Chapter 13
We have seen how labor market equilibrium
determines the quantity of labor employed, given a
fixed amount of capital, other factors of production
and the state of technology.
Recall that the quantity of real GDP at full employment
is potential GDP.
Over the business cycle, real GDP fluctuates around
potential GDP because the quantity of labor
employed fluctuates around the full employment level.
The aggregate supply-aggregate demand (AS-AD)
model explains these fluctuations.
Aggregate supply
All other things remaining constant, the higher the
price level, the greater is the quantity of real GDP
supplied; the lower the price level, the smaller is the
quantity of real GDP supplied.
The aggregate supply curve shows the quantities of
real GDP supplied at each price level:
As we move along the AS curve, the only thing that
can cause a change in the quantity of real GDP
supplied is a change in the price level.
E.g., if the price level increases from 115 to 130, real
GDP increases from $9 trillion to $10 trillion. If the
price level decreases from 115 to 100, real GDP
decreases from $9 trillion to $8 trillion. When the
price level is 115, the quantity of real GDP supplied
is $9 trillion, which is potential GDP.
Potential GDP is illustrated as a vertical line because
it does not change when the price level changes.
Potential GDP depends only on the economy’s ability
to produce real output and on the full employment
quantity of labor.
Why does the AS curve slope upward?
If the price level increases, the real wage rate
decreases.
Recall that, for an individual employer,
Real wage rate = __________________________
Nominal wage rate
Product price
An increase in the price level means that product
prices rise and the real wage rate falls.
A fall in the real wage rate means that the firm’s cost
of labor has decreased relative to the revenue an
hour’s labor can produce, and therefore the firm’s
profit increases.
An increase in firms’ profits causes existing firms to
increase their output rates and new firms to enter the
industry and start producing. The quantity of real
GDP supplied therefore increases.
A decrease in the price level means falling product
prices and rising real wage rates. Firms’ profits
decrease. Firms respond by reducing their output
rates and some firms exit the industry. The quantity of
real GDP supplied therefore decreases.
Shifts of the AS curve
A shift of the AS curve is called a change in
aggregate supply. A change in any factor, other than
the price level, that affects production causes a shift
in AS.
Shifts in AS can be either increases or decreases in
AS.
An increase in AS means an increase in the quantity
of real GDP supplied at each price level. The AS
curve shifts to the right. A decrease in AS means a
decrease in the quantity of real GDP supplied at each
price level. The AS curve shifts to the left:
The two main factors causing shifts of AS are:
Changes in potential GDP
Changes in the nominal wage rate or nominal prices
of other resources
A change in potential GDP:
If potential GDP increases, the economy can
produce more real GDP at full employment. But if
the economy can produce more at full employment,
it can also produce more at any level of employment.
Therefore, if the potential GDP line shifts to the right,
the entire AS curve also shifts to the right.
If potential GDP decreases, the economy produces
less at full employment and at all other levels of
employment. The shift to the left of the potential
GDP line is matched by a shift to the left of the AS
curve.
In effect, the potential GDP line “anchors” the AS
curve, so that shifts of the potential GDP line cause
equal shifts of the AS curve:
Changes in the nominal wage rate or nominal prices
of other resources:
An increase in the nominal wage rate or the nominal
price of another resource raises firms’ costs and
therefore reduces the quantity of output that firms are
willing to supply at each price level.
The quantity of real GDP supplied at any given price
level therefore decreases, and the AS curve shifts to
the left.
A decrease in the nominal wage rate or the nominal
price of another resource reduces firms’ costs and
therefore increases the quantity of output that firms
are willing to supply at each price level.
The quantity of real GDP supplied at any given price
level therefore increases, and the AS curve shifts to
the right.
Aggregate demand
The total quantity of real GDP demanded is the total
expenditure of consumers, businesses, government
and foreigners on final goods and services produced
in the U.S.
Y = C + I + G + NX
All other things remaining constant, the higher the
price level, the smaller is the quantity of real GDP
demanded; the lower the price level, the greater is
the quantity of real GDP demanded.
As we move along the AD curve, the only thing that
can cause a change in the quantity of real GDP
demanded is a change in the price level.
Why does the AD curve slope downward?
