1. McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20: Aggregate Demand, Aggregate Supply, and Stabilization Policy 1.Define the aggregate demand curve, explain why it slopes downward, and explain why it shifts 2.Define the aggregate supply curve, explain why it slopes upward, and explain why it shifts 3.Show how the aggregate demand and supply curves determine output and the price level in both the short run and the long run 4.Analyze how the economy adjusts to expansionary and recessionary gaps, and relate this to the concept of a self-correcting economy 5.Explain how stabilization policy can be used to close output gaps

2. 20-2 Aggregate Demand and Aggregate Supply Analyze fluctuations in both output and the price level –Short run and long run analysis Price level and output on the axis AD shows the relationship between planned spending and the price level AS shows how output produced by firms depends on the price level Potential output is shown to measure output gaps Price level P Output Y Aggregate Demand (AD) Aggregate Supply (AS) Y*

3. 20-3 Long-Run Equilibrium In the long run, –Actual output equals potential output –Actual price level equals expected price level Long-run equilibrium occurs at the intersection of –Aggregate demand –Aggregate supply and –Potential output Price level P Output Y Aggregate Demand AD Aggregate Supply AS Y*

4. 20-4 Short-Run Equilibrium Short-run equilibrium occurs when the AD and AS curves intersect at a level of output different from Y* –Point A in the graph Short-run equilibrium is temporary Caused by a shift in either AD or AS Price level P Output Y AD AS Y*Y1Y1 P1P1 A

5. 20-5 The Aggregate Demand Curve The aggregate demand curve shows the amount of output consumers, firms, government, and customers abroad want to purchase at each price level –All else the same –Slopes downwards –A higher price level reduces planned aggregate expenditure which reduces output via the multiplier effect PP C, I p,NX  PAE  Y 

6. 20-6 The Aggregate Demand Curve An increase in the price level reduces planned aggregate expenditure for three reasons: –The wealth effect –The interest rate effect –The exchange rate effect According to the wealth effect a higher price level reduces the real value of assets –Financial assets –Durable assets like houses Output Y AD Price level P

7. 20-7 The Aggregate Demand Curve According to the interest rate effect a higher price level causes –An increase in money demand –An increase in the interest rate given money supply is fixed –A decrease in planned consumption and planned investment PP MD  r  C, I p 

8. 20-8 The Aggregate Demand Curve According to the exchange rate effect a higher price level causes –Higher interest rates which make our financial assets more attractive –An increase in the demand for dollars –An increase in the value of the dollar –A decrease in net exports PP r  D $  NX 

9. 20-9 Shifts in the Aggregate Demand Curve A shift of the aggregate demand curve is called a change in aggregate demand At the given price level, something causes output to rise (an increase in aggregate demand) or fall (a decrease in aggregate demand) Two main causes: –Demand shocks –Stabilization policy

10. 20-10 Shifts in the Aggregate Demand Curve Demand shocks are changes in planned spending not caused by a change in output or a change in price level –Consumer confidence –Consumer wealth –Business confidence –Opportunities for firms to purchase new technologies –Foreign demand for US goods Output (Y) AD AD' Price level P

11. 20-11 Shifts in the Aggregate Demand Curve Stabilization policies are government policies used to affect planned aggregate expenditure and eliminate output gaps Fiscal policy –Change in government spending or taxes Monetary policy –Change in the nominal money supply which changes the interest rate Output (Y) AD AD' Price level P

12. 20-12 The Aggregate Supply Curve The aggregate supply curve (AS) shows the relationship between the amount of output firms want to produce and the price level –Holds all other factors constant The aggregate supply curve is upward sloping –An increase in aggregate demand will increase the willingness to supply and increase the price level In past chapters firms met demand at present prices –Holds in the very short run –Not possible to indefinitely hold price constant and increase output

