Chapter 13: Aggregate Demand and Aggregate …yluo/teaching/Econ1220/chapter13a.pdfAggregate Demand I In the short-run, real GDP ⁄uctuates around the long-run upward trend because

Chapter 13: Aggregate Demand and AggregateSupply Analysis

Yulei Luo

SEF of HKU

February 26, 2017

Learning Objectives

1. Identify the determinants of aggregate demand anddistinguish between a movement along the aggregate demandcurve and a shift of the curve.

2. Identify the determinants of aggregate supply and distinguishbetween a movement along the short-run aggregate supplycurve and a shift of the curve.

3. Use the aggregate demand and aggregate supply model toillustrate the di¤erence between short-run and long-runmacroeconomic equilibrium.

4. Use the dynamic aggregate demand and aggregate supplymodel to analyze macroeconomic conditions.

Aggregate Demand

I In the short-run, real GDP �uctuates around the long-runupward trend because of business cycles (BC). Real GDP andemployment co-move during BC.

I The BC also causes changes in prices and wages. Some �rmsreact to a decline in sales by cutting back on production, butthey may also cut the prices they charge and the wages theypay.

I Aggregate demand and aggregate supply model: A model thatexplains short-run �uctuations in real GDP and the price level.This model will help us analyze the e¤ects of recessions andexpansions on production, employment, and prices.

I (Conti.) Aggregate demand curve (AD): A curve showing therelationship between the price level (PL) and the quantity ofreal GDP demanded by households, �rms, and thegovernment.

I Short-run aggregate supply curve (SRAS): A curve showingthe relationship in the short run between the PL and thequantity of real GDP supplied by �rms.

I Fluctuations in real GDP and the PL are caused by shifts inthe AD curve or the AS curve.

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A Sneak Peek at the Model

In the short run, real GDP and the price level are determined by the intersection of the aggregate demand (AD) curve…Aggregate demand (AD) curve: A curve that shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government.…and the short-run aggregate supply (AS) curve.Short-run aggregate supply (AS) curve: A curve that shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms.

Aggregate demand and aggregate supply

Figure 13.1

Presenter

Presentation Notes

In the short run, real GDP and the price level are determined by the intersection of the aggregate demand curve and the short-run aggregate supply curve. In the figure, real GDP is measured on the horizontal axis, and the price level is measured on the vertical axis by the GDP deflator. In this example, the equilibrium real GDP is $17.0 trillion, and the equilibrium price level is 110.

Why Is the Aggregate Demand Curve Downward Sloping?

I Because a fall in the PL increases the quantity of real GDPdemanded.

Y = C + I + G +NX (1)

I The wealth e¤ect: How a change in the PL a¤ectsconsumption?

I Some of a household�s wealth is held in cash or other nominalassets that lose value as the price level rises and gain value asthe PL falls.

I As the PL falls, the real value of HH wealth rises, and so willconsumption because consumption is positively correlated withreal wealth.

I This e¤ect of the PL on consumption is called the wealthe¤ect.

I (Conti.) The interest rate e¤ect: How a change in the PLa¤ects investment?

I When prices rise, HHs and �rms need more money to �nancebuying and selling; consequently, they try to increase theamount of money they hold by withdrawing funds from banks,borrowing from banks, or selling bonds. These actions willincrease the interest rate (IR) charged on loans and bonds.

I A higher IR raises the cost of borrowing for �rms and HHs(e.g., borrow less to build new buildings, new houses, orautos). Investment and consumption will therefore be reduced.

I (Conti.) The international-trade e¤ect: How a change in thePL a¤ects net exports?

I If the PL in the US rises relative to the PLs in other countries,US exports will become relatively more expensive and foreignimports will become relatively less expensive.

I Consequently, some consumers in foreign countries will shiftfrom buying US products to buying domestic products, andsome US consumers will also shift from buying US products tobuying imported products, US exports will fall and US importswill rise, causing NXs to fall.

Shifts of the AD Curve versus Movements Along It

I Note that the AD curve tells the relationship bw the PL andthe quantity of real GDP demanded, holding everything elseconstant.

I If the PL changes, but other variables that a¤ect thewillingness of HHs, �rms, and gov. to spend are unchanged,the economy will move up or down a stationary AD curve.