The higher the price level, the lower the purchasing
power of a given nominal amount of money.
Therefore consumers and firms reduce their
expenditures. The quantity of real GDP demanded
decreases.
Also, the higher the price level in the U.S., holding
prices in other countries constant, the lower is
spending by foreigners and U.S. residents on U.S.produced goods and the higher is spending on
foreign-produced goods. Net exports from the U.S.
decrease. Therefore the quantity of domestically
produced real GDP demanded decreases.
The lower the price level, the greater the purchasing
power of money, and therefore expenditure
increases. Also, lower domestic prices relative to
foreign prices cause net export expenditure to
increase. For both of these reasons, the quantity of
real GDP demanded increases.
Shifts of the AD curve
A shift of the AD curve is called a change in
aggregate demand. A change in any factor, other
than the price level, that affects expenditure plans
causes a shift in AD.
Shifts in AD can be either increases or decreases in
AD.
An increase in AD means an increase in the quantity
of real GDP demanded at each price level. The AD
curve shifts to the right. A decrease in AD means a
decrease in the quantity of real GDP demanded at
each price level. The AD curve shifts to the left:
The main factors causing shifts of AD are:
Expectations
Fiscal and monetary policy
Changes in the world economy
Expectations:
An increase in expected future income increases
current consumption expenditure at any given level of
prices. AD increases.
An increase in expected future inflation causes an
increase in current consumption expenditure at any
given level of current prices, as households
purchase more goods and services in anticipation
of their prices rising in the future. AD increases.
An increase in expected future profit causes firms to
increase current investment expenditure at any
given level of prices. AD increases.
Fiscal and monetary policy:
An increase in government expenditure or a cut in
net taxes causes an increase in total expenditure at
any given level of prices. AD increases.
A cut in interest rates or an increase in the money
supply causes an increase in expenditure at any
given level of prices. AD increases.
The world economy:
If the U.S. dollar rises in value relative to foreign
currencies, foreign-produced goods become
relatively cheaper than U.S.-produced goods.
Expenditure on U.S.-produced goods (by both
foreigners and U.S. residents) decreases, and AD in
the U.S. therefore decreases.
An increase in income in foreign countries causes an
increase in foreigners’ expenditure, including their
expenditure on U.S. exports, and therefore an
increase in AD in the U.S.
The AD multiplier
When AD increases, the increase in expenditure
causes an increase in income. This increase in
income causes a further round of increased
consumption expenditure, and therefore a further
increase in AD.
For example, suppose there is initially an increase in
investment expenditure, ΔI:
The initial AD curve shifts out from AD0 to AD0+ΔI.
The extra investment spending causes an increase in
income which causes a further round of consumption
increases, etc., and AD increases further to AD1.
AD1 now describes aggregate spending plans at each
price level.
Macroeconomic equilibrium
Macroeconomic equilibrium occurs where the
quantity of real GDP supplied is equal to the quantity
of real GDP demanded, i.e., at the intersection of the
AS and AD curves.
Why is this an equilibrium?
Equilibrium occurs at a price level of 115, where the
quantity of real GDP supplied = the quantity of real
GDP demanded = $9 trillion.
If the price level is above 115, say, 130, the quantity of
real GDP supplied is $10 trillion at point A. But the
quantity of real GDP demanded is less than $10
trillion.
Firms are unable to sell all of their output. Therefore,
there is an unplanned increase in firms’ inventories.
Firms respond by reducing production and cutting
prices. The combination of a decrease in output and a
decrease in prices means a movement down along the
AS curve from point A toward point E.
If the price level is below 115, say, 100, the quantity of
real GDP supplied is $8 trillion at point B. But the
quantity of real GDP demanded is more than $8
trillion.
There is an unplanned decrease in firms’ inventories
as firms are unable to meet all of their customers’
demands. Firms respond by increasing production
and raising prices. The combination of an increase in
output and an increase in prices means a movement
up along the AS curve from point B toward point E.
Macroeconomic equilibrium can occur at full
employment, above full employment, or below full
employment:
Fluctuations in AD cause fluctuations in real GDP
around potential GDP.
At point E, AD0 intersects AS at potential GDP.
Equilibrium real GDP = Potential GDP
Equilibrium real GDP is $9 trillion. This is a full
employment equilibrium.
