In this chapter you will learn:

 About aggregate demand (AD) and the factors that cause it to change.
 About aggregate supply (AS) and the factors that cause it to change.
 How AD and AS determine an economy's equilibrium price level and level of real GDP.
 How the AD-AS model explains periods of demand-pull inflation, cost-push inflation, and
recession.

10.1 Real-Balances Effect

The real balances effect is also known as the Pigou effect, after its originator,
Arthur C. Pigou. (1877-1959). Pigou was born on the Isle of Wight in England,
and studied at Cambridge University. He eventually became the chair of political
economy at Cambridge University, succeeding Alfred Marshall, who influenced
Pigou greatly. Pigou was a welfare economist, meaning that he was concerned
with how to maximize social well-being beyond the scope of the individual. He
contributed to theories of income distribution, externalities, and price
discrimination.

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 Photograph courtesy of: http
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10.2 Efficiency Wage

 The notion that higher wages promote greater productivity - efficiency wages - appears often
in the history of economic thought. Although not credited with developing the term, Adam
Smith (1723-1790) was one of the first to articulate the idea. Smith argued that there exists a
positive relationship between wages and worker productivity. As Smith put it,
 The liberal reward for labour, as it encourages the propagation, so it increases the
industry of the common people. The wages of labour are the encouragement of
industry, which like every other human quality, improves in proportion to the
encouragement it receives. A plentiful subsistence increases the bodily strength of the
labourer, and the comfortable hope of bettering his position, and of ending his days in
ease and plenty, animates him to exert that strength to the utmost. Where wages are
high, accordingly, we shall always find the workmen more active, diligent, and
expeditious, than where they are low.
Keep in mind that Smith was writing during the time of the industrial revolution
in Great Britain. At that time it was common to have wages that barely
provided for physical subsistence, and often times fathers (the primary wage
laborer), would forgo meals so that children could eat. Higher wages would
allow workers, as Smith suggests, to increase bodily strength, and important
dimension to productivity in late 18th century Britain. Modern efficiency wage
theory focuses more on worker morale and labor turnover, and less on the
physical needs of workers, a central issue in Smith's time.

Robert Owen (1771-1858), owner of the New Lanark spinning mills in Scotland,
attempted to put the idea of efficiency wages into practice. Owen, who owned
and ran the mills from 1800-1820, also established the model community of
New Lanark. Operating during the industrial revolution, a period in which wages
were pushed to subsistence, Owen paid his workers significantly more than the
prevailing wages of the time, and his mills were both productive and profitable.

Several economists developed formal theories of efficiency wages. These

theories are summarized by George Akerlof and Janet Yellen, eds., in their
book, Efficiency Wage Models of the Labor Market (Cambridge: Cambridge
University Press, 1986).

10.1 Graphing Exercise: Aggregate Demand – Aggregate Supply

The aggregate demand – aggregate supply (AD–AS) model is useful for analyzing changes in both real
GDP and the price level. Changes in either aggregate demand, aggregate supply, or both can help to
explain recession and unemployment, inflation, and economic growth. Our analysis in this exercise will
focus on the short run effects of changes in aggregate supply and aggregate demand.

Exploration: How do changes in aggregate demand and supply

affect the equilibrium price level and real GDP?

The graph shows the aggregate demand and aggregate supply curves for a hypothetical economy. The
AD curve shows an inverse relationship between the aggregate price level and real GDP. This is
because an increase in the price level: 1) reduces the real value of dollar-denominated assets, which
reduces consumption expenditures (the real-balances effect); 2) increases the demand for money,
which increases interest rates and thereby reduces investment expenditures (the interest-rate effect);
and 3) makes domestically produced goods less attractive to foreigners, which reduces net exports
(the foreign purchases effect).

The aggregate supply curve, on the other hand, reflects the costs of producing a given level of GDP.
At very low levels of GDP, resources are unemployed and output may increase with little upward
pressure on the price level. However, as real GDP approaches full employment, bottlenecks for some
resources appear and costs begin to rise. The price level must rise sufficiently to cover these higher
production costs.

The economy is initially at the full employment level of real GDP, labeled Q 0, and the price level is
stable at price level P. To use the graph, click and drag either the AD or AS labels to shift the
aggregate demand or aggregate supply curve, respectively, to a new location. Clicking Reset will
restore the economy to full employment GDP and a stable price level. Click Update to establish the
new equilibrium as a starting point for additional analysis.