I If any variable changes other than the PL, the AD curve willshift. E.g., if gov spending increases and the PL remainsunchanged, the AD curve will shift to the right at every PL.

Three Variables That Shift the AD Curve

I Changes in government policies (Monetary and �scal policies)I Monetary policy (MP): The actions the Federal Reserve takesto manage the money supply and interest rates to pursuemacroeconomic policy objectives.

I Fiscal policy (FP): Changes in federal taxes and purchases thatare intended to achieve macroeconomic policy objectives.

I Gov uses monetary and �scal policies to shift the AD curve.I Lower IRs lower the cost to �rms and HHs of borrowing.Lower borrowing costs increase consumption and investment,which shifts the AD to the right. An increase in gov.purchases also shifts the AD to the right because they are onecomponent of AD.

I An increase in personal income taxes reduce consumptionspending and shift the AD curve to the left. Increases inbusiness taxes reduce the pro�tability and shift the AD to theleft.

I (Conti.) Changes in the expectations of households and �rmsI If HHs and �rms become more optimistic (pessimistic) abouttheir future incomes, they are likely to increase (reduce) theircurrent consumption spending, which will increase (reduce)AD.

I Similarly, if �rms become more optimistic (pessimistic) abouttheir future pro�tability of investment spending, the AD curvewill shift to the right.

I Changes in foreign variables: If �rms and HHs in othercountries buy fewer U.S. goods or if �rms and households inthe U.S. buy more foreign goods, net exports will fall, and theAD curve will shift to the left.

I If real GDP in the US increases faster than the real GDP inother countries, US imports will increase faster than USexports, and NXs will decline.

I If the exchange rate bw. the dollar and foreign currencies rises,NXs will also fall.

I Both changes will shift the AD curve to the left.

I (Conti.) If the exchange rate between the dollar and foreigncurrencies rises, NXs will fall because the price in foreigncurrency of U.S. products sold in other countries will rise, andthe dollar price of foreign products sold in the U.S. will fall.

I NXs will increase if the value of the dollar falls against othercurrencies.

I An increase in NXs at every price level will shift the AD curveto the right.

I A change in NXs that results from a change in the price levelin the U.S. will result in a movement along the AD curve, nota shift of the AD curve.


Shifts of the AD Curve vs. Movements along It

The aggregate demand curve shows the relationship between the price level and real GDP demanded, holding everything else constant.

A change in the price level not caused by a component of real GDP changing results in a movement along the AD curve.

A change in some component of aggregate demand, on the other hand, will shift the AD curve.


AD shifts: Changes in Monetary Policy

A government policy change could shift aggregate demand. There are two categories of government policies here:1. Monetary policy: The actions the Federal Reserve takes to

manage the money supply and interest rates to pursue macroeconomic policy objectives.

If the Federal Reserve causes interest rates to rise, investment spending will fall; if it causes interest rates to fall, investment spending will rise.

Variables that shift the aggregate demand curve

Table 13.1

shifts the aggregate An increase in… demand curve… because…


AD shifts: Changes in Fiscal Policy

2. Fiscal policy: Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives.

Increasing or decreasing taxes affects disposable income, and hence consumption. The government can also alter its level of government purchases.


Table 13.1



AD Shifts: Changes in Expectations

Households or firms could become more optimistic about the future, increasing consumption or investment respectively.

Of course, the opposite could also occur.


Table 13.1



AD Shifts: Changes in Foreign Variables

If foreign incomes rise more slowly than ours, their imports of our goods fall; if ours rise more slowly, our imports fall.

If our exchange rate (the value of the $US) rises, our exports become more expensive, so foreigners buy less of them (and we buy more imports, also).


Table 13.1



Makingthe

ConnectionRecessions and the Components of AD—part 1

We can understand the 2007-2009 recession better by examining what happened to the components of real GDP.

(The red bar indicates the period of the recession, per the NBER).

Consumption spending fell, relative to potential GDP during the recession.

• This was unusual: consumption usually stays steady during a recession.

Consumption also stayed low in the four post-recession years.


Makingthe


Residential investment had been falling before the recession, and continued to fall during it.

Spending on residential investment has continued to be below the pre-recession boom levels.


Makingthe


Net exports increased (became less negative) just before and during the recession.

• This was in part due to the falling value of the $US.

After the recession, net exports started to decrease once more, but then have stayed relatively steady.

• Loose monetary policy has kept the value of the $US down.

The Long-Run Aggregate Supply Curve

I The e¤ect of change in the PL on aggregate supply (i.e., thequantity of GS that �rms are willing and able to supply) isvery di¤erent in the short run (SR) than in the long run (LR),so we need two AS curves: one for SR and one for LR.

I Long-run aggregate supply (LRAS) A curve showing therelationship in the long run between the PL and the quantityof real GDP supplied.

I In the LR the level of real GDP is determined by the numberof workers, the capital stock, and the technology.

I In the LR changes in the PL doesn�t a¤ect real GDP becauseit doesn�t a¤ect the number of workers, the capital stock, andtechnology.

I Note that the level of real GDP in the LR is called potentialGDP or full employment GDP. There is no reason for thisnormal level of capacity to change just because the PL haschanged.


In the long run, the level of real GDP is determined by the number of workers, the level of technology, and the capital stock (factories, machinery, etc.).

• None of these elements are affected by the price level.

So the long-run aggregate supply curve does not depend on the price level; it is a vertical line, at the level of potential or full-employment GDP.

Long-Run Aggregate Supply Curve

The long-run aggregate supply curve

Figure 13.2

Presenter

Presentation Notes

Changes in the price level do not affect the level of aggregate supply in the long run. Therefore, the long-run aggregate supply (LRAS) curve is a vertical line at the potential level of real GDP. For instance, the price level was 107 in 2013, and potential GDP was $16.7 trillion. If the price level had been 117, or if it had been 97, long-run aggregate supply would still have been a constant $16.7 trillion. Each year, the long-run aggregate supply curve shifts to the right, as the number of workers in the economy increases, more machinery and equipment are accumulated, and technological change occurs.

The Short-Run Aggregate Supply Curve

I The SRAS is upward sloping because over the SR, as the PLincreases, the quantity of G&S �rms are willing to supply willincrease. As prices of �nal G&S rise, prices of inputs (such asthe wages or the prices of natural resources) rise more slowly.

I The reason for this is that some �rms and workers fail toaccurately predict changes in the price level.

I Pro�ts rise when the prices of the G&S �rms sell rise morerapidly than the prices they pay for inputs. Therefore, a higherPL leads to higher pro�ts and increases the willingness of�rms to supply more G&S.

I As the PL rises or falls, some �rms are slow to adjust theirprices. A �rm that is slow to raise (reduce) its prices when thePL is increasing (decreasing) may �nd its sales increasing(falling) and therefore will increase (decrease) production.

I (Conti.) Next questions are:I Why some �rms adjust prices more slowly than others?I Why might the wages and the prices of other inputs changemore slowly than the prices of �nal G&S?

I Most economists believe the explanation is that some �rmsand workers fail to predict accurately changes in the PL. Thethree most common reasons:

1. Contracts make some wages and prices �sticky�: Prices andwages are said to be �sticky�when they don�t respond quicklyto changes in demand or supply. Consider the Ford Motorcompany case. Suppose their managers negotiate a 3-yearcontract with the Labor union. Suppose that after thecontract is signed, the demand starts to increase rapidly andprices rise. Producing more is pro�table because they canincrease prices and wages are �xed by contract.

I (Conti.) The three most common reasons:

2. Firms are often slow to adjust wages. Many nonunion workersalso have their wages adjusted only once a year. If �rms adjustwages only slowly, a rise in the PL will increase the pro�tabilityof hiring more workers and producing more output, and a fallin the price level will decrease the pro�tability of hiring moreworkers and producing more output.

3. Menu costs (The costs to �rms of changing prices) make someprices sticky. Firms base their prices today partly on what theyexpect future prices to be. Consider the e¤ect of anunexpected increase in the PL. Firms will want to increase theprices they charge. However, some �rms may not be willing toincrease prices because of MCs. Because of their relatively lowprices, these �rms will �nd their sales increasing, which causethem to increase output.


Makingthe

ConnectionHow Sticky Are Wages?

There is disagreement among economists about how sticky wages and prices actually are.• To examine this, it is best to look at individual worker-level data.Some recent studies have done this, finding firms are reluctant to cut workers (nominal) wages. Instead, they:• Offer lower salaries

to new hires• Fire current

workers• Decreases raises

or freeze payThe graph shows the percentage of workers with no wage change in a given year.

Shifts of the SR-AS Curve vs. Movements Along It

I The SR-AS curve is the SR relationship bw the PL and thequantity supplied, holding constant all other variables thata¤ect the willingness of �rms to supply G&S.

I If the PL changes but other variables are unchanged, theeconomy will move up or down a stationary AS curve.

I If any variable other than the PL changes, the AS curve willshift.

Variables That Shift the SR-AS Curve

I Increases in the labor force and in the capital stock. As theLF and the capital stock grow, �rms will supply more outputat every PL, and the SR-AS curve will shift to the right.

I Technological change. As TC takes place, the productivity ofcapital and labor increases, which means that �rms canproduce more G&S with the same amount of labor andcapital. Firms are then willing to produce more at every PLand AS shifts to the right.

I Expected changes in the future price level. If workers and�rms expect the PL to increase by a certain percentage, theSR-AS curve will shift by an equivalent amount, holdingconstant all other variables that a¤ect the SR-AS curve.

I (Conti.) Adjustments of workers and �rms to errors in pastexpectations about PL.

I They sometimes make wrong predictions about the PL, so theywill attempt to compensate for these errors.

I If increases in the PL turn out to be unexpected high, theunion will take this into account when negotiating the nextcontract. The higher wages under the new contract willincrease the company�s costs and result in the company�sneeding to receive higher prices to produce the same quantity.

I Unexpected changes in the price of an important naturalresource.

I They can cause �rms�costs to be di¤erent from what they hadexpected.

I E.g., Oil prices. If oil prices rise unexpectedly, �rms will facerising costs and thus only supply the same level of product athigher prices, and the SR-AS curve will shift to the left.

I Supply shock An unexpected event that causes the SR-AScurve to shift.


Shifts of the SRAS Curve vs. Movements along It

The short-run aggregate supply curve describes the relationship between the price level and the quantity of goods and services firms are willing to supply, holding constant all other variables that affect the willingness of firms to supply goods and services.

A change in the price level not caused by factors that would otherwise affect short-run aggregate supply results in a movement along a stationary SRAS curve.

But some factors cause the SRAS curve to shift; we will consider them in turn.


SRAS Shifts: Factors of Production and Technology

An increase in the availability of the factors of production, like labor and capital, allows more production at any price level.A decrease in the availability of these factors decreases SRAS.Improvements in technology allow productivity to improve, and hence the level of production at any given price level.

Variables that shift the short-run aggregate supply curve

Table 13.2

shifts the short-run An increase aggregatein… supply curve… because…


SRAS Shifts: Expected Future Prices

If workers and firms believe the price level will rise by a certain amount, they will try to adjust their wages and prices accordingly.Widely-held expectations of future price-level increases are self-fulfilling.


Table 13.2


How expectations of the future price level affect the short-run aggregate supply curve

Figure 13.3

Presenter

Presentation Notes

The SRAS curve shifts to reflect worker and firm expectations of future prices. 1. If workers and firms expect that the price level will rise by 3 percent, from 110.0 to 113.3, they will adjust their wages and prices by that amount. 2. Holding constant all other variables that affect aggregate supply, the short-run aggregate supply curve will shift to the left. If workers and firms expect that the price level will be lower in the future, the short-run aggregate supply curve will shift to the right.


SRAS Shifts: Adjustments to Errors in Past Expectations

Workers and firms sometimes make incorrect predictions about the price level.As time passes, they will attempt to compensate for these errors.Suppose everyone failed to predict an increase in the price level. Prices rise, therefore so does output.Then once firms and workers notice the rising prices, they update their expectations and increase their price demands, decreasing short-run aggregate supply.


Table 13.2



SRAS Shifts: Unexpected Changes in Prices of Resources

A supply shock is an unexpected event that causes the short-run aggregate supply curve to shift.

Example: Oil prices increase suddenly. Firms immediately anticipate rising input prices, and as a consequence will only produce the same amount of output if their own prices rise.

Unexpected input price increases decrease SRAS; unexpected input price decreases would shift SRAS to the right instead.


Table 13.2


Recessions, Expansions, and Supply Shocks

I Because the full analysis of the AD-AS model can becomplicated, we begin with a simpli�ed case, using twoassumptions:

1. The economy has not been experiencing any in�ation. The PLis currently 100, and workers and �rms expect it to remain at100 in the future.

