Transcript Chapter 11 - The Citadel

Chapter 11
Aggregate Demand
and Supply
Introduction
Economists and financial news media
anticipate the latest measure of total
output by the Bureau of Economic
Analysis (BEA).
How does the BEA attempt to gauge the
economy’s performance?
You will find out in this chapter.
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8-2
Did You Know That...
• Decisions on how to categorize
business expenses will affect the
relative size of an increase or a
decrease in economic activity?
• Statisticians measuring our national
economic performance strive for
consistency in constructing their
measures across time?
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8-3
The Simple Circular Flow
• Two observations
1. In every economic exchange, the seller
receives exactly the same amount that the
buyer spends.
2. Goods and services flow in one direction
and money payments flow in the other.
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8-4
The Simple Circular Flow (cont'd)
• Profits explained
 Question
 Why
is profit a cost of production?
 Answer
 Profits
are the return entrepreneurs receive
for the risk they incur when organizing
productive activities.
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8-5
The Simple Circular Flow (cont'd)
• Final Goods and Services
 Goods and services that are at their final stage of
production and will not be transformed into yet
other goods or services
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8-6
Figure 8-1 The Circular Flow
of Income and Product
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8-7
The Simple Circular Flow (cont'd)
• Product Markets
 Transactions in which households buy goods
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8-8
The Simple Circular Flow (cont'd)
• Factor Markets
 Transactions in which businesses buy resources
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8-9
The Simple Circular Flow (cont'd)
• Total Income
 Wages, rent, interest, profits
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8-10
The Simple Circular Flow (cont'd)
• Question
 Why must total income
be identical to the dollar
value of total output?
• Answer
 Every transaction
simultaneously involves
an expenditure and
a receipt.
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8-11
National Income Accounting
• National Income Accounting
 A measurement system used to estimate
national income and its components
• Total Income
 The yearly amount earned by the nation’s
resources (factors of production)
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8-12
National Income Accounting (cont'd)
• Gross Domestic Product (GDP)
 The total market value of all final
goods and services produced by
factors of production located within
a nation’s borders
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8-13
National Income Accounting (cont'd)
• Observations
 GDP measures the dollar value of
final output.
 GDP measures the dollar value of final
goods and services produced per year
by factors of production located within
a nation’s borders.
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8-14
National Income Accounting (cont'd)
• Stress on final output
 What is a final good?
 Wheat?
 Steel?
 Oil?
 Bread?
 Automobile?
 Gasoline?
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8-15
National Income Accounting (cont'd)
• Intermediate Goods
 Goods used up entirely in the production of
final goods
• Value Added
 The dollar value of an industry’s sales
minus the value of intermediate goods
(for example, raw materials and parts)
used in production
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8-16
Table 8-1 Sales Value and Value Added
at Each Stage of Donut Production
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8-17
National Income Accounting (cont'd)
• Exclusion of financial transactions,
transfer payments, and
secondhand goods
 Numerous transactions occur that have
nothing to do with final goods and services
being produced.
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8-18
National Income Accounting (cont'd)
• Exclusion of financial transactions
 Securities

Stocks and bonds
 Government transfer payments

Social Security

Unemployment compensation
 Private transfer payments

Individual gifts

Corporate gifts
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8-19
National Income Accounting (cont'd)
• Transfer of secondhand
goods excluded
 Why not count the sale of a used
computer, guitar, or snowboard as part
of GDP?
• Other excluded transactions
 Household production
 Legal and illegal underground transactions
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8-20
National Income Accounting (cont'd)
• GDP’s limitations
 Excludes non-market production
 It is not necessarily a good measure of the
well-being of a nation.
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8-21
National Income Accounting (cont'd)
• GDP is a measure of the value of
production in terms of market prices,
and an indicator of economic activity.
• GDP is not a measure of a nation’s
overall welfare.
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8-22
Two Main Methods
of Measuring GDP
• Expenditure Approach
 Computing GDP by adding up the dollar
value at current market prices of all final
goods and services
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8-23
Two Main Methods
of Measuring GDP (cont'd)
Expenditure Approach
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8-24
Two Main Methods
of Measuring GDP (cont'd)
• Income Approach
 Measuring GDP by adding up all
components of national income, including
wages, interest, rent, and profits
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8-25
Two Main Methods
of Measuring GDP (cont'd)
Income Approach
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8-26
Two Main Methods
of Measuring GDP (cont'd)
• Deriving GDP by the expenditure approach
 Consumption Expenditure (C)

