12 chapter: >> Aggregate Demand and Aggregate Supply Krugman/Wells ©2009  Worth Publishers 1

How the aggregate demand curve illustrates the relationship between the aggregate price level and the quantity of aggregate output demanded in the economy How the aggregate supply curve illustrates the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy Why the aggregate supply curve in the short run is different from the aggregate supply curve in the long run

How the AS–AD model is used to analyze economic fluctuations How monetary policy and fiscal policy can stabilize the economy

Aggregate Demand The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, the government and the rest of the world.

The Aggregate Demand Curve Aggregate price level (GDP deflator, 2000 = 100) A movement down the AD curve leads to a lower aggregate price level and higher aggregate output. 1933 8.9 5.0 Figure Caption: Figure 12-1: The Aggregate Demand Curve The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded. The curve is downward-sloping due to the wealth effect of a change in the aggregate price level and the interest rate effect of a change in the aggregate price level. Here, the total quantity of goods and services demanded at an aggregate price level of 8.9, the actual number for 1933, is $636 billion in 2000 dollars, the actual quantity of aggregate output demanded in 1933. According to our hypothetical curve, however, if the aggregate price level had been only 5.0, the quantity of aggregate output demanded would have been $950 billion. Aggregate demand curve, AD 636 950 Real GDP (billions of 2000 dollars) 5

AGGREGATE DEMAND AD slopes downward because: Wealth (real balance) effect – purchasing power of money is less at higher price levels Interest rate effect – price level changes impact interest rates – in turn this effects consumption & investment spending (inverse effect) Foreign purchase effect – volume of imports/exports depend on relative price levels here & abroad EX: If US PL is higher = we buy more M & sell fewer X

The Aggregate Demand Curve It is downward-sloping for two reasons: The first is the wealth effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households’ wealth and reduces consumer spending. The second is the interest rate effect of a change in aggregate the price level—a higher aggregate price level reduces the purchasing power of households’ money holdings, leading to a rise in interest rates and a fall in investment spending and consumer spending.

The Aggregate Demand Curve and the Income-Expenditure Model Planned aggregate spending 45-degree line AE E Planned 2 2 AE Planned 1 AE Planned E 1 AE Figure Caption: Figure 12-2: How Changes in the Aggregate Price Level Affect Income-Expenditure Equilibrium Income–expenditure equilibrium occurs at the point where the curve AEPlanned, which shows real aggregate planned spending, crosses the 45-degree line. A fall in the aggregate price level causes the AEPlanned curve to shift from AEPlanned1 to AEPlanned2, leading to a rise in income-expenditure equilibrium GDP from Y1 to Y2. Planned Y Y 1 2 Real GDP 8

The Aggregate Demand Curve and the Income-Expenditure Model Planned aggregate spending 45-degree line (a) Change in Income–Expenditure Equilibrium AE Planned 2 E 2 Y2 AE AE E 1 Planned 1 Planned (b) Aggregate Demand Real GDP Y1 Aggregate price level Figure Caption: Figure 12-3: The Income–Expenditure Model and the Aggregate Demand Curve This figure shows how the aggregate demand curve can be derived from the income–expenditure model. Panel (a) shows how a fall in the aggregate price level causes the AEPlanned curve to shift up and the income–expenditure equilibrium GDP to rise from Y1 to Y2. Panel (b) shows how to use these results to draw the AD curve. At an aggregate price level of P1, real GDP is Y1. If the price level falls to P2, real GDP rises to Y2. At both combinations of aggregate price level and real GDP, the quantity of aggregate output demanded is equal to the level of planned aggregate spending and real GDP derived from the income–expenditure model. P P 2 Y2 1 AD Y1 Real GDP 9

Shifts of the Aggregate Demand Curve The aggregate demand curve shifts because of: changes in expectations wealth the stock of physical capital government policies fiscal policy – (gov’t spending / taxing) monetary policy – (money supply / interest rates)

Consumption Main determinant is income Other determinants: Wealth (value of assets) if W C S Expectations (for inflation or future wealth) Debts (if D increases, C & S will decrease) Taxes (if T increase, C & S decrease, etc)

Investment Component of GDP Investment determinants: Interest rate Costs of capital & operating costs Taxes Technology Excess capacity (inventories)

