Economics NINTH EDITION Chapter Aggregate Demand and Aggregate Supply Prepared by Brock Williams Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved Learning Objectives 9.1 Explain the role sticky wages and prices play in economic fluctuations 9.2 List the determinants of aggregate demand 9.3 Distinguish between the short run and long run aggregate supply curves 9.4 Explain how the short-run aggregate supply curve shifts over time Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.1 STICKY PRICES AND THEIR MACROECONOMIC CONSEQUENCES Fluctuations in the economy can be seen as failures in coordination Flexible and Sticky Prices • For most firms, the biggest cost of doing business is wages If wages are sticky, firms’ overall costs will be sticky as well This means that firms’ product prices will remain sticky, too • Sticky wages cause sticky prices and hamper the economy’s ability to bring demand and supply into balance in the short run How Demand Determines Output in the Short Run • Short run in macroeconomics The period of time in which prices not change or not change very much Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved APPLICATION MEASURING PRICE STICKINESS IN CONSUMER MARKETS APPLYING THE CONCEPTS #1: What does the behavior of prices in consumer markets demonstrate about how quickly prices adjust in the U.S economy? To analyze the behavior of retail prices, economist Anil Kashyap of the University of Chicago examined prices in consumer catalogs He looked at the prices of 12 selected goods from: • • • L.L Bean Recreational Equipment, Inc (REI) The Orvis Company, Inc The goods included shoes, blankets, chamois shirts, binoculars, and a fishing rod and fly What did he find? • • • Considerable price stickiness When prices did change, he observed a mixture of both large and small changes During periods of high inflation, prices tended to change more frequently Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.2 UNDERSTANDING AGGREGATE DEMAND (1 of 10) What Is the Aggregate Demand Curve? • Aggregate demand curve (AD) A curve that shows the relationship between the level of prices and the quantity of real GDP demanded Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.2 UNDERSTANDING AGGREGATE DEMAND (2 of 10) The Components of Aggregate Demand The aggregate demand curve plots the total demand for real GDP as a function of the price level The aggregate demand curve slopes downward, indicating that the quantity of aggregate demand increases as the price level in the economy falls Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.2 UNDERSTANDING AGGREGATE DEMAND (3 of 10) Why the Aggregate Demand Curve Slopes Downward REAL-NOMINAL PRINCIPLE What matters to people is the real value of money or income—its purchasing power—not the face value of money or income As the purchasing power of money changes, the aggregate demand curve is affected in three different ways: THE WEALTH EFFECT • Wealth effect The increase in spending that occurs because the real value of money increases when the price level falls Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.2 UNDERSTANDING AGGREGATE DEMAND (4 of 10) Why the Aggregate Demand Curve Slopes Downward THE INTEREST RATE EFFECT With a given supply of money in the economy, a lower price level will lead to lower interest rates With lower interest rates, both consumers and firms will find it cheaper to borrow money to make purchases As a consequence, the demand for goods in the economy (consumer durables purchased by households and investment goods purchased by firms) will increase THE INTERNATIONAL TRADE EFFECT In an open economy, a lower price level will mean that domestic goods (goods produced in the home country) become cheaper relative to foreign goods, so the demand for domestic goods will increase Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.2 UNDERSTANDING AGGREGATE DEMAND (5 of 10) Shifts in the Aggregate Demand Curve CHANGES IN THE SUPPLY OF MONEY An increase in the supply of money in the economy will increase aggregate demand and shift the aggregate demand curve to the right CHANGES IN TAXES A decrease in taxes will increase aggregate demand and shift the aggregate demand curve to the right CHANGES IN GOVERNMENT SPENDING At any given price level, an increase in government spending will increase aggregate demand and shift the aggregate demand curve to the right Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.2 UNDERSTANDING AGGREGATE DEMAND (6 of 10) Shifts in the Aggregate Demand Curve ALL OTHER CHANGES IN DEMAND Decreases in taxes, increases in government spending, and an increase in the supply of money all shift the aggregate demand curve to the right Higher taxes, lower government spending, and a lower supply of money shift the curve to the left Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.2 UNDERSTANDING AGGREGATE DEMAND (9 of 10) How the Multiplier Makes the Shift Bigger • Autonomous consumption spending The part of consumption spending that does not depend on income • Marginal propensity to consume (MPC) The fraction of additional income that is spent • Marginal propensity to save (MPS) The fraction of additional income that is saved Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.2 UNDERSTANDING AGGREGATE DEMAND (10 of 10) How the Multiplier Makes the Shift Bigger Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved APPLICATION TWO APPROACHES TO DETERMINING THE CAUSES OF RECESSIONS APPLYING THE CONCEPTS #2: How can we determine what factors cause recessions? Economists have used the basic framework of aggregate demand and supply analysis to explain recessions Recessions can occur either when there