Durable Consumer Goods


Nondurable Consumer Goods


Life span of more than three years
Goods that are used up in three years
Services

Mental or physical help
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8-27
Two Main Methods
of Measuring GDP (cont'd)
• Deriving GDP by the
expenditure approach
 Gross Private Domestic Investment (I)
 The
creation of capital goods, such as factories
and machines, that can yield production and
hence consumption in the future

Also included: changes in business inventories and
repairs made to machines, buildings
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8-28
Two Main Methods
of Measuring GDP (cont'd)
• Deriving GDP by the expenditure approach
 Gross Private Domestic Investment (I)

Producer Durables or Capital Goods


Fixed Investment


Life span of more than three years
Purchases by business of newly produced producer
durables or capital goods
Inventory Investment

Changes in stocks of finished goods and goods in
process, as well as changes in raw materials
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8-29
Two Main Methods
of Measuring GDP (cont'd)
• Deriving GDP by the
expenditure approach
 Government Expenditures (G)
 State,
local, and federal
 Valued
at cost
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8-30
Two Main Methods
of Measuring GDP (cont'd)
• Deriving GDP by the
expenditure approach
 Net Exports (Foreign Expenditures)
Net exports (X) = Total exports – Total imports
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8-31
Two Main Methods
of Measuring GDP (cont'd)
• Presenting the expenditure approach
 Where
C
= consumption expenditures
I
= investment expenditures
G
= government expenditures
X
= net exports
GDP = C + I + G + X
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8-32
Figure 8-2
GDP and Its Components
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8-33
Deriving GDP
by the Income Approach
• Gross Domestic Income (GDI)
 The sum of all income—wages, interest,
rent, and profits—paid to the four factors
of production
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8-34
Two Main Methods
of Measuring GDP (cont'd)
• Gross Domestic Income (GDI)
 Wages: salaries and labor income
 Rent: farms, houses, stores
 Interest: savings accounts
 Profits: sole proprietorships, partnerships,
corporations
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8-35
Figure 8-3 Gross Domestic Product
and Gross Domestic Income, 2007
(in billions of 2007 dollars per year)
Source: U.S. Department of Commerce. First quarter preliminary data annualized.
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8-36
Figure 8-3 Gross Domestic Product
and Gross Domestic Income, 2007
(in billions of 2007 dollars per year)
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8-37
Other Components of
National Income Accounting
• National Income (NI)
 The total of all factor payments to resource
owners
• Personal Income (PI)
 The amount of income that households
actually receive before they pay personal
income taxes
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8-38
Other Components of
National Income Accounting (cont'd)
• Disposable Personal Income (DPI)
 Personal income after personal income
taxes have been paid
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8-39
Table 8-2 Going from GDP
to Disposable Income, 2007
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8-40
Distinguishing Between Nominal
and Real Values
• Nominal Values
 Measurements in terms of the actual
market prices at which goods are sold;
expressed in current dollars, also called
money values
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8-41
Distinguishing Between Nominal
and Real Values (cont'd)
• Real Values
 Measurements after adjustments have
been made for changes in the average
of prices between years; expressed in
constant dollars
• Constant Dollars
 Dollars expressed in terms of real
purchasing power
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8-42
Example: Correcting GDP
for Price Index Changes
• Correcting GDP for price index changes
 Nominal (current) dollars GDP
 Real (constant) dollars GDP
Nominal GDP
x 100
Real GDP =
Price level*
*Price level: measured by the GDP deflator
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8-43
Table 8-3 Correcting GDP
for Price Index Changes
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8-44
Distinguishing Between Nominal
and Real Values (cont'd)
• Per capita GDP
 Adjusting for population growth
Real GDP
Per capita real GDP =
Population
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8-45
Figure 8-4 Nominal and Real GDP
Source: U.S. Department of Commerce
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8-46
Table 8-4
Comparing GDP Internationally
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8-47
Issues and Applications:
The Art of Estimating GDP
Often Requires Touch-Ups
• The Bureau of Economic Analysis gives an
advance estimate of quarterly GDP.
• The estimate receives considerable attention
from the news media.
• Nevertheless, the estimate is updated at
least two times.
• How different is the final result?
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8-48
Figure 8-5 Effects of Revisions
in GDP Estimates on Measured
GDP Growth Rates
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8-49
