Aggregate Demand and Aggregate Supply

INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL CHAPTER 17 / AGGREGATE DEMAND AND AGGREGATE SUPPLY 2005, South-Western/Thomson Learning

Figure 1: The Two-Way Relationship Between Output and the Price Level
Aggregate Demand Curve

Price Level

Real GDP

Aggregate Supply Curve

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The Price Level and The Money Market

 

First effect of a change in the price level occurs in the money market Rise in the price increases the demand for money and shifts the money demand curve rightward  It makes purchases more expensive  Drop in the price level
Makes purchases cheaper Decreases the demand for money Shifts the money demand curve leftward

Rise in the price level causes the interest rate to rise and interest-sensitive spending to fall  Equilibrium GDP decreases by a multiple of the decrease
in interest-sensitive spending 3

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The Price Level and Net Exports

The second effect of a higher price level brings in the foreign sector  A rise in the price level causes  Net exports to drop and  Equilibrium GDP to decrease by a multiple of the


drop in net exports

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Deriving The Aggregate Demand (AD) Curve

Figure 2 plots the price level on a vertical axis and the economys real GDP on the horizontal axis  If we continued to change the price level to other values we would find that each different price level results in a different equilibrium GDP  The aggregate demand (AD) curve tells us the equilibrium real GDP at any price level

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Figure 2: Deriving the Aggregate Demand Curve

Price Level
140

K J

100

AD

10

Real GDP ($ Trillions)

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Movements Along The AD Curve



A variety of events can cause the price level to change, and move us along the AD curve

 Its important to understand what happens in the economy as we make such

a move

Opposite sequence of events will occur if the price level falls, moving us rightward along the AD curve

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Shifts of The AD Curve



The distinction between movements along the AD curve and shifts of the curve itself is very important  Always keep the following rule in mind
When a change in the price level causes equilibrium GDP to change, we
move along the AD curve Whenever anything other than the price level causes equilibrium GDP to change, the AD curve itself shifts

What are these other influences on GDP?  Equilibrium GDP will change whenever there is a change in any of
the following

Government spending Taxes Autonomous consumption spending Investment spending The money supply curve The money demand curve

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Changes in the Money Market

Changes that originate in the money market will also shift the aggregate demand curve  An increase in the money supply shifts the AD curve rightward  A decrease in the money supply shifts the AD


curve leftward

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Figure 4(a): Effects of Key Changes on the Aggregate Demand Curve

(a) Price Level Price level moves us leftward along the AD curve Price level moves us rightward along the AD curve

P3

P1 P2

AD

Q3
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Q1

Q2

Real GDP

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Figure 4(b): Effects of Key Changes on the Aggregate Demand Curve

(b) Price Level Entire AD curve shifts rightward if: a, IP, G, or NX increases Net taxes decrease The money supply increases

AD2 AD1 Real GDP

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Figure 4(c): Effects of Key Changes on the Aggregate Demand Curve

(c) Price Level Entire AD curve shifts leftward if: a, IP, G, or NX decreases decreases Net taxes increase The money supply decreases

AD1 AD2 Real GDP

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The Aggregate Supply Curve



On the one hand, changes in the price level affect output  On the other hand, changes in output affect the

price level  This relationshipsummarized by the aggregate supply curveis the focus of this section

The effect of changes in output on the price level is complex, involving a variety of forces

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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

Often, all firms in the economy are affected by the same macroeconomic event  Causing prices to rise or fall throughout the economy To understand how macroeconomic events affect the price level, we begin with a very simple assumption  A firm sets price of its products as a markup over cost
per unit

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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

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GDP, Costs, and 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

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The Short Run

All three of our reasons are important in explaining why a change in output affects price level  They operate within different time frames  Our third explanationchanges in nominal wage rateis 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


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The Short Run



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 slowmoving bureaucracies  Wage changes in either direction can be costly to firms  Firms may benefit from developing reputations for paying stable wages

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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 level

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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 economys
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

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Figure 5: The Aggregate Supply Curve

Price Level AS

130 100 80 C A

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. 6
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13.5

Real GDP ($ Trillions)

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Movements Along the AS Curve



When a change in output causes price level to change, we move along economys AS curve  What happens in economy as we make such a
move?  As we move upward along AS curve, we can represent what happens as follows

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Shifts of the AS Curve



Figure 5 assumed that a number of important variables remained unchanged  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  Technological change  Nominal wage, etc. 23

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Figure 7(a): Effects of Key Changes on the Aggregate Supply Curve

(a) Price Level Real GDP moves us rightward along the AS curve P3 Real GDP moves us leftward along the AS curve P1 P2 AS

