23 Aggregate Demand and Aggregate Supply ESSENTIALS OF ECONOMICS FOURTH EDITION N. G R E G O R Y M A N K I W PowerPoint® Slides by Ron Cronovich © 2007 Thomson South-Western, all rights reserved In this chapter, look for the answers to these questions: What are economic fluctuations? What are their characteristics? How does the model of aggregate demand and aggregate supply explain economic fluctuations? Why does the Aggregate-Demand curve slope downward? What shifts the AD curve? What is the slope of the Aggregate-Supply curve in the short run? In the long run? What shifts the AS curve(s)? CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 1 Introduction Over the long run, real GDP grows about 3% per year on average. In the short run, GDP fluctuates around its trend. • recessions: periods of falling real incomes and rising unemployment • depressions: severe recessions (very rare) Short-run economic fluctuations are often called business cycles. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 2 Three Facts About Economic Fluctuations FACT 1: Economic fluctuations are irregular and unpredictable. $ 11,000 U.S. real GDP, billions of 2000 dollars 10,000 9,000 8,000 7,000 6,000 The shaded bars are recessions 5,000 4,000 3,000 2,000 1965 1970 1975 1980 1985 1990 1995 2000 2005 Three Facts About Economic Fluctuations FACT 2: Most macroeconomic quantities fluctuate together. $ 1,800 Investment spending, billions of 2000 dollars 1,600 1,400 1,200 1,000 800 600 400 200 1965 1970 1975 1980 1985 1990 1995 2000 2005 Three Facts About Economic Fluctuations FACT 3: As output falls, unemployment rises. 12 Unemployment rate, percent of labor force 10 8 6 4 2 0 1965 1970 1975 1980 1985 1990 1995 2000 2005 Introduction, continued Explaining these fluctuations is difficult, and the theory of economic fluctuations is controversial. Most economists use the model of aggregate demand and aggregate supply to study fluctuations. This model differs from the classical economic theories economists use to explain the long run. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 6 Classical Economics—A Recap The previous chapters are based on the ideas of classical economics, especially: The Classical Dichotomy, the separation of variables into two groups: • real – quantities, relative prices • nominal – measured in terms of money The neutrality of money: Changes in the money supply affect nominal but not real variables. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 7 Classical Economics—A Recap Most economists believe classical theory describes the world in the long run, but not the short run. In the short run, changes in nominal variables (like the money supply or P ) can affect real variables (like Y or the u-rate). To study the short run, we use a new model. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 8 The Model of Aggregate Demand and Aggregate Supply P The price level The model determines the eq’m price level and the eq’m level of output (real GDP). CHAPTER 23 SRAS P1 “Aggregate Demand” “Short-Run Aggregate Supply” AD Y1 Y Real GDP, the quantity of output AGGREGATE DEMAND AND AGGREGATE SUPPLY 9 The Aggregate-Demand (AD) Curve P The AD curve shows the quantity of all g&s demanded in the economy at any given price level. P2 P1 AD Y2 CHAPTER 23 Y1 AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 10 Why the AD Curve Slopes Downward Y = C + I + G + NX C, I, G, NX are the components of agg. demand. Assume G fixed by govt policy. To understand the slope of AD, must determine how a change in P affects C, I, and NX. CHAPTER 23 P P2 P1 AD Y2 Y1 AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 11 The Wealth Effect (P and C ) Suppose P rises. The dollars people hold buy fewer g&s, so real wealth is lower. People feel poorer, so they spend less. Thus, an increase in P causes a fall in C …which means a smaller quantity of g&s demanded. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 12 The Interest-Rate Effect (P and I ) Suppose P rises. Buying g&s requires more dollars. To get these dollars, people sell some of their bonds or other assets, which drives up interest rates. …which increases the cost of borrowing to fund investment projects. Thus, an increase in P causes a decrease in I …which means a smaller quantity of g&s demanded. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 13 The Exchange-Rate Effect (P and NX ) Suppose P rises. Interest rates go up (the interest-rate effect). U.S. bonds more attractive relative to foreign bonds. Foreign investors purchase more U.S. bonds, but first must convert their currency into $ …which appreciates the U.S. exchange rate. Makes U.S. exports more expensive to people abroad, imports cheaper to U.S. residents. Thus, an increase in P causes a decrease in NX …which means a smaller quantity of g&s demanded. 