Aggregate Supply and Aggregate Demand

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Aggregate Supply and Aggregate Demand

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  • 1. AggregateChapter Supply andAggregate19 DemandCHAPTER OUTLINE1. Define and explain the influences on aggregate supply.A. Aggregate Supply Basics1. Why the AS Curve Slopes Upwarda. Change in Output Rateb. Temporary Shutdowns and Restartsc. Business Failure and StartupB. Changes in Aggregate Supply1. Change in Potential GDP2. Change in Money Wage Rate3. Change in Money Prices of Other Resources2. Define and explain the influences on aggregate demand.A. Aggregate Demand Basics1. The Buying Power of Money2. The Real Interest Rate3. The Real Prices of Exports and ImportsB. Changes in Aggregate Demand1. Expectations2. Fiscal Policy and Monetary Policy3. The World EconomyC. The Aggregate Demand Multiplier3. Explain how trends and fluctuations in aggregate demand and aggregatesupply bring economic growth, inflation, and the business cycle.A. Macroeconomic EquilibriumB. Three Types of Macroeconomic Equilibrium1. Adjustment toward Full EmploymentC. Economic Growth and Inflation TrendsD. The Business CycleE. Inflation Cycles1. Demand-Pull Inflation2. Cost-Push InflationF. Deflation and the Great Depression 2015 Pearson Education, Inc.