Q2
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Q1

Q3

Real GDP

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Figure 7(b): Effects of Key Changes on the Aggregate Supply Curve

(b) Price Level Entire AS curve shifts upward if unit costs for any reason besides an increase in real GDP AS2 AS1

Real GDP
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Figure 7(c): Effects of Key Changes on the Aggregate Supply Curve

(c) Price Level AS1 AS2

Entire AS curve shifts downward if unit costs for any reason besides an decrease in real GDP

Real GDP
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Figure 8: Short-Run Macroeconomic Equilibrium

Price Level 140 E 100 F AD B AS

6
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10

14

Real GDP ($ Trillions)

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What Happens When Things Change?



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

Earlier weve 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

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An Increase in Government Purchases

Shifts AD curve rightward  Can see how it affects economy in short-run  Process weve just 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

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Figure 9: The Effect of a Demand Shock

Price Level AS

130 115 100 E

H J

AD2 AD1

10
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13.5 12.5

Real GDP($ Trillions)

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An 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

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An Decrease in Government Purchases

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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  Can represent situation as follows

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An Example: The Great Depression



U.S. economy collapsed far more seriously during 1929 through 1933the onset of the Great Depressionthan 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
Causing both output and price level to fall

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Demand Shocks: Adjusting to the Long-Run



In Figure 9, point H shows new equilibrium after a positive demand shock in short-runa 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 rate will fall, shifting AS curve downward

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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 economys 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

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Figure 10: The Long-Run Adjustment Process

Price Level AS2 AS1 P4 P3 P2 P1 K J H E AD2 AD1 YFE Y3 Y2
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Real GDP

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Demand Shocks: Adjusting to the Long Run



For a positive demand shock that shifts AD curve rightward, self-correcting mechanism works like this

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Figure 11: Long-Run Adjustment After a Negative Demand Shock

Price Level AS1 AS2

P1 P2 P3

E N M AD1 AD2

Y2
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YFE

Real GDP

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Demand Shocks: Adjusting to the Long Run



Complete sequence of events after a negative demand shock looks like this

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Demand Shocks: Adjusting to the Long Run



Can summarize economys self-correcting mechanism as follows  Whenever a demand shock pulls economy away from full
employment Self-correcting mechanism will eventually bring it back  When output exceeds its full-employment level, wages will eventually rise Causing a rise in price level and a drop in GDP until full
employment is restored

 When output is less than its full employment level wages

will eventually fall Causing a drop in price level and a rise in GDP until full
employment is restored
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The Long-Run Aggregate Supply Curve

 

Self-correcting mechanism provides an important link between economys long-run and short-run behaviors Long-run aggregate supply curve also illustrates another classical conclusion  An increase in government purchases causes complete crowding out
Rise in government purchases is precisely matched by a drop in
consumption and investment spending
Leaving total output and total spending unchanged

 

Self-correcting mechanism shows that, in long-run, economy will eventually behave as classical model predicts Notice the word eventually in the previous statement  This is why governments around the world are reluctant to rely on
self-correcting mechanism alone to keep economy on track

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Figure 12: The Long-Run Aggregate Supply Curve

Price Level Long-Run AS Curve

M AD1 AD3 YFE

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AD2

Real GDP

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Short-Run Effects of Supply Shocks



Figure 13 shows an example of a supply shock  An increase in world oil prices that shifts aggregate supply curve

upward, from AS1 and AS2  Called negative supply shock, because of negative effect on output
output and increasing price level

In short-run a negative supply shock shifts AS curve upward, decreasing

Notice sharp contrast between effects of negative supply shocks and negative demand shocks in short-run  Economists and journalists have coined term stagflation to describe
a stagnating economy experiencing inflation

A negative supply shock causes stagflation in short-run



Examples of positive supply shocks include unusually good weather, a drop in oil prices, and a technological change that lowers unit costs  In addition, a positive supply shock can sometimes be caused by
government policy

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Figure 13: The Effect of Supply Shocks

Price Level Long-Run AS Curve AS2 AS1 R P2 P1 P2 AD Y2
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AS3

YFE

Y3

Real GDP

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Long-Run Effects of Supply Shocks



What about effects of supply shocks in long-run?  In some cases, we need not concern ourselves with this
question, because some supply shocks are temporary

 

In other cases, however, a supply shock can last for an extended period In long-run, economy self-corrects after a supply shock, just as it does after a demand shock  When output differs from its full-employment level
Wage rate changes AS curve shifts until full employment is restored

