1. 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

2. 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

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

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

5. 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

6. 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

7. 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

8. 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.

9. 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

10. 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

11. 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

12. 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.

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

14. 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

17. 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

18. 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

19. 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

20. 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

21. 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

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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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