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Title: Aggregate%20demand%20and%20Aggregate%20Supply%20(AD%20and%20AS)


1
Aggregate demand and Aggregate Supply (AD and AS)
  • notice the data while potential GDP tends to
    move upward yr after yr, due to economic growth,
    actual GDP tends to rise above and fall below
    potential over shorter periods
  • Date reveals an important fact Deviations from
    potential output dont last forever
  • In some of these episodes, government
    policy-either fiscal or monetary-helped the
    economy to return to full employment more quickly
  • But even without corrective policies-such as
    during long parts of Great Ds of the 1930s-the
    economy shows a remarkable tendency to begin
    moving back towards potential output
  • What is the mechanism behind?
  • We will study the behavior of a new variable that
    we have put aside for several chapters the price
    level

2
Figure 1a Potential and Actual Real GDP,
1960-2001
3
Figure 1 The Two-Way Relationship Between
Output and the Price Level
4
AD and AS
  • There exist a two-way relationship between price
    level and output (see diagram 1)
  • Changes in price level cause changes in real GDP
    illustrated by Aggregate Demand curve
  • Changes in real GDP cause changes in price level
    illustrated by Aggregate Supply curve

5
The Aggregate Demand Curve
  • First step in understanding how price level
    affects economy is an important fact
  • When price level rises, money demand curve shifts
    rightward (because purchases become more
    expensive)
  • Shift in money demand, and its impact on the
    economy, is illustrated in Figure 2
  • Imagine a rather substantial rise in price
    levelfrom 100 to 140
  • Compared with our initial position, this new
    equilibrium has the following characteristics
  • Money demand curve has shifted rightward
  • Interest rate is higher
  • Aggregate expenditure line has shifted downward
  • Equilibrium GDP is lower
  • All of these changes are caused by a rise in
    price level
  • A rise in price level causes a decrease in
    equilibrium GDP

6
Figure 2a Deriving the Aggregate Demand Curve
(a)
Ms
H
E
500
7
Figure 2b/c Deriving the Aggregate Demand Curve
(c)
(b)
Price Level
AEr 6
H
AEr 9
140
E
Aggregate Expenditure ( Trillions)
E
100
H
AD
Real GDP ( Trillions)
Real GDP ( Trillions)
10
6
6
10
8
Deriving the Aggregate Demand Curve
  • Panel (c) of Figure 2 shows a new curve
  • Shows negative relationship between price level
    and equilibrium GDP
  • Call aggregate demand curve
  • Tells us equilibrium real GDP at any price level

9
Understanding the AD Curve
  • AD curve is unlike any other curve youve
    encountered in this text
  • In all other cases, our curves have represented
    simple behavioral relationships
  • But AD curve represents more than just a
    behavioral relationship between two variables
  • Each point on curve represents a short-run
    equilibrium in economy
  • A better name for AD curve would be equilibrium
    output at each price level curvenot a very
    catchy name
  • AD curve gets its name because it resembles
    demand curve for an individual product
  • AD curve is not a demand curve at all, in spite
    of its name

10
Movements Along the AD Curve
  • As you will see later in this chapter, a variety
    of events can cause price level to change, and
    move us along AD curve
  • Suppose price level rises, and we move from point
    E to point H along this curve
  • Following sequence of events occurs
  • Opposite sequence of events will occur if price
    level falls, moving us rightward along AD curve

11
Shifts of the AD Curve
  • When we move along AD curve in Figure 2, we
    assume that price level changes
  • But that other influences on equilibrium GDP are
    constant
  • Keep following rule in mind
  • When a change in price level causes equilibrium
    GDP to change, we move along AD curve
  • Whenever anything other than price level causes
    equilibrium GDP to change, AD curve itself shifts
  • Equilibrium GDP will change whenever there is a
    change in any of the following
  • Government purchases
  • Autonomous consumption spending
  • Investment spending
  • Net exports
  • Taxes
  • Money supply

12
An Increase in Government Purchases
  • Spending shocks initially affect economy by
    shifting aggregate expenditure line
  • In Figure 3, we assume economy begins at a price
    level of 100
  • Lets increase government purchases by 2
    trillion and ask what happens if price level
    remains at 100
  • An increase in government purchases shifts entire
    AD curve rightward
  • AD curve shifts rightward when government
    purchases, investment spending, autonomous
    consumption spending, or net exports increase, or
    when taxes decrease
  • Analysis also applies in the other direction
  • AD curve shifts leftward when government
    purchases, investment spending, autonomous
    consumption spending, or net exports decrease, or
    when taxes increase

