Aggregate demand and
Aggregate demand and Aggregate
Aggregate
Supply (AD and AS)
Supply (AD and AS)
notice the data: while potential GDP tends to notice the data: while potential GDP tends to move upward yrmove upward yr after yr, due to economic growth, actual GDP tends to rise
after yr, due to economic growth, actual GDP tends to rise above and fall below potential over shorter periods
above and fall below potential over shorter periods
Date reveals an important fact: Date reveals an important fact: Deviations from potentialDeviations from potential output don’t last forever
output don’t last forever
In some of these episodes, government policy-either fiscal orIn some of these episodes, government policy-either fiscal or monetary-he
monetary-helped the lped the economy to return to full economy to return to full employmentemployment more quickly
more quickly
But even without corrective policies-such as during long partsBut even without corrective policies-such as during long parts of Great Ds of the 1930s-the
of Great Ds of the 1930s-the economy shows a remarkableeconomy shows a remarkable tendency
tendency to begin to begin moving moving back toback towards potwards potential outential outputput
What is the mechanism behind?What is the mechanism behind?
WWe will study e will study the behavior of a the behavior of a new variable that we have putnew variable that we have put aside for several chapters: the price level
Figure
Figure 1a:
1a: Potential
Potential and
and Actual
Actual
Real GDP, 1960-2001
Real GDP, 1960-2001
A A c c t t u u a a l l a a n n d d P P o o t t e e n n t t i i a a l l R R e e a a l l G G D D P P ( ( B B i i l l l l i i o o n n
s s o o f f 1 1 9 9 9 9 6 6 D D o o l l l l a a r r s s ) ) 2,000 2,000 3,000 3,000 4,000 4,000 5,000 5,000 6,000 6,000 7,000 7,000 8,000 8,000 9,000
9,000 The orange line showsThe orange line shows full- full-employment
employment oror potential potential output.output.
The green line shows The green line shows actual
actual output.output. During recessions,During recessions, output declines. output declines.
During expansions, output During expansions, output rises
Figure
Figure 1:
1: The
The T
Two-W
wo-Way
ay Relationship
Relationship
Between Output and the Pri
Between Output and the Price Level
ce Level
Price Price Level
Level GDPGDPRealReal
Aggregate De
Aggregate Demand Curvemand Curve
Aggregate Supply Aggregate Supply
Curve Curve
AD and AS
AD and AS
There exist a two-way relationsh
There exist a two
-way relationship
ip
between price level and output (see
between price level and output (see
diagram 1)
diagram 1)
Changes in price level cause changes
Changes in price level cause changes
in real GDP
in real GDP –
– illustrated by Aggregate
illustrated by Aggregate
Demand curve
Demand curve
Changes in real GDP cause changes in
Changes in real GDP cause changes in
price level
price level –
– illustrated by Aggregate
illustrated by Aggregate
Supply curve
The Aggregate Demand Curve
First step in understanding how price level affects economy is an important fact
When price level rises, money demand curve shifts
rightward (because purchases become more expensive)
Shift in money demand, and its impact on the economy, is illustrated in Figure 2
Imagine a rather substantial rise in price level—from 100 to 140
Compared with our initial position, this new equilibrium has the following characteristics
Money demand curve has shifted rightward
Interest rate is higher
Aggregate expenditure line has shifted downward
Equilibrium GDP is lower
All of these changes are caused by a rise in price level
Figure 2a: Deriving the Aggregate
Demand Curve
(a) E H 500 Money ($ Billions) Interest Rate 6% 9% M sAs the price level rises, money demand increases and interest rate rises.
d 1
Figure 2b/c: Deriving the
Aggregate Demand Curve
(b) (c)
The rise in the interest rate causes real GDP to fall. Real GDP ($ Trillions) A g g r e g a t e E x p e n d i t u r e ( $ T r i l l i o n s ) 6 10 E AE r = 6% AE r = 9% H 140 100 Price Level H AD E On the AD curve, a higher price level is associated with a lower real GDP.
