0. 33 Aggregate Demand and Aggregate Supply P R I N C I P L E S O F
Aggregate Demand and Aggregate Supply 33
P R I N C I P L E S O F
F O U R T H E D I T I O N
This is perhaps the most important of the macro chapters. It develops the model of aggregate demand and aggregate supply, a paradigm that is widely used by many economists, policymakers, journalists, and business people. Mastering this chapter will give students much insight into how the world works, and will make the following two chapters easier to learn.
Most students find this to be one of the most challenging chapters in the textbook. However, much of the material here should be familiar from previous chapters – e.g., the Classical Dichotomy, the relationship between investment and interest rates, the relationship between net exports and the exchange rate. This chapter brings together much of this familiar material in a new context, which allows us to address new and exciting questions, such as: what causes recessions, and what can policymakers do to alleviate recessions?
This is one of the more challenging chapters to teach. I’ve invested a lot of time and thought into making a good PowerPoint presentation for this chapter. But there is a lot of variation in the approaches instructors use to teach this material. I encourage you to look over this chapter and make any changes you feel appropriate.
This chapter is also one of the longest in the textbook, and this PowerPoint file is also longer than average. As always, you can omit things you do not wish to cover, or things you would like students to learn on their own by reading the textbook.

1. Second Midterm This coming Thursday, regular lecture time.
It will cover chapters 26, 27, 28, and whatever we discuss today.
Scantron form;
No. 2 pencils;
Ink pens;
Non-programmable calculator;
Picture ID.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

2. Long run v.s. short run
Long run growth: what determines long-run output (and the related employment…)?
Short run fluctuations: what determines short-run output (and the related employment…)?
Aggregate demand and aggregate supply.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

3. In this chapter, look for the answers to these questions:
In this chapter, look for the answers to these questions:
What are economic fluctuations? What are their characteristics?
How does the model of aggregate demand and aggregate supply explain economic fluctuations?
Why does the Aggregate-Demand curve slope downward? What shifts the AD curve?
What is the slope of the Aggregate-Supply curve in the short run? In the long run? What shifts the AS curve(s)?
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

4. Introduction
Over the long run, real GDP grows about 3% per year on average.
In the short run, GDP fluctuates around its trend.
recessions: periods of falling real incomes and rising unemployment
depressions: severe recessions (very rare)
Short-run economic fluctuations are often called business cycles.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

5. Three Facts About Economic Fluctuations
FACT 1: Economic fluctuations are irregular and unpredictable. $
U.S. real GDP, billions of 2000 dollars
The shaded bars are recessions
On some displays, the numbers along the axes appear grainy. This is due to a quirk with PowerPoint, that often occurs when animation is added on a slide with a graph imported from Excel. If the graininess looks especially bad on the display in your classroom, you can make it go away by turning off the animation effects on this slide. (You’ll have to do the same for the following two slides, as well.)
Point out to students that the recessions (represented by the shaded bars) are of different durations and do not occur with any regularity. Hence, the common term “business cycle” is a bit misleading, as “cycle” implies something more regular and predictable.
UNITS: Billions of chained 2000 dollars
ORIGINAL SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis
WEBSITE WHERE I FOUND THIS DATA: series “GDPC1”

6. Three Facts About Economic Fluctuations
FACT 2: Most macroeconomic quantities fluctuate together. $
Investment spending, billions of 2000 dollars
Point out that investment falls during each recession (each shaded bar). This is true of other variables, as well: When the economy is in recession, incomes fall, consumer spending falls, profits fall, many stock prices fall, tax revenue falls (causing the budget deficit to rise), and spending on imports falls (causing the trade deficit to shrink).
UNITS: Billions of chained 2000 dollars
ORIGINAL SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis
WEBSITE WHERE I FOUND THIS DATA: series “GPDIC1”

7. Three Facts About Economic Fluctuations
FACT 3: As output falls, unemployment rises.
Unemployment rate, percent of labor force
During each recession, the unemployment rate rises. When firms cut back on production, they don’t need as many workers. Similarly, during expansions, we see the unemployment rate falling – as firms increase their output, they need more workers.
UNITS: Percent of labor force (seasonally adjusted)
ORIGINAL SOURCE: U.S. Department of Labor, Bureau of Labor Statistics
WEBSITE WHERE I FOUND THIS DATA: series “UNRATE”
Note: The source data was monthly. To be consistent with Figure 1c of the text, I graphed quarterly data, where each quarterly value is a simple average of the three monthly values.

