Chapter 28 - Aggregate demand and aggregate supply. After studying this chapter you will be able to understand: What the components of aggregate demand (AD) are and why the AD curve slopes downward? What the components of aggregate supply (AS) are and why the AS curve slopes upward? What factors shift AD and AS? What differences exist between the short and long run?
Chapter28 AggregateDemandandAggregateSupply â2014byMcGrawHillEducation Whatwillyoulearninthischapter? ã Whatthecomponentsofaggregatedemand(AD) areandwhytheADcurveslopesdownward ã Whatthecomponentsofaggregatesupply(AS) are and why the AS curve slopes upward. • What factors shift AD and AS • What differences exist between the short and long run • What the short‐ and long‐run effects of shifts in AD and AS are • What policy options are available to counteract shocks © 2014 by McGraw‐Hill Education Tying it all together • The last three chapters have focused separately on three features of the economy: Output (GDP) Prices Unemployment • These factors do not fluctuate independently • A demand and supply model for the macroeconomy would be useful • The model of aggregate demand and aggregate supply shows how output, prices, and employment are all tied together as part of a single economic equilibrium © 2014 by McGraw‐Hill Education Aggregate demand • Aggregate demand is equal to GDP, or AD = GDP = C + I + G + NX • The aggregate demand curve shows the relationship between the overall price level in the economy and output Price level …increases the amount of goods and services demanded P1 A decrease in the price level… P2 • We are interested in what happens when the prices of all goods go up or down • Price changes are measured by the price index or inflation Aggregate demand Y1 Y2 Output © 2014 by McGraw‐Hill Education Why does the AD curve slope downward? • Why the AD curve slopes downward is due to each component of AD Consumption (C): • As prices rise, people reduce consumption because their real wealth decreases – This is called the wealth effect Investment (I): • As prices rise, interest rates rise • This causes borrowing to decrease and results in a decrease in investment spending © 2014 by McGraw‐Hill Education Why does the AD curve slope downward? Government spending (G): • Most government spending is independent of the price level • Government spending does not contribute to a downward sloping AD Net exports (NX): • When U.S. prices increase, U.S. goods become relatively more expensive compared to other countries’ goods • Imports increase and exports decrease • As price levels increase, net exports decrease © 2014 by McGraw‐Hill Education Why does the AD curve slope downward? • There is a negative relationship between the price level and three of the national expenditure components: Consumption – negative relationship Investment – negative relationship Government spending – no relationship Netexports negativerelationship ã Thiscausesanegativerelationshipbetweenthe pricelevelandaggregateexpenditures â2014byMcGrawHillEducation Shiftingtheaggregatedemandcurve Theentireaggregatedemandcurvecanalsoshiftinresponsetonon price changes in any of the four components of aggregate demand A rightward shift of aggregate demand A leftward shift of aggregate demand Price level Price level AD1 AD2 AD AD2 Output Output • When a non‐price factor increases a component of AD, the entire AD curve shifts to the right • GDPishigher ateverypricelevel ã Whenanonpricefactordecreasesa componentofAD,theentireAD curveshiftstotheleft ã GDPislowerateverypricelevel â2014byMcGrawHillEducation Shifting the aggregate demand curve The main non‐price factors are as follows: Category Consumption Investment Government spending Net exports Increase (shift right) Decrease (shift left) • High expectations about future income increase consumer spending • Tax cuts increase consumer spending • Low expectations about future income lead to greater saving and less spending • Higher interest rates discourage borrowing • Confidence in the future of the economy leads firms to expand their businesses • A tax credit for small businesses inspires firms to buy new company cars • Firms cut back on spending in order to weather a recession • Taxes on capital increase, leaving less money for investment. • Increase in government spending spurs spending after a recession • Decrease in government spending in response to concerns about increasing debt leads to less spending • A new free trade agreement with Europe reduces most tariffs and other restrictions on U.S. goods • Economic growth abroad in China increases demand for