1. Starting from full employment, what will be the impact on real GDP and the price level of an
increase in desired consumption expenditures?
See answer here
2. Suppose the economy is operating at full employment and prices are stable. All else equal, will
an increase in wages and salaries increase the aggregate price level?
See answer here
3. Starting from a full-employment, stable price equilibrium, suppose aggregate demand
decreases. Which will result in a deeper recession—if the price level falls or if it remains the
same?
See answer here
4. The late 1990s were a period of dramatically rising stock values and rising labor productivity.
Real GDP increased, yet prices remained relatively stable. How might this be explained by the
AD–AS model?
See answer here

Problem 10.1 - Productivity and costs

Problem: Answer:

Suppose an economy's relationship between its aggregate a. Productivity is measured as the ratio of total
inputs and output can be represented by the following table, in output to total inputs. In this example,
which inputs and real GDP are expressed in billions: productivity is 4. 4 = $400/100.
b. Production cost is measured as the price of
each input times its price. Per unit production
Inputs Real GDP
cost is this amount divided by total output, or
100 400
real GDP. In this example, per unit production
105 420 cost at each level of output is $1.25. $1.25 =
110 440 ($5 x 100)/$400 = ($5 x 105)/$420 =($5 x
115 460 110)/$440 =($5 x 115)/$460.
a. What is the productivity level in this economy? c. The new productivity level is 4.4 = 1.1 x 4, a
b. Suppose each input costs $5. What is the per unit 10% increase over its previous level. This
production cost at each level of output? means that 100 billion units of inputs could
c. Suppose productivity increases by 10% with no change produce 100 x 4.4 = $440 billion of real GDP.
in input prices. Calculate the new per unit production The new per unit production cost is ($5 x
cost. 100)/$440 = $1.14, a drop of 10%.
d. Alternatively, suppose input prices increase by 10% d. Inputs would now cost $5.50 = 1.1 x 5. Per
with no change in productivity. Calculate the new per unit production cost is ($5.50 x 100)/$400 =
unit production cost. $1.375, an increase of 10% over its previous
e. True or false: "An equal percentage increase in value of $1.25.
productivity and input prices will have no impact on per e. True. Per unit production cost is the ratio of
unit production costs." total input cost to total output. If both
numerator and denominator increase in
proportion, the ratio is unchanged.

. Suppose that the aggregate demand and supply schedules for a hypothetical economy are as shown below:
 a. Use these sets of data to graph the aggregate demand and aggregate supply curves. What is the
equilibrium price level and the equilibrium level of real output in this hypothetical economy? Is the
equilibrium real output also necessarily the full-employment real output? Explain.
b. Why will a price level of 150 not be an equilibrium price level in this economy? Why not 250?
c. Suppose that buyers desire to purchase $200 billion of extra real output at each price level. Sketch in
the new aggregate demand curve as AD1. What factors might cause this change in aggregate demand?
What is the new equilibrium price level and level of real output?

5. Suppose that a hypothetical economy has the following relationship between its real output and the input
quantities necessary for producing that output:

a. What is productivity in this economy?

b. What is the per-unit cost of production if the price of each input unit is $2?
c. Assume that the input price increases from $2 to $3 with no accompanying change in productivity. What
is the new per-unit cost of production? In what direction would the $1 increase in input price push the
economy's aggregate supply curve? What effect would this shift of aggregate supply have on the price
level and the level of real output?
d. Suppose that the increase in input price does not occur but, instead, that productivity increases by 100
percent. What would be the new per-unit cost of production? What effect would this change in per-unit
production cost have on the economy's aggregate supply curve? What effect would this shift of
aggregate supply have on the price level and the level of real output?

6. What effects would each of the following have on aggregate demand or aggregate supply? In each case use a
 diagram to show the expected effects on the equilibrium price level and the level of real output. Assume all
other things remain constant.

a. A widespread fear of depression on the part of consumers.

b. A $2 increase in the excise tax on a pack of cigarettes.
c. A reduction in interest rates at each price level.
d. A major increase in Federal spending for health care.
e. The expectation of rapid inflation.
f. The complete disintegration of OPEC, causing oil prices to fall by one-half.
g. A 10 percent reduction in personal income tax rates.
h. A sizable increase in labor productivity (with no change in nominal wages).
i. A 12 percent increase in nominal wages (with no change in productivity).
j. Depreciation in the international value of the dollar.