8. Explaining the short-run fluctuations
Warning! This chapter is very theoretical.
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9. Introduction, continued
Explaining these fluctuations is difficult, and the theory of economic fluctuations is controversial.
Most economists use the model of aggregate demand and aggregate supply to study fluctuations.
This model differs from the classical economic theories economists use to explain the long run.
This is a slide you can probably cut if you wish to shorten your presentation of this chapter. It would be fine to just state this information verbally.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

10. Classical Economics
The previous chapters are based on the ideas of classical economics, especially:
The Classical Dichotomy, the separation of variables into two groups:
real – quantities, relative prices
nominal – measured in terms of money
The neutrality of money: Changes in the money supply affect nominal but not real variables.
If you have covered the long-run chapters before this one (as they are presented in the book), then your students have seen these terms already. It may be worth reminding your students that the Classical Dichotomy is what allowed us to study the real variables (like real GDP and its growth rate, the unemployment rate, investment, and the real wage) in separate chapters before we introduced nominal variables (like the price level and money supply).
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11. Classical Economics
Most economists believe classical theory describes the world in the long run, but not the short run.
In the short run, changes in nominal variables (like the money supply or P ) can affect real variables (like Y or the u-rate).
To study the short run, we use a new model.
As in previous chapters, “u-rate” is short for unemployment rate.
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12. The Model of Aggregate Demand and Aggregate SupplyP Y
The price level AD
SRAS
“Short-Run Aggregate Supply”
The model determines the eq’m price level P1 Y1
“Aggregate Demand”
NOTE: In edit mode (what PowerPoint calls “Normal view”), this slide looks cluttered. But in presentation (a.k.a. Slide Show) mode, it all works pretty well.
Suggestion: Briefly explain each element of the graph as it appears. (Brief is appropriate because each element will be discussed carefully in the following slides.)
The price level, P, is measured along the vertical axis. The aggregate quantity of goods and services – i.e., real GDP – is measured along the horizontal axis (and denoted Y, as in previous chapters). By focusing on the relationship between a nominal variable and a real one, we are highlighting the breakdown of the classical dichotomy.
The downward-sloping curve is the “aggregate-demand curve.” The upward-sloping curve is the “aggregate-supply curve” – actually, the short-run aggregate-supply curve. We will see soon that the aggregate supply curve looks different in the long run. The intersection of these curves determines the equilibrium price level and equilibrium real GDP. As in previous chapters, “eq’m” is short for “equilibrium.”
If you are more of a micro person, then please disregard the following.
Still reading? Then you must be a macro person. Excellent! Here’s something you might tell your students. This model LOOKS like the basic supply and demand model from chapter 4, but there’s a big difference. The basic supply & demand model determines the equilibrium price and quantity of a particular good, say, apples. The equilibrium price of apples is extremely important if you’re an apple grower. Ask your students to raise their hand if they plan on going into the apple-growing business. Chances are, none will raise their hands. The model of aggregate demand and supply, however, determines the equilibrium price and quantity of EVERYTHING (loosely speaking), i.e., the price level (cost of living) and real GDP (national income). So, the model of aggregate demand and aggregate supply is highly relevant to a broader group of people than just apple growers. How ’bout them apples!
and the eq’m level of output (real GDP).
Real GDP, the quantity of output
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

13. The Aggregate-Demand (AD) CurveP Y
The AD curve shows the quantity of all g&s demanded in the economy at any given price level. AD P2 Y2 P1 Y1
As in previous chapters, “g&s” stands for “goods and services.”
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

14. Why the AD Curve Slopes Downward
Y = C + I + G
C, I, G are the components of agg. Demand for a closed economy.
Assume G fixed by govt policy.
To understand the slope of AD, must determine how a change in P affects C, I, and NX. P Y AD P2 Y2 P1 Y1 Y1
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

15. The Wealth Effect (P and C )
Suppose P rises.
The dollars people hold buy fewer g&s, so real wealth is lower.
People feel poorer, so they spend less.
Thus, an increase in P causes a fall in C
…which means a smaller quantity of g&s demanded.
Note: the wealth effect concerns the impact of a change in P on wealth, not on income. When P falls, we are implicitly assuming that people’s real incomes are unchanged, and we are only considering the impact of the change in their real wealth on their consumption spending.
After all text on this slide has appeared, you might tell your students that this effect works in reverse, too: A fall in P raises real wealth, which causes consumption to rise, which increases the quantity of g&s demanded.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

16. The Interest-Rate Effect (P and I )
Suppose P rises.
Buying g&s requires more dollars.
To get these dollars, people sell some of their bonds or other assets, which drives up interest rates.
…which increases the cost of borrowing to fund investment projects.
Thus, an increase in P causes a increase in I
…which means a smaller quantity of g&s demanded.
Note: Again, we are holding real income (and everything else) constant.
Note: At this point some students will not understand why an increase in household demand for bonds causes interest rates to fall. If you wish, you can explain it now, or you can tell them not to worry about it for now – it will be covered in more detail in the following chapter (in the section on the Liquidity Preference Theory).
After all the text on this slide has appeared, you might tell your students that the interest-rate effect also works in reverse: A decrease in P causes a decrease in interest rates, which increases investment and hence the quantity of g&s demanded.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

