Lecture Principles of economics (Brief edition, 2e): Chapter 20 - Robert H. Frank, Ben S. Bernanke

Chapter 20 - Aggregate demand, aggregate supply, and stabilization policy. 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;...

Chapter 20: Aggregate Demand, Aggregate Supply, and Stabilization Policy 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 Analyze how the economy adjusts to expansionary and recessionary gaps, and relate this to the concept of a self-correcting economy Explain how stabilization policy can be used to close output gaps McGraw­Hill/Irwin         Copyright © 2011 by The McGraw­Hill Companies, Inc. All rights reserved Aggregate Demand and Aggregate Supply Price level P • Analyze fluctuations in both output and the price level – Short run and long run analysis • Price level and output on the axis • AD shows the relationship between planned spending and the price level Aggregate • AS shows how output Supply (AS) produced by firms depends Aggregate on the price level Demand (AD) • Potential output is shown Y* Output Y to measure output gaps 20­2 Long-Run Equilibrium Price level P • In the long run, – Actual output equals potential output – Actual price level equals expected price level • Long-run equilibrium occurs at the intersection of – Aggregate demand Aggregate Supply AS – Aggregate supply and – Potential output Aggregate Demand AD Y* Output Y 20­3 Short-Run Equilibrium • Short-run equilibrium occurs when the AD and AS curves intersect at a level of output different from Y* • Short-run equilibrium is temporary • Caused by a shift in • either AD or AS Price level P – Point A in the graph AS P1 A AD Y* Y1 Output Y 20­4 The Aggregate Demand Curve • The aggregate demand curve shows the amount of output consumers, firms, government, and customers abroad want to purchase at each price level – All else the same – Slopes downwards – A higher price level reduces planned aggregate expenditure which reduces output via the multiplier effect 20­5 The Aggregate Demand Curve Price level P • An increase in the price level reduces planned aggregate expenditure for three reasons: – The wealth effect – The interest rate effect – The exchange rate effect • According to the wealth effect a higher price level reduces the real value of assets – Financial assets AD – Durable assets like houses Output Y 20­6 The Aggregate Demand Curve • According to the interest rate effect a higher price level causes – An increase in money demand – An increase in the interest rate given money supply is fixed – A decrease in planned consumption and planned investment 20­7 The Aggregate Demand Curve • According to the exchange rate effect a higher price level causes – Higher interest rates which make our financial assets more attractive – An increase in the demand for dollars – An increase in the value of the dollar – A decrease in net exports 20­8 Shifts in the Aggregate Demand Curve • A shift of the aggregate demand curve is called a change in aggregate demand • At the given price level, something causes output to rise (an increase in aggregate demand) or fall (a decrease in aggregate demand) • Two main causes: – Demand shocks – Stabilization policy 20­9 Shifts in the Aggregate Demand Curve – – – – Consumer confidence Consumer wealth Business confidence Opportunities for firms to purchase new technologies – Foreign demand for US goods Price level P • Demand shocks are changes in planned spending not caused by a change in output or a change in price level AD AD' Output (Y) 20­10 Shifts in the Aggregate Demand Curve – Change in government spending or taxes • Monetary policy – Change in the nominal money supply which changes the interest rate Price level P • Stabilization policies are government policies used to affect planned aggregate expenditure and eliminate output gaps • Fiscal policy AD AD' Output (Y) 20­11 The Aggregate Supply Curve • The aggregate supply curve (AS) shows the relationship between the amount of output firms want to produce and the price level – Holds all other factors constant • The aggregate supply curve is upward sloping – An increase in aggregate demand will increase the willingness to supply and increase the price level • In past chapters firms met demand at present prices – Holds in the very short run – Not possible to indefinitely hold price constant and increase output 20­12 The Aggregate Supply Curve Price level P • The expected price level is the price level that is expected to prevail when the economy is producing at potential output • This is point A • Firms sell the usual amount Aggregate Supply (AS) • An increase in aggregate B P2 demand will move the A P e economy to point B • The AS curve is upward P3 C sloping Y2 Y* Y1 Output Y 20­13 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 AS supply is a leftward AS shift of the curve P • Three main causes Price level P 1 Y* Output Y 20­14 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, AS or natural resources AS • Use existing labor and P machines more efficiently Price level P Y1 Y2 Output Y 20­15 Shifts in the AS Curve • An increase in the expected price level shifts the AS curve upwards • To maintain profit, increase price • An increase in the AS expected price level AS will increase costs P in the future Price level P e Pe1 Y1 Output Y 20­16 Shifts in the AS Curve • A price shock is a change in an input price that is not caused by a change in output or the price level • Negative price shock : AS shifts left • Positive price shock : AS shifts right • A sudden rise in the price of oil increases prices of – Gasoline, diesel fuel, jet fuel, heating oil – Goods made with oil (synthetic rubber, plastics, etc.) • OPEC reduced supplies in 1973; price of oil quadrupled – Food shortages occurred at the same time – Sharp increase in inflation in 1974 20­17 Understanding Business Cycles • The economy is in long run equilibrium at P1 and Y* • Positive demand shock • Increase in government spending • Decrease in taxes – Expansionary gap – The dot-com bubble from 1995 – 2000 Price level P – Aggregate demand shifts from AD1 to AD2 AS1 P2 P1 AD2 AD1 Y* Y2 Output (Y) 20­18 Understanding Business Cycles • The economy is in long run equilibrium at P1 and Y* – Aggregate demand shifts from AD1 to AD2 • Increase in taxes – Recessionary gap – The great recession AS1 Price level P • Negative demand shock • Decrease in government spending P1 P2 AD1 AD2 Y2 Y* Output (Y) 20­19 Understanding Business Cycles • The economy is in long run equilibrium at P1 and Y* – AS shifts from AS1 to AS2 – – – – Oil price shock 1973-4 price of oil tripled 1979 price of oil doubled 2007-2008 price of oil doubled • Recessionary gap Price level (P) • Negative supply shock AS2 AS1 P2 P1 A AD Y2 Y* Output Y 20­20 An Expansionary Gap Price level P • Initial short-run equilibrium at A – AD is stable as long as there is no change in government policy or exogenous spending • Price level is below the expected price level AS2 • Firms are charging less and AS1 selling more than planned Pe – Raise nominal prices P1 A – Shifts AS curve to AS2 AD – Output is at potential, Y* Y* Y1 Output Y 20­21 A Recessionary Gap Price level P • Initial equilibrium is at A – AD curve remains stable unless government policy or exogenous spending changes • Price level is higher than AS1 the expected price level AS2 A – Firms are charging more P1 and selling less than Pe planned AD – Aggregate supply shifts to AS2 Y1 Y* Output Y • Long-run equilibrium 20­22 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 20­23 ... doubled 200 7 -2 00 8 price of oil doubled • Recessionary gap Price level (P) • Negative supply shock AS2 AS1 P2 P1 A AD Y2 Y* Output Y 20 20 An Expansionary Gap Price level P • Initial short-run equilibrium... Output Y • Long-run equilibrium 20 22 Self-Correcting Economy • In the long-run the economy tends to be selfcorrecting – Missing from Keynesian model – Keynesian model is short-run; no price... at the intersection of – Aggregate demand Aggregate Supply AS – Aggregate supply and – Potential output Aggregate Demand AD Y* Output Y 20 3 Short-Run Equilibrium • Short-run equilibrium occurs