Aggregate demand and aggregate supply model
A model that explains short-run fluctuations in real
GDP and the price level.
Aggregate Demand GDP has four components: consumption (C),
investment (I), government purchases (G), and net exports (NX). If we
let Y stand for GDP, we can write the following:
Y = C + I + G + NX
Why Is the Aggregate Demand Curve Downward Sloping?
The International-Trade Effect (substitution of foreign stuff for our
stuff): When our price level rises, foreigners buy less of our
exports and we import more things from abroad.
When our price level rises, the real value of our monetary wealth
declines. We feel poorer.
The Wealth Effect: When our monetary wealth declines, we
feel poorer and buy less.
When our price level rises, real money balances (M/P) become
scarcer and the interest rate rises.
The Interest-Rate Effect: A higher interest rate discourages
spending, investment spending in particular.
What Shifts the Aggregate Demand Curve?
Changes in Government Policies intended to achieve
macroeconomic objectives: high employment, price stability, steady
economic growth.
•Monetary policy Actions the Federal Reserve takes to manage the
money supply and interest rates.
•Fiscal policy Changes in federal taxes and purchases.
Changes in Expectations of Households and Firms
•If households become more optimistic about their future incomes,
they are likely to increase their current consumption.
Changes in Foreign Variables
•If foreign economies expand, foreign firms and households will
buy more U.S. goods.
•If the dollar depreciates, foreign firms and households will buy
more U.S. goods and U.S. firms and households will buy fewer
foreign goods.
Net exports will rise and the aggregate demand curve will shift to the
right.
Movements along the Aggregate Demand Curve
versus Shifts of the Aggregate Demand Curve
When price rises, less domestic
output is demanded owing to the
international-trade effect, the wealth
effect and the interest rate effect.
When taxes increase or government
spending decreases, when the
money supply is reduced or when
people lose confidence, aggregate
demand shifts to the left
Variables That Shift the Aggregate Demand Curve
Variables That Shift the Aggregate Demand Curve
The Long-Run Aggregate Supply Curve
LRAS reflects the economy’s output capacity at full employment of
available resources using the best available technology.
LRAS shifts outward as capital accumulates, the labor force grows
and as technology improves.
Aggregate Supply
The Short-Run Aggregate Supply Curve
Why does the short-run aggregate supply curve slope upward?
1 Contracts make some wages and prices “sticky.”
2 Firms are often slow to adjust wages.
3 Menu costs make some prices sticky.
Variables That Shift the Short-Run Aggregate Supply Curve
Expected Changes in the Future Price Level
Aggregate Supply
Variables That Shift the Short-Run Aggregate Supply Curve
Adjustments of Workers and Firms to Errors in Past
Expectations about the Price Level
Unexpected Changes in the Price of an Important
Natural Resource
Supply shock An unexpected
event that causes the short-run
aggregate supply curve to shift.
Variables That Shift the Short-Run Aggregate Supply Curve
Variables That Shift the Short-Run Aggregate Supply Curve
Unexpected Changes in the Price of an Important
Natural Resource
Macroeconomic Equilibrium
in the Long Run and the Short Run
Long-Run Macroeconomic
Equilibrium
Macroeconomic Equilibrium
in the Long Run and the Short Run
Recessions, Expansions, and Supply Shocks
Because the full analysis of the aggregate demand and
aggregate supply model can be complicated, we begin
with a simplified case, using two assumptions:
1 The economy has not been experiencing any
inflation. The price level is currently 100, and
workers and firms expect it to remain at 100
in the future.
2 The economy is not experiencing any long-run
growth. Potential real GDP is $10.0 trillion
and will remain at that level in the future.
Expansion...and restoration of full employment
The Short-Run
and Long- run
Effects of an
Increase in
Aggregate
Demand: Rising
wages and prices
shift AD inward
Recession...and textbook restoration of full employment
The Short-Run and LongRun Effects of a Decrease
in Aggregate Demand:
Declining wages and
prices shift AD outward
Making
Does It Matter What Causes
a Decline in Aggregate
Connection
Demand?
the
The collapse in spending on housing
added to the severity of the 2007–2009
recession.
Spending on residential construction has declined
prior to every recession since 1955.
Macroeconomic Equilibrium
in the Long Run and the Short Run
Recessions, Expansions, and Supply Shocks
Supply Shock
Stagflation A combination
of inflation and recession,
usually resulting from a
supply shock.
Macroeconomic Equilibrium
in the Long Run and the Short Run
Supply Shock
 Stagflation
The Short-Run and Long-Run Effects of a Supply Shock
A Dynamic Aggregate Demand
and Aggregate Supply Model
We can create a dynamic aggregate demand and aggregate supply
model by making three changes to the basic model...but we won’t
Realistically,
• Potential real GDP increases continually,
shifting the long-run aggregate supply curve to
the right.
• During most years, the aggregate demand
curve will be shifting to the right.
• Except during periods when workers and firms
expect high rates of inflation, the short-run
aggregate supply curve will be shifting to the
right as productivity increases.
Key Terms
Aggregate demand and aggregate supply model
Aggregate demand curve
Fiscal policy
Long-run aggregate supply curve
Menu costs
Monetary policy
Short-run aggregate supply curve
Stagflation
Supply shock
Macroeconomic Schools of Thought
Keynesian revolution The name given to the widespread
acceptance during the 1930s and 1940s of John Maynard Keynes’s
macroeconomic model and activist policy prescriptions.
These alternative schools of thought use models that differ
significantly from the standard aggregate demand and aggregate
supply model. We can briefly consider each of the three major
alternative models:
1 The monetarist model
2 The new classical model
3 The real business cycle model
Macroeconomic Schools of Thought
The Monetarist Model
The monetarist model—also known as the neo-Quantity Theory of
Money model—was developed beginning in the 1940s by Milton
Friedman, an economist at the University of Chicago who was
awarded the Nobel Prize in Economics in 1976.
Monetary growth rule A plan for increasing the
quantity of money at a fixed rate that does not respond
to changes in economic conditions.
Monetarism The macroeconomic theories of Milton
Friedman and his followers; particularly the idea that
the quantity of money should be increased at a
constant rate.
Macroeconomic Schools of Thought
The New Classical Model
The new classical model was developed in the mid-1970s by a
group of economists including Nobel laureate Robert Lucas of the
University of Chicago, Thomas Sargent of New York University,
and Robert Barro of Harvard University.
New classical macroeconomics The macroeconomic
theories of Robert Lucas and others, particularly the
idea that workers and firms have rational expectations.
Macroeconomic Schools of Thought
The Real Business Cycle Model
Beginning in the 1980s, some economists, including Nobel
laureates Finn Kydland of Carnegie Mellon University and Edward
Prescott of Arizona State University, argued that Lucas was correct
in assuming that workers and firms formed their expectations
rationally and that wages and prices adjust quickly to supply and
demand but wrong about the source of fluctuations in real GDP.
Real business cycle model A macroeconomic model
that focuses on real, rather than monetary, causes of
the business cycle.
Making
Karl Marx: Capitalism’s Severest Critic
Connection … or most perceptive analyst?
the
Karl Marx predicted that a final
economic crisis would lead to
the collapse of the market system.