17. The Slope of the AD Curve: Summary
An increase in P reduces the quantity of g&s demanded because: P Y P2 Y2
the wealth effect (C falls) P1
the interest-rate effect (I falls) AD
Note that the red arrow is not equal to the fall in C, but rather to the fall in demand due to the fall in C. The difference is due to the Keynesian multiplier: the initial fall in C causes a fall in Y, which causes a further (but smaller) fall in C, which causes a further (but smaller) fall in Y, and so forth. It might not be appropriate to cover the Keynesian multiplier at this point – it will be discussed in the following chapter – but mentioning that the red arrow is not the same as the fall in C might prevent students from learning something they will later have to unlearn. Similarly, the green arrow represents not the fall in I, but the fall in demand due to the fall in I. And similarly for the goldish-brown arrow and NX. Y1
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

18. Why the AD Curve Might Shift
Any event that changes C, I, G – except a change in P – will shift the AD curve.
Example: A stock market boom makes households feel wealthier, consume more, and the AD curve shifts right. P Y
AD2
AD1 P1 Y1 Y2
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

19. AD Shifts arising from things affecting C:
The world becomes more uncertain, people decide to save more: C falls, AD shifts left
The stock market crashes, the consumer confidence drops: C falls, AD shifts left
tax cut: C falls, AD shifts right
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

20. AD Shifts Arising from things affecting I
Firms decide to upgrade their computers: I rises, AD shifts right
Firms become pessimistic about future demand: I falls, AD shifts left
Central bank uses monetary policy to reduce interest rates: I rises, AD shifts right
Investment Tax Credit or other tax incentive: I rises, AD shifts right
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

21. AD Shifts Arising from Changes in G
Congress increases spending on homeland security: G rises, AD shifts right
State govts cut spending on road construction: G falls, AD shifts left
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

22. A C T I V E L E A R N I N G 1: Exercise
Try this without looking at your notes.
What happens to the AD curve in each of the following scenarios?
A. A ten-year-old investment tax credit expires.
B. A fall in prices increases the real value of consumers’ wealth.
C. State governments eliminates sales taxes.
You might encourage your students to draw a separate diagram of the AD curve for each scenario, and show on the diagram what happens to the curve. 22

23. A C T I V E L E A R N I N G 1: Answers
A. A ten-year-old investment tax credit expires.
I falls, AD curve shifts left.
B. A fall in prices increases the real value of consumers’ wealth.
Move down along AD curve (wealth-effect).
C. State governments eliminates sales taxes. C rises, AD shifts right. 23

24. Second-midterm -Pen & No. 2 Pencil
-Scantron F-288 Par-L (same as last time)
-non-programmable calculator -UCI ID
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

25. The Aggregate-Supply (AS) Curves
The AS curve shows the total quantity of g&s firms produce and sell at any given price level. P Y
LRAS
SRAS
In the short run, AS is upward-sloping.
The slope of the AS curve depends on the time horizon:
In the short run, the aggregate supply curve is upward-sloping. (Hence the upward-sloping curve labeled “SRAS” – “SR” stands for “short run”).
In the long run, the aggregate supply curve is vertical.
These slopes will be explained in the following slides.
In the long run, AS is vertical.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

26. The Long-Run Aggregate-Supply Curve (LRAS)
The natural rate of output (YN) is the amount of output the economy produces when unemployment is at its natural rate.
YN is also called potential output or full-employment output. P Y
LRAS
The book does not use the notation YN. I use it here to keep the slides from getting too cluttered, and also to make it easier for students to take notes: it’s easier for them to write “YN” than “the natural rate of output.” YN
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

27. (Classical dichotomy)
Why LRAS Is Vertical
YN depends on the economy’s stocks of labor, capital, and natural resources, and on the level of technology.
An increase in P P Y
LRAS P2 P1
does not affect any of these, so it does not affect YN.
(Classical dichotomy)
This is review from the chapter entitled “Production and Growth.” YN
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

28. Why the LRAS Curve Might ShiftP Y
LRAS1
LRAS2 YN ’
Any event that changes any of the determinants of YN will shift LRAS.
Example: Immigration increases L, causing YN to rise. YN
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

29. LRAS Shifts Arising from Changes in L
The Baby Boom generation retires: L falls, LRAS shifts left
New govt policies reduce the natural rate of unemployment: the % of the labor force normally employed rises, LRAS shifts right
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