2. The economy is not experiencing any long-run growth.Potential real GDP is $14.0 trillion and will remain at thatlevel in the future.

I Stag�ation A combination of in�ation and recession, usuallyresulting from a supply shock.


Long-Run Macroeconomic Equilibrium

In the long run, we expect the economy to produce at the level of potential GDP—i.e., the LRAS level.So the long-run macroeconomic equilibrium occurs when the AD and SRAS curves intersect at the LRAS level.Our next task is to explain why long-run macroeconomic equilibrium cannot occur at any other level of output.For simplicity, assume:1. No inflation; the current

and expected-future price level is 100.

2. No long-run growth; i.e. the LRAS curve is not moving.

Long-run macroeconomic equilibrium

Figure 13.4

Presenter

Presentation Notes

In long-run macroeconomic equilibrium, the AD and SRAS curves intersect at a point on the LRAS curve. In this case, equilibrium occurs at real GDP of $17.0 trillion and a price level of 110.


Long-Run Macroeconomic Equilibrium

Suppose that interest rates rise. AD moves left because:• Firms and households reduce their planned investments,

decreasing aggregate demand.• Workers lose their jobs, and firms experience decreases in sales.• Workers become

willing to accept lower wages, and firms expect lower prices for their output.

So the SRAS curve moves to the right, with goods and services sold for lower prices, until we return to full-employment.

The short-run and long-run effects of a decrease in aggregate demand

Figure 13.5

Presenter

Presentation Notes

In the short run, a decrease in aggregate demand causes a recession. In the long run, it causes only a decline in the price level.


Makingthe

ConnectionDoes It Matter What Causes AD to Fall?

GDP has four components; an decrease in any of the four could cause a recession. Does it make any difference which component causes the recession?

• Most post-WWII recessions in the U.S. have been preceded by falls in residential construction.

• Recent research suggests that recessions caused by financial crises tend to be larger and more long-lasting than declines due to other factors.


Expansion

Suppose that firms become more optimistic about the future.• They increase their

investment, shifting AD to the right.

• Unemployment falls below its natural rate, forcing employers to pay more; the increased demand for goods raises prices.

• Firms and workers raise their expectations about the price level, shifting SRAS to the left—restoring long run equilibrium.

The short-run and long-run effects of an increase in aggregate demand

Figure 13.6

Presenter

Presentation Notes

In the short run, an increase in aggregate demand causes an increase in real GDP. In the long run, it causes only an increase in the price level.


Supply Shock

In the previous analyses, AD moved suddenly. What if instead SRAS moved suddenly? We call this a supply shock.

For example, suppose a sudden increase in oil prices shifts SRAS to the left.

• This causes stagflation, a combination of inflation and recession, usually resulting from a supply shock.

The short-run and long-run effects of a supply shock:(a) A recession with a rising price level—the short-run effect of a supply shock

Figure 13.7a

Presenter

Presentation Notes

Panel (a) shows that a supply shock, such as a large increase in oil prices, will cause a recession and a higher price level in the short run. The recession caused by the supply shock increases unemployment and reduces output. Panel (b) shows that rising unemployment and falling output result in workers being willing to accept lower wages and firms being willing to accept lower prices. The short-run aggregate supply curve shifts from SRAS2 to SRAS1. Equilibrium moves from point B back to potential GDP and the original price level at point A.


Adjustment back to Potential GDP from a Supply Shock

With the lower level of output, people are unemployed and products go unsold.

• Workers accept a lower wage, and firms decrease prices in order to clear inventories.

With the decrease in expectations about prices, SRAS moves to the right, restoring long-run equilibrium. The short-run and long-run

effects of a supply shock:(b) adjustment back to potential GDP—the long run effect of a supply shock

Figure 13.7b


How Long Does Adjustment to Long-Run Equilibrium Take?

How long does it take to restore full employment?

• It depends on the severity of the supply shock, but it is likely to take several years.

An alternative to waiting this long is to use fiscal or monetary policy to increase aggregate demand.

• This will result in permanently higher prices but may be worth the cost.

