CASE  FAIR  OSTER ECONOMICS PRINCIPLES OF E L E V E N T H E D I T I O N CASE  FAIR  OSTER PEARSON Prepared by: Fernando Quijano w/Shelly Tefft

The Determination of Aggregate Output, the Price Level, and the Interest Rate 27 C H A P T E R O U T L I N E The Aggregate Supply (AS) Curve Aggregate Supply in the Short Run Shifts of the Short-Run Aggregate Supply Curve The Aggregate Demand (AD) Curve Planned Aggregate Expenditure and the Interest Rate The Behavior of the Fed Deriving the AD Curve The Final Equilibrium Other Reasons for a Downward-Sloping AD Curve The Long-Run AS Curve Potential GDP

The Aggregate Supply (AS) Curve aggregate supply The total supply of all goods and services in an economy. aggregate supply (AS) curve A graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level. Although it is called an aggregate supply curve, it is better thought of as a “price/output response” curve—a curve that traces out the price decisions and output decisions of all firms in the economy under different levels of aggregate demand.

Aggregate Supply in the Short Run  FIGURE 27.1 The Short-Run Aggregate Supply Curve In the short run, the aggregate supply curve (the price/output response curve) has a positive slope. At low levels of aggregate output, the curve is fairly flat. As the economy approaches capacity, the curve becomes nearly vertical. At capacity, Ȳ, the curve is vertical.

Why an Upward Slope? Wages are a large fraction of total costs and wage changes lag behind price changes. This gives us an upward sloping short-run AS curve. Why the Particular Shape? Consider the vertical portion of the AS curve. At some level the overall economy is using all its capital and all the labor that wants to work at the market wage. At this level (Ȳ), increased demand for labor and output can be met only by increased prices. Neither wages nor prices are likely to be sticky. At low levels of output, the AS curve is flatter. Small price increases may be associated with relatively large output responses. We may observe relatively sticky wages upward at this point on the AS curve.

Shifts of the Short-Run Aggregate Supply Curve The vertical part of the short-run AS curve represents the economy’s maximum (capacity) output, which is determined by the economy’s existing resources, like the size of its labor force, capital stock, and the current state of technology. New discoveries of oil or problems in the production of energy can also shift the AS curve through effects on the marginal cost of production in many parts of the economy. cost shock, or supply shock A change in costs that shifts the short-run aggregate supply (AS) curve.

 FIGURE 27.2 Shifts of the Short-Run Aggregate Supply Curve

The Aggregate Demand (AD) Curve The aggregate demand (AD) curve is derived from the model of the goods market in Chapters 23 and 24 and from the behavior of the Fed. We begin with the goods market. Planned Aggregate Expenditure and the Interest Rate We can use the fact that planned investment depends on the interest rate to consider how planned aggregate expenditure (AE) depends on the interest rate. Recall that planned aggregate expenditure is the sum of consumption, planned investment, and government purchases. That is, AE ≡ C + I + G

 FIGURE 27.3 The Effect of an Interest Rate Increase on Planned Aggregate Expenditure and Equilibrium Output An increase in the interest rate from 3 percent to 6 percent lowers planned aggregate expenditure and thus reduces equilibrium output from Y0 to Y1.

The effects of a change in the interest rate on the equilibrium level of output in the goods market include: A high interest rate (r) discourages planned investment (I). Planned investment is a part of planned aggregate expenditure (AE). Thus, when the interest rate rises, planned aggregate expenditure (AE) at every level of income falls. Finally, a decrease in planned aggregate expenditure lowers equilibrium output (income) (Y) by a multiple of the initial decrease in planned investment.

Using a convenient shorthand: IS curve Relationship between aggregate output and the interest rate in the goods market. With the interest rate fixed, an increase in government spending (G) increases AE and thus Y in equilibrium.

 FIGURE 27.4 The IS Curve In the goods market, there is a negative relationship between output and the interest rate because planned investment depends negatively on the interest rate. Any point on the IS curve is an equilibrium in the goods market for the given interest rate.

which is a shift of the IS curve to the right.  FIGURE 27.5 Shift of the IS Curve An increase in government spending (G) with the interest rate fixed increases output (Y), which is a shift of the IS curve to the right.

