Chapter 13: Aggregate Demand and Aggregate Supply

1
Chapter 13Aggregate Demand and Aggregate Supply
2

• Aggregate Demand for Goods Services

3
Aggregate Demand for Goods Services

• Aggregate demand curve -- indicates the various
  quantities of domestically produced goods
  services that purchasers are willing to buy
  at different price levels .

• The AD curve slopes downward to the right,
  indicating an inverse relationship between the
  amount of goods services demanded and the price
  level.

4
Aggregate Demand Curve
5
Why Does the Aggregate Demand Curve Slope
Downward

• The Wealth Effect A lower price level will
  increase the purchasing power of the fixed
  quantity of money.

• The Interest Rate Effect A lower price level
  will make the nominal interest rate appear lower
  which will stimulate additional purchases during
  the current period.
• The Foreign Purchases Effect Other things
  constant, a lower price level will make
  domestically produced goods less expensive
  relative to foreign goods.

6

• Factors that Shift Aggregate Demand

7
Factors that Shift Aggregate Demand

• A change of businesses and consumers Expectations
  about the future
• A change in Real Wealth. .
• A change in Consumer Debt.
• A change in Taxes or Government Spending.

8
Shifts in Aggregate Demand
9

• Aggregate Supply of Goods and Services

10
Aggregate Supply of Goods Services

• When considering the Aggregate Supply curve, it
  is important to distinguish between the
  short-run and the long-run.

• Short-run -- time period during which some
  prices, particularly those in resource
  markets, are set by prior contracts and
  agreements. Therefore, in the short-run,
  households and businesses are unable to adjust
  these prices when unexpected changes occur,
  including unexpected changes in the price
  level.

• Long-run -- a time period of sufficient
  duration that people have the opportunity
  to modify their behavior in response to
  economic changes.

11

• Short-Run Aggregate Supply (SRAS)

12
Short-Run Aggregate Supply (SRAS)

• SRAS indicates the various quantities of goods
  services that domestic firms will supply in
  response to changing demand conditions that alter
  the level of prices in the goods services
  market.

• SRAS curve slopes upward to the right.
• The upward slope reflects the fact that in the
  short run an unanticipated increase in the price
  level will improve the profitability of firms and
  they will respond with an expansion in output.

13
Short-Run Aggregate Supply Curve
14
Shifts in Aggregate Supply

• Factors that change SRAS
• A change in resource costs such as wages, rent,
  and interest.
• Unexpected supply shocks such as a change in
  weather or in the world price of a key imported
  resource.
• A change in Taxes or Government Spending

15
Shifts in Short Run Aggregate Supply
16

• Long-Run Aggregate Supply (LRAS)

17
Long-Run Aggregate Supply (LRAS)

• LRAS indicates the relationship between the price
  level and quantity of output after decision
  makers have had sufficient time to adjust their
  prior commitments where possible.

• LRAS curve is vertical.
• LRAS is related to the economy's production
  possibilities frontier. A higher price level does
  not loosen the constraints imposed by the
  economy's resource base, level of technology, and
  the efficiency of its institutional arrangements.

18
Long-Run Aggregate Supply Curve
19
Shifts in Long Run Aggregate Supply

• Factors that change LRAS
• A change in the supply of resources.
• A change in technology and productivity.
• Institutional changes that change the efficiency
  of resource use such as trade agreements.

20
Shifts in Long RunAggregate Supply

• Such factors as an increase in the stock of
  capital or an improvement in technology will
  expand the economys potential output and shift
  the LRAS to the right (note that SRAS will also
  shift to the right).

• Such factors as a reduction in resource prices,
  favorable weather, or a temporary decrease in the
  world price of an important imported resource
  would shift SRAS to the right (note that LRAS
  will remain constant).

21

• Anticipated and Unanticipated Changes

22
Anticipated and Unanticipated Changes

• Anticipated changes are foreseen by economic
  participants.

• Decision makers have time to adjust to them
  before they occur.
• Unanticipated changes catch people by surprise.

23

• Unanticipated Changes in Aggregate Demand

24
Unanticipated Changes in Aggregate Demand

• Impact of unanticipated reductions in AD
• Weak demand and lower prices in the goods
  services market will reduce profit margins. Many
  firms will incur losses.
• Firms will reduce output, the rate of
  unemployment will rise above the natural rate,
  and output will temporarily fall short of the
  economy's long-run potential.
• With time, long-term contracts will be modified.
• Eventually, lower resource costs and a lower real
  interest rate will direct the economy back to
  long-run equilibrium, but this may be a lengthy
  and painful process.

25
Unanticipated Reduction in Aggregate Demand

• The short-run impact of an unanticipated
  reduction in AD (shift from AD1 to AD2) will be a
  decline in output (decreases to Y2), and a lower
  price level (P95).

• Temporarily, profit margins decline, output
  falls, and unemployment rises higher than the
  natural rate.

26
Unanticipated Reduction in Aggregate Demand
Price level
SRAS1
AD1
Goods Services(real GDP)

• In the long-run, weak demand and excess supply in
  the resource market will lead to lower wage rates
  and resource prices resulting in an expansion in
  short-run aggregate supply to SRAS2.

• In the long-run, a new equilibrium at a lower
  price level (P90) and an output consistent with
  the economys sustainable potential will result.

• This method of restoring equilibrium may be both
  long and painful.

27
Unanticipated Changes in Aggregate Demand

• Impact of unanticipated increases in AD
• Initially, the strong demand and higher price
  level in the goods services market will
  temporarily improve profit margins.
• Output will increase, the rate of unemployment
  will drop below the natural rate, and output will
  temporarily exceed the economy's long-run
  potential.
• With time, however, contracts will be modified
  and resource prices will rise and return to their
  competitive relation with product prices.
• Once this happens, output will recede to the
  economy's long-run potential.