Investment Investment is: Business spending for capital stock Most volatile component of AD/GDP Assumed to require a loan Decisions are based on marginal cost (interest) vs. marginal benefits (expected rate of return)

Shifts of the Aggregate Demand Curve (a) Rightward Shift (b) Leftward Shift Decrease in aggregate demand Aggregate price level Aggregate price level Increase in aggregate demand Figure Caption: Figure 12-4: Shifts of the Aggregate Demand Curve Panel (a) shows the effect of events that increase the quantity of aggregate output demanded at any given aggregate price level, such as improvements in business and consumer expectations or increased government spending. Such changes shift the aggregate demand curve to the right, from AD1 to AD2. Panel (b) shows the effect of events that decrease the quantity of aggregate output demanded at any given price level, such as a fall in wealth caused by a stock market decline. This shifts the aggregate demand curve leftward from AD1 to AD2. AD AD AD AD 1 2 2 1 Real GDP Real GDP 14

Factors that Shifts the Aggregate Demand Curve Changes in expectations If consumers and firms become more optimistic, . . . . . . aggregate demand increases. If consumers and firms become more pessimistic, . . . . . . aggregate demand decreases. Changes in wealth If the real value of household assets rises, . . . . . . aggregate demand increases. If the real value of household assets falls, . . . . . . aggregate demand decreases. Size of the existing stock of physical capital If the existing stock of physical capital is relatively small, .. aggregate demand increases. If the existing stock of physical capital is relatively large, ..aggregate demand decreases. Fiscal policy If the government increases spending or cuts taxes, . . . .. aggregate demand increases. If the government reduces spending or raises taxes, . . . . aggregate demand decreases. Monetary policy If the central bank increases the quantity of money, . .. . . aggregate demand increases. If the central bank reduces the quantity of money, . . . . . . aggregate demand decreases

A movement along versus a shift of the aggregate demand curve In the last section we explained that one reason the AD curve is downward sloping is due to the wealth effect of a change in the aggregate price level: a higher aggregate price level reduces the purchasing power of households’ assets and leads to a fall in consumer spending, C. But in this section we’ve just explained that changes in wealth lead to a shift of the AD curve. Aren’t those two explanations contradictory? Which one is it?

A movement along versus a shift of the aggregate demand curve The answer is both: it depends on the source of the change in wealth. A movement along the AD curve occurs when a change in the aggregate price level changes the purchasing power of consumers’ existing wealth (the real value of their assets). This is the wealth effect of a change in the aggregate price level—a change in the aggregate price level is the source of the change in wealth.

Moving Along the Aggregate Demand Curve Faced with a sharp increase in the aggregate price level—the rate of consumer price inflation reached 14.8% in March of 1980—the Federal Reserve stuck to a policy of increasing the quantity of money slowly. The aggregate price level was rising steeply, but the quantity of money circulating in the economy was growing slowly. The net result was that the purchasing power of the quantity of money in circulation fell. This led to an increase in the demand for borrowing and a surge in interest rates.

Moving Along the Aggregate Demand Curve The prime rate climbed above 20%. High interest rates, in turn, caused both consumer spending and investment spending to fall: in 1980 purchases of durable consumer goods like cars fell by 5.3% and real investment spending fell by 8.9%. In other words, in 1979–1980 the economy responded just as we’d expect if it were moving upward along the aggregate demand curve from right to left. Due to the wealth effect and the interest rate effect of a change in the aggregate price level, the quantity of aggregate output demanded fell as the aggregate price level rose.

Aggregate Supply The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output in the economy.

The Short-Run Aggregate Supply Curve The short-run aggregate supply curve is upward-sloping because nominal wages are sticky in the short run: a higher aggregate price level leads to higher profits and increased aggregate output in the short run. The nominal wage is the dollar amount of the wage paid.