Now, if AD increases to AD1, firms’ inventories
decrease and firms respond by increasing production
and raising prices to meet the higher demand.
Equilibrium real GDP increases to $10 trillion at point
A. Equilibrium real GDP now exceeds potential
GDP. This is an above-full employment equilibrium.
If AD now decreases to AD2, firms’ inventories
increase and firms respond by cutting production and
lowering prices in order to sell all of their output.
Equilibrium real GDP decreases to $8 trillion at point
B. Equilibrium real GDP is now less than potential
GDP. This is a below-full employment equilibrium.
The business cycle
Fluctuations in AD can cause business cycle
fluctuations in real GDP. When AD increases from
AD0 to AD1, equilibrium real GDP increases from full
employment, at $9 trillion, to $10 trillion, which is a
business cycle expansion.
If AD now decreases back to AD0, equilibrium real
GDP decreases again to $9 trillion, the full
employment level.
If AD decreases further to AD2, equilibrium real GDP
decreases to $8 trillion and the economy is in a
recession, with equilibrium real GDP below full
employment.
If AD increases again to AD0, equilibrium real GDP
increases back to the full employment level of $9
trillion.
The causes of these AD fluctuations are any of the
factors we have discussed: changes in expectations,
fiscal or monetary policy, or global economic
conditions.
AS fluctuations
Recall that AS can shift either because of a change in
potential GDP or because of a change in the nominal
price of labor or some other major resource.
Potential GDP grows during periods of rapid
technological change and capital accumulation.
A good example of a change in the price of a major
resource is a change in the price of crude oil. Oil is
used as an input in the production of many goods and
services because oil is used to produce electrical
power and fuel for transportation.
Assume that the economy is initially in equilibrium at
full employment, i.e., equilibrium real GDP = potential
GDP.
Now, oil prices rise. Firms face higher transportation
and energy costs and therefore reduce production.
AS decreases from AS0 to AS1:
Equilibrium real GDP decreases below potential GDP
and the price level rises. The economy is in a
recession because real GDP is below full
employment. But there is also inflation.
A combination of recession and inflation is called
stagflation, and occurred in the U.S. and the global
economy in the mid-1970s and early 1980s.
Starting from the same full employment equilibrium, if
oil prices fall, firms’ transportation and energy costs
decrease and firms increase production. AS increases
from AS0 to AS2:
Equilibrium real GDP increases above potential GDP
and the price level falls. The economy is in an abovefull employment equilibrium. In the mid-1980s, an
economic expansion coincided with slowing inflation.
Adjustment to full employment
When a shift in AD moves the economy to an
equilibrium that is above or below full employment,
automatic forces operate to bring the economy back
to full employment in the long run.
AD increases from AD0 to AD1. Equilibrium real GDP
increases above potential GDP. There is now an
inflationary gap. This is a gap between actual GDP
and full employment GDP that causes prices to rise:
The increase in the price level reduces the
purchasing power of workers’ wages, while firms’
profits have increased.
Workers demand higher wages to compensate them
for higher prices, and other input suppliers likewise
demand higher prices for their inputs. Firms agree to
these demands because they want to maintain their
output and employment in the face of strong demand
for their products.
As nominal wage rates and nominal prices of other
inputs rise, AS decreases. The AS curve shifts from
AS0 to AS1 and equilibrium real GDP decreases back
to potential GDP. Full employment equilibrium is
restored:
A decrease in AD from AD0 to AD2 causes equilibrium
real GDP to decrease below potential GDP. There is
now a deflationary gap. This is a gap between actual
GDP and full employment GDP that causes prices to
fall:
The economy is now in recession at an equilibrium
level of real GDP that is below full employment, and
the price level has fallen.
Those workers who are still employed see the
purchasing power of their wages rise due to the
drop in prices. Firms’ profits decrease and, due to
the surplus of unemployed labor, nominal wages
fall. As firms reduce output, they purchase fewer
inputs, and therefore nominal input prices fall too.
As nominal wage rates and nominal prices of other
inputs fall, AS increases. The AS curve shifts from
AS0 to AS2 and equilibrium real GDP increases back
to potential GDP. Full employment equilibrium is
again restored: