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Aggregate Supply and Aggregate Demand

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Aggregate Supply and Aggregate Demand

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2. 2015 PearsonWhy did the U.S. economygo into recession in 2008? 3. Aggregate Supply andAggregate Demand 2015 Pearson19CHAPTER CHECKLISTWhen you have completed yourstudy of this chapter, you will be able to1 Define and explain the influences on aggregate supply.2 Define and explain the influences on aggregate demand.3 Explain how trends and fluctuations in aggregatedemand and aggregate supply bring economic growth,inflation, and the business cycle. 4. 19.1 AGGREGATE SUPPLYThe quantity of real GDP supplied is the total amount offinal goods and services that firms in the United Statesplan to produce.The quantity of real GDP supplied depends on thequantities of 2015 Pearson Labor employed Capital, human capital, and the state oftechnology Land and natural resources Entrepreneurial talent 5. 19.1 AGGREGATE SUPPLYAt full employment: 2015 Pearson The real wage rate makes the quantity of labordemanded equal to the quantity of labor supplied. Real GDP equals potential GDP.Over the business cycle: The quantity of labor employed fluctuates aroundits full employment level. Real GDP fluctuates around potential GDP. 6. 19.1 AGGREGATE SUPPLYAggregate Supply BasicsAggregate supply is the relationship between thequantity of real GDP supplied and the price level whenall other influences on production plans remain thesame.Other things remaining the same, 2015 Pearson When the price level rises, the quantity of realGDP supplied increases. When the price level falls, the quantity of real GDPsupplied decreases. 7. 19.1 AGGREGATE SUPPLYAlong the aggregate supply curve, the only influence onproduction plans that changes is the price level.All the other influences on production plans remainconstant. Among these other influences are 2015 Pearson The money wage rate The money prices of other resourcesIn contrast, along the potential GDP line, when the pricelevel changes the money wage rate changes to keepthe real wage rate at the full-employment level. 8. 19.1 AGGREGATE SUPPLYFigure 19.1 shows the aggregate supply schedule andaggregate supply curve.Each point A to Eon the AS curvecorresponds to arow of theschedule. 2015 Pearson 9. 19.1 AGGREGATE SUPPLY1. Potential GDP is $16 trillion and when the price level is 105,real GDP equals potential GDP.2. If the price level isabove 105, realGDP exceedspotential GDP.3. If the price level isbelow 105, realGDP is less thanpotential GDP. 2015 Pearson 10. 19.1 AGGREGATE SUPPLYWhy the AS Curve Slopes UpwardWhen the price level rises and the money wage rate isconstant, the real wage rate falls and employmentincreases. The quantity of real GDP supplied increases.When the price level falls and the money wage rate isconstant, the real wage rate rises and employmentdecreases. The quantity of real GDP supplieddecreases. 2015 Pearson 11. 19.1 AGGREGATE SUPPLY Changes in Aggregate SupplyAggregate supply changes when any influence onproduction plans other than the price level changes.In particular, aggregate supply changes when 2015 Pearson Potential GDP changes. The money wage rate changes. The money prices of other resources change. 12. 19.1 AGGREGATE SUPPLYChanges in Potential GDPAnything that changes potential GDP changesaggregate supply and shifts the aggregate supply curve.Figure 19.2 on the next slide illustrates. 2015 Pearson 13. 19.1 AGGREGATE SUPPLYPoint C at the intersection ofthe potential GDP line andAS curve is an anchor point.1. An increase in potentialGDP shifts the potentialGDP line rightward and ...2. The aggregate supplycurve shifts rightwardfrom AS0 to AS1. 2015 Pearson 14. 19.1 AGGREGATE SUPPLYChange in Money Wage RateA change in the money wage rate changes aggregatesupply because it changes firms costs.The higher the money wage rate, the higher are firmscosts and the smaller is the quantity that firms arewilling to supply at each price level.So an increase in the money wage rate decreasesaggregate supply. 2015 Pearson 15. 19.1 AGGREGATE SUPPLYFigure 19.3 shows theeffect of a change in themoney wage rate.A rise in the money wagerate decreases aggregatesupply and the aggregatesupply curve shifts leftwardfrom AS0 to AS2.A rise in the money wagerate does not changepotential GDP. 2015 Pearson 16. 19.1 AGGREGATE SUPPLYChange in Money Prices of Other ResourcesA change in the money prices of other resourceschanges aggregate supply because it changes firmscosts.The higher the money prices of other resources, thehigher are firms costs and the smaller is the quantitythat firms are willing to supply at each price level.So an increase in the money prices of other resourcesdecreases aggregate supply. 2015 Pearson 17. 19.2 AGGREGATE DEMANDThe quantity of real GDP demanded is the total amountof final goods and services produced in the UnitedStates that people, businesses, governments, andforeigners plan to buy.This quantity is the sum of the real consumptionexpenditure (C), investment (I), government expenditureon goods and services (G), and exports (X) minusimports (M).That is, 2015 PearsonY = C + I + G + X M 18. 19.2 AGGREGATE DEMANDAggregate Demand BasicsAggregate demand is the relationship between thequantity of real GDP demanded and the price levelwhen all other influences on expenditure plans remainthe same.Other things remaining the same, 2015 Pearson When the price level rises, the quantity ofreal GDP demanded decreases. When the price level falls, the quantity ofreal GDP demanded increases. 19. 19.2 AGGREGATE DEMANDFigure 19.4 shows the aggregate demand schedule andaggregate demand curve.Each point A to Eon the AD curvecorresponds to arow of theschedule. 2015 Pearson 20. 19.2 AGGREGATE DEMANDThe quantity of real GDP demanded1. Decreases whenthe price levelrises.2. Increases whenthe price levelfalls. 2015 Pearson 21. 19.2 AGGREGATE DEMANDThe price level influences the quantity of real GDPdemanded because a change in the price level bringschanges in 2015 Pearson The buying power of money The real interest rate The real prices of exports and imports 22. 19.2 AGGREGATE DEMANDThe Buying Power of MoneyA rise in the price level lowers the buying power ofmoney and decreases the quantity of real GDPdemanded.For example, if the price level rises and other thingsremain the same, a given quantity of money will buyless goods and services, so people cut their spending.So the quantity of real GDP demanded decreases. 2015 Pearson 23. 19.2 AGGREGATE DEMANDThe Real Interest RateWhen the price level rises, the real interest rate rises.An increase in the price level increases the amount ofmoney that people want to holdincreases the demandfor money.When the demand for money increases, the nominalinterest rate rises.In the short run, the inflation rate doesnt change, so arise in the nominal interest rate brings a rise in the realinterest rate. 2015 Pearson 24. 19.2 AGGREGATE DEMANDFaced with a higher real interest rate, businesses andpeople delay plans to buy new capital goods andconsumer durable goods and cut back on spending.So the quantity of real GDP demanded decreases. 2015 Pearson 25. 19.2 AGGREGATE DEMANDThe Real Prices of Exports and ImportsWhen the U.S. price level rises and other things remainthe same, the prices in other countries do not change.So a rise in the U.S. price level makes U.S.-madegoods and services more expensive relative to foreign-made 2015 Pearsongoods and services.This change in real prices encourages people to spendless on U.S.-made items and more on foreign-madeitems. 26. 19.2 AGGREGATE DEMANDIn the long run, when the price level changes by more inone country than in other countries, the exchange ratechanges.The exchange rate neutralizes the price level change,so this international price effect on buying plans is ashort-run effect only.But the short-run effect is powerful. 2015 Pearson 27. 19.2 AGGREGATE DEMANDChanges in Aggregate DemandA change in any factor that influences expenditure plansother than the price level brings a change in aggregatedemand. 2015 Pearson When aggregate demand increases, the aggregatedemand curve shifts rightward. When aggregate demand decreases, theaggregate demand curve shifts leftward. 28. 19.2 AGGREGATE DEMANDThe factors that change aggregate demand are 2015 Pearson Expectations about the future Fiscal policy and monetary policy The state of the world economy 29. 