Aggregate Demand Aggregate Supply Slides by John Pamela

Figure 1: The Two-Way Relationship Between Output and the Price Level Aggregate Demand Curve Price Level Real GDP Aggregate Supply Curve 2

The Aggregate Demand Curve • First step in understanding how price level affects economy is an important fact – When price level rises, money demand curve shifts rightward • Shift in money demand, and its impact on the economy, is illustrated in Figure 2 • Imagine a rather substantial rise in price level—from 100 to 140 • Compared with our initial position, this new equilibrium has the following characteristics – – Money demand curve has shifted rightward Interest rate is higher Aggregate expenditure line has shifted downward Equilibrium GDP is lower • All of these changes are caused by a rise in price level • A rise in price level causes a decrease in equilibrium GDP 3

Figure 2 a: Deriving the Aggregate Demand Curve (a) Interest Rate 9% 6% Ms H As the price level rises, money demand increases and interest rate rises. E 500 Money ($ Billions) 4

Figure 2 b/c: Deriving the Aggregate Demand Curve (c) Aggregate Expenditure ($ Trillions) (b) E The rise in the interest rate causes real GDP to fall. H 6 AEr = 6% AEr = 9% 10 Real GDP ($ Trillions) Price Level 140 H 100 On the AD curve, a higher price level is associated with a lower real GDP. E AD 6 10 Real GDP ($ Trillions) 5

Deriving the Aggregate Demand Curve • Panel (c) of Figure 2 shows a new curve – Shows negative relationship between price level and equilibrium GDP • Call aggregate demand curve – Tells us equilibrium real GDP at any price level 6

Understanding the AD Curve • AD curve is unlike any other curve you’ve encountered in this text – In all other cases, our curves have represented simple behavioral relationships • But AD curve represents more than just a behavioral relationship between two variables – Each point on curve represents a short-run equilibrium in economy • A better name for AD curve would be “equilibrium output at each price level” curve—not a very catchy name – AD curve gets its name because it resembles demand curve for an individual product – AD curve is not a demand curve at all, in spite of its name 7

Movements Along the AD Curve • As you will see later in this chapter, a variety of events can cause price level to change, and move us along AD curve – Suppose price level rises, and we move from point E to point H along this curve – Following sequence of events occurs – Opposite sequence of events will occur if price level falls, moving us rightward along AD curve 8

Shifts of the AD Curve • When we move along AD curve in Figure 2, we assume that price level changes – But that other influences on equilibrium GDP are constant – Keep following rule in mind • When a change in price level causes equilibrium GDP to change, we move along AD curve • Whenever anything other than price level causes equilibrium GDP to change, AD curve itself shifts • Equilibrium GDP will change whenever there is a change in any of the following – – – Government purchases Taxes Autonomous consumption spending Investment spending Net exports Money supply 9

An Increase in Government Purchases • Spending shocks initially affect economy by shifting aggregate expenditure line • In Figure 3, we assume economy begins at a price level of 100 • Let’s increase government purchases by $2 trillion and ask what happens if price level remains at 100 – An increase in government purchases shifts entire AD curve rightward • AD curve shifts rightward when government purchases, investment spending, autonomous consumption spending, or net exports increase, or when taxes decrease • Analysis also applies in the other direction – AD curve shifts leftward when government purchases, investment spending, autonomous consumption spending, or net exports decrease, or when taxes increase 10

Figure 3: A Spending Shock Shifts the AD Curve Real Aggregate Expenditure ($ Trillions) (a) (b) At any given price level, an increase in government purchases shifts the AE line upward, raising real GDP. H Since real GDP is higher at the given price level, the AD curve shifts rightward. Price Level AE 2 AE 1 100 E H E 10 13. 5 AD 1 AD 2 Real GDP ($ Trillions) 10 13. 5 Real GDP ($ Trillions) 11

Changes in the Money Supply • Changes in money supply will also shift aggregate demand curve – Imagine that Fed conducts open market operations to increase money supply – AD curve shifts rightward • A decrease in money supply would have the opposite effect 12