7. Assume that (a) the price level is flexible upward but not downward and (b) the economy is currently
operating at its full-employment output. Other things equal, how will each of the following affect the equilibrium
price level and equilibrium level of real output in the short run?

a. An increase in aggregate demand.

b. A decrease in aggregate supply, with no change in aggregate demand.
c. Equal increases in aggregate demand and aggregate supply.
d. A decrease in aggregate demand.
e. An increase in aggregate demand that exceeds an increase in aggregate supply.

Aggregate Demand
Aggregate Demand Curve : A schedule that shows amounts of real output (real GDP) that buyers
collectively desire to purchase at each possible price level. (Thus, price level and real domestic
output are inversely related.)
Rationale of downward slope of AD curve:
 Real-balances effect (i.e. Wealth Effect): A change in the price level
o A higher price level reduces the real value (purchasing power) of the public's
accumulated savings balances. In other words, the real value of assets with fixed money values (eg.
savings accounts, bonds) diminishes. Keep in mind that wealth also includes physical assets such
as houses and cars; as such, a fall in the value of housing will diminish the wealth of homeowners.
o Simply put, a lower price level makes you seem wealthier while a higher price level
makes you seem less wealthy.
o The public is then more poor in real terms and will reduce spending.
 Higher prices mean less consumption.
 Interest-rate effect: A change in the interest-rate level
o Assume that the supply of money in an economy is fixed.
 low price levels will cause interest rates to decrease and result in more
consumer spending
 If the price level rises, consumers and businesses need more money to
consume or invest. Therefore, a higher price level increases demand for money
 An increase in money demand will drive up the price paid for its use -
this is interest.
 Higher interest rates then reduces investment or consumption which
require loans.
Foreign purchases effect (i.e. Net Export Effect):
 When domestic price levels rise relatively to foreign products, foreigners buy fewer U.S.
goods, and Americans buy more foreign goods. Thus, U.S. exports fall and U.S. imports rise
o The rise in the price level of U.S. goods reduces the quantity of U.S. goods
demanded as net exports.

Difference between AD curve and microeconomics demand curve:

 No substitute effect, because you cannot substitute all goods.
 No income effect, because a lower price level actually means less nominal income for the
resource suppliers -- e.g. lower wages, rents, interests, profits.

*We study aggregate demand to see how fluctuations in C, I, G, and Xn affect the AD curve*

Determinants of Aggregate Demand / AD shifters

Note: change in determinant that directly changes amount of real GDP
o multiplier effect produces greater change in AD than initiating change in spending
o shift along the curve = changes in real GDP

 Consumer spending: (C)

o Consumer Wealth: Consumer wealth includes both financial assets and physical
assets. A sharp increase in the real value of consumer wealth prompts people to save less and buy
more products, shifting the AD curve to the right. Also vise versa.
o Expectations:
 Expectation of future income rises, ppl tend to spend more of their current
incomes. Thus current consumption spending increases, and the AD curve shifts to the right. Also, a
widely helped expectation of surging inflation in the near future may increase aggregate demand
today because consumers will want to buy products before their price escalate.
o Household debt: Increased household debt enables consumers collectively to
increase their consumption spending, which shifts the AD curve to the right.
o Taxes: A reduction in personal income tax rates raises take-home income and
increases consumer purchases. Tax cuts shift the AD curve to the right.
 Investment spending: (unstable) (I)
o Real Interest Rates:
 An increase in real interest-rate will decrease investments aka shift
aggregate demand curve to the left. It identifies a change in the real interest rate resulting from a
change in the nation's money supply.
 An increase in the money supply lowers the interest rate, thereby increasing
investment and aggregate demand and vice versa.
o Expected Returns:
 Expected future business condition: If firms think that the future is looking
good, they will probably invest more today to help boost up their profits. However, if they think the
future is looking bleak, they will cut back on investment, thus shifting AD to the left.
 Technology: New and better technology helps to shift AD to the right because
they usually have a high expected rate of return.
 For example, recent advances in microbiology have motivated
pharmaceutical companies to establish new labs and production facilities because there is a greater
demand for those capital goods.
 Degree of excess capacity: When there's more excess capacity (unused
capital), there will be less investment, meaning an inward shift of the AD curve. But once they realize
that they have used up their capital, the expected returns on new investment rise, they will start
investing more, meaning an outward shift of the AD curve.
 Business taxes: An increase in business taxes will cut out more of the after-
tax profits so investment and AD will decrease and shift left. Conversely, a decrease in taxes will
shift the curve out.
 Government spending: (G)
o When the government spends more, the AD curve shifts to the right, as long as the
interest rates and tax collections do not change
o A decrease of government spending, such as fewer projects in transportation, will
shift the AD curve to the left.
 Net export spending: (Xn)
o A rise in net exports (higher exports relative to imports) shift the aggregate demand
curve to the right.
o

 National income abroad: Rising national income abroad encourages

foreigners to buy more products. Net exports of the U.S. thus rise and aggregate demand curve shift
to the right.
 Exchange rates: change in the dollar's exchange rate. The price of foreign
currencies in terms of the U.S. dollar-- may affect U.S. exports and therefore aggregate demand. If
the U.S. dollar depreciates in terms of the euro, the new higher value euros enables consumers to
obtain more dollars with each euro--> exports rise, imports fall --> AD shifts out.