The Short-Run Aggregate Supply Curve Aggregate price level (GDP deflator, 2000 = 100) Short-run aggregate supply curve, SRAS 11.9 1929 A movement down the SRAS curve leads to deflation and lower aggregate output. 8.9 1933 Figure Caption: Figure 12-5: The Short-Run Aggregate Supply Curve The short-run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the short run, the period in which many production costs such as nominal wages are fixed. It is upward sloping because a higher aggregate price level leads to higher profit per unit of output and higher aggregate output given fixed nominal wages. Here we show numbers corresponding to the Great Depression, from 1929 to 1933: when deflation occurred and the aggregate price level fell from 11.9 (in 1929) to 8.9 (in 1933), firms responded by reducing the quantity of aggregate output supplied from $865 billion to $636 billion measured in 2000 dollars. 636 865 Real GDP (billions of 2000 dollars) 22

What’s Truly Flexible, What’s Truly Sticky Empirical data on wages and prices don’t wholly support a sharp distinction between flexible prices of final goods and services and sticky nominal wages. On one side, some nominal wages are in fact flexible even in the short run because some workers are not covered by a contract or informal agreement with their employers. Since some nominal wages are sticky but others are flexible, we observe that the average nominal wage—the nominal wage averaged over all workers in the economy—falls when there is a steep rise in unemployment.

What’s Truly Flexible, What’s Truly Sticky On the other side, some prices of final goods and services are sticky rather than flexible. For example, some firms, particularly the makers of luxury or name-brand goods, are reluctant to cut prices even when demand falls. Instead they prefer to cut output even if their profit per unit hasn’t declined. These complications don’t change the basic picture, though. In the end, the short-run aggregate supply curve is still upward sloping.

Shifts of the Short-Run Aggregate Supply Curve (a) Leftward Shift (b) Rightward Shift Aggregate price level Aggregate price level SRAS SRAS 1 2 SRAS SRAS 2 1 Figure Caption: Figure 12-6: Shifts of the Short-Run Aggregate Supply Curve Panel (a): A decrease in short-run aggregate supply: the short-run aggregate supply curve shifts leftward from SRAS1 to SRAS2, and the quantity of aggregate output supplied at any given aggregate price level falls. Panel (b): An increase in short-run aggregate supply: the short-run aggregate supply curve shifts rightward from SRAS1 to SRAS2,and the quantity of aggregate output supplied at any given aggregate price level rises. Increase in short-run aggregate supply Decrease in short-run aggregate supply Real GDP Real GDP 25

Shifts of the Short-Run Aggregate Supply Curve Changes in commodity prices nominal wages productivity lead to changes in producers’ profits and shift the short-run aggregate supply curve.

Factors that Shift Short-Run Aggregate Supply Changes in “inputs” prices If “inputs” prices fall, . . . . . . short-run aggregate supply increases. If “inputs” prices rise, . . . . . . short-run aggregate supply decreases. Changes in nominal wages If nominal wages fall, . . . . . . short-run aggregate supply increases. If nominal wages rise, . . . . . . short-run aggregate supply decreases. Changes in productivity If workers become more productive, . . . short-run aggregate supply increases. If workers become less productive, . . . . short-run aggregate supply decreases

Long-Run Aggregate Supply Curve The long-run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible.

Long-Run Aggregate Supply Curve Aggregate price level (GDP deflator, 2000 = 100) Long-run aggregate supply curve, LRAS 15.0 …leaves the quantity of aggregate output supplied unchanged in the long run. A fall in the aggregate price level… 7.5 Figure Caption: Figure 12-7: Long-Run Aggregate Supply Curve The long-run aggregate supply curve shows the quantity of aggregate output supplied when all prices, including nominal wages, are flexible. It is vertical at potential output, YP , because in the long run an increase in the aggregate price level has no effect on the quantity of aggregate output supplied. $800 Real GDP (billions of 2000 dollars) Potential output, YP 29

Actual and Potential Output from 1989 to 2007 Figure Caption: Figure 12-8: Actual and Potential Output from 1989 to 2007 This figure shows the performance of actual and potential output in the United States from 1989 to 2007. The black line shows estimates of U.S. potential output, produced by the Congressional Budget Office, and the blue line shows actual aggregate output. The purple-shaded years are periods in which actual aggregate output fell below potential output, and the green-shaded years are periods in which actual aggregate output exceeded potential output. As shown, significant shortfalls occurred in the recessions of the early 1990s and after 2000. Actual aggregate output was significantly above potential output in the boom of the late 1990s. Source: Congressional Budget Office; Bureau of Economic Analysis. 30

Economic Growth Shifts the LRAS Curve Rightward Notes to the Instructor: This figure is from the earlier edition.