10
6 Real GDP
Deriving the Aggregate Demand
Curve
Panel (c) of Figure 2 shows a
new curve
Shows negative relationship
between price level and
equilibrium GDP
Call aggregate demand curve
Tells us equilibrium real GDP
at any price level
Understanding the AD Curve
AD curve is unlike any other curve you’ve encountered
in this text
In all other cases, our curves have represented simple behavioral relationships
But AD curve represents more than just a behavioral relationship between two variables
Each point on curve represents a short-run equilibrium in economy
A better name for AD curve would be “equilibrium
output at each price level” curve—not a very catchy name
AD curve gets its name because it resembles demand curve for an individual product
Movements Along the AD Curve
As you will see later in this chapter, a variety of
events can cause price level to change, and move us along AD curve
Suppose price level rises, and we move from point E to point H along this curve
Following sequence of events occurs
Opposite sequence of events will occur if price level falls, moving us rightward along AD curve
Shifts of the AD Curve
When we move along AD curve in Figure 2, we assume that price level changes
But that other influences on equilibrium GDP are constant
Keep following rule in mind
When a change in price level causes equilibrium GDP to change, we move along AD curve
Whenever anything other than price level causes equilibrium GDP to change, AD curve itself shifts
Equilibrium GDP will change whenever there is a change in any of the following
Government purchases
Autonomous consumption spending
Investment spending
Net exports
Taxes
An Increase in Government
Purchases
Spending shocks initially affect economy by shifting aggregate expenditure line
In Figure 3, we assume economy begins at a price level of 100
Let’s increase government purchases by $2 trillion
and ask what happens if price level remains at 100
An increase in government purchases shifts entire AD curve rightward
AD curve shifts rightward when government purchases, investment spending, autonomous
consumption spending, or net exports increase, or when taxes decrease
Analysis also applies in the other direction AD curve shifts leftward when government
purchases, investment spending, autonomous
consumption spending, or net exports decrease, or when taxes increase
Figure 3: A Spending Shock Shifts
the AD Curve
(a) (b) H 10 13.5 E AE 1 AE 2 At any given price level, anincrease in government
purchases shifts the AE line upward, raising real GDP.
R e a l A g g r e g a t e E x p e n d i t u r e ( $ T r i l l i o n s ) Real GDP ($ Trillions) 100 10 13.5 AD1 AD2 E H Since real GDP is higher at the given price level, the AD curve shifts rightward.
Real GDP ($ Trillions) Price
Changes in the Money Supply
Changes in money supply will also
shift aggregate demand curve
Imagine that Fed conducts open market operations to increase money supply
AD curve shifts rightward
A decrease in money supply would
have the opposite effect
Shifts vs. Movements Along the AD
Curve: A Summary
Figure 4 summarizes how some
events in economy cause a
movement along AD curve, and other
events shift AD curve
Panels (b) and (c) of Figure 4 tell us
how a variety of events affect AD
curve, but
nothow they affect real
GDP
Where will price level end up?