19.2 AGGREGATE DEMANDExpectationsAn increase in expected future income increases theamount of consumption goods that people plan to buytoday and increases aggregate demand.An increase in expected future inflation increasesaggregate demand today because people decide to buymore goods and services now before their prices rise.An increase in expected future profit increases theinvestment that firms plan to undertake today andincreases aggregate demand. 2015 Pearson 30. 19.2 AGGREGATE DEMANDFiscal Policy and Monetary PolicyGovernments can use fiscal policy to influenceaggregate demand.Fiscal policy is changing taxes, transfer payments, andgovernment expenditure on goods and services.The Federal Reserve can use monetary policy toinfluence aggregate demand.Monetary policy is changing the quantity of money andthe interest rate. 2015 Pearson 31. 19.2 AGGREGATE DEMANDA tax cut or an increase in either transfer payments orgovernment expenditure on goods and servicesincreases aggregate demand.A cut in the interest rate or an increase in the quantityof money increases aggregate demand. 2015 Pearson 32. 19.2 AGGREGATE DEMANDThe World EconomyThe foreign exchange rate and foreign income influenceaggregate demand.The foreign exchange rate is the amount of foreigncurrency you can buy with a U.S. dollar.Other things remaining the same, a rise in the foreignexchange rate decreases aggregate demand.An increase in foreign income increases U.S. exportsand increases U.S. aggregate demand. 2015 Pearson 33. 19.2 AGGREGATE DEMANDFigure 19.5 shows changesin aggregate demand.1. Aggregate demandincreases if Expected future income,inflation, or profitsincrease. Fiscal policy or monetarypolicy actions increaseplanned expenditure. The exchange rate falls orforeign income increases. 2015 Pearson 34. 19.2 AGGREGATE DEMAND2. Aggregate demanddecreases if Expected future income,inflation, or profitsdecrease. Fiscal policy or monetarypolicy actions decreaseplanned expenditure. The exchange rate risesor foreign incomedecreases. 2015 Pearson 35. 19.2 AGGREGATE DEMANDThe Aggregate Demand MultiplierThe aggregate demand multiplier is an effect thatmagnifies changes in expenditure plans and bringspotentially large fluctuations in aggregate demand. 2015 Pearson 36. 19.2 AGGREGATE DEMANDWhen any influence on aggregate demand changesexpenditure plans: 2015 Pearson The change in expenditure changes income. And the change in income induces a change inconsumption expenditure. The increase in aggregate demand is the initialincrease in expenditure plus the induced increasein consumption expenditure. 37. 19.2 AGGREGATE DEMANDFigure 19.6 shows theaggregate demand multiplier.1. An increase in investmentincreases aggregate demandand increases income.2..The increase in incomeinduces an increase inconsumption expenditure, so3. Aggregate demand increasesby more than the initialincrease in investment. 2015 Pearson 38. 19.3 EXPLAINING ECONOMIC TRENDS ANDFLUCTUATIONSAggregate supply and aggregate demand determinereal GDP and the price level.Macroeconomic equilibrium occurs when thequantity of real GDP demanded equals the quantity ofreal GDP supplied.Macroeconomic equilibrium occurs at the point ofintersection of the AD curve and the AS curve.Figure 19.7 on the next slide illustrates macroeconomicequilibrium. 2015 Pearson 39. 19.3 EXPLAINING ECONOMIC TRENDS ANDSuppose that the price levelis 95 and that real GDP is$15 trillion, at point A.At the price level 95 , thequantity of real GDPdemanded exceeds$15 trillion.1. Firms cannot meet thedemand for their output, sothey increase production andraise prices. 2015 PearsonFLUCTUATIONS 40. 19.3 EXPLAINING ECONOMIC TRENDS ANDSuppose that the price levelis 115 and that real GDP is$17 trillion, at point B.At the price level 115, thequantity of real GDPdemanded is less than$17 trillion.2. Firms cannot sell all theyproduce, so they cutproduction and lower prices. 2015 PearsonFLUCTUATIONS 41. 19.3 EXPLAINING ECONOMIC TRENDS ANDMacroeconomicequilibrium occurs whenthe price level is 105 andreal GDP is $16 trillion. 2015 PearsonFLUCTUATIONS 42. 19.3 EXPLAINING ECONOMIC TRENDS ANDIn macroeconomic equilibrium, the economy might be at fullemployment or above or below full employment.Full-employment equilibriumwhen equilibrium real GDPequals potential GDPoccurs where the AD curve intersectsthe AS curve.Recessionary gap is a gap that exists when potentialGDP exceeds real GDP and that brings a falling price level.Inflationary gap is a gap that exists when real GDPexceeds potential GDP and that brings a rising price level. 