From the Short Run to the Long Run (a) Leftward Shift of the Short-Run Aggregate Supply Curve (b) Rightward Shift of the Short-Run Aggregate Supply Curve Aggregate price level Aggregate price level L R AS L R AS S R AS S R AS 2 A fall in nominal wages shifts SRAS rightward. 1 S R AS 2 A rise in nominal wages shifts SRAS leftward. S R AS 1 A1 A1 P P 1 1 Figure Caption: Figure 12-9: From the Short Run to the Long Run Panel (a): The initial short-run aggregate supply curve is SRAS1. At the aggregate price level, P1, the quantity of aggregate output supplied, Y1, exceeds potential output, YP. Eventually, low unemployment will cause nominal wages to rise, leading to a leftward shift of the short-run aggregate supply curve from SRAS1 to SRAS2. Panel (b): At the aggregate price level, P1, the quantity of aggregate output supplied is less than potential output. This reflects the fact that the short-run aggregate supply curve has shifted to the right, due to both the short-run adjustment process in the economy and to a rightward shift of the long-run aggregate supply curve. Y Y Real GDP Y Y P 1 1 P Real GDP 32

Are we there yet? what the long run really means We’ve used the term long run in two different contexts. In an earlier chapter we focused on long-run economic growth: growth that takes place over decades. In this chapter we introduced the long-run aggregate supply curve, which depicts the economy’s potential output: the level of aggregate output that the economy would produce if all prices, including nominal wages, were fully flexible. It might seem that we’re using the same term, long run, for two different concepts. But we aren’t: these two concepts are really the same thing. Because the economy always tends to return to potential output in the long run, actual aggregate output fluctuates around potential output, rarely getting too far from it. As a result, the economy’s rate of growth over long periods of time—say, decades—is very close to the rate of growth of potential output. And potential output growth is determined by the factors we analyzed in the chapter on long-run economic growth. So that means that the “long run” of long-run growth and the “long run” of the long-run aggregate supply curve coincide.

Prices and Output During the Great Depression Figure Caption: Figure 12-10: Prices and Output During the Great Depression From 1929 to 1933, prices and aggregate output fell together. And from 1933 to 1937, prices and aggregate output rose together. That is, during the period of 1929 to 1937, the economy behaved as if it were first moving down and then up the short-run aggregate supply curve. By the late 1930s, however, aggregate output was above 1929 levels even though the aggregate price level was still lower than it was in 1929. This reflects the fact that the short-run aggregate supply curve had shifted to the right during this period, due to both the short-run adjustment process in the economy and to a rightward shift of the long-run aggregate supply curve. 34

The AS–AD Model The AS-AD model uses the aggregate supply curve and the aggregate demand curve together to analyze economic fluctuations.

Short-Run Macroeconomic Equilibrium The economy is in short-run macroeconomic equilibrium when the quantity of aggregate output supplied is equal to the quantity demanded. The short-run equilibrium aggregate price level is the aggregate price level in the short-run macroeconomic equilibrium. Short-run equilibrium aggregate output is the quantity of aggregate output produced in the short-run macroeconomic equilibrium.

The AS–AD Model Aggregate price level Short-run macroeconomic equilibrium P E E SR Figure Caption: Figure 12-11: The AS–AD model The AS–AD model combines the short-run aggregate supply curve and the aggregate demand curve. Their point of intersection, ESR , is the point of short-run macroeconomic equilibrium where the quantity of aggregate output demanded is equal to the quantity of aggregate output supplied. PE is the short-run equilibrium aggregate price level, and YE is the short-run equilibrium level of aggregate output. AD Y Real GDP E 37

SHOCKS Demand Shocks: “Positive” – cause more goods to be consumed at a higher price (i.e. new medicine, stimulus $) “Negative” – cause less quantity of goods to be consumed, and those consumers still in the market pay a lower price for the good Supply Shocks: “Positive” – technological advances that quickly improve the productivity of labor and the return of capital. “Negative” - any natural disaster or other unanticipated event that disrupts the production process and/or supply-chain