U.S. goods and services • Other countries increase their tariffs on U.S. goods, making the goods more expensive • The dollar strengthens, making U.S. goods and services more expensive for international consumers, decreasing demand © 2014 by McGraw‐Hill Education Active Learning: AD shifts Indicate whether each of the following situations results in an increase or decrease in aggregate demand Consumers feel confident that incomes will increase significantly in the next year The government is concerned about increasing its debt and thus reduces government spending China increases the tariffs on U.S. goods The government awards small factories a taxcredit,whichmanyusetobuildnew manufacturingplants â2014byMcGrawHillEducation 10 Aggregatesupply ã Aggregatesupplyisthesumtotaloftheproductionofall thefirmsintheeconomy ã Theaggregatesupplycurve shows the relationship between the overall price level in the economy and total production by firms • The AS curve represents production in the economy as a whole, not just of one good or service. It describes how much firms decide to produce • The economy operates differently in the short run and longrun,sothereare twodifferentAScurves ã The longrunaggregatesupplycurve(LRAS) ã Theshortrun aggregatesupplycurve(SRAS) â2014byMcGrawHillEducation 11 Short‐run aggregate supply (SRAS) In the short run, the AS curve slopes upward Price level Short-run aggregate supply (SRAS) P2 P1 Y1 Y2 • Prices of final goods increase more quickly than input prices • An increase in the final goods’ price level increases firmsprofits ã Firmsrespondby increasing production Output â2014byMcGrawHillEducation 12 Longrunaggregatesupply(LRAS) • The long run is not a set amount of time – It is the time required for input prices to fully adjust to economic conditions • When input costs adjust, firms no longer earn positive economic profits • The economy returns to where it started • Changes in the price‐level do not affect aggregate supply in the long run Long-run aggregate supply (LRAS) Price level • In the long run, the aggregate supply curve is fixed • The long‐run aggregate supply curve is not affected by the price level, causing it to be vertical • The LRAS curve represents potential output in the economy. P2 P1 Output Yp â2014byMcGrawHillEducation 13 Thebusinesscycle ã Economiesdonotalwaysproducetotheirpotentialoutput • Business cycles are fluctuations of output around the level of potential output – When output is higher than potential output, the economy is in a boom – When output is below potential output, the economy is in a recession • The U.S. business cycle has occurred frequently over the last 50 years Percent Annual growth rate of real per capita GDP But notice that the yearly average fluctuated quite a bit Long-run average growth The average real GDP per capita growth rate was around 3% between 1960 and 2010 -2 -4 1960 1970 © 2014 by McGraw‐Hill Education 1980 1990 2000 2010 14 Year Shifts in the SRAS curve If inputs become more expensive, firms will want to supply fewer goods at any price level in the short‐run Price level LRAS SRAS SRAS • The SRAS curve shifts to the left • Supply shocks are significant events that directly affect production and the AS curve in the short run Output © 2014 by McGraw‐Hill Education 15 Shifts in the LRAS curve In the long run, production decisions are influenced by inputs, regardless of the overall price level Price level • The LRAS curve shifts outward if there is an increase in available inputs • Everything that shifts the LRAS also shifts the SRAS LRAS LRAS 2020 2010 Yp (2010) Yp (2020) Output © 2014 by McGraw‐Hill Education 16 Shifts in the LRAS curve The main factors that shift LRAS are as follows Factor Increases LRAS Technology Technological innovation allows for greater production using the same amount of inputs Decreases LRAS Foreign investment in factories and machines increases available capital Capital A new law stripping away intellectual property rights reduces the incentive to innovate Depreciation and wear breaks down capital Immigration increases the available Aging population takes supply of labor workers out of the labor force Labor Education Universal primary education gives Reduction of federal college everyone a chance to go to school grants Natural resources New energy sources allow factories Climate change permanently to produce more with the same reduces the amount of land inputs that can be farmed © 2014 by McGraw‐Hill Education 17 Economic fluctuations Equilibrium in the national economy is at the point where AD = AS Price level LRAS SRAS P* AD