1. © 2005 Thomson C hapter 4 Aggregate Demand and Aggregate Supply

2. © 2005 Thomson 2 Gottheil - Principles of Economics, 4e Economic Principles The phases of the business cycle Gross Domestic Product (GDP) The CPI and GDP deflator Nominal and real GDP Aggregate demand and aggregate supply Macroeconomic equilibrium Demand-pull and cost-push inflation

3. © 2005 Thomson 3 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Recession A phase in the business cycle in which the decline in the economy’s real GDP persists for at least a half-year. A recession is marked by relatively high unemployment. Depression Severe recession.

4. © 2005 Thomson 4 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Prosperity A phase in the business cycle marked by a relatively high level of real GDP, full employment, and inflation.

5. © 2005 Thomson 5 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Business cycle Alternating periods of growth and decline in an economy’s GDP. No two business cycles are identical. The number of months in any given phase of the cycle varies from cycle to cycle.

6. © 2005 Thomson 6 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Trough The bottom of a business cycle. This is the time period when the economy’s unemployment rate is greatest and output declines to the cycle’s minimum level.

7. © 2005 Thomson 7 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Recovery A phase in the business cycle, following a recession, in which real GDP increases and unemployment declines.

8. © 2005 Thomson 8 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Peak The top of a business cycle. This is the time period when output reaches its maximum level, the labor force is fully employed, and increasing pressure on prices is likely to generate inflation.

9. © 2005 Thomson 9 Gottheil - Principles of Economics, 4e Why Recession? Why Prosperity? Downturn A phase in the business cycle in which real GDP declines, inflation moderates, and unemployment emerges.

10. © 2005 Thomson 10 Gottheil - Principles of Economics, 4e EXHIBIT 1THE BUSINESS CYCLE

11. © 2005 Thomson 11 Gottheil - Principles of Economics, 4e Measuring the National Economy Total value of all final goods and services, measured in current market prices, produced in the economy during a year. Final goods and services refers to everything produced that is not itself used to produce other goods and services During a given year refers to a specific calendar year. Produced in the economy refers to any good or service produced in the United States, regardless of whether a US-owned or a foreign-owned company is producing. Gross Domestic Product (GDP)

12. © 2005 Thomson 12 Gottheil - Principles of Economics, 4e Measuring the National Economy To compare GDP across years, we must devise some way of eliminating the effect of inflation.

13. © 2005 Thomson 13 Gottheil - Principles of Economics, 4e Measuring the National Economy Nominal GDP GDP measured in terms of current market prices—that is, the price level at the time of measurement. (It is not adjusted for inflation.) Real GDP GDP adjusted for changes in the price level.

14. © 2005 Thomson 14 Gottheil - Principles of Economics, 4e Measuring the National Economy Price indices are designed to remove the effect of price changes. The consumer price index and the GDP deflator are the two indices most commonly used.

15. © 2005 Thomson 15 Gottheil - Principles of Economics, 4e Measuring the National Economy Consumer Price Index (CPI) A measure comparing the prices of consumer goods and services that a household typically purchases to the prices of those goods and services purchased in a base year.

16. © 2005 Thomson 16 Gottheil - Principles of Economics, 4e Measuring the National Economy Price level A measure of prices in one year expressed in relation to prices in a base year.

17. © 2005 Thomson 17 Gottheil - Principles of Economics, 4e Measuring the National Economy Example: Suppose in 1998 (the base year) a basket of goods including such things as food, clothing, and fuel cost $350. The $350 converts to a price level index of 100, P = 100. Suppose in the next year, 1999, the same basket of goods cost $385. The 1999 CPI, measured against the 1998 base year of 100, is 110. P = ($385/$350) × 100 = 110.

18. © 2005 Thomson 18 Gottheil - Principles of Economics, 4e Measuring the National Economy Example: A 1999 P = 110 indicates that from 1998 to 1999 the cost of goods and services that consumers typically buy increased by 10 percent.

19. © 2005 Thomson 19 Gottheil - Principles of Economics, 4e Measuring the National Economy GDP deflator A measure comparing the prices of all goods and services produced in the economy during a given year to the prices of those goods and services purchased in a base year. This price index includes not only consumer goods and services, but also producer goods, investment goods, exports and imports, and goods and services purchased by government.

20. © 2005 Thomson 20 Gottheil - Principles of Economics, 4e EXHIBIT 2CONVERTING NOMINAL GDP TO REAL GDP: 1995–2002 ($ BILLIONS, 1996 = 100) Source: U.S. Department of Commerce, Bureau of Economic Analysis.

21. © 2005 Thomson 21 Gottheil - Principles of Economics, 4e Deriving Equilibrium GDP in the Aggregate Demand and Supply Model The aggregate demand and aggregate supply model is one model used to explain how GDP is determined.

22. © 2005 Thomson 22 Gottheil - Principles of Economics, 4e Deriving Equilibrium GDP in the Aggregate Demand and Supply Model Aggregate supply The total quantity of goods and services that firms in the economy are willing to supply at varying price levels.

23. © 2005 Thomson 23 Gottheil - Principles of Economics, 4e Deriving Equilibrium GDP in the Aggregate Demand and Supply Model There are three distinct segments of the aggregate supply curve: 1.Horizontal segment. Real GDP increases without affecting the economy’s price level. 2.Upward-sloping segment. A positive relationship between real GDP and price level. 3.Vertical segment. All resources are fully employed, so that real GDP cannot increase.