14 The Slope of the AD Curve: Summary An increase in P reduces the quantity of g&s demanded because: P P2 • the wealth effect (C falls) • the interest-rate P1 AD effect (I falls) • the exchange-rate effect (NX falls) CHAPTER 23 Y2 Y1 AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 15 Why the AD Curve Might Shift Any event that changes C, I, G, or NX – except a change in P – will shift the AD curve. Example: A stock market boom makes households feel wealthier, C rises, the AD curve shifts right. P P1 AD2 AD1 Y1 CHAPTER 23 Y2 AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 16 AD Shifts Arising from Changes in C people decide to save more: C falls, AD shifts left stock market crash: C falls, AD shifts left tax cut: C rises, AD shifts right CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 17 AD Shifts Arising from Changes in I Firms decide to upgrade their computers: I rises, AD shifts right Firms become pessimistic about future demand: I falls, AD shifts left Central bank uses monetary policy to reduce interest rates: I rises, AD shifts right Investment Tax Credit or other tax incentive:I rises, AD shifts right CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 18 AD Shifts Arising from Changes in G Congress increases spending on homeland security: G rises, AD shifts right State govts cut spending on road construction: G falls, AD shifts left CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 19 AD Shifts Arising from Changes in NX A boom overseas increases foreign demand for our exports: NX rises, AD shifts right International speculators cause exchange rate to appreciate: NX falls, AD shifts left CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 20 ACTIVE LEARNING Exercise 1: Try this without looking at your notes. What happens to the AD curve in each of the following scenarios? A. A ten-year-old investment tax credit expires. B. The U.S. exchange rate falls. C. A fall in prices increases the real value of consumers’ wealth. D. State governments replace their sales taxes with new taxes on interest, dividends, and capital gains. 21 ACTIVE LEARNING Answers 1: A. A ten-year-old investment tax credit expires. I falls, AD curve shifts left. B. The U.S. exchange rate falls. NX rises, AD curve shifts right. C. A fall in prices increases the real value of consumers’ wealth. Move down along AD curve (wealth-effect). D. State governments replace sales taxes with new taxes on interest, dividends, and capital gains. C rises, AD shifts right. 22 The Aggregate-Supply (AS) Curves The AS curve shows the total quantity of g&s firms produce and sell at any given price level. P LRAS SRAS In the short run, AS is upward-sloping. In the long run, AS is vertical. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 23 The Long-Run Aggregate-Supply Curve (LRAS) The natural rate of output (YN) is the amount of output the economy produces when unemployment is at its natural rate. YN is also called potential output or full-employment output. CHAPTER 23 P LRAS YN AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 24 Why LRAS Is Vertical YN depends on the economy’s stocks of labor, capital, and natural resources, and on the level of technology. An increase in P does not affect any of these, so it does not affect YN. (Classical dichotomy) CHAPTER 23 P LRAS P2 P1 YN AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 25 Why the LRAS Curve Might Shift Any event that changes any of the determinants of YN will shift LRAS. P LRAS1 LRAS2 Example: Immigration increases L, causing YN to rise. YN CHAPTER 23 Y’ N AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 26 LRAS Shifts Arising from Changes in L The Baby Boom generation retires: L falls, LRAS shifts left New govt policies reduce the natural rate of unemployment: the % of the labor force normally employed rises, LRAS shifts right CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 27 LRAS Shifts Arising from Changes in Physical or Human Capital Investment in factories or equipment: K rises, LRAS shifts right More people get college degrees: Human capital rises, LRAS shifts right Earthquakes or hurricanes destroy factories: K falls, LRAS shifts left CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 28 LRAS Shifts Arising from Changes in Natural Resources A change in weather patterns makes farming more difficult: LRAS shifts left Discovery of new mineral deposits: LRAS shifts right Reduction in supply of imported oil or other resources: LRAS shifts right CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 29 LRAS Shifts Arising from Changes in Technology Technological advances allow more output to be produced from a given bundle of inputs: LRAS shifts right. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 30 Using AD & AS to Depict LR Growth and Inflation Over the long run, tech. progress shifts LRAS to the right and growth in the money supply shifts AD to the right. Result: ongoing inflation and growth in output. CHAPTER 23 P LRAS2000 LRAS1990 LRAS1980 P2000 P1990 AD2000 P1980 AD1990 AD1980 Y1980 Y1990 Y2000 AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 31 Short Run Aggregate Supply (SRAS) P The SRAS curve is upward sloping: Over the period of 1-2 years, an increase in P causes an increase in the quantity of g & s supplied. SRAS P2 P1 Y1 CHAPTER 23 Y2 AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 32 Why the Slope of SRAS Matters If AS is vertical, fluctuations in AD do not cause fluctuations in output or employment. If AS slopes up, then shifts in AD do affect output and employment. CHAPTER 23 LRAS P Phi SRAS Phi ADhi Plo AD1 Plo ADlo Ylo Y1 Yhi AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 33 Three Theories of SRAS In each, • some type of market imperfection • result: Output deviates from its natural rate when the actual price level deviates from the price level people expected. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 34 Three Theories of SRAS P SRAS When P > PE the expected price level PE When P < PE Y YN Y < YN CHAPTER 23 Y > YN AGGREGATE DEMAND AND AGGREGATE SUPPLY 35 1. The Sticky-Wage Theory Imperfection: Nominal wages are sticky in the short run, they adjust sluggishly. • Due to labor contracts, social norms. Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 36 1. The Sticky-Wage Theory If P > PE, revenue is higher, but labor cost is not. Production is more profitable, so firms increase output and employment. Hence, higher P causes higher Y, so the SRAS curve slopes upward. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 37 2. The Sticky-Price Theory Imperfection: Many prices are sticky in the short run. • Due to menu costs, the costs of adjusting prices. • Examples: cost of printing new menus, the time required to change price tags. Firms set sticky prices in advance based on PE. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 38 2. The Sticky-Price Theory Suppose the Fed increases the money supply unexpectedly. In the long run, P will rise. In the short run, firms without menu costs can raise their prices immediately. Firms with menu costs wait to raise prices. Meantime, their prices are relatively low, which increases demand for their products, so they increase output and employment. Hence, higher P is associated with higher Y, so the SRAS curve slopes upward. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 39 3. The Misperceptions Theory Imperfection: Firms may confuse changes in P with changes in the relative price of the products they sell. If P rises above PE, a firm sees its price rise before realizing all prices are rising. The firm may believe its relative price is rising, and may increase output and employment. So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 40 What the 3 Theories Have in Common: Each of the 3 theories implies Y deviates from YN when P deviates from PE. Y = YN + a (P – PE) Output Natural rate of output (long-run) CHAPTER 23 Expected price level a > 0, measures how much Y responds to unexpected changes in P Actual price level AGGREGATE DEMAND AND AGGREGATE SUPPLY 41 SRAS and LRAS The imperfections in these theories are temporary. Over time, • sticky wages and prices become flexible • misperceptions are corrected In the LR, • PE = P • AS curve is vertical CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 42 SRAS and LRAS Y = YN + a(P – PE) P LRAS In the long run, PE = P and Y = YN. SRAS PE YN CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 43 Why the SRAS Curve Might Shift Everything that shifts LRAS shifts SRAS, too. P Also, PE shifts SRAS: If PE rises, workers & firms set higher wages. At each P, production is less profitable, Y falls, SRAS shifts left. CHAPTER 23 LRAS SRAS SRAS PE PE YN AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 44 The Long-Run Equilibrium In the long-run equilibrium, P LRAS SRAS PE = P, Y = YN , and unemployment is at its natural rate. PE AD YN CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 45 Economic Fluctuations Caused by events that shift the AD and/or AS curves. Four steps to analyzing economic fluctuations: 1. Determine whether the event shifts AD or AS. 2. Determine whether curve shifts left or right. 3. Use AD-AS diagram to see how the shift changes Y and P in the short run. 4. Use AD-AS diagram to see how economy moves from new SR eq’m to new LR eq’m. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 46 The Effects of a Shift in AD Event: stock market crash P 1. affects C, AD curve LRAS 2. C falls, so AD shifts left 3. SR eq’m at B. P and Y lower, unemp higher 4. Over time, PE falls, SRAS shifts right, until LR eq’m at C. Y and unemp back at initial levels. CHAPTER 23 SRAS1 A P1 P2 SRAS2 B P3 AD1 C AD2 Y2 YN AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 47 Two Big AD Shifts: 1. The Great Depression U.S. Real GDP, billions of 2000 dollars From 1929-1933, CHAPTER 23 700 650 600 550 AGGREGATE DEMAND AND AGGREGATE SUPPLY 1934 unemp rose from 3% to 25% 750 1933 P fell 22% 800 1932 Y fell 27% 850 1931 • • • stock prices fell 90%, reducing C and I 900 1930 • money supply fell 28% due to problems in banking system 1929 • 48 Two Big AD Shifts: 2. The World War II Boom 2,000 Y rose 90% 1,400 P rose 20% 1,200 unemp fell from 17% to 1% 1,000 1,800 1,600 CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 1944 1943 1942 800 1939 • • • govt outlays rose from $9.1 billion to $91.3 billion 1941 • U.S. Real GDP, billions of 2000 dollars 1940 From 1939-1944, 49 ACTIVE LEARNING Exercise 2: Draw the AD-SRAS-LRAS diagram for the U.S. economy, starting in a long-run equilibrium. A boom occurs in Canada. Use your diagram to determine the SR and LR effects on U.S. GDP, the price level, and unemployment. 