Y* â2014byMcGrawHillEducation ã Shortrunequilibriumoccurs attheintersectionoftheAD andSRAS • The long‐run equilibrium occurs where the AD curve crosses both the LRAS and SRAS – Prices are at expected levels – The short run level of output is the same as the long run level of potential output Output 18 Effects of a shift in aggregate demand Using the AD‐AS model, the short‐ and long‐run effects of a rightward shift in AD can be predicted. Price level Short run Price level LRAS Long run LRAS SRAS2 SRAS P2 P1 SRAS1 E3 P3 P2 P1 E2 E1 E2 E1 AD2 AD2 AD1 Y1 Y2 • • • AD1 Y3 Y2 Output Increase in consumer confidence causes AD to increase Output is above long‐run potential Prices increase © 2014 by McGraw‐Hill Education Output The increase in AD causes wages and input prices to rise SRAS decreases Output returns to original level Prices increase again 19 • • • • Effects of a shift in aggregate demand Using the AD‐AS model, the short‐ and long‐run effects of a leftward shift in AD can be predicted. Short run Price level Price level Long run LRAS LRAS SRAS1 SRAS P1 P2 P1 P2 P3 E1 E2 AD1 E1 E3 • • • Y1 Y2 Output Decrease in consumer confidence causes AD to decrease Output is below long run potential Prices decrease © 2014 by McGraw‐Hill Education AD1 AD2 AD2 Y2 SRAS2 E2 • • • • Y3 Output The decrease in AD causes wages and input prices to fall SRAS increases Output returns to original level Prices decrease again 20 Effects of a shift in aggregate demand Changes in AD in the short and long run are summarized as follows Shift Example Short run Long run Increase in AD Increase in government spending: increases G Output increases Price increases Output unchanged Price increases Decrease in AD Reduction in consumer confidence: reduces C Output decreases Output unchanged Price decreases Price decreases © 2014 by McGraw‐Hill Education 21 Effects of a shift in aggregate supply Supply‐side shocks can also be analyzed. Suppose a temporary supply‐side shock hits the economy Price level Long run Short run Price level LRAS LRAS SRAS1 SRAS2 SRAS1 E2 P2 SRAS2 P P E1 P1 E2 E1 AD Y2 Y1 AD Y2 Output Temporary supply side shock causes • the SRAS to decrease Output falls below long run potential • Pricesincrease ã ã ã ã ã â2014byMcGrawHillEducation Y1 Output ThedecreaseinSRAScauseswagesto fall (price of labor decreases) SRAS increases Output increases to original level Prices decrease to original level 22 Effects of a shift in aggregate supply Suppose a permanent supply‐side shock hits the economy Price level Short run Price level LRAS2 LRAS2 LRAS1 SRAS2 SRAS1 P2 P1 P3 E2 LRAS1 SRAS3 SRAS1 E3 P1 E1 Long run E1 AD AD Y2 Y1 • • • Y3 Output Permanentsupplysideshockcauses theLRAStodecrease InputpricesrisecausingtheSRASto decrease Pricesincreaseandoutputdecreases â2014byMcGrawHillEducation ã ã ã Y1 Output As prices continue to rise, the SRAS decreases until it reaches the long run equilibrium Prices increase again Output decreases to long‐run equilibrium. 23 Comparing demand and supply shocks • The AD/AS model is a powerful tool for: – Understanding overall economic conditions – Formulating policy responses to shocks • It is important to distinguish between supply and demand shocks Event Temporary increase in the price of oil Technological innovation What kind of shock? Short-run supply shock Long-run supply shock Drop in consumer confidence Demand shock Sudden increase in immigration Long-run supply shock © 2014 by McGraw‐Hill Education 24 Active Learning: Demand and supply shocks Indicate what type of shock is caused by each of the following situations Situation Type of Shock Consumer confidence increases A hurricane destroys many factories on the east coast There is a large surge in the number of immigrants into the U.S The discovery of new oil reserves causes a temporary decrease in thepriceofoil â2014byMcGrawHillEducation 25 Comparingdemandandsupplyshocks ã Thereareclearpredictionsabouthowdifferenttypesof shockswillaffectpricesandoutput ã Thesepredictionsgivecluestowhattypeofshock occurred Supply or demand? Demand side Demand side Temporary shock: Supply side Temporary shock: Supply side Permanent shock: Supply side Positive shock Short-run: Output increases Price increases Long-run: No change in output Price increases Short-run: Output increases Price decreases Long-run: No change in output No change in price Long-run: Output increases Price decreases Negative shock Short-run: Output decreases Price decreases Long-run: No change in output Price decreases Short-run: Output decreases Price increases Long-run: No change in output No change in price Long-run: Output decreases Price increases © 2014 by McGraw‐Hill Education 26 Active Learning: Short‐ and long‐run predictions For each of the following situations, indicate how the AD/AS model predicts prices and output will change Situation Short run Long run An increase in consumption positive AD shock Unusually high rainfall increases current year wheat crop yields negative SRASshock TheFEDincreasesinterestrates whichdiscouragesborrowing negativeADshock â2014byMcGrawHillEducation 27 Theroleofpublicpolicy ã Itcantakealongtimefortheeconomytofully adjust to demand and supply shocks • Waiting for adjustments is often difficult on producers and consumers • Voters often call upon politicians to respond during a recession. • The government can try to boost the economy outofarecessionthroughgovernment spending â2014byMcGrawHillEducation 28 Theroleofpublicpolicy ã Thegovernmentcantrytocounterthis negativedemandshockbyspendingmoreto causeaggregatedemandtoincrease ã Such policies are challenging to implement – It is difficult to gauge the overall effect of government spending on AD – It is rare to perfectly design policy to restore AD to its original level – Government intervention impacts the long‐run outcomes © 2014 by McGraw‐Hill Education 29 Government spending to counter negative demand shocks The government may respond to a housing crisis as shown below Government stimulus Housing-market crash Price level Price level LRAS LRAS SRAS SRAS P1 E1 P3 P2 E2 P2 E3 E2 AD1 AD1 AD3 AD2 AD2 Y2 ã ã ã Y1 â2014byMcGrawHillEducation Y2 Y3 Output Thecrashofthehousingmarket causes AD to decrease Short term price level falls Short term output falls • • • Output Government spending increases AD Equilibrium price level increases Output increases, but is still lower than the original level 30 10 Government spending to counter negative supply shocks The government may respond to Midwestern drought as shown below Government response Drought shifts aggregate supply Price level Price level LRAS LRAS SRAS2 SRAS2 SRAS1 P P P3 P2 P1 E2 E1 E3 E1 AD Y2 • • • Y1 AD AD Y2 Output The drought causes SRAS to decrease Short term prices rise Short term output falls SRAS1 E2 • • • Y1 Output Government spending increases AD New equilibrium prices are higher Outputincreases totheoriginal level â2014byMcGrawHillEducation 31 Governmentspendingsummarized ã Thelongrunresultofgovernment interventionishigherprices,butoutput may more quickly return to long‐run levels • Why would the government ever choose to intervene? – The speed of recovery could be slow otherwise – Lower prices are not always good for certain goods and services • Governmentspendingisashorttermpolicy actionusedtoaddressshorttermshocks â2014byMcGrawHillEducation 32 Summary ã TheAD/ASmodelhelpstounderstandwhat drivesprices,unemployment,andGDPin contextoftheeconomy ã ADshowstherelationshipbetweenoverall pricesandtotaldemandintheeconomy ã ADisdownwardslopingbecauseconsumption, investment,andnetexportsalldecreasewhen pricesrise â2014byMcGrawHillEducation 33 11 Summary • AS shows the relationship between overall prices and total production • There are two supply curve: one for the short run and one for the long run – The SRAS is upward‐sloping because it takes time for prices and/or wages to adjust – TheLRAScurveisverticalbecausesupplydoesnt dependonpricesinthelongrun â2014byMcGrawHillEducation 34 Summary ã PositiveADshocksresultinincreasedprices andoutputintheshortrun Inthelongrun,outputreturnstoitsoriginallevel andpricesrisehigher ã NegativeADshocksresultinlowerpricesand outputintheshortrun Inthelongrun,outputreturnstoitsoriginallevel andpricesfallfurther â2014byMcGrawHillEducation 35 Summary • Prices and output only change in the long run when there are permanent AS shocks • The government can increase spending to counteract shocks in the short run – Increases in government spending produce higher prices in the long run © 2014 by McGraw‐Hill Education 36 12 .. .Aggregate? ?demand • Aggregate? ?demand? ?is equal to GDP, or AD = GDP = C + I + G + NX • The? ?aggregate? ?demand? ?curve shows the relationship between the overall price level in the economy? ?and? ?output... Comparingdemandandsupplyshocks ã Thereareclearpredictionsabouthowdifferenttypesof shockswillaffectpricesandoutput • These predictions give clues to what type of shock occurred Supply or demand? Demand. .. Changes in the price‐level do not affect? ?aggregate? ?supply? ?in the long run Long-run aggregate supply (LRAS) Price level • In the long run, the? ?aggregate? ? supply? ?curve is fixed • The long‐run? ?aggregate? ?supply? ? curve is not affected by the