Shifts of Aggregate Demand: Short-Run Effects (a) A Negative Demand Shock (b) A Positive Demand Shock Aggregate price level Aggregate price level Y 2 P AD A negative demand shock... E P 2 Y AD A positive demand shock... S R AS S R AS ...leads to a higher aggregate price level and higher aggregate output. P 1 E ...leads to a lower aggregate price level and lower aggregate output. 1 2 P E E Figure Caption: Figure 12-12: Demand Shocks A demand shock shifts the aggregate demand curve, moving the aggregate price level and aggregate output in the same direction. In panel (a) a negative demand shock shifts the aggregate demand curve leftward from AD1 to AD2, reducing the aggregate price level from P1 to P2 and aggregate output from Y1 to Y2. In panel (b) a positive demand shock shifts the aggregate demand curve rightward, increasing the aggregate price level from P1 to P2 and aggregate output from Y1 to Y2. 1 1 AD 1 AD 1 Y Y 1 Real GDP 1 Real GDP 39

Shifts of the SRAS Curve (a) A Negative Supply Shock (a) A Positive Supply Shock Aggregate price level Aggregate price level A positive supply shock... A negative supply shock... SRAS Y 2 E P SRAS SRAS P 2 Y SRAS 1 1 E 1 P 1 ...leads to a higher aggregate output and lower aggregate price level. ...leads to a lower aggregate output and a higher aggregate price level. P E E 1 2 Figure Caption: Figure 12-13: Supply Shocks A supply shock shifts the short-run aggregate supply curve, moving the aggregate price level and aggregate output in opposite directions. Panel (a) shows a negative supply shock, which shifts the short-run aggregate supply curve leftward, causing stagflation—lower aggregate output and a higher aggregate price level. Here the short-run aggregate supply curve shifts from SRAS1 to SRAS2 , and the economy moves from E1 to E2. The aggregate price level rises from P1 to P2 , and aggregate output falls from Y1 to Y2. Panel (b) shows a positive supply shock, which shifts the short-run aggregate supply curve rightward, generating higher aggregate output and a lower aggregate price level. The short-run aggregate supply curve shifts from SRAS1 to SRAS2 , and the economy moves from E1 to E2. The aggregate price level falls from P1 to P2 , and aggregate output rises from Y1 to Y2. An event that shifts the short-run aggregate supply curve is a supply shock. 1 AD AD Y Real GDP Y Real GDP 1 1 40

SHORT-RUN EQUILIBRIUM PRACTICE

The Supply Shock of 2007-2008 In the summer of 2007, for reasons that are still a matter of dispute, the prices of many raw materials sold on world markets began shooting up. By the middle of 2008, the price of oil had doubled, the price of rice had tripled, and there had been major increases in the prices of many other commodities, from wheat to iron ore. The surge in raw-material prices amounted to a global negative supply shock, affecting all economies. This figure shows the rate of inflation, as measured by the percentage increase in the consumer price index over the previous year, for five major economies from May 2007 to May 2008. The countries started from very different initial positions, ranging from 2.7% inflation in the United States to zero inflation in Japan. Yet all of the countries experienced a substantial jump in prices. 42

Long-Run Macroeconomic Equilibrium The economy is in long-run macroeconomic equilibrium when the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve.

Long-Run Macroeconomic Equilibrium Aggregate price level L R AS S R AS P E Long-run macroeconomic equilibrium E LR Figure Caption: Figure 12-14: Long-Run Macroeconomic Equilibrium Here the point of short-run macroeconomic equilibrium also lies on the long-run aggregate supply curve, LRAS. As a result, actual aggregate output is equal to potential output. The economy is in long-run macroeconomic equilibrium at ELR. AD Y Real GDP P Potential output 44

Short-Run Versus Long-Run Effects of a Negative Demand Shock 2. …reduces the aggregate price level and aggregate output and leads to higher unemployment in the short run… Aggregate price level L R AS S R AS 1 SRAS 2 P E 1 1 1. An initial negative demand shock… P 3. …until an eventual fall in nominal wages in the long run increases short-run aggregate supply and moves the economy back to potential output. 2 E 2 Figure Caption: Figure 12-15: Short-Run Versus Long-Run Effects of a Negative Demand Shock In the long run the economy is self-correcting: demand shocks have only temporary effects on aggregate output. Starting at E1, a negative demand shock shifts AD1 leftward to AD2. In the short run the economy moves to E2 and a recessionary gap arises: the aggregate price level declines from P1 to P2, aggregate output declines from Y1 to Y2, and unemployment rises. But in the long run nominal wages fall in response to high unemployment, and SRAS1 shifts rightward to SRAS2: aggregate output rises from Y2 to Y1, and the aggregate price level declines again, from P2 to P3. Long-run macroeconomic equilibrium is eventually restored at E3. P 3 E 3 AD 1 AD 2 Y Y 2 1 Potential output Real GDP Recessionary gap 45