The Behavior of the Fed  FIGURE 27.6 Fed Behavior

As the Fed thinks about its interest rate setting, it considers factors other than current output and inflation, such as levels of consumer confidence, possible fragility of the domestic banking sector, and possible financial problems abroad. For our purposes we will label all these factors (except output and inflation) as “Z” factors, which lie outside our model and are likely to vary from period to period in ways that are hard to predict. Fed rule Equation that shows how the Fed’s interest rate decision depends on the state of the economy.

 FIGURE 27.7 Equilibrium Values of the Interest Rate and Output In the Fed rule, the Fed raises the interest rate as output increases, other things being equal. Along the IS curve, output falls as the interest rate increases because planned investment depends negatively on the interest rate. The intersection of the two curves gives the equilibrium values of output and the interest rate for given values of government spending (G), the price level (P), and the factors in Z.

What Does Ben Bernanke Really Care About? E C O N O M I C S I N P R A C T I C E What Does Ben Bernanke Really Care About? As the economy sputtered along in late 2012 and early 2013, a number of newspaper articles began to appear focusing on what Ben Bernanke really cared about. One article was titled “Does Ben Bernanke Care Too Much About Jobs?” while another journalist opined “Ben Bernanke Doesn’t Care about the Price of Your Hamburger.” At this point you should see that these colorful headlines are just asking what are the variables in the Fed rule! THINKING PRACTICALLY In his research work while a professor at Princeton, Bernanke emphasized the dangers of inflation. As Fed Chair, he has spent more time worrying about output. Why is this? (Hint: go back and look at the data graphs.)

Deriving the AD Curve Because many prices rise together when the overall price level rises, we cannot use the ceteris paribus assumption to draw the AD curve. The logic that explains why a simple demand curve slopes downward fails to explain why the AD curve also has a negative slope. Aggregate demand falls when the price level increases because the higher price level leads the Fed to raise the interest rate, which decreases planned investment and thus aggregate output. The higher interest rate causes aggregate output to fall.

The AD curve is derived from Figure 27.7.  FIGURE 27.8 The Aggregate Demand (AD) Curve The AD curve is derived from Figure 27.7. Each point on the AD curve is an equilibrium point in Figure 27.7 for a given value of P. When P increases, the Fed raises the interest rate (the Fed rule in Figure 27.7 shifts to the left), which has a negative effect on planned investment and thus on Y. The AD curve reflects this negative relationship between P and Y.

The Final Equilibrium  FIGURE 27.9 Equilibrium Output and the Price Level

Other Reasons for a Downward-Sloping AD Curve The AD curve slopes down in our analysis because the Fed raises the interest rate when P increases and because planned investment depends negatively on the interest rate. There is also a real wealth effect on consumption that contributes to a downward-sloping AD curve. real wealth effect The change in consumption brought about by a change in real wealth that results from a change in the price level.

The Long-Run AS Curve When the AD curve shifts from AD0 to AD1,  FIGURE 27.10 The Long-Run Aggregate Supply Curve When the AD curve shifts from AD0 to AD1, the equilibrium price level initially rises from P0 to P1 and output rises from Y0 to Y1. Wages respond in the longer run, shifting the AS curve from AS0 to AS1. If wages fully adjust, output will be back to Y0. Y0 is sometimes called potential GDP.

Potential GDP Recall that even the short-run AS curve becomes vertical at some particular level of output. The vertical portion of the short-run AS curve exists because there are physical limits to the amount that an economy can produce in any given time period. potential output, or potential GDP The level of aggregate output that can be sustained in the long run without inflation. Short-Run Equilibrium Below Potential Output Although different economists have different opinions on how to determine whether an economy is operating at or above potential output, there is general agreement that there is a maximum level of output (below the vertical portion of the short-run aggregate supply curve) that can be sustained without inflation.

The Simple “Keynesian” Aggregate Supply Curve E C O N O M I C S I N P R A C T I C E The Simple “Keynesian” Aggregate Supply Curve With planned aggregate expenditure of AE1 and aggregate demand of AD1, equilibrium output is Y1. A shift of planned aggregate expenditure to AE2, corresponding to a shift of the AD curve to AD2, causes output to rise but the price level to remain at P1. If planned aggregate expenditure and aggregate demand exceed YF, however, there is an inflationary gap and the price level rises to P3. THINKING PRACTICALLY Why is the distance between AE3 and AE2 called an inflationary gap?

AE ≡ C + I + G R E V I E W T E R M S A N D C O N C E P T S Equations: aggregate supply aggregate supply (AS) curve cost shock, or supply shock Fed rule IS curve potential output, or potential GDP real wealth effect Equations: AE ≡ C + I + G