2015 PearsonFLUCTUATIONS 43. 19.3 EXPLAINING ECONOMIC TRENDS ANDFLUCTUATIONSFigure 19.8(a) shows thethree types of macro-economic 2015 Pearsonequilibrium.1.With real GDP less thanpotential GDP, the economyis below full employment.A recessionary gapemerges.With real GDP equal topotential GDP, the economyis at full employment. 44. 19.3 EXPLAINING ECONOMIC TRENDS AND2. When real GDPexceeds potentialGDP, the economy isabove fullemployment.An inflationary gapemerges. 2015 PearsonFLUCTUATIONS 45. 19.3 EXPLAINING ECONOMIC TRENDS ANDAdjustment toward Full EmploymentWhen real GDP is below or above potential GDP, themoney wage rate gradually changes to bring fullemployment.Figure 19.8(b) illustrates this adjustment. 2015 PearsonFLUCTUATIONS 46. 19.3 EXPLAINING ECONOMIC TRENDS ANDIn a recessionary gap ,there is a surplus of laborand firms can hire newworkers at a lower wagerate.As the money wage ratefalls, the AS curve shiftsfrom AS1 toward AS*.The price level falls andreal GDP increases. 2015 PearsonFLUCTUATIONS 47. 19.3 EXPLAINING ECONOMIC TRENDS ANDIn an inflationary gap ,there is a shortage of laborand to hire new workersfirms raise the wage rate.As the money wage raterises, the AS curve shiftsfrom AS2 toward AS*.The price level rises andreal GDP decreases. 2015 PearsonFLUCTUATIONS 48. 19.3 EXPLAINING ECONOMIC TRENDS ANDEconomic Growth and Inflation TrendsEconomic growth results from a growing labor force andincreasing labor productivity, which together makepotential GDP grow.Inflation results from a growing quantity of money thatoutpaces the growth of potential GDP.The AS-AD model can be used to understand economicgrowth and inflation trends. 2015 PearsonFLUCTUATIONS 49. 19.3 EXPLAINING ECONOMIC TRENDS ANDIn the AS-AD model,Economic growth arises from increasing potential GDPa persistent rightward shift in the potential GDP line.Inflation arises from a persistent increase in aggregatedemand at a faster pace than that of the increase inpotential GDPa persistent rightward shift of the ADcurve at a faster pace than the growth of potential GDP. 2015 PearsonFLUCTUATIONS 50. 19.3 EXPLAINING ECONOMIC TRENDS ANDThe Business CycleThe business cycle results from fluctuations inaggregate supply and aggregate demand.Aggregate supply fluctuates because labor productivitygrows at a variable pace, which brings fluctuations inthe growth rate of potential GDP.The resulting cycle is called a real business cycle. 2015 PearsonFLUCTUATIONS 51. 19.3 EXPLAINING ECONOMIC TRENDS ANDBut the main source of the business cycle is aggregatedemand fluctuations.The key reason is that the swings in aggregate demandoccur more quickly than changes in the money wagerate that change aggregate supply.The result is that the economy swings from inflationarygap to full employment to recessionary gap and backagain. 2015 PearsonFLUCTUATIONS 52. 19.3 EXPLAINING ECONOMIC TRENDS ANDInflation CyclesJust as there are cycles in real GDP, there are cycles ininflation, and these cycles interact.To study the interaction of real GDP cycles and inflationcycles we distinguish between two sources of inflation:Demand-pull inflationCost-push inflation 2015 PearsonFLUCTUATIONS 53. 19.3 EXPLAINING ECONOMIC TRENDS ANDDemand-Pull InflationAn inflation that starts because aggregate demandincreases is called demand-pull inflation.Any factor that increases aggregate demand can startan inflation, but the only factor that can sustain it isgrowth in the quantity of money. 2015 PearsonFLUCTUATIONS 54. 19.3 EXPLAINING ECONOMIC TRENDS ANDFigure 19.9 illustratesthe process.Each time the quantity ofmoney increases, the ADcurve shifts rightward.Each time real GDP exceedspotential GDP, the moneywage rate rises and the AScurve shifts leftward.A demand-pull inflationresults. 2015 PearsonFLUCTUATIONS 55. 19.3 EXPLAINING ECONOMIC TRENDS ANDFLUCTUATIONSCost-Push InflationAn inflation that starts because aggregate supplyincreases is called cost-push inflation.Any factor that increases aggregate supply can start aninflation, but the only factor that can sustain it is growthin the quantity of money. 2015 Pearson 56. 