Presentation on theme: "Aggregate Demand and Aggregate Supply Chapter 15"— Presentation transcript:
1 Aggregate Demand and Aggregate Supply Chapter 15
2 In this chapter we derive the: The Price LevelUp to this point, we have not said much about prices and the price level (P)In this chapter we derive the:Aggregate Demand curve which shows the relation between aggregate expenditure (AE) and the price level (P)Aggregate Supply curve shows the relation between aggregate production and the price level (P)
3 Derivation of Aggregate Demand (AD) Curve Start with money demand. An increase in the price level shifts the money demand curve rightwardincreasing the equilibrium interest rate (if the Fed does not increase the money supply)causing the aggregate expenditure line to shift downwardresulting in a lower equilibrium level of GDP.
4 Deriving the Aggregate Demand Curve (a) InterestRateMoney ($ billions)500MSM2dAs the price level, say the CPI, increases from 100 to 140, money demand increases and the interest rate rises.B9%M1dA6%
6 The Aggregate Demand Curve a curve indicating equilibrium GDP at each price level, with a constant money supplyits NOT a demand curve at all!it is actually an “equilibrium-output-at-each-price-level” curve
7 The Aggregate Demand Curve Movements along the AD curvea change in the price level causes equilibrium GDP to changeThis inverse relationship between P and Y caused by the change in the interest rate is called the interest rate effect
8 The Aggregate Demand (AD) Curve Another reason for a downward-sloping aggregate demand curve is the Real Wealth EffectThis is the change in consumption brought about by a change in real wealth that results from a change in the price level.
9 Nominal and Real Wealth Nominal Wealth (W) = Assets – LiabilitiesReal Wealth is the purchasing power of wealth =Two things change real wealth: W or P
10 As P↓ => (W/P)↑ => C↑=> AE↑ => Y↑ BAE0A450Y0Y1YAs P ↑ =>(W/P) ↓ => C ↓ => AE ↓ => Y ↓P and Y move in opposite directions. The AD curveSlopes downward to the right.
11 What shifts the AD curve ? Changes in any of the variables that shift the AE curve:Government purchases (G)Planned Investment spending (IP)Autonomous consumption spending (a)Taxes (T)Net exports (NX)The money supply (M)
13 A Spending Change Shifts the AD Curve Real AggregateExpenditure($ Trillions)Real GDP ($ Trillions)45°AE2F12.5At any given price level, an increase in government purchases shifts the AE line upward, raising real GDP.Get the multiplier effect we introduced in chapter 11.AE1E10Price levelReal GDP ($ Trillions)AD2AD1Since real GDP is higher at the given price level, the AD curve shifts rightward.H to J is the multiplier effect we introduced in chapter 11J10100H12.5
16 The Aggregate Supply Curve Assumptions:Firms set the price of their products as a markup over unit cost of productionp = unit cost + mark-upAverage percentage markup in the economy is determined by competitive conditions in the economyso we treat the mark-up as stable (fixed) from year to yearThe competitive structure of the economy changes very slowly
17 The Aggregate Supply Curve In general, changes in GDP affects unit costs of productionAs total GDP(output) increases:greater amounts of inputs are needed to produce the greater outputthe prices for non-labor inputs risethe price of labor, the nominal wage rate, can also increase (but we make an assumption about this in the short-run!)
18 The Aggregate Supply Curve We assume that in the short-run the price of labor, nominal wages, are “fixed”, “sticky”union contractscan be costly to firmsreputation for paying stable wagesslow-moving bureaucraciesTHIS IS A KEY ASSUMPTION!!!nominal wage rate is fixed in the short runchanges in output have no effect on the nominal wage rate in the short run
19 The Aggregate Supply Curve In the short run, a change in output will affect non-labor costs of productiona rise in real GDP raises firms’ unit costsInput requirements increase: coal, oil lumber, copper,…….The prices of these non-labor inputs riseA decrease in real GDP lowers unit costsInput requirements decreasePrices of non-labor inputs fall
20 The Aggregate Supply Curve Aggregate Supply (AS) curvea curve indicating the price level consistent with firms’ unit costs and markups for any level of output (Y) in the short runit is actually a “short-run-price-level-at-each-output-level” curveits upward slopingPrice level on the vertical axisTotal output on the horizontal axis
22 The Aggregate Supply Curve Movements along the AS curveA change in real GDP causes the price level to changeWages are sticky! Labor costs do not change in the short-run.
23 Another View of the Aggregate Supply Curve In the short run there must be a lag between changes in output prices and changes in input prices, otherwise the aggregate supply (price/output response) curve would be vertical.If input and output prices rise by the same percentage amount, no firm would find it advantageous to change its level of output.
