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

n $GDP: The market value of all final goods and services produced in our economy in a year n 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. n Real GDP (= Y): $GDP measured at base year prices Real GDP = $GDP/Price Deflator Y = $GDP/P Spending  Output  Income  Spending

Aggregate Demand and Aggregate Supply... Equilibrium output Quantity of Output Price Level 0 Equilibrium price level Aggregate supply Aggregate demand

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

The Aggregate-Demand Curve... Quantity of Output Price Level 0 Aggregate demand P1P1 Y1Y1 Y2Y2 P2P2 2. …increases the quantity of goods and services demanded. 1. A decrease in the price level...

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

Why the Aggregate Demand Curve Might Shift u Shifts arising from Consumption uChanges in wealth uHouse prices uStock prices u Shifts arising from Investment uResponses to interest rate uNew technologies uAnimal Spirits u Shifts arising from Government Purchases u Shifts arising from Net Exports

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

The Short-Run Aggregate Supply Curve... Quantity of Output Price Level 0 Short-run aggregate supply Y1Y1 P1P1 Y2Y2 2. reduces the quantity of goods and services supplied in the short run. P2P2 1. A decrease in the price level

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

The Long-Run Aggregate- Supply Curve... Quantity of Output Natural rate of output Price Level 0 Long-run aggregate supply P1P1 P2P2 2. …does not affect the quantity of goods and services supplied in the long run. 1. A change in the price level…

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

The Long-Run Equilibrium Quantity of Output Price Level 0 Short-run aggregate supply Long-run aggregate supply Aggregate demand A Equilibrium price Natural rate of output

1. A decrease in aggregate demand… AD 2 A Contraction in Aggregate Demand... Quantity of Output Price Level 0 Short-run aggregate supply, AS 1 Long-run aggregate supply Aggregate demand, AD 1 A P1P1 Y1Y1 B P2P2 Y2Y2 2. …causes output to fall in the short run… AS 2 C P3P3 3. …but over time, the short-run aggregate-supply curve shifts… 4. …and output returns to its natural rate.

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

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

Equilibrium in the Money Market... Quantity of Money Interest Rate 0 Money demand Quantity fixed by the Fed Money supply r2r2 M d2d2 r1r1 M d1d1 Equilibrium interest rate Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Aggregate demand (b) The Aggregate Demand Curve Quantity of Output 0 Price Level (a) The Money Market Quantity of Money Quantity fixed by the Fed 0 r1r1 Money supply Interest Rate Money demand at price level P 1, MD 1 Y1Y1 P1P1 The Money Market and the Slope of the Aggregate Demand Curve... Money demand at price level P 2, MD 2 2. …increases the demand for money… 1. An increase in the price level… P2P2 3. …which increases the equilibrium equilibrium rate… r2r2 4. …which in turn reduces the quantity of goods and services demanded. Y2Y2

Y2Y2 AD 2 3. …which increases the quantity of goods and services demanded at a given price level. 1. When the Fed increases the money supply… MS 2 A Monetary Injection... Y1Y1 P Quantity of Output 0 Price Level Aggregate demand, AD 1 (a) The Money Market Quantity of Money 0 Money supply, MS 1 r1r1 Interest Rate (b) The Aggregate-Demand Curve r2r2 2. …the equilibrium interest rate falls… Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

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

The Multiplier Effect... Aggregate demand, AD 1 Quantity of Output 0 Price Level AD 2 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion… $20 billion AD 3 2. …but the multiplier effect can amplify the shift in aggregate demand.

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

AD 3 4. …which in turn partly offsets the initial increase in aggregate demand. The Crowding-Out Effect... Aggregate demand, AD 1 (b) The Shift in Aggregate Demand Quantity of Output 0 Price Level (a) The Money Market Quantity of Money Quantity fixed by the Fed 0 r1r1 Money demand, MD 1 Money supply Interest Rate 1. When an increase in government purchases increases aggregate demand… AD 2 $20 billion 3. …which increases the equilibrium interest rate… r2r2 MD 2 2. …the increase in spending increases money demand…

Automatic Stabilizers u 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. u Automatic stabilizers include the tax system and some forms of government spending.

The Case for Active Stabilization Policy The Employment Act has two implications: u The government should avoid being the cause of economic fluctuations. u 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 uObama 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

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