19.3 EXPLAINING ECONOMIC TRENDS ANDFigure 19.10 illustratesthe process.Each time a cost increases,the AS curve shifts leftward.Each time real GDPdecreases to below potentialGDP, the Fed increases thequantity of money and theAD curve shifts rightward.A cost-push inflation results. 2015 PearsonFLUCTUATIONS 57. 19.3 EXPLAINING ECONOMIC TRENDS ANDDeflation and the Great DepressionWhen a financial crisis hit in October 2008, manypeople feared a repeat of the events of the 1930s.During the Great Depression (1929 through 1933), theprice level fell by 22 percent and real GDP decreasedby 31 percent.During the 20082009 recession, real GDP fell by lessthan 4 percent and the price level continued to rise,although more slowly.Why was the Great Depression so bad? Why was20082009 so mild in comparison? 2015 PearsonFLUCTUATIONS 58. 19.3 EXPLAINING ECONOMIC TRENDS ANDDuring the Great Depression, banks failed and thequantity of money fell by 25 percent.The Fed stood by and took no action to counteract the fallof buying power, so aggregate demand collapsed.Because the money wage rate didnt fall immediately, thedecrease in aggregate demand brought a large fall in realGDP.The money wage rate and price level fell eventually, butnot until employment and real GDP had shrunk to 75percent of their 1929 levels. 2015 PearsonFLUCTUATIONS 59. 19.3 EXPLAINING ECONOMIC TRENDS ANDDuring the 2008 financial crisis, the Fed bailed outtroubled financial institutions and doubled the monetarybase.The quantity of money kept growing.Also, the government increased its own expenditures,which added to aggregate demand.The combined effects of continued growth in the quantityof money and increased government expenditure limitedthe fall in aggregate demand and prevented a largedecrease in real GDP. 2015 PearsonFLUCTUATIONS 60. 19.3 EXPLAINING ECONOMIC TRENDS ANDThe challenge that now lies ahead is to unwind themonetary and fiscal stimulus as the components of privateexpenditureconsumption expenditure, investment, andexportsbegin to increase.As these components return to more normal levels,aggregate demand will increase.Too much monetary and fiscal stimulus will bring aninflationary gap and faster inflation.Too little monetary and fiscal stimulus will leave arecessionary gap. 2015 PearsonFLUCTUATIONS 61. What causes the business cycle and what in particular causedthe 20082009 recession?Business Cycle TheoryThe mainstream business cycle theory is that potential GDPgrows at a steady rate while aggregate demand grows at afluctuating rate.Because the money wage rate is slow to change, if aggregatedemand grows more quickly than potential GDP, real GDPincreases above potential GDP and an inflationary gapemerges.The inflation rate rises and real GDP is pulled back towardpotential GDP. 2015 Pearson 62. If aggregate demand grows more slowly than potential GDP,real GDP falls below potential GDP and a recessionary gapemerges.The inflation rate slows, but the money wage rate respondsvery slowly to the recessionary gap and real GDP does notreturn to potential GDP until another increase in aggregatedemand occurs.Fluctuations in investment are the main source of aggregatedemand fluctuations.A recession can occur if aggregate supply decreases to bringstagflation. Also, a recession might occur because bothaggregate demand and aggregate supply decrease. 2015 Pearson 63. The 20082009 RecessionAt the peak in 2008, realGDP was $15 trillion andthe price level was 99.In the second quarter of2009, real GDP had fallen to$14.3 trillion and the pricelevel had risen to 100.A recessionary gapappeared in 2009. 2015 Pearson 64. The financial crisis thatbegan in 2007 andintensified in 2008 decreased the supply ofloanable funds andinvestment fell.In particular, constructioninvestment collapsed. 2015 Pearson 65. Recession in the globaleconomy lowered thedemand for U.S. exports,so this component ofaggregate demand alsodecreased.The decrease in aggregatedemand was moderated by alarge injection of spending bythe U.S. government, but itdid not stop aggregatedemand from decreasing. 2015 Pearson 66. We cannot account for thecombination of a rise in theprice level and a fall in realGDP with a decrease inaggregate demand alone.Aggregate supply must alsohave decreased.The rise in oil prices in 2007and a rise in the money wagerate were two factors thatbrought a decrease inaggregate supply. 2015 PearsonEYE on the BUSINESSYCLE