13. 20-13 The Aggregate Supply Curve The expected price level is the price level that is expected to prevail when the economy is producing at potential output This is point A Firms sell the usual amount An increase in aggregate demand will move the economy to point B The AS curve is upward sloping Price level P Output Y Aggregate Supply (AS) P2P2 Y1Y1 B Y2Y2 P3P3 C Y*Y* PePe A

14. 20-14 Shifts in the AS Curve A change in aggregate supply is a shift of the aggregate supply curve An increase in aggregate supply is a rightward shift of the curve A decrease in aggregate supply is a leftward shift of the curve Three main causes Price level P Output Y AS 1 Y*Y* P1P1 AS 2

15. 20-15 Shifts in the AS Curve Increasing available resources and technology will shift the AS curve to the right Supply more output without having to increase price Hire more labor, capital, or natural resources Use existing labor and machines more efficiently Price level P Output Y AS 2 Y2Y2 P1P1 AS 1 Y1Y1

16. 20-16 Shifts in the AS Curve An increase in the expected price level shifts the AS curve upwards To maintain profit, increase price An increase in the expected price level will increase costs in the future Price level P Output Y AS 1 Pe1Pe1 Pe2Pe2 AS 2 Y1Y1

17. 20-17 Shifts in the AS Curve A price shock is a change in an input price that is not caused by a change in output or the price level Negative price shock : AS shifts left Positive price shock : AS shifts right A sudden rise in the price of oil increases prices of –Gasoline, diesel fuel, jet fuel, heating oil –Goods made with oil (synthetic rubber, plastics, etc.) OPEC reduced supplies in 1973; price of oil quadrupled –Food shortages occurred at the same time –Sharp increase in inflation in 1974

18. 20-18 Understanding Business Cycles The economy is in long run equilibrium at P 1 and Y* –Aggregate demand shifts from AD 1 to AD 2 Positive demand shock Increase in government spending Decrease in taxes –Expansionary gap –The dot-com bubble from 1995 – 2000 Price level P Output (Y) AD 1 AS 1 Y* P1P1 AD 2 P2P2 Y2Y2

19. 20-19 Understanding Business Cycles The economy is in long run equilibrium at P 1 and Y* –Aggregate demand shifts from AD 1 to AD 2 Negative demand shock Decrease in government spending Increase in taxes –Recessionary gap –The great recession Price level P Output (Y) AD 1 AS 1 Y* P1P1 AD 2 P2P2 Y2Y2

20. 20-20 Understanding Business Cycles The economy is in long run equilibrium at P 1 and Y* –AS shifts from AS 1 to AS 2 Negative supply shock –Oil price shock –1973-4 price of oil tripled –1979 price of oil doubled –2007-2008 price of oil doubled Recessionary gap Price level (P) Output Y AD AS 1 Y2Y2 Y* AS 2 P1P1 A P2P2

21. 20-21 An Expansionary Gap Initial short-run equilibrium at A –AD is stable as long as there is no change in government policy or exogenous spending Price level is below the expected price level Firms are charging less and selling more than planned –Raise nominal prices –Shifts AS curve to AS 2 –Output is at potential, Y* Price level P Output Y AD AS 1 Y*Y1Y1 AS 2 P1P1 A PePe

22. 20-22 A Recessionary Gap Initial equilibrium is at A –AD curve remains stable unless government policy or exogenous spending changes Price level is higher than the expected price level –Firms are charging more and selling less than planned –Aggregate supply shifts to AS 2 Long-run equilibrium Price level P Output Y AD AS 1 Y*Y1Y1 P1P1 A PePe AS 2

23. 20-23 Self-Correcting Economy In the long-run the economy tends to be self- correcting –Missing from Keynesian model –Keynesian model is short-run; no price adjustments Given time, output gaps disappear without any changes in monetary or fiscal policy Whether stabilization policies are needed depends on the speed of the self-correction process –If the economy returns to potential output quickly, stabilization policies may be destabilizing –The greater the gap, the longer the adjustment period