The short-run and long-run effects of a supply shock:(b) adjustment back to potential GDP—the long run effect of a supply shock

Figure 13.7b


Makingthe

ConnectionForecasts for Returning to Potential GDP

After the 2007-2009 recession, different groups estimated how long itwould take to return to potential GDP.In 2011, the White House and the Congressional Budget Office estimated that we would return to full employment by 2016.The Federal Reserve disagreed, believing it would take even longer.For comparison, the second worst post-Depression recession was in 1981-1982; recovery then took less than three years.


Makingthe

ConnectionForecasts for Returning to Potential GDP

How accurate were these forecasts? It turns out, they were too optimistic.Economists still disagree about why the U.S. economy was taking so long to return to potential GDP; we will discuss this in later chapters.

2011 Estimates of 2013 Output Gap Actual Output GapWhite House

3.8%CBO2.7%

Federal Reserve2.1% 5.4%

A Dynamic AD-AS Model

I The basic AD-AS model just discussed gives some misleadingresults:

I It incorrectly predicts that a recession caused by the AD curveshifting to the left will cause the PL to fall, which has nothappened for an entire year since the 1930s.

I The problem arises from the two assumptions:

1. no continuing in�ation2. no long-run growth.

I In the dynamic setting, we assume potential real GDP growsover time and in�ation continues every year.

I (Conti.) We can then create a dynamic AD-AS model bymaking three changes to the basic model.

1. Potential real GDP increases continually, shifting the long-runAS curve to the right.

I If assuming that no other variables that a¤ect the SR-AScurve have changed, the LR-AS and SR-AS curves will shift tothe right by the same amount. Note that SR-AS is alsoa¤ected by other factors.

2. During most years, the AD curve will be shifting to the right.

I As population grows and income grows, consumption,investment, and gov spending will increase over time. The ADcurve will shift to the right. The AD curve shifting to the leftwill push the economy into recession.

I3 (cont.) Except during periods when workers and �rms expecthigh rates of in�ation, the short-run AS curve will be shiftingto the right.

I The dynamic model provides a more accurate explanation ofthe source of most in�ation. In Figure 13.9, the SR-AS curveshifts to the right by less than the LR-AS because theanticipated increase in prices o¤sets some of the TC andincreases in the LF and capital stock.

I Although in�ation is generally a result of total spendinggrowing faster than total production, a shift to the left ofSR-AS can also cause an increase in the PL, just like thesupply shock.


Dynamic AD and AS Model

A dynamic aggregate demand and aggregate supply model

Figure 13.8

Presenter

Presentation Notes

We start with the basic aggregate demand and aggregate supply model. In the dynamic model, increases in the labor force and capital stock as well as technological change cause long-run aggregate supply to shift over the course of a year, from LRAS1 to LRAS2. Typically, these same factors cause short-run aggregate supply to shift from SRAS1 to SRAS2. Aggregate demand will shift from AD1 to AD2 if, as is usually the case, spending by consumers, firms, and the government increases during the year.


What Is the Usual Cause of Inflation?

The usual cause of inflation is total spending increasing faster than production.

• AD moves further right than does LRAS.

• SRAS moves to the right; but the anticipated rise in the price level causes it to move less far than LRAS.

• Long run equilibrium is restored but with a higher price level. Using dynamic aggregate

demand and aggregate supply to understand inflation

Figure 13.9

Presenter

Presentation Notes

The most common cause of inflation is total spending increasing faster than total production. 1. The economy begins at point A, with real GDP of $17.0 trillion and a price level of 110. An increase in full-employment real GDP from $17.0 trillion to $17.4 trillion causes long-run aggregate supply to shift from LRAS1 to LRAS2. Aggregate demand shifts from AD1 to AD2. 2. Because AD shifts to the right by more than the LRAS curve, the price level in the new equilibrium rises from 110 to 114.


The Recession of 2007-2009

Three main factors combined to cause the recession:

The end of the housing bubble

House prices rose in the early 2000s—initially due to low interest rates, but then due to speculation. In 2006, the speculative bubble began to deflate, and the spending on residential investment fell.

The financial crisis

As many people defaulted on their mortgages, many financial institutions took heavy losses. This financial crisis led to a credit crunch, decreasing consumption and investment spending.

The rapid increase in oil prices during 2008

Several factors combined to increase the price of oil from $34 per barrel in 2004 to $140 per barrel in mid-2008. This supply shockexacerbated the ongoing recession.


