Chapter 24 - Aggregate demand, aggregate supply, and business cycles. In this chapter you will learn: Define the aggregate demand curve, explain why it slopes downward, and explain why it shifts; define the aggregate supply curve, explain why it slopes upward, and explain why it shifts; show how the aggregate demand and supply curves determine output and the price level in both the short run and the long run;...
Aggregate Demand, Aggregate Supply, and Business Cycles Chapter 24 McGrawHill/Irwin Copyright © 2015 by McGrawHill Education (Asia). All rights reserved 241 Learning Objectives Define the aggregate demand curve, explain why it slopes downward, and explain why it shifts Define the aggregate supply curve, explain why it slopes upward, and explain why it shifts Show how the aggregate demand curve and aggregate supply curve determine output and the inflation rate over the business cycle Analyze how the economy adjusts to expansionary and recessionary gaps, and relate this to the concept of a self-correcting economy 242 The Great Recession in U.S • • • Began December 2007 Most lengthy and severe recession since the great depression Causes: Large housing price bubble burst in July 2006 – • 30% decline in housing prices over next 18 months Financial panic in the fall of 2008 – • Difficult to borrow Oil price shock – • Gas hit $4 per gallon in July 2008 243 Aggregate Demand and Aggregate Supply • • • • • Analyze fluctuations in both output and the inflation rate – Short run and long run analysis Inflation rate and output on the axis AD shows the relationship between planned spending and the inflation rate Aggregat AS shows how output e produced by firms depends Supply (AS) on the inflation rate Aggregate Demand (AD) Potential output is shown Y* to measure output gaps Output Y 244 Long-Run Equilibrium • • In the long run, – Actual output equals potential output – Actual inflation rate equals expected price level Long-run equilibrium occurs at the intersection of – Aggregate demand – Aggregate supply and Aggrega te – Potential output Supply Y* (AS) Aggregate Demand (AD) Output Y 245 Short-Run Equilibrium • Short-run equilibrium occurs when the AD and AS curves intersect at a level of output different from Y* – • • • Point A in the graph Short-run equilibrium is temporary Caused by a shift in either AD or AS AS P1 A AD Y* Y Output Y 246 The Aggregate Demand Curve • The aggregate demand curve shows the amount of output consumers, firms, government, and customers abroad want to purchase at each inflation rate – – – All else the same Slopes downwards A higher inflation rate reduces planned aggregate expenditure which reduces output via the multiplier effect 247 Shifts in the Aggregate Demand Curve • • • A shift of the aggregate demand curve is called a change in aggregate demand At the given inflation rate, something causes output to rise (an increase in aggregate demand) or fall (a decrease in aggregate demand) Two main causes: – – Demand shocks Stabilization policy 248 Shifts in the Aggregate Demand Curve • Demand shocks are changes in planned spending not caused by a change in output or a change in the inflation rate Consumer confidence – Consumer wealth – Business confidence – Opportunities for firms to purchase new – technologies – Foreign demand for domestic goods AD AD' Output (Y) 249 Shifts in the Aggregate Demand Curve • • Stabilization policies are government policies used to affect planned aggregate expenditure and eliminate output gaps Fiscal policy Change in government spending or taxes – • Monetary policy Change in the nominal money supply which – changes the interest rate AD AD' Output (Y) 2410 The Output Gap and Inflation Relationship of Output to Potential Output Behavior of Inflation Expansionary gap Y > Y* Inflation increases No output gap Y = Y* Inflation is stable Recessionary gap Y < Y* Inflation decreases 2417 The Aggregate Supply Curve Current inflation ( ) = expected inflation ( e) + inflation from an output gap • • • • If the economy is operating at potential output, then Aggregate = e = at A Supply (AS) If the economy has an B inflationary gap, Y > Y* A and > e at B C If the economy has an expansionary gap, Y2Y* Y1 Output (Y) Y < Y* and < e at C The AS curve slopes up Inflation ( ) • 2418 Shifts in the AS Curve • • • • A change in aggregate supply is a shift of the aggregate supply curve An increase in aggregate supply is a rightward shift of the curve A decrease in aggregate supply is a leftward AS2 shift