50 ACTIVE LEARNING Answers 2: Event: boom in Canada P 1. affects NX, AD curve LRAS SRAS2 2. shifts AD right 3. SR eq’m at point B. P and Y higher, unemp lower P3 4. Over time, PE rises, SRAS shifts left, until LR eq’m at C. Y and unemp back at initial levels. P1 C SRAS1 B P2 A AD2 AD1 YN Y2 Y 51 The Effects of a Shift in SRAS Event: oil prices rise 1. increases costs, P shifts SRAS (assume LRAS constant) 2. SRAS shifts left 3. SR eq’m at point B. P2 P higher, Y lower, unemp higher P1 From A to B, stagflation, a period of falling output and rising prices. CHAPTER 23 LRAS SRAS2 SRAS1 B A AD1 Y2 YN AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 52 Accommodating an Adverse Shift in SRAS If policymakers do nothing, 4. Low employment causes wages to fall, SRAS shifts right, until LR eq’m at A. Or, policymakers could use fiscal or monetary policy to increase AD and accommodate the AS shift: Y back to YN, but P permanently higher. CHAPTER 23 P LRAS SRAS2 P3 P2 P1 C B A SRAS1 AD2 AD1 Y2 YN AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 53 The 1970s Oil Shocks and Their Effects 1973-75 1978-80 Real oil prices + 138% + 99% CPI + 21% + 26% Real GDP – 0.7% + 2.9% # of unemployed persons + 3.5 million + 1.4 million CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 54 John Maynard Keynes, 1883-1946 • The General Theory of Employment, Interest, and Money, 1936 • Argued recessions and depressions can result from inadequate demand; policymakers should shift AD. • Famous critique of classical theory: The long run is a misleading guide to current affairs. In the long run, we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us when the storm is long past, the ocean will be flat. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 55 CONCLUSION This chapter has introduced the model of aggregate demand and aggregate supply, which helps explain economic fluctuations. Keep in mind: these fluctuations are deviations from the long-run trends explained by the models we learned in previous chapters. In the next chapter, we will learn how policymakers can affect aggregate demand with fiscal and monetary policy. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 56 CHAPTER SUMMARY Short-run fluctuations in GDP and other macroeconomic quantities are irregular and unpredictable. Recessions are periods of falling real GDP and rising unemployment. Economists analyze fluctuations using the model of aggregate demand and aggregate supply. The aggregate demand curve slopes downward because a change in the price level has a wealth effect on consumption, an interest-rate effect on investment, and an exchange-rate effect on net exports. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 57 CHAPTER SUMMARY Anything that changes C, I, G, or NX – except a change in the price level – will shift the aggregate demand curve. The long-run aggregate supply curve is vertical, because changes in the price level do not affect output in the long run. In the long run, output is determined by labor, capital, natural resources, and technology; changes in any of these will shift the long-run aggregate supply curve. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 58 CHAPTER SUMMARY In the short run, output deviates from its natural rate when the price level is different than expected, leading to an upward-sloping short-run aggregate supply curve. The three theories proposed to explain this upward slope are the sticky wage theory, the sticky price theory, and the misperceptions theory. The short-run aggregate-supply curve shifts in response to changes in the expected price level and to anything that shifts the long-run aggregate supply curve. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 59 CHAPTER SUMMARY Economic fluctuations are caused by shifts in aggregate demand and aggregate supply. When aggregate demand falls, output and the price level fall in the short run. Over time, a change in expectations causes wages, prices, and perceptions to adjust, and the short-run aggregate supply curve shifts rightward. In the long run, the economy returns to the natural rates of output and unemployment, but with a lower price level. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 60 CHAPTER SUMMARY A fall in aggregate supply results in stagflation – falling output and rising prices. Wages, prices, and perceptions adjust over time, and the economy recovers. CHAPTER 23 AGGREGATE DEMAND AND AGGREGATE SUPPLY 61