Spending  Output  Income  Spending Aggregate Demand and Aggregate Supply Y = C + I + G + NX Why AD slopes downward Why AD might shift Why Short-run AS (SRAS) slopes upward Vertical LRAS Why AS might shift—Recall: CostsSupply “Long-run” (Medium run) AS-AD Equilibrium Expectations Augmented Phillips Curve Okun’s Law Money Supply—Money multiplier Money Demand—Money market equilibrium Response to monetary expansion Response to fiscal expansion Spending multiplier/Crowding out Automatic stabilizers Rules vs. discretion GROWTH

Spending  Output  Income  Spending $GDP: The market value of all final goods and services produced in our economy in a year GDP Deflator (=P): The dollar value of a year’s outputs relative to what it would have been had prices remained constant at base year prices. In practice, the increase in a year’s prices over the prior year’s (for all the things produced this year – C,I,G, and X) chained to the base year. Real GDP (= Y): $GDP measured at base year prices Real GDP = $GDP/Price Deflator Y = $GDP/P

Aggregate Demand and Aggregate Supply... Price Level Aggregate supply Equilibrium price level Aggregate demand Equilibrium output Quantity of Output

The Aggregate Demand Curve The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX

The Aggregate-Demand Curve... Price Level P1 Y1 1. A decrease in the price level... Y2 P2 Aggregate demand 2. …increases the quantity of goods and services demanded. Quantity of Output

Why the Aggregate Demand Curve Is Downward Sloping Price Level and Consumption: Wealth Effect …the purchasing power of money balances Price Level and Investment: Interest Rate Effect Price Level and Net Exports: The Exchange-Rate Effect via real balances and interest rate

Why the Aggregate Demand Curve Might Shift Shifts arising from Consumption Changes in wealth House prices Stock prices Shifts arising from Investment Responses to interest rate New technologies Animal Spirits Shifts arising from Government Purchases Shifts arising from Net Exports

The Aggregate Supply Curve In the long run, the aggregate-supply curve is vertical. In the short run, the aggregate-supply curve is upward sloping.

The Short-Run Aggregate Supply Curve... Price Level Short-run aggregate supply Y1 P1 P2 1. A decrease in the price level Y2 2. reduces the quantity of goods and services supplied in the short run. Quantity of Output

Why the Aggregate Supply Curve Slopes Upward in the Short Run Sticky – wages  Profit Up when Prices Up High output  Low Unemployment  Wages Up  Prices Up

The Long-Run Aggregate- Supply Curve... Price Level Long-run aggregate supply P1 1. A change in the price level… 2. …does not affect the quantity of goods and services supplied in the long run. P2 Natural rate of output Quantity of Output

Shifts arising from Labor Why the Aggregate Supply Curve Might Shift: Recall: Supply reflects costs Shifts arising from Labor Higher wages  higher costs  given output can/will only be supplied at higher price Shifts arising from Capital Increase in capacity  increase in supply Shifts arising from Natural Resources Increase in resource price  increased costs Shifts arising from Technology. Shifts arising from the Expected Price Level.

The Long-Run Equilibrium Quantity of Output Price Level Short-run aggregate supply Long-run Aggregate demand A Equilibrium price Natural rate of output

A Contraction in Aggregate Demand... 2. …causes output to fall in the short run… Price Level Long-run aggregate supply Short-run aggregate supply, AS1 AS2 C P3 3. …but over time, the short-run aggregate-supply curve shifts… 1. A decrease in aggregate demand… AD2 P1 A B P2 Y2 4. …and output returns to its natural rate. Aggregate demand, AD1 Y1 Quantity of Output

Money Supply Means of Payment: Currency + Demand Deposits The money supply is controlled by the Fed through: Open-market operations Changing reserve requirements Changing the discount rate The public’s willingness to deposit money in banks and bank willingness to lend matter as well

As a result, the quantity of money demanded is reduced The opportunity cost of holding money is the interest that could be earned on interest-earning assets—bonds An increase in the interest rate raises the opportunity cost of holding money. As a result, the quantity of money demanded is reduced 12

Equilibrium in the Money Market... Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Equilibrium in the Money Market... Interest Rate Quantity fixed by the Fed Money supply Money demand r1 M d 1 Equilibrium interest rate r2 M d 2 Quantity of Money 18

Quantity fixed by the Fed The Money Market and the Slope of the Aggregate Demand Curve... (a) The Money Market (b) The Aggregate Demand Curve Interest Rate Money supply Price Level Money demand at price level P2, MD2 2. …increases the demand for money… 1. An increase in the price level… P2 3. …which increases the equilibrium equilibrium rate… r2 4. …which in turn reduces the quantity of goods and services demanded. Y2 P1 Aggregate demand r1 Money demand at price level P1, MD1 Y1 Quantity of Money Quantity fixed by the Fed Quantity of Output

2. …the equilibrium interest rate falls… Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Monetary Injection... (a) The Money Market (b) The Aggregate-Demand Curve Interest Rate Money supply, MS1 1. When the Fed increases the money supply… MS2 Price Level Y2 AD2 3. …which increases the quantity of goods and services demanded at a given price level. P r1 r2 2. …the equilibrium interest rate falls… Aggregate demand, AD1 Quantity of Money Y1 Quantity of Output 25

Changes in Government Purchases Macroeconomic effects from change in government purchases: The multiplier effect The crowding-out effect 33

The Multiplier Effect... Price Level AD3 2. …but the multiplier effect can amplify the shift in aggregate demand. AD2 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion… $20 billion Aggregate demand, AD1 Quantity of Output 34

Formula for the Simpler Spending Multiplier Multiplier = 1/(1 - MPC) MPC is the marginal propensity to consume It is the fraction of extra income that households consume rather than save. The greater the MPC, the more total output (Y), income and spending results from an initial increase in spending 38

The Crowding-Out Effect... (a) The Money Market (b) The Shift in Aggregate Demand Interest Rate AD3 4. …which in turn partly offsets the initial increase in aggregate demand. Price Level 1. When an increase in government purchases increases aggregate demand… AD2 $20 billion Money supply MD2 2. …the increase in spending increases money demand… 3. …which increases the equilibrium interest rate… r2 r1 Money demand, MD1 Aggregate demand, AD1 Quantity of Money Quantity of Output Quantity fixed by the Fed 39

Automatic Stabilizers Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. Automatic stabilizers include the tax system and some forms of government spending. 45

The Case for Active Stabilization Policy The Employment Act has two implications: The government should avoid being the cause of economic fluctuations. The government should respond to changes in the private economy in order to stabilize aggregate demand, e.g., the Bush tax rebate and Obama’s stimulus package Obama insisted that only government could “break the vicious cycles that are crippling our economy,” prevent “the catastrophic failure of financial institutions,” restart the flow of credit and restore the regulations needed to prevent such a crisis in the future. January 8, 2009 42

The Case Against Active Stabilization Policy Active monetary and fiscal policies may destabilize the economy. Monetary and fiscal policies affect the economy with a substantial lag. They suggest the economy should be left to deal with the short-run fluctuations on its own. Avoid monetary mischief 42