Did You Know That...
• The price of a bottle of Coca-Cola remained
unchanged at 5 cents from 1886–1959?
• Prices of final goods and services have not
always adjusted immediately in response to
changes in aggregate demand?
• The classical model and the Keynesian
approach help in understanding variations in
real GDP and the price level?
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11-50
The Classical Model
• The classical model was the first
attempt to explain
 Determinants of the price level
 National levels of real GDP
 Employment
 Consumption
 Saving
 Investment
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11-51
The Classical Model (cont'd)
• Classical economists—Adam Smith,
J.B. Say, David Ricardo, John Stuart
Mill, Thomas Malthus, A.C. Pigou, and
others—wrote from the 1770s to
the 1930s.
• They assumed wages and prices were
flexible, and that competitive markets
existed throughout the economy.
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11-52
The Classical Model (cont'd)
• Say’s Law
 A dictum of economist J.B. Say that supply
creates its own demand
 Producing goods and services generates the
means and the willingness to purchase other
goods and services.
 Supply creates its own demand; hence it
follows that desired expenditures will equal
actual expenditures.
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11-53
Figure 11-1 Say’s Law and the
Circular Flow
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11-54
The Classical Model (cont'd)
• Assumptions of the classical model
 Pure competition exists.
 Wages and prices are flexible.
 People are motivated by self-interest.
 People cannot be fooled by money illusion.
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11-55
The Classical Model (cont'd)
• Money Illusion
 Reacting to changes in money prices
rather than relative prices
 If a worker whose wages double when the
price level also doubles thinks he or she is
better off, that worker is suffering from
money illusion.
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11-56
The Classical Model (cont'd)
• Consequences of the assumptions
 If the role of government in the economy is
minimal,
 If pure competition prevails, and all prices and
wages are flexible,
 If people are self-interested, and do not
experience money illusion,
 Then problems in the macroeconomy will be
temporary and the market will correct itself.
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11-57
The Classical Model (cont'd)
• Equilibrium in the credit market
 When income is saved, it is not reflected in
product demand.
 It is a type of leakage from the circular flow
of income and output, because saving
withdraws funds from the income stream.
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11-58
The Classical Model (cont'd)
• Equilibrium in the credit market
 Classical economists contended each
dollar saved would be matched by
business investment.
 Leakages would thus equal injections.
 At equilibrium, the price of credit—the
interest rate—ensures that the amount
of credit demanded equals the
amount supplied.
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11-59
Figure 11-2 Equating Desired Saving
and Investment in the Classical Model
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11-60
Equating Desired Saving and
Investment in the Classical Model
• Summary
 Changes in saving and investment create
a surplus or shortage in the short run.
 In the long run, this is offset by changes in
the interest rate.
 This interest rate adjustment returns the
market to equilibrium where S = I.
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11-61
International Example: A Global
Credit Market Awash in Saving
• In the 2000s, the U.S. credit market received
substantial inflows of saving from abroad.
• The result has been a rightward shift in the
U.S. saving supply curve, contributing to
generally lower equilibrium interest rates.
• What would happen to U.S. interest rates if
foreign residents decided to shift their saving
to other nations?
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11-62
The Classical Model (cont'd)
• Question
 Would unemployment be a problem in the
classical model?
• Answer
 No, classical economists assumed
wages would always adjust to the full
employment level.
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11-63
Figure 11-3
Equilibrium in the Labor Market
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11-64
Table 11-1 The Relationship
Between Employment and Real GDP
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11-65
Classical Theory, Vertical Aggregate
Supply, and the Price Level
• In the classical model, long-term
unemployment is impossible.
• Say’s law, coupled with flexible interest rates,
prices, and wages would tend to keep
workers fully employed.
• The LRAS curve is vertical.
• A change in aggregate demand will cause a
change in the price level.
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11-66
Figure 11-4 Classical Theory and
Increases in Aggregate Demand
Classical theorists
believed that Say’s law,
flexible interest rates,
prices, and wages
would always lead to
full employment at real
GDP of $12 trillion
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11-67
Figure 11-5 Effect of a Decrease
in Aggregate Demand in the