30. LRAS Shifts Arising from Changes in Physical or Human Capital
Investment in factories or equipment: K rises, LRAS shifts right
More people get college degrees: Human capital rises, LRAS shifts right
Earthquakes or hurricanes destroy factories: K falls, LRAS shifts left
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

31. LRAS Shifts Arising from Changes in Natural Resources
A change in weather patterns makes farming more difficult: LRAS shifts left
Discovery of new mineral deposits: LRAS shifts right
Reduction in supply of imported oil or other resources: LRAS shifts right
It might be worth mentioning that the change in weather patterns or reduction in imported resources would have to be reasonably long-lasting for the LRAS curve to shift. Short-lived changes are more likely to affect SRAS than LRAS.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

32. LRAS Shifts Arising from Changes in Technology
Technological advances allow more output to be produced from a given bundle of inputs: LRAS shifts right.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

33. In short: Anything that affects growth shifts LRAS!
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

34. Using AD & AS to Depict LR Growth and Inflation
LRAS2000
Over the long run, tech. progress shifts LRAS to the right
LRAS1990 P Y
LRAS1980
AD2000
AD1990
and growth in the aggregate demand shifts AD to the right.
P2000
P1990
AD1980
P1980
Result: ongoing inflation and growth in output.
In the following chapter, it will be more clear why money supply growth shifts the AD curve rightward.
Y1980
Y1990
Y2000
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

35. Short Run Aggregate Supply (SRAS)
The SRAS curve is upward sloping:
Over the period of 1-2 years, an increase in P P Y
SRAS P2 Y2
causes an increase in the quantity of g & s supplied. P1 Y1
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

36. Why the Slope of SRAS Matters
LRAS P Y
ADhi
If AS is vertical, fluctuations in AD do not cause fluctuations in output or employment.
Phi
SRAS
Phi
Yhi
ADlo
Plo
Ylo
If AS slopes up, then shifts in AD do affect output and employment.
AD1
Plo
Before introducing the three theories of short-run aggregate supply, it’s worth taking a moment to show students why the slope of SRAS is critically important in the theory of economic fluctuations. Y1
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

37. Three Theories of SRAS In each, some type of market imperfection
In each,
some type of market imperfection
result: Output deviates from its natural rate when the actual price level deviates from the price level people expected.
Each of these theories provides a reason why the aggregate supply curve might have a positive slope in the short run.
It would be most helpful if students carefully read this section of the chapter!
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

38. the expected price level
Three Theories of SRAS P Y
When P > PE YN
SRAS
the expected price level PE
When P < PE
The preceding slide contained this statement: “Output deviates from its natural rate when the actual price level deviates from the price level people expected.”
This graph illustrates the following:
When P = PE, Y = YN
When P < PE, Y < YN
When P > PE, Y > YN
Y < YN
Y > YN
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

39. The Sticky-Wage Theory
Imperfection: Nominal wages are sticky in the short run, they adjust sluggishly.
Due to labor contracts, social norms.
Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

40. The Sticky-Wage Theory
The labor contract sets nominal wages according to expected prices.
If P > PE, revenue is higher, but labor cost is not.
Production is more profitable, so firms increase output and employment.
Hence, higher P causes higher Y, so the SRAS curve slopes upward.
“If P > PE”
means
“If it turns out that the actual price level is higher than firms had expected...”
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

41. The Sticky-Wage Theory
The sticky wage theory implies Y deviates from YN when P deviates from PE.
Y = YN + a (P – PE)
Output
Natural rate of output (long-run)
a > 0, measures how much Y responds to unexpected changes in P
Actual price level
Expected price level
Economists debate which of these theories is correct. It’s possible that each of them contains some element of truth.
For our purposes here, the similarities between these theories are more important than their differences: all three imply that output deviates from its long-run level (the “natural rate of output”) when the price level (P) deviates from the level people had expected (PE).
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

42. SRAS and LRAS
The imperfections in these theories are temporary. Over time,
sticky wages and prices become flexible
misperceptions are corrected
In the LR,
PE = P
AS curve is vertical
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

43. SRAS and LRAS Y = YN + a (P – PE) P LRAS In the long run, PE = P SRAS
Y = YN + a (P – PE) P Y
LRAS
In the long run, PE = P
and Y = YN.
SRAS PE
Notice that when the price level equals the expected price level, output is equal to its long-run value, the natural rate of output.
Interpretation:
In the short run, people may be fooled about the price level, or they may be locked into wages or prices that were set before they knew what the price level would actually be. Hence, in the short run, P may differ from PE.
But in the long run, expectations catch up to reality, P = PE, and therefore Y = YN, as in the Classical model.
Thus, our theory of economic fluctuations is basically the Classical model (which we studied for several chapters) augmented with some kind of market imperfection (such as sticky wages). The impact of the market imperfection occurs only in the short run, so the long-run behavior of our model is Classical. YN
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