is a sharp decrease in demand or a decrease in aggregate supply Economic historian Peter Temin looked at all recessions from 1893 to 1990 to determine their causes He found, recessions were caused by many different factors • Sometimes, as in 1929, they were caused by shifts in aggregate demand from the private sector, as consumers cut back their spending • Other times, as in 1981, the government cut back on aggregate demand to reduce inflation • Supply shocks were the cause of the recessions in 1973 and 1979 • The most severe shock hit the U.S economy in 1931 and converted an economic downturn into the Great Depression He believes that foreign monetary developments were the ultimate source of this shock to the U.S economy Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.3 UNDERSTANDING AGGREGATE SUPPLY (1 of 7) • Aggregate supply curve (AS) A curve that shows the relationship between the level of prices and the quantity of output supplied The Long-Run Aggregate Supply Curve • Long-run aggregate supply curve A vertical aggregate supply curve that represents the idea that in the long run, output is determined solely by the factors of production Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.3 UNDERSTANDING AGGREGATE SUPPLY (2 of 7) The Long-Run Aggregate Supply Curve In the long run, the level of output, yp, is independent of the price level Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.3 UNDERSTANDING AGGREGATE SUPPLY (3 of 7) The Long-Run Aggregate Supply Curve DETERMINING OUTPUT AND THE PRICE LEVEL Output and prices are determined at the intersection of AD and AS An increase in aggregate demand leads to a higher price level Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.3 UNDERSTANDING AGGREGATE SUPPLY (4 of 7) The Short-Run Aggregate Supply Curve • Short-run aggregate supply curve A relatively flat aggregate supply curve that represents the idea that prices not change very much in the short run and that firms adjust production to meet demand Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.3 UNDERSTANDING AGGREGATE SUPPLY (5 of 7) The Short-Run Aggregate Supply Curve With a short-run aggregate supply curve, shifts in aggregate demand lead to large changes in output but small changes in price Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.3 UNDERSTANDING AGGREGATE SUPPLY (6 of 7) The Short-Run Aggregate Supply Curve What factors determine the costs firms must incur to produce output? The key factors are • Input prices (wages and materials) • The state of technology • Taxes, subsidies, or economic regulations Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.3 UNDERSTANDING AGGREGATE SUPPLY (7 of 7) Supply Shocks • Supply shocks External events that shift the aggregate supply curve An adverse supply shock, such as an increase in the price of oil, will cause the AS curve to shift upward The result will be higher prices and a lower level of output • Stagflation A decrease in real output with increasing prices Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved APPLICATION OIL PRICE DECLINES AND THE U.S ECONOMY • APPLYING THE CONCEPTS #3: Do declines in oil prices always help the U.S Economy? • Economists have generally believed that falling oil prices will benefit the U.S economy and lead to higher economic growth • Falling oil prices should lead to falling gasoline and heating oil prices and put more money in the pockets of consumers that will lead to increases in aggregate demand • Since fuel is an input into production, lower oil prices may also increase aggregate supply • But the decrease in oil prices in 2014 and 2015 have had only a modest effect on economic growth • Consumers appeared to have used the extra money to reduce overall debt instead of other consumption • Lower oil prices reduce the incentive for firms to produce energy and invest in new capital and equipment Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.4 FROM THE SHORT RUN TO THE LONG RUN (1 of 3) In the short run, the economy produces at y0, which exceeds potential output yp Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.4 FROM THE SHORT RUN TO THE LONG RUN (2 of 3) With output exceeding potential, the shortrun AS curve shifts upward over time The economy adjusts to the long-run equilibrium at a1 Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.4 FROM THE SHORT RUN TO THE LONG RUN (3 of 3) Looking Ahead • The aggregate demand and aggregate supply model in this chapter provides an overview of how demand affects output and prices in both the short run and the long run • The next several chapters explore more closely how aggregate demand determines output in the short run Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved KEY TERMS Aggregate demand curve (AD) Aggregate supply curve (AS) Autonomous consumption spending Consumption function Long-run aggregate supply curve Marginal propensity to consume (MPC) Marginal propensity to save (MPS) Multiplier Short-run aggregate supply curve Short run in macroeconomics Stagflation Supply shocks Wealth effect Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved ... aggregate demand and aggregate supply model in this chapter provides an overview of how demand affects output and prices in both the short run and the long run • The next several chapters explore... increase aggregate demand and shift the aggregate demand curve to the right CHANGES IN TAXES A decrease in taxes will increase aggregate demand and shift the aggregate demand curve to the right... real GDP demanded Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 9.2 UNDERSTANDING AGGREGATE DEMAND (2 of 10) The Components of Aggregate Demand The aggregate demand curve