The Recession of 2007-2009 in the Dynamic Model

In 2007, the economy was more or less in long-run equilibrium.As usual, potential GDP increased from 2007 to 2008.• But aggregate demand

did not keep pace (housing bubble, financial crisis).

At the same time, increasing oil prices shifted short-run aggregate supply to the left.• The result: higher prices

and below-potential real GDP.

The beginning of the recession of 2007-2009

Figure 13.10

Presenter

Presentation Notes

Between 2007 and 2008, the AD curve shifted to the right, but not by nearly enough to offset the shift to the right of the LRAS curve, which represented the increase in potential GDP from $14.84 trillion to $15.20 trillion. Because of a sharp increase in oil prices, short-run aggregate supply shifted to the left, from SRAS2007 to SRAS2008. Real GDP decreased from $14.88 trillion in 2007 to $14.83 trillion in 2008, which was far below the potential GDP, shown by LRAS2008. Because the increase in aggregate demand was small, the price level increased only from 97.3 in 2007 to 99.2 in 2008, so the inflation rate for 2008 was only 2.0 percent.


Macroeconomics Schools of Thought

Macroeconomic theory is relatively less settled than microeconomic theory.

Macroeconomics developed as a separate field within economics after the Great Depression.

John Maynard Keynes’ book The General Theory of Employment, Interest, and Money inspires the model we have addressed in this chapter. It also inspired the Keynesian revolution: the name given to the widespread acceptance during the 1930s and 1940s of John Maynard Keynes’ macroeconomic model.

Modern followers of Keynes refer to themselves as new Keynesians, and emphasize the stickiness of wages and prices in explaining fluctuations in real GDP—a concept which Keynes did not include in his original model.


Other Schools of Thought #1: Monetarism

Monetarism refers to the macroeconomic theories of Milton Friedman and his followers, particularly the idea that the quantity of money should be increased at a constant rate.

Friedman argued in the 1940s that most fluctuations in real output were caused by fluctuations in the money supply.

• Therefore, the Federal Reserve should concentrate less on interest rates, and more on following a monetary growth rule, a plan for increasing the quantity of money at a fixed rate that does not respond to changes in economic conditions.

Monetarism is based on the quantity theory of money, which we will examine in the next chapter.


Other Schools of Thought #2: New Classical Economics

New Classical macroeconomics emerged in the 1970s; it consists of the macroeconomic theories of Robert Lucas and others, particularly the idea that workers and firms have rational expectations.

In the New Classical school of thought, workers and firms develop expectations about price levels. If these expectations are wrong, then the real wage will be too high or too low, causing firms to reduce or increase employment respectively—recession or expansion.

• New Classical economists believe these fluctuations can be minimized by helping workers and firms to form correct expectations—again, a consistent monetary growth rule.


Other Schools of Thought #3: Real Business Cycle Theory

The Real business cycle model of the economy focuses on real, rather than monetary, causes of the business cycle.

Adherents to this model also believe that workers and firms form rational expectations about prices and wages, which adjust quickly to supply and demand. But they argue that the main sources of fluctuations in real GDP are temporary productivity shocks.

• They maintain that aggregate supply is vertical even in the short run and unaffected by the price level. It is supply shocks that affect the level of real output.


Other Schools of Thought #4: The Austrian School

The Austrian school of economics:• Began in the late 19th century with the writings of Carl Menger• Was advanced by Ludwig von Mises, and Friedrich von Hayek

The Austrian school argues for the superiority of the market system over economic planning.• Hayek particularly argued that only the price system could make

use of all of the dispersed information to achieve efficiency.

He also developed a theory of the business cycle wherein central bank-induced low interest rates cause the business cycle, by prompting overinvestment.• Austrians argue the 2007-2009 recession fits this model—the Fed

cut interest rates too low in fighting the 2001 recession, they claim.


Which School of Thought Is Correct?

To date, we do not know which school of thought is correct about the economy.

• Many pieces of evidence can be interpreted in several different ways.

• Economists cannot isolate particular elements to study and conduct controlled experiments.

So it is likely that debate about the applicability of schools of thought, and optimal policies for governments to pursue, will continue for the foreseeable future.

Documents

Chapter 13: Aggregate Demand and Aggregate …yluo/teaching/Econ1220/chapter13a.pdfAggregate Demand I In the short-run, real GDP ⁄uctuates around the long-run upward trend because