24 Slope Matters! Shape of the Short-run Aggregate Supply Curve - Ordinary Conditions Moderate Levels of :Unemployment -Unemployment Rate: 5 -10%Some excess Capacity -Ex. Cap Rate: 10-25%AS exhibits a Positive Slope
25 Aggregate Supply Curve - Ordinary Conditions Implications With the positive slope:Change in output (Y) causes a moderate change in the price level (P)
26 Shape of the Short-run Aggregate Supply Curve - Slack Conditions High Levels of:Unemployment -Unemployment Rate > 10%Lot of excess Capacity - Ex Cap Rate > 25%• AS is Almost Flat
27 Shape of the Short-run Aggregate Supply Curve - Slack Conditions - Implications With a flat slope:The economy can expand a lot with small increase in P because of the excess capacity.
28 Shape of the Short-run Aggregate Supply Curve - Tight Conditions Low Levels of:Unemployment -Unemployment Rate < 3%Little excess Capacity-Ex Cap Rate < 10%• AS is Very Steep
29 Large increase in P for a relatively small increase in GDP (Y). Shape of the Short-run Aggregate Supply Curve - Tight Conditions - ImplicationASLarge increase in P for a relatively small increase in GDP (Y).
30 The Aggregate Supply Curve is not a straight line Capacity[--Slack-----][--Ordinary--][--Tight--]
31 What Causes the Aggregate Supply Curve to Shift? Increase in AS means the AS curve shifts downward:Lower world oil pricesGood weatherTechnological changeRegulationLower nominal wagesDecrease in AS means the AS curve shifts upward:Higher world oil pricesBad weatherTechnological change(negative?), stupid pills(?)Higher nominal wages
34 Effects of Key Changes on the Aggregate Supply Curve (b, c) Price LevelReal GDPPrice LevelReal GDPAS2AS1AS1AS2Entire AS curve shifts downward if unit costs ↓ for any reason besides a decrease in real GDPEntire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP
35 AD and AS: Short-Run Equilibrium Short-run macroeconomic equilibriuma combination of price level and GDP consistent with both the AD and AS curves
36 Short-Run Macroeconomic Equilibrium PriceLevelReal GDPASADExcess SupplyB140614E10010F80Excess DemandAt point E, the price level of 100 is consistent with an output of $10 trillion along the AD curve. The output level of $10 trillion is consistent with a price level of 100 along the AS curve. At any other combination of price level and output, such as point F or point B, at least one condition for equilibrium will not be satisfied.
37 Short-Run Macroeconomic Equilibrium At point B, AS > AD. Excess Supply.P will fall from 140 to 100 and Y will fall from 14 to 10.As P and Y fall, the interest rate falls which means C and Ip increases causing AD to increase.Movements along the curves!PriceLevelReal GDPASADExcess SupplyB140614E10010F80Excess DemandThe is a lot more complicated than the basic AE model presented in chapters 10 and 11 where only Y fell as inventories increased.Here, Y, P , money demand, the interest rate(r) and AE all adjust.
38 Short-Run Macroeconomic Equilibrium At point F, AD > AS.Excess Demand.P will increase from 80 to 100 and Y will increase from 6 to 10.As P and Y increase, the interest rate rises which means C and Ip fall causing AD to decreaseMovements along the curves!PriceLevelReal GDPASADExcess SupplyB140614E10010F80Excess DemandThe is a lot more complicated than the basic AE model presented in chapters 10 and 11 where only Y fell as inventories decreased. Here, Y, P , money demand, the interest rate(r) and AE all adjust.
39 What Happens When Things Change? Demand shockthis is any event that causes the AD curve to shiftfor example, a change in government purchases or a change in the money supplySupply shockan event that causes the AS curve to shifte.g., increase or decrease in world oil price, regulation, nominal wages.
40 The Effect of a Demand Shock: Increase G Starting at point E, an increase in government purchases would shift the AD curve rightward to AD2Relate back to the Keynesian 450 graph. Multiplier= (1/(1-MPC).PriceLevelReal GDP$ TrillionsASAD1AD2N110EJ11.510010.012.5Point J illustrates where the economy would move if the price level remained constant; multiplier = (1/(1-MPC).But, as output increases, the price level rises. Thus, the economy moves along the AS curve from point E to point N.
41 What Happens When Things Change? Increase in government purchasesCrowding-out of interest-sensitive spending. Multiplier is less than (1/(1-MPC). Inflation and rising interest rates reduce the size of the multiplier.
42 The Effect of a Demand Shock As P increases, money demand increases. If the money supply is constant, the interest rate rises and crowds-out interest sensitive investment and consumer spending. Move up along the AD curve from point J to N.Crowding-out of interest-sensitive spending means the size of the multiplier is reduced.Inflation and the increase in the interest rate reduce the size of the multiplier.
43 What Happens When Things Change? Decrease in government purchasesCrowding-in of interest-sensitive spending. Multiplier is larger than (1/(1-MPC). Falling prices and falling interest rates increase the size of the multiplier.