Shifts vs. Movements Along the AD Curve: A Summary • Figure 4 summarizes how some events in economy cause a movement along AD curve, and other events shift AD curve • Panels (b) and (c) of Figure 4 tell us how a variety of events affect AD curve, but not how they affect real GDP • Where will price level end up? – First step in answering that question is to understand the other side of the relationship between GDP and price level 13

Figure 4 a: Effects of Key Changes on the Aggregate Demand Curve (a) Price Level Price level ↑ moves us leftward along the AD curve P 3 Price level ↓ moves us rightward along the AD curve P 1 P 2 AD Q 3 Q 1 Q 2 Real GDP 14

Figure 4 b: Effects of Key Changes on the Aggregate Demand Curve (b) Price Level Entire AD curve shifts rightward if: • a, IP, G, or NX increases • Net taxes decrease • The money supply increases AD 2 AD 1 Real GDP 15

Figure 4 c: Effects of Key Changes on the Aggregate Demand Curve (c) Price Level Entire AD curve shifts rightward if: decreases • a, IP, G, or NX decreases • Net taxes increase • The money supply decreases AD 1 AD 2 Real GDP 16

Costs and Prices • Price level in economy results from pricing behavior of millions of individual business firms – In any given year, some of these firms will raise their prices, and some will lower them • But often, all firms in the economy are affected by the same macroeconomic event – Causing prices to rise or fall throughout the economy • To understand how macroeconomic events affect the price level, we begin with a very simple assumption – A firm sets price of its products as a markup over cost per unit 17

Costs and Prices • Percentage markup in any particular industry will depend on degree of competition there • In macroeconomics, we are not concerned with how the markup differs in different industries – But rather with average percentage markup in economy • Determined by competitive conditions • Competitive structure changes very slowly, so average percentage markup should be somewhat stable from year-to-year • But a stable markup does not necessarily mean a stable price level, because unit costs can change – In short-run, price level rises when there is an economy-wide increase in unit costs • Price level falls when there is an economy-wide decrease in unit costs 18

GDP, Costs, and the Price Level • Why should a change in output affect unit costs and price level? – As total output increases • Greater amounts of inputs may be needed to produce a unit of output • Price of non-labor inputs rise • Nominal wage rate rises • A decrease in output affects unit costs through the same three forces, but with opposite result 19

The Short Run • All three of our reasons are important in explaining why a change in output affects price level – However, they operate within different time frames • But our third explanation—changes in nominal wage rate— is a different story • For a year or more after a change in output, changes in average nominal wage are less important than other forces that change unit costs • Some of the more important reasons why wages in many industries respond so slowly to changes in output – Many firms have union contracts that specify wages for up to three years – Wages in many large corporations are set by slow-moving bureaucracies – Wage changes in either direction can be costly to firms – Firms may benefit from developing reputations for paying stable wages 20

The Short Run • Nominal wage rate is fixed in short-run – We assume that changes in output have no effect on nominal wage rate in short-run • Since we assume a constant nominal wage in short-run, a change in output will affect unit costs through the other two factors – In short-run, a rise (fall) in real GDP, by causing unit costs to increase (decrease), will also cause a rise (decrease) in price level 21

Deriving the Aggregate Supply Curve • Figure 5 summarizes discussion about effect of output on price level in short-run • Each time we change level of output, there will be a new price level in short-run – Giving us another point on the figure – If we connect all of these points, we obtain economy’s aggregate supply curve • Tells us price level consistent with firms’ unit costs and their percentage markup at any level of output over short-run • A more accurate name for AS curve would be “short-run-price-level-at-each-output-level” curve 22

Figure 5: The Aggregate Supply Curve Price Level AS 130 B 100 80 A Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises. C Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price level falls. 6 10 13. 5 Real GDP ($ Trillions) 23

Movements Along the AS Curve • When a change in output causes price level to change, we move along economy’s AS curve – What happens in economy as we make such a move? – As we move upward along AS curve, we can represent what happens as follows 24