28
Unanticipated Increase in Aggregate Demand

• In response to an unanticipated increase in AD
  for goods services (shift from AD1 to AD2),
  prices will rise to P105 and output will
  temporarily exceed full-employment capacity
  (increases to Y2).

29
Unanticipated Increase in Aggregate Demand
Price level
SRAS1
AD2
AD1
Goods Services(real GDP)

• With the passage of time, prices in resource
  markets, including the labor market, will rise
  due to the strong demand. As a result, higher
  costs reduce aggregate supply to SRAS2.

• In the long-run, a new equilibrium at a higher
  price level (P110) and an output consistent with
  the economys sustainable potential will occur.

• Thus, the increase in demand will expand output
  only temporarily.

30

• Impact of Changes in Aggregate Supply

31
Impact of Changes in Aggregate Supply

• Economic growth and anticipated shifts in
  long-run aggregate supply.

• Increases in LRAS will make it possible to
  produce and sustain a larger rate of output.
• Both LRAS and SRAS will shift to the right and
  output will increase.
• These changes generally take place slowly and
  therefore they need not disrupt long-run
  equilibrium.

32
Growth in Aggregate Supply

• Here we illustrate the impact of economic growth
  due to capital formation or a technological
  advancement, for example.

• Both LRAS and SRAS increase (to LRAS2 and SRAS2)
  the full employment output of the economy expands
  from YF1 to YF2.

• A sustainable, higher level of real output and
  real income is the result. If the money supply
  is held constant, a new long-run equilibrium will
  emerge at a larger output rate (YF2) and lower
  price level (P2).

33

• The Business Cycle -- Revisited

34
The Business Cycle -- Revisited

• Recessions occur because prices in the goods
  services market are low relative to the costs of
  production and resource prices.

• The two causes of recessions
• unanticipated reductions in aggregate demand,
  and,
• unfavorable supply shocks.

• An unsustainable economic boom occurs when prices
  in the goods services market are high relative
  to costs and resource prices.

• The two causes of booms are
• unanticipated increases in aggregate demand, and,
  
• favorable supply shocks.

35
Expansions, Recessions, and the Rate of
Unemployment

• Here we illustrate the periods of expansion
  and contraction (recession) since 1960.

• Note how the reductions in real GDP (shaded
  periods) in the top graph are associated
  with increases in the rate of unemployment
  well above the natural rate (bottom graph).

• The AD/AS model indicates that recessions are
  caused by unanticipated reductions in AD that are
  likely to accompany abrupt reductions in the
  inflation rate and/or adverse supply shocks that
  might occur, for example, when there is a large
  increase in the price of a key imported resource,
  such as crude oil.

36

• Does the Market Have a Self-Corrective
  Mechanism That Will Keep it on Track?

37
Does the Market Have a Self-Corrective
Mechanism That Will Keep it on Track?

• There are three reasons to believe that it does

• Consumption demand is relatively stable over the
  business cycle.
• Changes in real interest rates will help to
  stabilize aggregate demand and redirect economic
  fluctuations.
• Interest rates will tend to fall during a
  recession and rise during and economic boom.
• Changes in real resource prices will redirect
  economic fluctuations.
• Real resource price will tend to fall during a
  recession and rise during an economic expansion.

38
Changes in Real Interest Rates and Resource
Prices Over the Business Cycle
Real interest rates fall (because of weak demand
for investment)
Real interest rates rise (because of
strongdemand for investment)
r
r
Real resource prices fall (because of weak demand
and high unemployment)
Real resource prices rise (because of strong
demand and low unemployment)

• When aggregate output is less than the economys
  full employment potential (YF), weak demand for
  investment leads to lower real interest rates,
  while slack employment in resource markets will
  place downward pressure on wages and other
  resource prices (Pr).

• Conversely, when output exceeds YF, strong demand
  for capital goods and tight labor market
  conditions will result in rising real interest
  rates and resource prices (Pr).

39
The Economys Self Corrective Mechanism

• If output is temporarily less than capacity,
  lower interest rates (reflecting the weak demand
  for investment funds) will stimulate aggregate
  demand (shifting AD from AD1 to AD2).

• In addition, lower resource prices will reduce
  production prices (because of weak demand and
  abnormally high unemployment) and thereby
  stimulate SRAS (shifting SRAS to SRAS2).

• This output will move the economy toward
  full-employment capacity. However, this
  self-correction process may take some time.

40
The Economys Self Corrective Mechanism

• If output is temporarily greater than the
  economys potential, higher real interest rates
  and resource prices will lead to a lower but
  sustainable rate of output.

• Higher interest rates will reduce AD (from AD1 to
  AD2).

• At the same time, higher resource prices will
  increase production costs and therefore reduce
  SRAS (from SRAS1 to SRAS2).

• These forces direct output toward full-employment
  potential (YF).

41

• The Great Debate -- How rapidly does
  the self-corrective mechanism work?

42
The Great Debate -- How rapidly does the
self-corrective mechanism work?

• Many economists believe that the self-corrective
  mechanism works slowly.

• If this is the case, then market economies will
  still experience prolonged periods of abnormally
  high unemployment and below-capacity output.
• Others believe that the self-corrective mechanism
  works fairly rapidly if it is not disrupted by
  perverse monetary and fiscal policy.
• This is an important and continuing debate that
  we will return to and analyze in more detail as
  we proceed.

43
EndChapter 13