Classical Model
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11-68
Keynesian Economics and the Keynesian
Short-Run Aggregate Supply Curve
• The classical economists’ world was one of
fully utilized resources.
• In the 1930s, Europe and the United States
entered a period of economic decline that
could not be explained by the classical model
• John Maynard Keynes developed an
explanation that has become known as the
Keynesian model.
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11-69
Keynesian Economics and
the Keynesian Short-Run
Aggregate Supply Curve (cont'd)
• Keynes and his followers argued
 Prices, including wages (the price of labor)
are inflexible, or “sticky”, downward
 An increase in aggregate demand, AD, will
not raise the price level
 A decrease in AD will not cause firms to
lower the price level
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11-70
Keynesian Economics and
the Keynesian Short-Run
Aggregate Supply Curve (cont'd)
• Keynesian Short-Run Aggregate
Supply Curve
 The horizontal portion of the aggregate
supply curve in which there is excessive
unemployment and unused capacity in
the economy
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11-71
Figure 11-6 Demand-Determined
Equilibrium Real GDP at Less
Than Full Employment
Keynes assumed
prices will not fall
when aggregate
demand falls
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11-72
Keynesian Economics and
the Keynesian Short-Run
Aggregate Supply Curve (cont'd)
• Real GDP and the price level, 1934–1940
 Keynes argued that in a depressed economy,
increased aggregate spending can increase
output without raising prices.
 Data showing the U.S. recovery from the Great
Depression seem to bear this out.
 In such circumstances, real GDP is
demand driven.
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11-73
Figure 11-7 Real GDP and the
Price Level, 1934–1940
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11-74
Keynesian Economics and
the Keynesian Short-Run
Aggregate Supply Curve (cont'd)
• The Keynesian model
 Equilibrium GDP is demand-determined.
 The Keynesian short-run aggregate supply
schedule shows sources of price rigidities.
 Union
and long-term contracts explain
inflexibility of nominal wage rates.
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11-75
Example: Bringing Keynesian Short-Run
Aggregate Supply Back to Life
• New Keynesians contend the SRAS curve is
essentially flat.
• Based on research, they contend SRAS is
horizontal because firms adjust their prices
about once a year.
• If the SRAS schedule were really horizontal,
how could the price level ever increase?
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11-76
Output Determination Using Aggregate
Demand and Aggregate Supply: Fixed versus
Changing Price Levels in the Short Run
• The underlying assumption of the simplified
Keynesian model is that the relevant range of
the short-run aggregate supply schedule
(SRAS) is horizontal.
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11-77
Output Determination Using Aggregate
Demand and Aggregate Supply: Fixed versus
Changing Price Levels in the Short Run (cont'd)
• The price level has drifted upward in
recent decades.
• Prices are not totally sticky.
• Modern Keynesian analysis recognizes
some—but not complete—price
adjustment takes place in the short run.
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11-78
Output Determination Using Aggregate
Demand and Aggregate Supply: Fixed versus
Changing Price Levels in the Short Run (cont'd)
• Short-Run Aggregate Supply Curve
 Relationship between total planned
economywide production and the price
level in the short run, all other things
held constant
 If prices adjust incompletely in the short
run, the curve is positively sloped.
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11-79
Figure 11-8 Real GDP Determination
with Fixed versus Flexible Prices
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11-80
Output Determination Using Aggregate
Demand and Aggregate Supply: Fixed versus
Changing Price Levels in the Short Run (cont'd)
• In modern Keynesian short run, when the
price level rises partially, real GDP can be
expanded beyond the level consistent with its
long-run growth path.
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11-81
Output Determination Using Aggregate
Demand and Aggregate Supply: Fixed versus
Changing Price Levels in the Short Run (cont'd)
• All these adjustments cause real GDP to
rise as the price level increases
 Firms use workers more intensively, (getting
workers to work harder)
 Existing capital equipment used more intensively,
(use machines longer)
 If wage rates held constant, a higher price level
leads to increased profits, which leads to lower
unemployment as firms hire more
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11-82
Shifts in the Aggregate Supply Curve
• Just as non-price-level factors can
cause a shift in the aggregate demand
curve, there are non-price-level factors
that can cause a shift in the aggregate
supply curve.
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11-83
Shifts in the Aggregate
Supply Curve (cont'd)
• Shifts in both the short- and long-run
aggregate supply
• Shifts in SRAS only
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11-84