2. 58 Part 5 . UNDERSTANDING THE MACROECONOMY Whats New in this Edition?Chapter 19 is slightly updated from the sixth edition,featuring updated data for 2013 throughout the chapter. Where We AreChapter 19 introduces the AS-AD model and then explainsthe influences on both aggregate supply and aggregatedemand. It uses aggregate demand and aggregate supply toexplain how fluctuations in them create the business cycle. Where Weve BeenThis chapter moves away from long-run economic growth,covered in Chapter 17 to concentrate on economicfluctuations, the business cycle, and the AS-AD model. Where Were GoingThe next chapter focuses on fiscal policy and monetarypolicy. It starts by describing the federal budget process andthe supply-side effects of fiscal policy on employment andpotential GDP as well as the demand-side effects of fiscalpolicy on employment and real GDP. Then it exploresmonetary policy and studies how it affects the economy anddifferent monetary policy rules.IN THE CLASSROOM Class Time NeededAlthough it might be possible to cover the material in this chapter in two classsessions, it is sufficiently important and challenging that spending at least threeclass periods is a good investment. Depending on the current state of theeconomy, you can spend upwards of three or more class periods on it!An estimate of the time per checklist topic is: 19.1 Aggregate Supply40 to 50 minutes 19.2 Aggregate Demand40 to 50 minutes 19.3 Explaining Economic Trends and Fluctuations50 to 70 minutesClassroom Activity: You might spend some time talking about the latest business cyclemovements and the impact on real GDP, unemployment, and inflation. This is a good placeto remind students of these three main economic aggregates on which we focus and howthey fluctuate through time. You might visit the webpage of the NBER for any updates fromthe Business Cycle Dating Committee ( Showstudents that this is where the news media are likely to get their information regarding 2015 Pearson Education, Inc. 3. Chapter 19 . Aggregate Supply and Aggregate Demand 59recessions and expansions in the economy. Then explain that the AS-AD model can be usedto explain the business cycle fluctuations in real GDP and the price level. 2015 Pearson Education, Inc. 4. 60 Part 5 . UNDERSTANDING THE MACROECONOMYCHAPTER LECTURE 19.1 Aggregate SupplyThe purpose of the AS-AD model is to explain how the price level and real GDP are determined.Real GDP depends on labor, capital, technology, land, and entrepreneurial talent. In the shortrun, only the quantity of labor can vary, so fluctuations in employment lead to changes in realGDP. When the quantity of labor demanded equals the quantity of labor supplied, there is fullemployment in the labor market and real GDP equals potential GDP.Aggregate Supply Basics The aggregate supply is therelationship between the quantity ofreal GDP supplied and the pricelevel when all other influences onproduction plans (the money wagerate, the prices of other resources,and potential GDP) remain constant. As illustrated in the figure, the AScurve is upward sloping. This slope reflects that a higherprice level combined with a fixedmoney wage rate lowers the realwage rate, thereby increasing thequantity of labor employed andhence increasing real GDP. The potential GDP line is verticalbecause moving along it both the price level and money wage rate and money pricesof other resources change by the same percentage.Why the AS Curve Slopes UpwardLecture Launcher: Remind your students that the AS curve used in this chapter is a short-runaggregate supply curve because it assumes product prices and resources prices do not movein lock step with one another. That is to say wages, materials prices, energy prices and thelike move with a lag behind product prices. To launch your lecture, walk through thisthought experiment with your students. Ask your class if firms are likely to be motivated tostep up production if product prices rise. They will have no trouble responding in theaffirmative. Now tell your students that the higher price is actually the result of an increase inthe general price level. Ask them how quickly workers are likely to respond by asking forwage increases. The answer is that it will take time for workers to see the general price levelhas risen and their real wages are now lower. Eventually they will demand higher wages.Firms are forced to grant the wage hikes because the labor market is tight and if they did notraise wages, they would lose workers. But until workers realize their real wage has fallen,firms are in the position of receiving higher prices with no change in money wages, so theyincrease their production. And with this result, you have demonstrated the upward-slopingaggregate supply curve! 2015 Pearson Education, Inc. 5. Chapter 19 . Aggregate Supply and Aggregate Demand 61 When the price level changes, three reactions create the positive relationship between theprice level and quantity of real GDP supplied: Changes in output rate: When the price level rises and the money wage rate doesntchange, the quantity of labor demanded increases and production increases. Temporary shutdowns and restarts: The price level relative to costs is an influenceon temporary shutdown decisions. If the price level rises relative to costs, fewer firmswill decide to shut down, so more firms operate and the quantity of real GDPsupplied increases. Business failure and startup: Real GDP changes when the number of firms inbusiness changes. If the price level rises relative to costs, profits increase, the numberof firms in business increases, and the quantity of real GDP supplied increases.Changes in Aggregate Supply When the price level changes and the money wage rate and other resource prices remainconstant, real GDP departs from potential GDP and there is a movement along the AScurve. The AS curve, however, does not shift. When potential GDP increases, aggregate supply increases and AS curve shiftsrightward. The potential GDP line also shifts rightward. Short-run aggregate supply changes and the AS curve shifts when there is a change inthe money wage rate or other resource prices. A rise in the money wage rate or otherresource prices decreases short-run aggregate supply and shifts the AS curve leftward. Inthis case, the potential GDP line does not shift. 19.2 Aggregate DemandThe quantity of real GDP demanded is the sumof consumption expenditure (C ), investment(I ), government expenditures (G ), and netexports (X - M ), or Y = C + I + G + (X - M ).Aggregate Demand Basics The relationship between the quantityof real GDP demanded and the pricelevel is called aggregate demand.Other things remaining the same, thehigher the price level, the smaller is thequantity of real GDP demanded. As the figure shows, the AD curve isdownward sloping. Moving along theaggregate demand curve the only thingthat changes is the price level.Why the AD Curve Slopes Downward The negative relationship between the price level and the quantity of real GDPdemanded, that is, the negative slope of the AD curve, reflects three factors: The buying power of money: When the price level rises, the buying of moneydecreases and so people decrease consumption expenditure. 2015 Pearson Education, Inc. 6. 62 Part 5 . UNDERSTANDING THE MACROECONOMY The real interest rate: When the price level rises, the demand for money increases,which raises the nominal interest rate. Because the inflation rate does notimmediately change, the real interest rate also rises so that people decrease theirconsumption expenditure and firms decrease their investment. The real price of exports and imports: When the price level rises, domestic goodsbecome more expensive relative to foreign goods so people decrease the quantity ofdomestic goods demanded.Changes in Aggregate Demand Any factor that influences expenditure plans other than the price level changes aggregatedemand and shifts the aggregate demand curve. Factors that change aggregate demand are: Expectations: Expectations of higher future income, expectations of higher futureinflation, and expectations of higher future profits increase aggregate demand andshift the AD curve rightward. Fiscal policy and monetary policy: The government influences the economy bysetting and changing taxes, making transfer payments, and purchasing goods andservices, which is called fiscal policy. Tax cuts, increased transfer payments, orincreased government purchases increase aggregate demand. Monetary policyconsists of changes in interest rates and in the quantity of money in the economy. Anincrease in the quantity of money and lower interest rates increase aggregatedemand. The world economy: Exchange rates and foreign income affect net exports (X - M )and, therefore, aggreg