45 To sum up the short-run - A positive demand shockshifts the AD curve rightwardincreases both real GDP and the price level in the short runA negative demand shockshifts the AD curve leftwarddecreases both real GDP and the price level in the short run
46 Demand Shocks: Adjusting to Long Run In the short run we treat the wage rate and labor costs as givenIn the long runthe wage rate will changewhen output is above full employmentWage rate will rise, shifting the AS curve upwardwhen output is below full employmentWage rate will fall, shifting the AS curve downward
47 Demand Shocks: Adjusting to Long Run Self-correcting mechanismthe adjustment process where price and wage changes return the economy to full-employment output in the long runIf a demand shock pulls the economy away from full employmentchanges in the wages and the price level will eventually cause the economy to correct itself and return to full-employment output
48 Demand Shocks: Adjusting to Long Run Positive demand shockNOTE: Y >YFE => U <Un
49 Long-Run Adjustment after a Positive Demand Shock St point E, a positive demand shock would shift the aggregate demand curve to AD2, raising both output and the price level.In the short-run the economy moves to point N, output is above the full-employment level, YFE.Firms compete to hire scarce workers, driving up the wage rate. In the long-run the higher wage rate will shift the AS curve to AS2.The economy returns to full-employment output at point L in the long-run.PriceLevelReal GDPAS2AD2AS1LP4AD1P2NY2P1EYFE
50 Demand Shocks: Adjusting to Long Run Negative demand shockNOTE: Y <YFE => U >Un
51 Long-Run Adjustment after a Negative Demand Shock PriceLevelReal GDPAS1AD1AD2AS2EP1YFEP2NY2P3MStarting from point E, a negative demand shock shifts the AD curve to AD2, lowering GDP and the price level. In the short-run, output is below the full-employment level at point N. With unemployed labor available, wages and unit costs will fall, causing firms to lower their prices. The AS curve shifts downward until full employment is regained at point M, with a lower price level in the long-run.
52 Demand shock : The self-correcting mechanism in the long-run When output exceeds its full-employment levelWages will eventually riseCausing a rise in the price level and a drop in GDP until full employment is restoredWhen output is less than its full-employment levelWages will eventually fallCausing a drop in the price level and a rise in GDP until full employment is restored
53 Long-run Aggregate Supply Curve A vertical lineIndicating all possible output and price-level combinations at which the economy could end up in the long runThe self-correcting mechanismShows us that, in the long run, the economy will eventually behave as the classical model predicts
54 This figure illustrates a positive demand shock, but focuses on the long-run effects. The initial equilibrium is at point E, with output at full employment (YFE) and price level P1. After the positive demand shock and all the long-run adjustments to it, the economy ends up at point L with a higher price level (P4), but the same full-employment output level (YFE). The long-run AS curve—a vertical line—shows all possible combinations of price level and output for the economy, skipping over the short-run changes. The vertical, long-run AS curve shows that in the long run, demand shocks can affect the price level but not output.The Long-Run AS CurvePriceLevelReal GDPLong-Run AS CurveAS2AD2AS1LP4AD1P2NY2P1EYFE
55 Supply Shocks Negative supply shock. In the short run the AS curve shifts upwardDecreasing output and increasing the price levelcauses stagflation (falling output and rising prices)Positive supply shock. In the short runthe AS curve shifts downwardIncreasing output and decreasing the price level
56 The Effect of a Negative Supply Shock PriceLevelReal GDPYFELong-Run AS CurveA negative supply shock would shift the AS curve upward from AS1 to AS2.In the short-run, equilibrium is at point R, the price level is higher and output (Y2) is below YFE.Eventually, wages will fall, causing unit costs to fall, and the AS curve will shift back down to its original position.AS1AS2ADRP2Y2EP1
57 The Effect of a Positive Supply Shock PriceLevelReal GDPYFELong-Run AS CurveA positive supply shock would shift the AS curve down from AS1 to AS2. In the short-run equilibrium at point R, the price level is lower and output is above YFE.Eventually, wages will rise, causing unit costs to rise, and the AS curve will shift back up to its original position.AS1ADAS2EP1RP2Y2
58 Supply Shocks In the long run The economy self-corrects after a long-lasting supply shockWhen output differs from its full-employment levelThe wage rate changesAS curve shifts until full employment is restored
59 The Story of Two Recessions The recession ofa supply-shock recessioncaused by a reduction in oil supplyPrice of oil doubledThe recession ofa powerful, negative demand shockHome prices – fallingStock prices – plunged
60 An AD and AS Analysis of Two Recessions: 1990-91Recession PriceLevelReal GDP1. In 1990, a supply shockfrom higher oil prices shifted the AS curve leftward …AS1991AD1990P2AS1990RY2E3. and the price level to riseP1YFE2. causing output to fall…
61 An AD and AS Analysis of Two Recessions: 2008-09 Recession PriceLevelReal GDP4. In , a demand shock from several factors caused the AD curve to shift leftward …AS2007AD2007AD2009EP1YFE6. and the price level to fallP25. causing output to fall…RY2
64 The Aggregate Supply Curve is not a straight line Expansionary policy is inflationary and has small impact on aggregate output (Y)P4AD4P3AD3Expansionary policy is not inflationary and has relatively large impact on aggregate output (Y)P2P1AD2CapacityAD1[--Slack-----][--Ordinary--][--Tight--]