
consumption expenditure.
29.3 AGGREGATE DEMAND
• The increase in aggregate demand is the initial
increase in expenditure plus the induced increase
in consumption expenditure.
29.3 AGGREGATE DEMAND
Figure 29.8 shows the aggregate
demand multiplier.
1. An increase in investment
increases aggregate demand
and increases income.
2..The increase in income
induces an increase in
consumption expenditure, so
3. Aggregate demand increases
by more than the initial
increase in investment.
29.4 UNDERSTANDING BUSINESS CYCLES
Aggregate supply and aggregate demand determine
real GDP and the price level.
Changes in aggregate supply and aggregate demand
bring changes in real GDP and the price level.
These changes generate the business cycle.
29.4 UNDERSTANDING BUSINESS CYCLES
Aggregate Demand Fluctuations
Consider a business cycle that results from fluctuations
in aggregate demand with no changes in aggregate
supply.
Over time, potential GDP grows and the fullemployment price level rises.
To focus on the business cycle, we’ll ignore economic
growth and inflation and suppose that potential GDP
and the full-employment price level is constant.
29.4 UNDERSTANDING BUSINESS CYCLES
Figure 29.9 shows
an aggregate
demand cycle.
Real GDP is $9.5
trillion at the
intersection of AS
and AD0 in part
(a), and the
economy is in a
trough at point A
in part (c).
29.4 UNDERSTANDING BUSINESS CYCLES
An increase in
investment
increases
aggregate
demand through
AD1 to AD2.
The economy
moves from A
through full
employment at B
to a cycle peak at
C.
29.4 UNDERSTANDING BUSINESS CYCLES
A decrease in
investment
decreases
aggregate
demand trough
AD3 to AD4.
The economy
moves from C
through full
employment at D
to a cycle trough
at E.
29.4 UNDERSTANDING BUSINESS CYCLES
Aggregate Supply Fluctuations
Aggregate supply fluctuates for two types of reasons.
• Potential GDP grows at an uneven pace.
• The money price of a major resource, such as
crude oil, might change.
Stagflation
A combination of recession (falling real GDP) and
inflation (rising price level).
29.4 UNDERSTANDING BUSINESS CYCLES
Figure 29.10 shows an oil
price cycle.
A rise in the price of oil
decreases aggregate
supply and shifts the AS
curve leftward to AS1.
Real GDP decreases, and
the price level rises.
The economy experiences
stagflation.
29.4 UNDERSTANDING BUSINESS CYCLES
A fall in the price of oil
increases aggregate supply
and shifts the AS curve
rightward to AS2.
The price level falls and real
GDP increases.
The economy experiences an
expansion.
29.4 UNDERSTANDING BUSINESS CYCLES
Adjustment Toward Full Employment
When the economy is away from full employment,
forces operate to restore full employment.
Inflationary gap
A gap that exists when real GDP exceeds potential GDP
and that brings a rising price level.
Deflationary gap
A gap that exists when potential GDP exceeds real GDP
and that brings a falling price level.
29.4 UNDERSTANDING BUSINESS CYCLES
Figure 29.11 shows
adjustments toward full
employment.
Real GDP exceeds potential
GDP — there is an
inflationary gap.
As the money wage rate
gradually rises, aggregate
supply decreases, real GDP
decreases, and the price level
rises.
29.4 UNDERSTANDING BUSINESS CYCLES
Potential GDP exceeds real
GDP — there is a
deflationary gap.
The money wage rate
eventually starts to fall,
aggregate supply
increases, real GDP
increases, and the price
level falls.