Shifts of the AS Curve • Figure 5 assumed that a number of important variables remained unchanged – But in real world, unit costs sometimes change for reasons other than a change in output • In general, we distinguish between a movement along AS curve, and a shift of curve itself, as follows – When a change in real GDP causes the price level to change, we move along AS curve • When anything other than a change in real GDP causes price level to change, AS curve itself shifts • What can cause unit costs to change at any given level of output? – – Changes in world oil prices Changes in the weather Technological change Nominal wage, etc. 25

Figure 6: Shifts of the Aggregate Supply Curve AS 2 Price Level 140 100 AS 1 L A 10 When unit costs rise at any given real GDP, the AS curve shifts upward–e. g. , an increase in world oil prices or bad weather for farm production. Real GDP ($ Trillions) 26

Figure 7 a: Effects of Key Changes on the Aggregate Supply Curve (a) Price Level AS Real GDP ↑ moves us rightward along the AS curve P 3 Real GDP ↓ moves us leftward along the AS curve P 1 P 2 Q 1 Q 3 Real GDP 27

Figure 7 b: Effects of Key Changes on the Aggregate Supply Curve (b) Price Level AS 2 AS 1 Entire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP Real GDP 28

Figure 7 c: Effects of Key Changes on the Aggregate Supply Curve (c) Price Level AS 1 AS 2 Entire AS curve shifts downward if unit costs ↓ for any reason besides an decrease in real GDP Real GDP 29

AD and AS Together: Short-Run Equilibrium • Where will the economy settle in short-run? – Where is our short-run macroeconomic equilibrium? • We know that in equilibrium, economy must be at some point on AD curve • Short-run equilibrium requires economy be operating on its AS curve • Only when economy is at point E—on both curves—will we have reached a sustainable level of real GDP and the price level 30

Figure 8: Short-Run Macroeconomic Equilibrium AS Price Level B 140 E 100 F AD 6 10 14 Real GDP ($ Trillions) 31

What Happens When Things Change? • Now that we know how short-run equilibrium is determined, and armed with our knowledge of AD and AS curves, we are ready to put model through its paces • Our short-run equilibrium will change when either AD curve, AS curve, or both, shift – An event that causes AD curve to shift is called a demand shock – An event that causes AS curve to shift is called a supply shock • In earlier chapters, we’ve used phrase spending shock – A change in spending by one or more sectors that ultimately affects entire economy – Demand shocks and supply shocks are just two different categories of spending shocks 32

An Increase in Government Purchases • Shifts AD curve rightward – Can see how it affects economy in short-run • Process we’ve just described is not entirely realistic – Assumes that when government purchases rise, first output increases, and then price level rises – In reality, output and price level tend to rise together 33

Figure 9: The Effect of a Demand Shock AS Price Level 130 115 100 H J E AD 1 10 13. 5 12. 5 AD 2 Real GDP($ Trillions) 34

An Increase in Government Purchases • Can summarize impact of price-level changes – When government purchases increase, horizontal shift of AD curve measures how much real GDP would increase if price level remained constant • But because price level rises, real GDP rises by less than horizontal shift in AD curve 35

An Decrease in Government Purchases 36

An Increase in the Money Supply • Although monetary policy stimulates economy through a different channel than fiscal policy – Once we arrive at AD and AS diagram, two look very much alike – Can represent situation as follows 37

Other Demand Shocks • A positive demand shock—shifts AD curve rightward – Increases both real GDP and price level in short -run • A negative demand shock—shifts AD curve leftward – Decreases both real GDP and price level in short-run 38

An Example: The Great Depression • U. S. economy collapsed far more seriously during 1929 through 1933—the onset of the Great Depression—than it did at any other time • What do we know about demand shocks that caused Great Depression? – Fall of 1929, bubble of optimism burst – Stock market crashed, and investment and consumption spending plummeted – Demand for products exported by United States fell – Fed reacted by cutting money supply sharply • Each of these events contributed to a leftward shift of AD curve – Causing both output and price level to fall 39