44. Why the SRAS Curve Might Shift
Everything that shifts LRAS shifts SRAS, too.
Also, PE shifts SRAS:
If PE rises,
workers & firms set higher wages.
At each P, production is less profitable, Y falls, SRAS shifts left. P Y
LRAS
SRAS
SRAS PE PE YN
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

45. The Long-Run Equilibrium
In the long-run equilibrium,
PE = P,
Y = YN ,
and unemployment is at its natural rate. P Y
LRAS
SRAS PE AD YN
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

46. Economic Fluctuations
Caused by events that shift the AD and/or AS curves.
Four steps to analyzing economic fluctuations:
1. Determine whether the event shifts AD or AS.
2. Determine whether curve shifts left or right.
3. Use AD-AS diagram to see how the shift changes Y and P in the short run.
4. Use AD-AS diagram to see how economy moves from new SR eq’m to new LR eq’m.
This four-step approach is new to the 4th edition of the textbook. It is based on the three-step approach used in chapter 4 to analyze changes in the basic supply & demand model.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

47. The Effects of a Shift in AD
Event: stock market crash
1. affects C, AD curve
2. C falls, so AD shifts left
3. SR eq’m at B. P and Y lower, unemp higher
4. Over time, PE falls, SRAS shifts right, until LR eq’m at C. Y and unemp back at initial levels. P Y
LRAS YN
AD1
SRAS1
AD2 P1 A
SRAS2 P2 Y2 B P3 C
The results from this exercise apply to any event that shifts AD to the left, whether a stock market crash, recession abroad, wave of pessimism, or other.
The stock market crash reduces consumers’ wealth, which depresses their spending. The AD curve shifts to the left.
The new short-run equilibrium is at point B, where P and Y are lower, and hence unemployment is higher. (Remember Fact #3 about economic fluctuations: unemployment and output move in opposite directions.)
At point B, P < PE. Over time, PE falls, wages fall, and sticky prices become flexible and fall. The SRAS curve moves rightward.
This process continues until the economy arrives at point C, where GDP and unemployment are back at their natural rates, and PE = P once again.
Notice that, in the absence of policy intervention, the economy “self-corrects.” Of course, this process takes time, and policymakers may not want to wait. At point B, policymakers could use fiscal or monetary policy to shift aggregate demand to the right and move the economy back to A.
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48. Two Big AD Shifts: 1. The Great Depression
From ,
money supply fell 28% due to problems in banking system
stock prices fell 90%, reducing C and I
Y fell 27%
P fell 22%
unemp rose from 3% to 25%
U.S. Real GDP, billions of 2000 dollars
Two possible causes of the Great Depression: the fall in the money supply, and the stock market crash. Either would shift the AD curve left, causing P and Y to fall and causing unemployment to rise.
Data source: Bureau of Economic Analysis, U.S. Department of Commerce
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

49. Two Big AD Shifts: 2. The World War II Boom
U.S. Real GDP, billions of 2000 dollars
From ,
govt outlays rose from $9.1 billion to $91.3 billion
Y rose 90%
P rose 20%
unemp fell from 17% to 1%
This boom was clearly caused by a surge in govt spending. Our model predicts an increase in G would shift AD to the right, increasing P and Y, and reducing unemployment. These predictions are consistent with the data.
Source for GDP data: Bureau of Economic Analysis, U.S. Department of Commerce
Source for data on government outlays: Economic Report of the President, 2005 edition, Table B
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50. A C T I V E L E A R N I N G 2: Exercise
Draw the AD-SRAS-LRAS diagram for the U.S. economy, starting in a long-run equilibrium.
A boom occurs in Canada. Use your diagram to determine the SR and LR effects on U.S. GDP, the price level, and unemployment. 50

51. A C T I V E L E A R N I N G 2: Answers
Event: a tax cut
1. affects C, AD curve
2. shifts AD right
3. SR eq’m at point B. P and Y higher, unemp lower
4. Over time, PE rises, SRAS shifts left, until LR eq’m at C. Y and unemp back at initial levels. P Y
LRAS YN
SRAS2
AD2 P3 C
SRAS1
AD1 P2 Y2 B P1 A
The boom in Canada increases the incomes of Canadian consumers. In turn, their spending rises. Some of their spending is on products from the U.S., so their spending increase causes U.S. exports to rise.
This shifts the U.S. AD curve to the right. The new short-run equilibrium is at point B, where P and Y are higher, and hence unemployment is lower.
At B, P > PE. Over time, PE rises, wages rise, and sticky prices become flexible and rise. The SRAS curve moves leftward.
This process continues until the economy arrives at point C, where GDP and unemployment are back at their natural rates, and expectations about P have caught up to reality. 51