13
Figure 3 A Spending Shock Shifts the AD Curve
(a)
(b)
Price Level
AE2
AE1
H
Real Aggregate Expenditure ( Trillions)
100
H
E
E
AD1
AD2
Real GDP ( Trillions)
Real GDP ( Trillions)
10
13.5
10
13.5
14
Changes in the Money Supply
  • Changes in money supply will also shift aggregate
    demand curve
  • Imagine that Fed conducts open market operations
    to increase money supply
  • AD curve shifts rightward
  • A decrease in money supply would have the
    opposite effect

15
Shifts vs. Movements Along the AD Curve A
Summary
  • Figure 4 summarizes how some events in economy
    cause a movement along AD curve, and other events
    shift AD curve
  • Panels (b) and (c) of Figure 4 tell us how a
    variety of events affect AD curve, but not how
    they affect real GDP
  • Where will price level end up?
  • First step in answering that question is to
    understand the other side of the relationship
    between GDP and price level

16
Figure 4a Effects of Key Changes on the
Aggregate Demand Curve
(a)
Price Level
P3
P1
P2
AD
Real GDP
Q3
Q1
Q2
17
Figure 4b Effects of Key Changes on the
Aggregate Demand Curve
(b)
Price Level
AD2
AD1
Real GDP
18
Figure 4c Effects of Key Changes on the
Aggregate Demand Curve
(c)
Price Level
decreases
AD1
AD2
Real GDP
19
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
  • But often, all firms in the economy are affected
    by the same macroeconomic event
  • Causing prices to rise or fall throughout the
    economy what interest us in macroeconomics
  • 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

20
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

21
GDP, Costs, and the Price Level
  • Primary concern here impact of real GDP on unit
    costs and, therefore, on 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

22
The Short Run
  • All three of our reasons are important in
    explaining why a change in output affects price
    level
  • However, they operate within different time
    frames
  • But 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
  • 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
    slow-moving bureaucracies
  • Wage changes in either direction can be costly to
    firms
  • Firms may benefit from developing reputations for
    paying stable wages

23
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

24
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

25
Figure 5 The Aggregate Supply Curve
Price Level
AS
130
B
100
A
80
C
Real GDP ( Trillions)
13.5
10
6
26
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

27
Shifts of the AS Curve
  • Figure 5 assumed that a number of important
    variables remained unchanged
  • But in real world, 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.

28
Figure 6 Shifts of the Aggregate Supply Curve
AS2
Price Level
AS1
L
140
100
A
Real GDP ( Trillions)
10
29
Figure 7a Effects of Key Changes on the
Aggregate Supply Curve
(a)
Price Level
AS
P3
P1
P2
Real GDP
Q2
Q1
Q3
30
Figure 7b Effects of Key Changes on the
Aggregate Supply Curve
(b)
AS2
Price Level
AS1
Real GDP
31
Figure 7c Effects of Key Changes on the
Aggregate Supply Curve
(c)
Price Level
AS1
AS2
Real GDP
32
AD and AS Together Short-Run Equilibrium
  • Where will the economy settle in short-run?
  • Where is our short-run macroeconomic equilibrium?
  • We know that in equilibrium, economy must be at
    some point on AD curve
  • Short-run equilibrium requires economy be
    operating on its AS curve
  • Only when economy is at point Eon both
    curveswill we have reached a sustainable level
    of real GDP and the price level

33
Figure 8 Short-Run Macroeconomic Equilibrium
AS
Price Level
B
140
E
100
F
AD
Real GDP ( Trillions)
10
6
14
34
What Happens When Things Change?
  • Now that we know how short-run equilibrium is
    determined, and armed with our knowledge of AD
    and AS curves, we are ready to put model through
    its paces
  • 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
  • In earlier chapters, 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

35
An Increase in Government Purchases
  • Shifts AD curve rightward
  • Can see how it affects economy in short-run
    increases output and rises interest rate in the
    money market
  • Process 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

36
Figure 9 The Effect of a Demand Shock
AS
Price Level
130
H
115
J
100
E
AD2
AD1
Real GDP( Trillions)
10
13.5
12.5
37
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

38
An Decrease in Government Purchases
39
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

40
Other Demand Shocks
  • A positive demand shockshifts AD curve rightward
  • Increases both real GDP and price level in
    short-run
  • A negative demand shockshifts AD curve leftward
  • Decreases both real GDP and price level in
    short-run

41
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

42
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

43
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

44
Figure 10 The Long-Run Adjustment Process
Price Level
AS2
AS1
P4
K
J
P3
P2
H
P1
E
AD2
AD1
YFE
Y3
Y2
Real GDP
45
Demand Shocks Adjusting to the Long Run
  • For a positive demand shock that shifts AD curve
    rightward, self-correcting mechanism works like
    this

46
Figure 11 Long-Run Adjustment After A Negative
Demand Shock
Price Level
AS1
AS2
P1
E
P2
N
P3
M
AD1
AD2
Real GDP
YFE
Y2
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