Short-Run Versus Long-Run Effects of a Positive Demand Shock AS 2 3. …until an eventual rise in nominal wages in the long run reduces short-run aggregate supply and moves the economy back to potential output. Aggregate price level AD 2 An initial positive demand shock… L R AS S R AS 1 E 3 P 3 E 2 2. …increases the aggregate price level and aggregate output and reduces unemployment in the short run… P 2 E1 Figure Caption: Figure 12-16: Short-Run Versus Long-Run Effects of a Positive Demand Shock Starting at E1 a positive demand shock shifts AD1 rightward to AD2, and the economy moves to E2 in the short run. This results in an inflationary gap as aggregate output rises from Y1 to Y2, the aggregate price level rises from P1 to P2, and unemployment falls to a low level. In the long run, SRAS1 shifts leftward to SRAS2 as nominal wages rise in response to low unemployment. Aggregate output falls back to Y1, the aggregate price level rises again to P3, and the economy returns to long-run macroeconomic equilibrium at E3. P 1 AD 1 Potential output Y Y Real GDP 1 2 Inflationary gap 46

Gap Recap There is a recessionary gap when aggregate output is below potential output. There is an inflationary gap when aggregate output is above potential output. The output gap is the percentage difference between actual aggregate output and potential output.

Gap Recap The economy is self-correcting when shocks to aggregate demand affect aggregate output in the short run, but not the long run.

Where’s the Deflation? The AD–AS model says that either a negative demand shock or a positive supply shock should lead to a fall in the aggregate price level—that is, deflation. In fact, however, the United States hasn’t experienced an actual fall in the aggregate price level since 1949. What happened to the deflation? The basic answer is that since World War II economic fluctuations have taken place around a long-run inflationary trend. Before the war, it was common for prices to fall during recessions, but since then negative demand shocks have been reflected in a decline in the rate of inflation rather than an actual fall in prices. A very severe negative demand shock could still bring deflation, which is what happened in Japan.

Negative Supply Shocks Negative supply shocks pose a policy dilemma: a policy that stabilizes aggregate output by increasing aggregate demand will lead to inflation, but a policy that stabilizes prices by reducing aggregate demand will deepen the output slump.

Negative Supply Shocks Figure Caption: Figure 12-17: Negative Supply Shocks Are Relatively Rare but Nasty Only two of eleven postwar recessions seem to fit the profile of a recession caused by a negative supply shock: the recession that followed the increase in oil prices after the 1973 Arab–Israeli war and the recession that followed another surge in oil prices after the Iranian revolution. These two recessions were, however, the worst in terms of unemployment. A third recession that began in December 2007 was at least partially caused by a spike in oil prices. 51

Supply Shocks versus Demand Shocks in Practice Recessions are mainly caused by demand shocks. But when a negative supply shock does happen, the resulting recession tends to be particularly severe. There’s a reason the aftermath of a supply shock tends to be particularly severe for the economy: macroeconomic policy has a much harder time dealing with supply shocks than with demand shocks. The reason the Federal Reserve was having a hard time in 2008, as described in the opening story, was the fact that in early 2008 the U.S. economy was in a recession partially caused by a supply shock (although it was also facing a demand shock).

Macroeconomic Policy Economy is self-correcting in the long run. Most economists think it takes a decade or longer!!! John Maynard Keynes: “In the long run we are all dead.” Stabilization policy is the use of government policy to reduce the severity of recessions and rein in excessively strong expansions. Notes to the Instructor: There can be drawbacks, however, because such deficit and erroneous predictions can increase economic policies that may contribute to a long-term rise in the budget instability.