52. The Effects of a Shift in SRAS
Event: oil prices rise
1. increases costs, shifts SRAS (assume LRAS constant)
2. SRAS shifts left
3. SR eq’m at point B. P higher, Y lower, unemp higher
From A to B, stagflation, a period of falling output and rising prices. P Y
LRAS YN
SRAS2
AD1
SRAS1 P2 Y2 B P1 A
An increase in oil prices might also affect LRAS. For simplicity, and to be consistent with the textbook, we assume it only affects the SRAS curve.
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53. Accommodating an Adverse Shift in SRAS
If policymakers do nothing,
4. Low employment causes wages to fall, SRAS shifts right, until LR eq’m at A. P Y
LRAS YN
SRAS2
AD2 P3 C
AD1
SRAS1 P2 Y2 B
Or, policymakers could use fiscal or monetary policy to increase AD and accommodate the AS shift:
Y back to YN, but P permanently higher. P1 A
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

54. The 1970s Oil Shocks and Their Effects
Real oil prices
+ 3.5 million
– 0.7%
+ 21%
+ 138%
+ 1.4 million
+ 2.9%
+ 26%
+ 99%
CPI
Real GDP
The first oil shock:
Oil prices more than doubled in just two years, causing SRAS to shift leftward. As our model predicts, the price level rose, GDP fell, and unemployment rose.
From 1975 to 1978, oil prices rose at less than the rate of inflation, the number of unemployed persons fell by 1.7 million, and real GDP grew by 16%. The economy was self-correcting.
But just when things were getting better, the second oil shock hit. Oil prices doubled, due in part to a revolution in Iran in Again, as our model predicts, SRAS shifted left, inflation rose, and unemployment increased. The table shows that real GDP rose 2.9% during this period – but remember, this is not an annual rate, it is 2.9% for the entire period, which is substantially below the long-run average growth rate of about 3% per year.
Data sources:
CPI and unemployment: Bureau of Labor Statistics,
GDP and oil prices: FRED database, Federal Reserve Bank of St Louis,
# of unemployed persons
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

55. John Maynard Keynes,
The General Theory of Employment, Interest, and Money, 1936
Argued recessions and depressions can result from inadequate demand; policymakers should shift AD.
Famous critique of classical theory:
The long run is a misleading guide to current affairs. In the long run, we are all dead.
Much of the theory in this chapter and the one that follows originates in the work of Keynes. This slide reproduces his famous critique of the long-run focus of classical macroeconomics.
In one way, this slide is a good candidate for cutting, if you think this PowerPoint file is too long. Students can easily read about Keynes on their own, in the FYI box that appears in the textbook at the end of this chapter.
On the other hand, showing this in class gives students a nice break from all the theory they have sat through. And students may not read the FYI box on their own.
Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us when the storm is long past, the ocean will be flat.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

56. CONCLUSION
This chapter has introduced the model of aggregate demand and aggregate supply, which helps explain economic fluctuations.
Keep in mind: these fluctuations are deviations from the long-run trends explained by the models we learned in previous chapters.
In the next chapter, we will learn how policymakers can affect aggregate demand with fiscal and monetary policy.
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57. CHAPTER SUMMARY
Short-run fluctuations in GDP and other macroeconomic quantities are irregular and unpredictable. Recessions are periods of falling real GDP and rising unemployment.
Economists analyze fluctuations using the model of aggregate demand and aggregate supply.
The aggregate demand curve slopes downward because a change in the price level has a wealth effect on consumption, an interest-rate effect on investment, and an exchange-rate effect on net exports.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

58. CHAPTER SUMMARY
Anything that changes C, I, G, or NX – except a change in the price level – will shift the aggregate demand curve.
The long-run aggregate supply curve is vertical, because changes in the price level do not affect output in the long run.
In the long run, output is determined by labor, capital, natural resources, and technology; changes in any of these will shift the long-run aggregate supply curve.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

59. CHAPTER SUMMARY
In the short run, output deviates from its natural rate when the price level is different than expected, leading to an upward-sloping short-run aggregate supply curve. The three theories proposed to explain this upward slope are the sticky wage theory, the sticky price theory, and the misperceptions theory.
The short-run aggregate-supply curve shifts in response to changes in the expected price level and to anything that shifts the long-run aggregate supply curve.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