24. © 2005 Thomson 24 Gottheil - Principles of Economics, 4e Deriving Equilibrium GDP in the Aggregate Demand and Supply Model Aggregate demand The total quantity of goods and services demanded by households, firms, foreigners, and government at varying price levels. Increases in the price level affect people’s real wealth, their lending and borrowing activity, and the nation’s trade with other nations. The quantity of goods and services demanded in the economy declines when price levels increase.

25. © 2005 Thomson 25 Gottheil - Principles of Economics, 4e EXHIBIT 3AGGREGATE SUPPLY AND AGGREGATE DEMAND

26. © 2005 Thomson 26 Gottheil - Principles of Economics, 4e Deriving Equilibrium GDP in the Aggregate Demand and Supply Model The aggregate demand curve shifts when there is a change in the quantity of goods and services demanded at a particular price level. Government spending, income levels, and expectations about the future are all factors that can cause the curve to shift.

27. © 2005 Thomson 27 Gottheil - Principles of Economics, 4e Deriving Equilibrium GDP in the Aggregate Demand and Supply Model The aggregate supply curve shifts due to factors such as changes in resource availability and resource prices.

28. © 2005 Thomson 28 Gottheil - Principles of Economics, 4e EXHIBIT 4SHIFTS IN AGGREGATE DEMAND AND AGGREGATE SUPPLY

29. © 2005 Thomson 29 Gottheil - Principles of Economics, 4e Exhibit 4: Shifts in Aggregate Demand and Aggregate Supply What might cause the aggregate demand curve in panel a of Exhibit 4 to shift to the right? Increases in government spending, increases in incomes, and optimistic expectations could all cause the aggregate demand curve to shift to the right.

30. © 2005 Thomson 30 Gottheil - Principles of Economics, 4e Macroeconomic Equilibrium Macroequilibrium The level of real GDP and the price level that equate the aggregate quantity demanded and the aggregate quantity supplied.

31. © 2005 Thomson 31 Gottheil - Principles of Economics, 4e Exhibit 5: Achieving Macroeconomic Equilibrium 1. At what price level and real GDP is macroequilibrium achieved in Exhibit 5? Macroequilibrium is achieved at P = 101.95 and real GDP = $8.1595 trillion.

32. © 2005 Thomson 32 Gottheil - Principles of Economics, 4e Exhibit 5: Achieving Macroeconomic Equilibrium 2. What happens when the price level increases to P = 110? At P = 110, the aggregate quantity demanded falls to $5 trillion and the aggregate quantity supplied increases to $9 trillion.

33. © 2005 Thomson 33 Gottheil - Principles of Economics, 4e Time Line on Equilibrium, Inflation, and Unemployment The U.S. commitment to support England during World War II changed the pace and direction of our national economy significantly.

34. © 2005 Thomson 34 Gottheil - Principles of Economics, 4e Time Line on Equilibrium, Inflation, and Unemployment Demand-pull inflation Inflation caused primarily by an increase in aggregate demand (such as during wars when government spending increases).

35. © 2005 Thomson 35 Gottheil - Principles of Economics, 4e Equilibrium, Inflation, and Unemployment Stagflation A period of stagnating real GDP, rapid inflation, and relatively high levels of unemployment (oil crisis in the 1970s).

36. © 2005 Thomson 36 Gottheil - Principles of Economics, 4e Time Line on Equilibrium, Inflation, and Unemployment Cost-push inflation Inflation caused primarily by a decrease in aggregate supply.

37. © 2005 Thomson 37 Gottheil - Principles of Economics, 4e Time Line on Equilibrium, Inflation, and Unemployment During the second half of the 1980s, the economy was performing about as well as it ever had in the last quarter century. Tax reforms, ready credit, leveraged buyouts, a commercial real estate boom, and optimistic expectations contributed to the already strong aggregate demand.

38. © 2005 Thomson 38 Gottheil - Principles of Economics, 4e Time Line on Equilibrium, Inflation, and Unemployment The recession of 1990-91 was caused by an inward shift in aggregate demand. Reduced federal revenue sharing with states, downsized government budgets, cuts in demand for military goods, and high levels of debt acquired during the 1980s are all to blame.

39. © 2005 Thomson 39 Gottheil - Principles of Economics, 4e The Longest Prosperity Phase: 1992-2000 (Clinton years) Economists attribute the boom to supply-side factors: A rise in the nation’s productivity caused by the diffusion of computer technology throughout the economy. The absence of rising inflation.

40. © 2005 Thomson 40 Gottheil - Principles of Economics, 4e The 2001-02 Recession and 9/11 The 1992-2000 buying spree left consumers without the means to keep the spree alive. Terrorist attacks created a heightened sense of economic uncertainty.

41. © 2005 Thomson 41 Gottheil - Principles of Economics, 4e Can We Avoid Unemployment and Inflation? Although the desired macroequilibrium outcome would occur at a real GDP level consistent with full employment and no inflation, this level is not always achieved.

42. © 2005 Thomson 42 Gottheil - Principles of Economics, 4e Can We Avoid Unemployment and Inflation? Some economists believe government should act in ways to help shift macroequilibrium to this position.

43. © 2005 Thomson 43 Gottheil - Principles of Economics, 4e Can We Avoid Unemployment and Inflation? Increasing or decreasing government spending and income taxes are two methods government can use to attempt to shift the aggregate demand curve.

44. © 2005 Thomson 44 Gottheil - Principles of Economics, 4e EXHIBIT 7OBTAINING FULL-EMPLOYMENT GDP WITHOUT INFLATION

45. © 2005 Thomson 45 Gottheil - Principles of Economics, 4e Exhibit 7: Obtaining Full-Employment GDP Without Inflation How might government shift the aggregate demand curve from AD to AD′ in Exhibit 7? Government could increase spending and reduce income taxes in order to shift the demand curve to the right.