Figure 4a: Effects of Key Changes
on the Aggregate Demand Curve
(a) Real GDP Price Level P 3 Q3 Q1 Q2 AD P 1 P 2
Price level ↑ moves us leftward along the AD curve
Price level ↓ moves us rightward along the AD curve
Figure 4b: Effects of Key Changes
on the Aggregate Demand Curve
Entire AD curve shifts rightward if: • a, IP , G, or NX increases
• Net taxes decrease
• The money supply increases
AD2 AD1
(b)
Real GDP Price Level
Figure 4c: Effects of Key Changes
on the Aggregate Demand Curve
AD2
decreases
Entire AD curve shifts leftward if: • a, IP , G, or NX decreases
• Net taxes increase
• The money supply decreases
(c)
Real GDP Price Level
Costs and Prices
Price level in economy results from pricing behavior of millions of individual business firms
In any given year, some of these firms will raise
their prices, and some will lower them
But often, all firms in the economy are
affected by the same macroeconomic event
Causing prices to rise or fall throughout the
economy – what interest us in macroeconomics
To understand how macroeconomic events affect the price level, we begin with a very simple assumption
20
Costs and Prices
Percentage markup in any particular industry will depend on degree of competition there
In macroeconomics, we are not concerned with how the markup differs in different industries
But rather with average percentage markup in economy
Determined by competitive conditions
Competitive structure changes very slowly, so average percentage markup should be somewhat stable from year-to-year
But a stable markup does not necessarily mean a stable price level, because unit costs can change In short-run, price level rises when there is an
economy-wide increase in unit costs
Price level falls when there is an economy-wide decrease in unit costs
GDP, Costs, and the Price Level
Primary concern here: impact of real GDP on unit costs and, therefore, on the price level Why should a change in output affect unit
costs and price level?
As total output increases
Greater amounts of inputs may be needed to produce a unit of output
Price of non-labor inputs rise Nominal wage rate rises
A decrease in output affects unit costs through the same three forces, but with opposite result
22
The Short Run
All three of our reasons are important in explaining why a change in output affects price level
However, they operate within different time frames
But our third explanation—changes in nominal wage rate—
is a different story
For a year or more after a change in output, changes in
average nominal wage are less important than other forces that change unit costs
Some of the more important reasons why wages in many industries respond so slowly to changes in output
Many firms have union contracts that specify wages for up to three years
Wages in many large corporations are set by slow-moving bureaucracies
Wage changes in either direction can be costly to firms
Firms may benefit from developing reputations for paying stable wages
The Short Run
Nominal wage rate is fixed in short-run
We assume that changes in output have no effect on nominal wage rate in short-run
Since we assume a constant nominal
wage in short-run, a change in output
will affect unit costs through the other
two factors
In short-run, a rise (fall) in real GDP, by causing unit costs to increase (decrease), will also cause a rise (decrease) in price
Deriving the Aggregate Supply
Curve
Figure 5 summarizes discussion about
effect of output on price level in short-run Each time we change level of output, there
will be a new price level in short-run
Giving us another point on the figure
If we connect all of these points, we obtain
economy’s aggregate supply curve
Tells us price level consistent with firms’ unit
costs and their percentage markup at any level of output over short-run
A more accurate name for AS curve would be “short-run-price-level-at-each-output-level” curve
Figure 5: The Aggregate Supply
Curve
Price Level Real GDP ($ Trillions) 130 100 80 C AS 13.5 10 6 A B Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises.Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price level falls.
Movements Along the AS Curve
When a change in output causes price level to change, we move along
economy’s AS curve
What happens in economy as we make such
a move?
As we move upward along AS curve, we can
Shifts of the AS Curve
Figure 5 assumed that a number of important variables remained unchanged
But in real world, unit costs sometimes change for reasons other than a change in output
In general, we distinguish between a movement along AS curve, and a shift of curve itself, as follows
When a change in real GDP causes the price level to change, we move along AS curve
When anything other than a change in real GDP causes price level to change, AS curve itself shifts
What can cause unit costs to change at any given level of output?
Changes in world oil prices
Changes in the weather
Figure 6: Shifts of the Aggregate
Supply Curve
Price Level Real GDP ($ Trillions) 100 AS1 AWhen unit costs rise at any given real GDP, the AS curve shifts upward –e.g., an increase in world oil prices or bad
weather for farm production. 140
10
AS2
Figure 7a: Effects of Key Changes
on the Aggregate Supply Curve
(a) Real GDP Price Level P 3 Q Q Q P 1 P 2 AS Real GDP ↑ moves us rightward along the AS curve Real GDP ↓ moves us leftward along the AS curve
Figure 7b: Effects of Key Changes
on the Aggregate Supply Curve
Real GDP Price Level
(b)
AS1 AS2
Entire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP
Figure 7c: Effects of Key Changes
on the Aggregate Supply Curve
Real GDP Price Level
(c)
AS1
AS2
Entire AS curve shifts downward if unit costs ↓ for any reason besides an decrease in real GDP
32
AD and AS Together: Short-Run
Equilibrium
Where will the economy settle in
short-run?
