Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 7 Aggregate Demand, Aggregate Supply, and the Self-Correcting Economy

Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Chapter 7

Aggregate Demand, Aggregate Supply, and the Self-Correcting Economy

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-2

Review of Demand Shocks

• Consumption: Changes in consumer confidence, stockmarket prices and housing prices can alter autonomous C

• Planned Investment: Changes in business optimism and expectations of future profits can alter I

• Money Supply: Changes in the money supply affect the interest rate, which affects interest-sensitive components of autonomous C and I

• Exchange Rates: Changes in e can affect net exports


Aggregate Demand

• The Aggregate Demand (AD) curve shows the different combinations of the price level and real output at which the money and commodity markets are both in equilibrium.

• Recall: Any increase in C + I + G + NX will cause the AD curve to shift to the right.


Figure 7-1 Effect on Real Income of Different Values of the Price Level


Figure 7-2 The Effect on the AD Curve of a Doubling of the Nominal Money Supply


Figure 7-3 The Effect on the AD Curve of a Decline in Planned Autonomous Spending


Aggregate Supply

• The Short-Run Aggregate Supply (SAS) curve shows the amount of output that business firms are willing to produce at different price levels, holding constant the nominal wage rate.– The SAS curve is upward sloping since an increase in

the price level will increase profits for firms assuming wages and other input costs are fixed. This results in firms increasing output at higher prices.

• The Long-Run Aggregate Supply (LAS) curve shows the amount that business firms are willing to produce when the nominal wage rate has fully adjusted to any changes in the price level.


Controversies Surrounding AS

• The three possible shapes of the AS curve has created decades of controversy.

• The horizontal AS curve assumes prices are fixed but is unrealistic because it cannot explain inflation.

• The vertical AS curve assumes prices are perfectly flexible and is useful to analyze inflation, but cannot explain unemployment.

• The positively sloped short-run AS curve assumes that wages are fixed, so it cannot be applied to the long run, but it helps to explain short-run fluctuations in output.


Figure 7-4 Effect of a Rightward Shift in the AD Curve with Three Alternative Short-Run Aggregate Supply Curves


Deriving the SAS Curve

• Assume that wages are fixed in the short run and that prices are merely “sticky.”

• If prices rise, firms benefit because the real wage paid to their workers falls.

• Thus, firms can increase output if the price level rises because their profits increase!– P Y , which yields an upward-sloping SAS curve

• How steep is the SAS curve?– If Labor Demand is relatively inelastic, SAS will be steeper!

– Why? If P W/P LD by a little Y by a little


Figure 7-5 The Labor Demand Curve and the Short-Run Aggregate Supply Curve


Figure 7-6 The Short-Run Aggregate Supply Curve for Two Different Values of the Wage Rate, and W0 W1


Determining the Equilibrium W/P

• Recall: LD depends negatively on the real wage

• We will assume that LS increases with W/P

• What increases or shifts LS to the right?– An increase in the working-age population

– A decrease in the availability of unemployment or welfare benefits

• W/P is determined by the equality of LD and LS


Figure 7-7 Determination of the Equilibrium Real Wage Rate


Figure 7-8 Effects on the Price Level and Real Income of an Increase in Planned Autonomous Spending from to AD1 to AD0


The Quantity Theory of Money

• Classical economists believed that flexible prices were the self-correcting forces that could stabilize real GDP.

• The “Quantity Equation” was a model developed by classical economists:

• MSV = PY

• The Quantity Theory of Money holds that:– Actual output tends to grow steadily

– Velocity is determined by payment practices

– MS changes therefore affect the price level and have little effect on output


The Failure of Self-Correction

• The Keynesian Revolution started with publication of John Maynard Keyne’s The General Theory in 1936 in response to failures of classical economic ideas during The Great Depression.

• Monetary Impotence is the failure of real GDP to respond to an increase in the real MS when either: – The IS curve is vertical

– The LM curve is horizontal (i.e. Liquidity Trap)

• Rigid Wages refers to the failure of the nominal wage rate to adjust by the amount needed to maintain equilibrium in the labor market.


Figure 7-9 Effect of a Decline in Planned Spending When the Price Level Is Perfectly Flexible


Figure 7-10 The Lack of Effect of a Drop in the Price Level When There Is a Failure of Self-Correction


Figure 7-11 Effect of a Decline in Planned Spending When the Nominal Rate Is Fixed at W0


Stabilizing and Destabilizing Effects of P

• Stabilizing Effects of P – The Pigou or Real Balance Effect is the direct stimulus to AD

caused by an increase in the real money supply and does not require a decline in the interest rate.

– The Keynes Effect is the stimulus to AD caused by a decline in the interest rate.

• Destabilizing Effects of P – The Expectations Effect is the decline in AD caused by the

postponement of purchases when consumers expect P.– The Redistribution Effect is the decline in AD caused by the effect

of falling prices in redistributing income from high-spending debtors to low-spending savers.


What Caused the Great Depression?

• Real investment fell by 74% from 1929 to 1933

• Sharp fall in consumption spending

• Fall in NX due to failure to devalue the USD until 1933 and protective tariffs

• Bank failures

• Tight monetary policy: Nominal MS fell by 25% from 1929 to 1933

• No price decline from 1936 to 1940– 26% decline from 1929 to 1933


Table 7-1 Money, Output, Unemployment, Prices, and Wages in the Great Depression, 1929–41


International Perspective: Why Was the Great Depression Worse in the United States than in Europe?


Figure 7-12 The Price Level (P) and the Ratio of Actual to Natural Real GDP (Y /YN) During the Great Depression, 1929–41


Chapter Equations


Chapter Equations

Changes in Aggregate DemandChanges in Real GDP

Fixed Price Level(7.1)

(7.2)sM V PY

Documents

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 7 Aggregate Demand, Aggregate Supply, and the Self-Correcting Economy