Aggregate Supply
Aggregate Supply: The schedule or curve showing the level of real domestic output that firms will
produce at each level.

Aggregate Supply in the long-run:

 Long Run: A period in which nominal wages
(resource prices) match changes in the price level.This
occurs because enough time has passed for firms to
adjust to any changes in price level.
 Long Run Aggregate Supply is only possible with
flexible labor markets
 Ceterus paribus (other things equal), Aggregate
Supply in the long run is vertical at the economy's full-
employment (including the natural rate of unemployment)
output because resources and capital are at full capacity;
thus, if one company attempts to attract workers through
increasing wages, employees from other firms will come,
not new workers.
 Therefore the curve is perfectly inelastic, vertical
curve shown.
 Because real profit does not change, the firm will not alter its production. Real GDP will
remain at full-employment level.
 Shifters:
o change in labor
o technology
o productivity (education, more machines)
o open up trade with other nations

Aggregate Supply in the short-run:

 Short Run: A period in which nominal wages
(resource prices) do not match changes in price level. This
occurs because firms have not had enough time to adjust
to changes in price level. During this period, the prices of
the factors of production do not change, especially the
price of labor (wage rate) is fixed.
 There's a positive/direct relationship between the
price level and the total output and so, the SRAS curve
slopes upward because to produce more output, firms are
likely to face higher costs of production, which increases
the price levels.
 At outputs below the Qf level, the slope of the
aggregate supply curve is relatively flat: -- large amounts
of unused resources, can be put back to work with a little
upward pressure on per-unit production costs
 At outputs above the Qf level, the slope of the aggregate supply curve is relatively steep.
-majority of resources is already employed, so adding more reduces the efficiency of workers,
capital, and total output rises less rapidly than total input cost. In other words, when the output level
exceeds Qf, the price level rises more rapidly over the same amount of increased output.
 Can having three distinct segments:
o Horizontal -unemployment & high excess capacity.
o Upsloping - increase in real output = increase in price level; full-employment near,
producer costs rise.
o Vertical - full-employment w/ Natural Rate of Unemployment (NRU), full capacity is
assumed, and increase output = increase in resource and product prices. With full employment this
production equals the economies potential output.

Changes in Aggregate Supply: Determinants of Aggregate Supply

 Input prices: Input or resource prices (domestic or imported)
o Domestic Resource Prices:
 Wages and Salaries
 Labor supply ↑ → wage ↓→ aggregate supply ↑ (curve shifts right)
 Labor supply ↓→ wage ↑→aggregate supply ↓(curve shifts left)
 Rents and Capital Investments:
 Price of machinery ↓because prices of steel ↓→ per unit production
cost ↓→ aggregate supply ↑(curve shifts right)
 Land resources ↑due to irrigation or technological innovations → per
unit production cost ↓→aggregate supply ↑(curve shifts right)

o Prices of Imported Resources:

o

 A decrease in the price of imported resources increases U.S. aggregate

supply (curve shifts right).
 An increase in the price of imported resources reduces U.S. aggregate
supply (curve shifts left).
 Exchange rates also play a role:
 If dollar appreciates, domestic produces face a lower dollar price of
foreign resources.
 increase in imports shift AS to the right.
o Market Power: A change in the ability to set prices above competitive levels.
 OPEC's fluctuation market power.
 increase in power = increase in oil prices which reduced U.S.
Aggregate supply dramatically leftward anddrove up per-unit production costs.
 decrease in power = decrease in oil prices which increased U.S
Aggregate supply
 Productivity:
o Measure of the relationship between a nation's level of real output and the amount of
resources used to produce that output.


o Productivity = total output/total input.

o An increase in productivity enables the economy to obtain more real output from its
limited resources. It does this by reducing the per-unit cost of output.
 per-unit production cost= total input cost/ total output.
o By reducing the per-unit production cost, an increase in productivity shifts the
aggregate supply curve to the right.
o higher productivity --> lower per-unit cost --> AS curve shifts out.
o The main source of productivity advance is improved production technology, better-
educated workforce, improved forms of business enterprises, and the reallocation of labor resources
from lower to higher productivity uses.