Figure 11-9 Shifts in Both Shortand Long-Run Aggregate Supply
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11-85
Figure 11-10 Shifts in SRAS Only
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11-86
Table 11-2
Determinants of Aggregate Supply
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11-87
Consequences of Changes
in Aggregate Demand
• Aggregate Demand Shock
 Any event that causes the aggregate
demand curve to shift inward or outward
• Aggregate Supply Shock
 Any event that causes the aggregate
supply curve to shift inward or outward
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11-88
Figure 11-11 The Short-Run Effects of Stable
Aggregate Supply and a Decrease in
Aggregate Demand: The Recessionary Gap
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11-89
Consequences of Changes
in Aggregate Demand (cont'd)
• Recessionary Gap
 The gap that exists whenever equilibrium
real GDP per year is less than fullemployment real GDP as shown by the
position of the LRAS curve
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11-90
Consequences of Changes
in Aggregate Demand (cont'd)
• Inflationary Gap
 The gap that exists whenever equilibrium
real GDP per year is greater than fullemployment real GDP as shown by the
position of the LRAS curve
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11-91
Figure 11-12 The Effects of Stable
Aggregate Supply with an Increase in
Aggregate Demand: The Inflationary Gap
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11-92
Explaining Short-Run
Variations in Inflation
• In a growing economy, the explanation
for persistent inflation is that aggregate
demand rises over time at a faster
pace than the full-employment level
of real GDP.
• Short-run variations in inflation,
however, can arise as a result of both
demand and supply factors.
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11-93
Explaining Short-Run
Variations in Inflation (cont'd)
• Demand-Pull Inflation
 Inflation caused by increases in aggregate
demand not matched by increases in
aggregate supply
• Cost-Push Inflation
 Inflation caused by decreases in short-run
aggregate supply
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11-94
Figure 11-13 Cost-Push Inflation
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11-95
International Policy Example:
Can Iran’s Vicious Cycle of Supply
Shocks be Smoothed?
• Iran, located at the boundary between
two plates of the earth’s crust, has
experienced hundreds of earthquakes
since 1990.
• The economic effects in each case
were predictable: fewer resources
meant the aggregate supply curve
shifted leftward.
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11-96
International Policy Example:
Can Iran’s Vicious Cycle of Supply
Shocks be Smoothed? (cont'd)
• How might the establishment and
enforcement of building codes promote
long-term Iranian growth as well as help
shield the nation from recurring
aggregate supply shocks?
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11-97
Aggregate Demand and Supply
in an Open Economy
• The open economy is one of the
reasons why aggregate demand
slopes downward.
 When the domestic price level rises, U.S.
residents want to buy cheaper-priced
foreign goods.
 The opposite occurs when the U.S.
domestic price level falls.
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11-98
Aggregate Demand and Supply
in an Open Economy (cont'd)
• Currently, the foreign sector of the U.S.
economy constitutes over 14% of all
economic activities.
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11-99
Figure 11-14 The Two Effects
of a Weaker Dollar, Panel (a)
• Decrease in the
value of the dollar
raises the cost of
imported inputs.
• SRAS decreases.
• With AD constant,
the price level rises.
• GDP decreases.
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11-100
Figure 11-14 The Two Effects
of a Weaker Dollar, Panel (b)
• Decrease in
the value of the
dollar makes net
exports rise.
• AD increases.
• With SRAS
constant, the
price level rises
with GDP.
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11-101
Issues and Applications: Oil Prices Still
Matter, But Not As Much As Before
• Oil prices still matter, but not as much
as before.
• Whoops!—Oil prices must be adjusted
for inflation.
• Reduced sensitivity of aggregate supply
to oil price changes.
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11-102
Figure 11-15 Inflation-Adjusted Oil
Prices and Oil’s Role in Producing
Real GDP, Panel (a)
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11-103
Figure 11-15 Inflation-Adjusted Oil
Prices and Oil’s Role in Producing
Real GDP, Panel (b)
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11-104
Summary Discussion
of Learning Objectives
• The four assumptions of the classical
model are
1. Pure competition prevails
2. Wages and prices are flexible
3. People are motivated by self-interest
4. No money illusion
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
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Key Terms and Concepts
• aggregate demand
• aggregate demand
curve
• circular flow of
income
• exports
• aggregate supply
• imports
• aggregate supply
curve
• net exports
• cash balance
• open economy
effect
• real-balance effect
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
11-106