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Using the Theory: The Recession of 1990-91



Story of 1990-91 recession begins in mid1990, when Iraq invaded Kuwait  During this conflict, Kuwaits oil was taken off
world market, as was Iraqs  Reduction in oil supplies resulted in a rapid and substantial increase in price of oil

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Using the Theory: The Recession of 2001



Story of 2001 recession was quite different  This time, there was no spike in oil prices and no other significant

supply shock to plague economy  Rather, there was a demand shock, and a Federal Reserve policy during the year before the recession that might have made it a bit worse

During late 1990s, Fed had become concerned that investment boom and consumer optimism were shifting AD curve rightward too rapidly  Creating a danger that we would overshoot potential GDP and set off
higher inflation  Fed responded by tightening money supply and raising interest rate  Effects of this policy may have continued into early 2001, exacerbating decrease in investment that was occurring for other reasons

In this way, rate hikes themselves may have contributed to a further

leftward shift of AD curve
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Figure 14(a): An AD and AS analysis of Two Recessions

1. In 1990, a supply shock from (a)higher oil prices shifted the AS curve leftward . . . Price Level AS1991 AS1990 R P2 P1 E 2. causing output to fall . . . AD1990 3. and the price level to rise. Real GDP

Y2

YFE

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Figure 14(b): An AD and AS analysis of Two Recessions

4. In 2001, a demand shock from (b) several factors caused the AD curve to shift leftward . . . Price Level AS2000

P2 P1

E R

5. causing output to fall . . . AD2000

6. and the price level to fall. Y2

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AD2001 YFE Real GDP

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Figure 15(a/b): GDP and the Price Level in Two Recessions

The 1990-91 Recession
(a) Real GDP ($ Trillions) 6.75 6.72 6.69 6.66 6.63 6.60 130 125 120
1989:3 1990:2 1991:1 1989:3 1990:2 1991:1

(b) CPI 140 135

Year and Quarter

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Year and Quarter

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Figure 15(c/d): GDP and the Price Level in Two Recessions

The 2001 Recession (c) Real GDP ($ Trillions) 9.35 9.30 176 9.25 9.20 9.15 172 9.10 174 CPI 178 (d)

2000:1 2001:1 Year and Quarter

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2000:1 2001:1 Year and Quarter

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Using the Theory: Jobless Expansions

  

After a recession, economy enters expansion phase of business cycle

 Employment usually grows rapidly during this period as well

But in our two most recent recessions, economy experienced abnormal, prolonged periods during which employment did not grow at all Figure 16 illustrates behavior of employment during our two most recent recession

 Called trough of recession

 

Vertical axis shows an employment indexemployment divided by employment at the trough Blue line shows that employment falls during the contraction phase of average cycle

 Rises rapidly during the first year of the expansion phase



But red and pink lines show what happened in first year of our most recent expansionsduring 1992 and 2002

 In both cases, employment drifted slightly downward, telling us that total

number of jobs decreased during year

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Figure 16: The Average Expansion Versus Two Recent Jobless Expansions
Employment 1.04 Index (Trough = 1) 1.03 1.02 1.01 1.00 0.99 -6 -4 -2 0 +2 +4 +6 +8 +10 +12 After 1991 Recession After Average Recession After 2001 Recession

Months Before and After the Trough

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Explaining Jobless Expansions



Since story is similar for both of these expansions, lets focus on period from late 2001 to late 2002 the first year of expansion after our most recent recession  Using equation for economic growth
Real GDP = productivity x average hours x (emp/pop) x
population

But equation can be used in different ways  Now were using equation to account for deviations in
employment away from full employment in short-run

For this purpose, well need to make some adjustments to equation  Real GDP = productivity x average hours x employment
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Explaining Jobless Expansions



Lets convert equation to percentage changes  % real GDP = % productivity + %

employment

Finally, rearranging  % employment (-0.3%) = % real GDP (2.9%) % productivity (3.2%)

Numbers in parentheses show actual percentage changes for each of these variables during 2002
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Explaining Jobless Expansions



Why didnt real GDP growth keep up with productivity?  Because growth in real GDP was unusually low  Productivity grew at about the same rate as average expansion, in

spite of the low growth in output  Throughout period, firms were reluctant to hire full-time, permanent workers

Created uncertainty about strength and duration of expansion Instead, business expanded output by hiring part-time and temporary
workers 

Why would this boost productivity?  Enabled firms to adjust their workforce more easily to fluctuations in
production

Phrase jobless expansion refers to just part of expansion phase  Eventually, employment catches upeven to higher levels of output
made possible by productivity growth

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