 Legal-institutional environment:
o Business taxes and subsidies
 Business taxes ↑, per-unit production costs ↑, supply↓
 Subsidy ↑, per-unit production costs ↓, supply ↑
o Government regulations – regulation ↑, per-unit production costs ↑, supply ↓

Equilibrium and Changes in Equilibrium

The intersection of the aggregate demand curve AD and the aggregate supply curve AS establishes
the economy's equilibrium price level and equilibrium real output.

Increases in AD: demand-pull inflation:

 Is as though, the higher demand is "pulling" prices up so much so that inflation exists.
 This inflation occurs when demand for goods and services exceeds existing supplies; thus
the price level is being pulled up by the increase in aggregate demand.
 Assume that economy is operating at full-employment output, but businesses and the
government want to increase their spending (AD curve to the right).
 Consumers are becoming more wealthy and they demand more products, but the supply
sector cannot catch up with the rapidly growing demand, therefore the price levels are brought up
 There is a positive GDP gap, where actual GDP > potential GDP.
o Ex: U.S. during Vietnam war in the 1960s, where large government spending on the
war shifted the economy's AD curve to the right, producing great inflation.
 Rise of price level reduces size of multiplier effect: For any initial increase in aggregate
demand, resulting increase in real output will be smaller the greater the increase in price level

Decreases in AD: recession and cyclical unemployment:

 Deflation (i.e. price level decreases) is rare in the economy, but it is still possible. However,
deflation is NOT a good thing despite its "inflation" counterpart. Price levels should be STABLE, not
decreasing.
 Recessions caused by a negative GDP gap are usually unaccompanied by a price level
decrease; thus the term "GDP gap but no deflation", also called disinflation, constituting a recession
and creating cyclical unemployment.
 Reasons why the price level tends to be inflexible in a downward direction during declines in
aggregate demand in the United States:
o Fear of price wars: big firms fear that if they lower their prices, competitors will lower
theirs and even make deeper price cuts so the initial price cut would set off a price war- successively
deeper price cuts. Each firm would eventually end up with far less profit or higher losses than would
be the case if each had simply maintained its original prices. To avoid this, firms would reduce
production and lay off workers instead of making the initial price cut
o Menu costs: costs of 'printing new menus' when price is reduced by the firm; prices
of estimating the magnitude anbd duration of the shift in demand to determine whether to lower
prices, of repricing inventory items, printing/mailing new catalogs, communicating new prices to
customers
o Wage contracts: difficult to profit from cuts of product prices without cutting wage
rates; wages are usually inflexible downward b/c many laborers are under contracts prohibiting wage
cuts
o Morale, effort, and productivity:
 Efficiency wages: wages that elicit max. work effort and minimize labor costs
per unit of output
 if the higher labor costs resulting from reduced productivity exceed the cost
savings from lower wage, then wage cuts will increase rather than reduce labor costs per unit of
output
o Minimum wage: a legal floor under the wages of the least skilled workers; firms
paying minimum wage cannot reduce the wage rate when AD declines

Decreases in AS: cost-push inflation:

 Is as though diminishing supply of g/s are "pushing" inflation higher.
 Costs ↑ → AS ↓ → PL ↑ = inflation
- "Double" negative effects – inflation and recession (y ↓)
 When a resource causes the cost of production for a wide variety of goods, this causes a
decrease in aggregate supply and there is cost-push inflation (rising price levels).
 Ex: Terrorist attack on oil facilities drives up oil prices by 300%.
 A decrease in AS is doubly bad because:
o there is cost-push inflation
o recession and negative GDP gap
o
o
 Stagflation- Period with decreasing output(AD and AS shifts left), rising price levels
(inflation), and increasing unemployment. Out put has decrease but Price level increase. This is
experienced during an economic recession, such as the current state of the U.S. economy as the
graph illustrates.
 Increases in AS: full-employment with price-level stability:
 Normally, a shift of the aggregate demand curve to the right will result in expansion of output
and inflation. However, if the aggregate supply curve also shifts to the right, the economy will
experience strong economic growth, full employment, and only very mild inflation.
 The aggregate supply curve will shift to the right when larger than usual increases in
productivity (ex: burst of new technology).
 Expanding output beyond the full-employment level will lead to higher inflation.