of the curve AS1 Three main causes – Changes in available resources and technology – Changes in inflation expectations – Inflation shock Y* Output Y 2419 Shifts in the AS Curve • • • • Increasing available resources and technology will shift the AS curve to the right Supply more output without having to increase price Hire more labor, capital, AS1 or natural resources AS2 Use existing labor and machines more efficiently Y1 Y2 Output Y 2420 Inflation Expectations If actual inflation exceeds expectations, expected inflation increases – – AS curve shifts to the left At each level of output, inflation is higher AS2 Inflation ( ) • AS1 Y* Output (Y) 2421 Inflation Shock • An inflation shock is a sudden change in the normal behavior of inflation – • A sudden rise in the price of oil increases prices of – – – • A shock is not related to an output gap Gasoline, diesel fuel, jet fuel, heating oil Goods made with oil (synthetic rubber, plastics, etc.) Transportation of most goods OPEC reduced supplies in 1973; price of oil quadrupled in the United States – – Food shortages occurred at the same time Sharp increase in inflation in 1974 2422 Inflation Shocks • An adverse inflation shock shifts the aggregate supply curve to the left – – • Increases inflation at each output level Oil price increases in 1973 A favorable inflation shock shifts the aggregate supply curve to the right – – Lower inflation at each output level Oil price decrease in 1986 2423 Understanding Business Cycles • The economy is in long run equilibrium at P1 and Y* – Aggregate demand shifts from AD1 to AD2 Positive demand shock • Increase in government spending • • AS1 Decrease in taxes Expansionary gap – The dot-com bubble from 1995 – 2000 – AD Y* AD Y Output (Y) 2424 Understanding Business Cycles • The economy is in long run equilibrium at P1 and Y* – Aggregate demand shifts from AD1 to AD2 Negative demand shock • Decrease in government spending • • – – AS1 Increase in taxes Recessionary gap The great recession Y Y* AD AD Output (Y) 2425 Understanding Business Cycles • The economy is in long run equilibrium at P1 and Y* – • AS shifts from AS1 to AS2 Negative supply shock Oil price shock – 1973-4 price of oil tripled – 1979 price of oil doubled – 2007-2008 price of oil doubled – • Recessionary gap AS2 AS1 A AD Y Y* Output Y 2426 An Expansionary Gap AS2 AS1 A AD Y* Y Output Y 2427 Adjustment from an Expansionary Gap • When output is above potential output, firms increase prices faster than the expected rate of inflation – – – – – • Causes inflation to increase above expected level As inflation rises, the Fed increases interest rates Consumption and planned investment spending decrease Planned aggregate expenditures decrease Output decreases This process continues until the economy reaches equilibrium at the potential level of output – Actual inflation is higher than initial level of inflation 2428 A Recessionary Gap • AS1 A AS2 AD Y1 Y* Output Y 2429 Self-Correcting Economy • • • In the long-run the economy tends to be selfcorrecting – Missing from Keynesian model – Keynesian model is short-run; no price adjustments Given time, output gaps disappear without any changes in monetary or fiscal policy Whether stabilization policies are needed depends on the speed of the self-correction process – If the economy returns to potential output quickly, stabilization policies may be destabilizing – The greater the gap, the longer the adjustment period 2430 Self-Correcting Economy • A slow self-correcting mechanism – • A fast self-correcting mechanism – • Fiscal and monetary policy can help stabilize the economy Fiscal and monetary policy are not effective and may destabilize the economy The speed of correction will depend on • • – The use of long-term contracts The efficiency and flexibility of labor markets Fiscal and monetary policy are most useful when attempting to eliminate large output gaps 2431 ... high 24 15 • The Role of Long-Term Contracts Long-term contracts reduce the cost of negotiations between buyers and sellers – – – • • Cost - Benefit Principle Labor contracts may be multi-year... potential level of output – Actual inflation is higher than initial level of inflation 24 28 A Recessionary Gap • AS1 A AS2 AD Y1 Y* Output Y 24 29 Self-Correcting Economy • • • In the long-run the... tripled – 1979 price of oil doubled – 200 7-2 008 price of oil doubled – • Recessionary gap AS2 AS1 A AD Y Y* Output Y 24 26 An Expansionary Gap AS2 AS1 A AD Y* Y Output Y 24 27 Adjustment from