Where is our short-run macroeconomic equilibrium?
We know that in equilibrium, economy must be at some point on AD curve
Short-run equilibrium requires economy be operating on its AS curve
Only when economy is at point E—on
both curves—will we have reached a
sustainable level of real GDP and the
price level
Figure 8: Short-Run
Macroeconomic Equilibrium
Price Level Real GDP ($ Trillions) 140 100 AS 10 6 14 E B AD FWhat Happens When Things
Change?
Now that we know how short-run equilibrium is
determined, and armed with our knowledge of AD and AS curves, we are ready to put model through its
paces
Our short-run equilibrium will change when either AD curve, AS curve, or both, shift
An event that causes AD curve to shift is called a demand shock
An event that causes AS curve to shift is called a supply shock
In earlier chapters, we’ve used phrase spending shock
A change in spending by one or more sectors that ultimately affects entire economy
Demand shocks and supply shocks are just two different categories of spending shocks
An Increase in Government
Purchases
Shifts AD curve rightward
Can see how it affects economy in short-run: increases output and rises interest rate in
the money market
Process described is not entirely realistic
Assumes that when government purchases rise, first output increases, and then price level rises
In reality, output and price level tend to rise together
Figure 9: The Effect of a Demand
Shock
Price Level Real GDP($ Trillions) 100 130 AS 10 12.5 13.5 E J H AD1 AD2 115An Increase in Government
Purchases
Can summarize impact of price-level changes
When government purchases increase, horizontal
shift of AD curve measures how much real GDP would increase if price level remained constant
But because price level rises, real GDP rises by less than horizontal shift in AD curve
An Decrease in Government
Purchases
An Increase in the Money Supply
Although monetary policy stimulates
economy through a different channel than fiscal policy
Once we arrive at AD and AS diagram, two
look very much alike
Other Demand Shocks
A positive demand shock—shifts AD
curve rightward
Increases both real GDP and price level in short-run
A negative demand shock—shifts AD
curve leftward
Decreases both real GDP and price level in short-run
An Example: The Great Depression
U.S. economy collapsed far more seriously during 1929 through 1933—the onset of the Great Depression—than it did at any other time
What do we know about demand shocks that caused Great Depression?
Fall of 1929, bubble of optimism burst
Stock market crashed, and investment and
consumption spending plummeted
Demand for products exported by United States
fell
Fed reacted by cutting money supply sharply
Each of these events contributed to a leftward shift of AD curve
Demand Shocks: Adjusting to the
Long-Run
In Figure 9, point H shows new equilibrium after a positive demand shock in
short-run—a year or so after the shock
But point H is not necessarily where economy
will end up in long-run
In short-run, we treat wage rate as given
But in long-run, wage rate can change
When output is above full employment, wage
rate will rise, shifting AS curve upward
When output is below full employment, wage
Demand Shocks: Adjusting to the
Long Run
Increase in government purchases has no effect on equilibrium GDP in long-run
Economy returns to full employment, which is
just where it started
This is why long-run adjustment process is often
called economy’s self -correcting mechanism If a demand shock pulls economy away
from full employment
Change in wage rate and price level will
eventually cause economy to correct itself and return to full-employment output
Figure 10: The Long-Run
Adjustment Process
Price Level Real GDP P 2 P 3 P 4 P 1Y FE Y 3 Y 2 H E AS2 AS1 AD2 AD1 J K
Demand Shocks: Adjusting to the
Long Run
For a positive demand shock that shifts AD curve rightward, self-correcting