60. CHAPTER SUMMARY
Economic fluctuations are caused by shifts in aggregate demand and aggregate supply.
When aggregate demand falls, output and the price level fall in the short run. Over time, a change in expectations causes wages, prices, and perceptions to adjust, and the short-run aggregate supply curve shifts rightward. In the long run, the economy returns to the natural rates of output and unemployment, but with a lower price level.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

61. CHAPTER SUMMARY
A fall in aggregate supply results in stagflation – falling output and rising prices. Wages, prices, and perceptions adjust over time, and the economy recovers.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

62. Fiscal Policy and Aggregate Demand
Fiscal policy: the setting of the level of govt spending and taxation by govt policymakers
Expansionary fiscal policy
an increase in G and/or decrease in T
shifts AD right
Contractionary fiscal policy
a decrease in G and/or increase in T
shifts AD left
Fiscal policy has two effects on AD.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

63. The Multiplier Effect
If the govt buys $20b of planes from Boeing, Boeing’s revenue increases by $20b.
This is distributed to Boeing’s workers (as wages) and owners (as profits or stock dividends).
These people are also consumers, and will spend a portion of the extra income.
This extra consumption causes further increases in aggregate demand.
$20b = $20 billion
Multiplier effect: the additional shifts in AD that result when fiscal policy increases income and thereby increases consumer spending
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

64. The Multiplier Effect
A $20b increase in G initially shifts AD to the right by $20b.
The increase in Y causes C to rise, which shifts AD further to the right. Y P
AD3
AD2
AD1 P1 Y1 Y2 Y3
$20 billion
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

65. Marginal Propensity to Consume
How big is the multiplier effect? It depends on how much consumers respond to increases in income.
Marginal propensity to consume (MPC): the fraction of extra income that households consume rather than save
E.g., if MPC = 0.8 and income rises $100, C rises $80.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

66. A Formula for the Multiplier
Notation: G is the change in G, Y and C are the ultimate changes in Y and C
Y = C + I + G + NX identity
Y = C + G I and NX do not change
Y = MPC Y + G because C = MPC Y
solved for Y 1
1 – MPC
Y = G
The multiplier
This slide uses simple algebra to derive a formula for the simple spending multiplier.
If you do not wish to cover this derivation, you can skip to the next slide, which just shows the formula for the multiplier. However, you will need to explain the “delta” notation, as the formula on the next slide includes the terms G and Y.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

67. A Formula for the Multiplier
The size of the multiplier depends on MPC.
e.g., if MPC = 0.5 multiplier = 2
if MPC = multiplier = 4
if MPC = 0.9 multiplier = 10
A bigger MPC means changes in Y cause bigger changes in C, which in turn cause more changes in Y. 1
1 – MPC
Y = G
The multiplier
If you skipped the previous slide, which shows the algebraic derivation of the multiplier, then you may need to explain the delta notation to students.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

68. Other Applications of the Multiplier Effect
The multiplier effect: each $1 increase in G can generate more than a $1 increase in agg demand.
Also true for the other components of GDP.
Example: Suppose a recession overseas reduces demand for U.S. net exports by $10b.
Initially, agg demand falls by $10b.
The fall in Y causes C to fall, which further reduces agg demand and income.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

69. Changes in Taxes A tax cut increases households’ take-home pay.
A tax cut increases households’ take-home pay.
Households respond by spending a portion of this extra income, shifting AD to the right.
The size of the shift is affected by the multiplier and crowding-out effects.
Another factor: whether households perceive the tax cut to be temporary or permanent.
A permanent tax cut causes a bigger increase in C – and a bigger shift in the AD curve – than a temporary tax cut.
The textbook gives a nice example: the first President Bush reduced federal income tax withholding to stimulate consumer spending to combat the recession. However, this was just a temporary reallocation of tax liability and, consequently, had a very small affect on aggregate demand. See the textbook for more details.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

70. A C T I V E L E A R N I N G 3: Exercise
The economy is in recession. Shifting the AD curve rightward by $200b would end the recession.
A. If MPC = .8 and there is no crowding out, how much should Congress increase G to end the recession?
B. If there is crowding out, will Congress need to increase G more or less than this amount?
This exercise gets students to apply the preceding material on the effects of fiscal policy on aggregate demand.
Finding the answers requires students use the formula for the multiplier, but does not require that students understand the algebraic derivation of this formula.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY 70

71. A C T I V E L E A R N I N G 3: Answers
The economy is in recession. Shifting the AD curve rightward by $200b would end the recession.
A. If MPC = .8 and there is no crowding out, how much should Congress increase G to end the recession?
Multiplier = 1/(1 – .8) = 5
Increase G by $40b to shift agg demand by 5 x $40b = $200b.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY 71