Keynes and the Long Run The British economist Sir John Maynard Keynes (1883–1946), probably more than any other single economist, created the modern field of macroeconomics. In 1923 Keynes published A Tract on Monetary Reform, a small book on the economic problems of Europe after World War I. In it he decried the tendency of many of his colleagues to focus on how things work out in the long run: “This 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 that when the storm is long past the sea is flat again.”

Macroeconomic Policy The high cost — in terms of unemployment — of a recessionary gap and the future adverse consequences of an inflationary gap  Active stabilization policy, using fiscal or monetary policy to offset shocks.

Macroeconomic Policy Policy in the face of supply shocks: There are no easy policies to shift the short-run aggregate supply curve. Policy dilemma: a policy that counteracts the fall in aggregate output by increasing aggregate demand will lead to higher inflation, but a policy that counteracts inflation by reducing aggregate demand will deepen the output slump.

Is Stabilization Policy Stabilizing? Has the economy actually become more stable since the government began trying to stabilize it? Yes. Data from the pre–World War II era are less reliable than more modern data, but there still seems to be a clear reduction in the size of economic fluctuations. It’s possible that the greater stability of the economy reflects good luck rather than policy. But on the face of it, the evidence suggests that stabilization policy is indeed stabilizing.

1. The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded. 2. The aggregate demand curve is downward sloping for two reasons. The first is the wealth effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households’ wealth and reduces consumer spending. The second is the interest rate effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households’ and firms’ money holdings, leading to a rise in interest rates and a fall in investment spending and consumer spending.

3. The aggregate demand curve shifts because of changes in expectations, changes in wealth not due to changes in the aggregate price level, and the effect of the size of the existing stock of physical capital. Policy makers can use fiscal policy and monetary policy to shift the aggregate demand curve. 4. The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied.

5. The short-run aggregate supply curve is upward sloping because nominal wages are sticky in the short run: a higher aggregate price level leads to higher profit per unit of output and increased aggregate output in the short run. 6. Changes in commodity prices, nominal wages, and productivity lead to changes in producers’ profits and shift the short-run aggregate supply curve. 7. In the long run, all prices are flexible and the economy produces at its potential output. If actual aggregate output exceeds potential output, nominal wages will eventually rise in response to low unemployment and aggregate output will fall. If potential output exceeds actual aggregate output, nominal wages will eventually fall in response to high unemployment and aggregate output will rise. So the long-run aggregate supply curve is vertical at potential output.

8. In the AD–AS model, the intersection of the short-run aggregate supply curve and the aggregate demand curve is the point of short-run macroeconomic equilibrium. It determines the short-run equilibrium aggregate price level and the level of short-run equilibrium aggregate output. 9. Economic fluctuations occur because of a shift of the aggregate demand curve (a demand shock) or the short-run aggregate supply curve (a supply shock). A demand shock causes the aggregate price level and aggregate output to move in the same direction as the economy moves a long the short-run aggregate supply curve. A supply shock causes them to move in opposite directions as the economy moves along the aggregate demand curve. A particularly nasty occurrence is stagflation—inflation and falling aggregate output—which is caused by a negative supply shock.

10. Demand shocks have only short-run effects on aggregate output because the economy is self-correcting in the long run. In a recessionary gap, an eventual fall in nominal wages moves the economy to long-run macroeconomic equilibrium, where aggregate output is equal to potential output. In an inflationary gap, an eventual rise in nominal wages moves the economy to long-run macroeconomic equilibrium. We can use the output gap, the percentage difference between actual aggregate output and potential output, to summarize how the economy responds to recessionary and inflationary gaps. Because the economy tends to be self-correcting in the long run, the output gap always tends toward zero.

11. The high cost—in terms of unemployment—of a recessionary gap and the future adverse consequences of an inflationary gap lead many economists to advocate active stabilization policy: using fiscal or monetary policy to offset demand shocks. There can be drawbacks, however, because such policies may contribute to a long-term rise in the budget deficit and crowding out of private investment, leading to lower long-run growth. Also, poorly timed policies can increase economic instability. 12. Negative supply shocks pose a policy dilemma: a policy that counteracts the fall in aggregate output by increasing aggregate demand will lead to higher inflation, but a policy that counteracts inflation by reducing aggregate demand will deepen the output slump.

coming attraction: Chapter 13: Fiscal Policy The End of Chapter 12 coming attraction: Chapter 13: Fiscal Policy