72. A C T I V E L E A R N I N G 3: Answers
The economy is in recession. Shifting the AD curve rightward by $200b would end the recession.
B. If there is crowding out, will Congress need to increase G more or less than this amount?
Crowding out reduces the impact of G on AD.
To offset this, Congress should increase G by a larger amount.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY 72

73. Using Policy to Stabilize the Economy
Since the Employment Act of 1946, economic stabilization has been a goal of U.S. policy.
Economists debate how active a role the govt should take to stabilize the economy.
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74. The Case for Active Stabilization Policy
Keynes: “animal spirits” cause waves of pessimism and optimism among households and firms, leading to shifts in aggregate demand and fluctuations in output and employment.
Also, other factors cause fluctuations, e.g.,
booms and recessions abroad
stock market booms and crashes
If policymakers do nothing, these fluctuations are destabilizing to businesses, workers, consumers.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

75. The Case for Active Stabilization Policy
Proponents of active stabilization policy believe the govt should use policy to reduce these fluctuations:
when GDP falls below its natural rate, should use expansionary monetary or fiscal policy to prevent or reduce a recession
when GDP rises above its natural rate, should use contractionary policy to prevent or reduce an inflationary boom
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

76. Keynesians in the White House
1961: John F Kennedy pushed for a tax cut to stimulate agg demand. Several of his economic advisors were followers of Keynes.
2001: George W Bush pushed for a tax cut that helped the economy recover from a recession that had just begun.
This slide covers a Case Study in the chapter.
Of course, there are lots of other examples of Keynesians in the White House.
President Reagan (who believed himself a supply-sider!) pushed through large tax cuts and spending increases during his first term, which helped the economy out of a nasty recession.
President Clinton inherited a very weak economy, and proposed investment tax credits and other initiatives to stimulate aggregate demand.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

77. The Case Against Active Stabilization Policy
Monetary policy affects economy with a long lag:
firms make investment plans in advance, so I takes time to respond to changes in r
most economists believe it takes at least 6 months for mon policy to affect output and employment
Fiscal policy also works with a long lag:
Changes in G and T require Acts of Congress.
The legislative process can take months or years.
The legislative process can be quite lengthy.
A bill is introduced in Congress, debated, amended, and voted on in each chamber of Congress. The House and the Senate must reconcile any differences, and the reconciled bill must pass a vote in both chambers. Then, the President must sign the bill into law.
In addition to the time it takes for this process to occur, there are often compromises made along the way for political reasons. So, many people have trouble imagining that fiscal policy could be used in an active way to respond to shocks as they occur.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

78. The Case Against Active Stabilization Policy
Due to these long lags, critics of active policy argue that such policies may destabilize the economy rather than help it:
By the time the policies affect agg demand, the economy’s condition may have changed.
These critics contend that policymakers should focus on long-run goals, like economic growth and low inflation.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

79. CONCLUSION
Policymakers need to consider all the effects of their actions. For example,
When Congress cuts taxes, it needs to consider the short-run effects on agg demand and employment, and the long-run effects on saving and growth.
When the Fed reduces the rate of money growth, it must take into account not only the long-run effects on inflation, but the short-run effects on output and employment.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

80. Final Thursday, June 12th, 1:30 to 3:30pm.
Final will cover chapters 23, 24, 25, 28, and 33.
You are suppose to hand in your extra assignment to one of the TAs before or on this Friday (June 5th).
You can also give it to me. I will be in my office from 3:00 to 5:00 this Friday.
I will curve the class before taking into account the extra-credit assignment.
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81. CHAPTER SUMMARY
In the theory of liquidity preference, the interest rate adjusts to balance the demand for money with the supply of money.
The interest-rate effect helps explain why the aggregate-demand curve slopes downward: An increase in the price level raises money demand, which raises the interest rate, which reduces investment, which reduces the aggregate quantity of goods & services demanded.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

82. CHAPTER SUMMARY
An increase in the money supply causes the interest rate to fall, which stimulates investment and shifts the aggregate demand curve rightward.
Expansionary fiscal policy – a spending increase or tax cut – shifts aggregate demand to the right. Contractionary fiscal policy shifts aggregate demand to the left.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

83. CHAPTER SUMMARY
When the government alters spending or taxes, the resulting shift in aggregate demand can be larger or smaller than the fiscal change:
The multiplier effect tends to amplify the effects of fiscal policy on aggregate demand.
The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY

84. CHAPTER SUMMARY
Economists disagree about how actively policymakers should try to stabilize the economy.
Some argue that the government should use fiscal and monetary policy to combat destabilizing fluctuations in output and employment.
Others argue that policy will end up destabilizing the economy, because policies work with long lags.
CHAPTER AGGREGATE DEMAND AND AGGREGATE SUPPLY