Demand Shocks: Adjusting to the Long-Run • In Figure 9, point H shows new equilibrium after a positive demand shock in short-run—a year or so after the shock – But point H is not necessarily where economy will end up in long-run • In short-run, we treat wage rate as given – But in long-run, wage rate can change – When output is above full employment, wage rate will rise, shifting AS curve upward – When output is below full employment, wage rate will fall, shifting AS curve downward 40

Demand Shocks: Adjusting to the Long Run • Increase in government purchases has no effect on equilibrium GDP in long-run – Economy returns to full employment, which is just where it started – This is why long-run adjustment process is often called economy’s self-correcting mechanism • If a demand shock pulls economy away from full employment – Change in wage rate and price level will eventually cause economy to correct itself and return to fullemployment output 41

Figure 10: The Long-Run Adjustment Process Price Level AS 2 AS 1 P 4 K J P 3 P 2 P 1 H E AD 2 AD 1 YFE Y 3 Y 2 Real GDP 42

Demand Shocks: Adjusting to the Long Run • For a positive demand shock that shifts AD curve rightward, self-correcting mechanism works like this 43

Figure 11: Long-Run Adjustment After A Negative Demand Shock Price Level AS 1 AS 2 P 1 P 2 N P 3 E M AD 1 AD 2 YFE Real GDP 44

Demand Shocks: Adjusting to the Long Run • Complete sequence of events after a negative demand shock looks like this 45

Demand Shocks: Adjusting to the Long Run • Can summarize economy’s self-correcting mechanism as follows – Whenever a demand shock pulls economy away from full employment • Self-correcting mechanism will eventually bring it back – When output exceeds its full-employment level, wages will eventually rise • Causing a rise in price level and a drop in GDP until full employment is restored – When output is less than its full employment level wages will eventually fall • Causing a drop in price level and a rise in GDP until full employment is restored 46

The Long-Run Aggregate Supply Curve • Self-correcting mechanism provides an important link between economy’s long-run and short-run behaviors • Long-run aggregate supply curve also illustrates another classical conclusion – An increase in government purchases causes complete crowding out • Rise in government purchases is precisely matched by a drop in consumption and investment spending – Leaving total output and total spending unchanged • Self-correcting mechanism shows that, in long-run, economy will eventually behave as classical model predicts • But notice the word eventually in the previous statement – This is why governments around the world are reluctant to rely on self-correcting mechanism alone to keep economy on track 47

Figure 12: The Long-Run Adjustment Process Price Level Long-Run AS Curve AS 2 AS 1 P 4 P 2 P 1 K H E AD 2 AD 1 YFE Y 2 Real GDP 48

Short-Run Effects of Supply Shocks • Figure 13 shows an example of a supply shock – An increase in world oil prices that shifts aggregate supply curve upward, from AS 1 and AS 2 – Called negative supply shock, because of negative effect on output • In short-run a negative supply shock shifts AS curve upward, decreasing output and increasing price level • Notice sharp contrast between effects of negative supply shocks and negative demand shocks in short-run – Economists and journalists have coined term “stagflation” to describe a stagnating economy experiencing inflation • A negative supply shock causes stagflation in short-run • Examples of positive supply shocks include unusually good weather, a drop in oil prices, and a technological change that lowers unit costs – In addition, a positive supply shock can sometimes be caused by government policy 49

Figure 13: The Effect of a Supply Shock Price Level Long-Run AS Curve AS 2 AS 1 P 2 R P 1 E AD Y 2 YFE Real GDP 50

Long-Run Effects of Supply Shocks • What about effects of supply shocks in long-run? – In some cases, we need not concern ourselves with this question, because some supply shocks are temporary • In other cases, however, a supply shock can last for an extended period • In long-run, economy self-corrects after a supply shock, just as it does after a demand shock – When output differs from its full-employment level • Wage rate changes • AS curve shifts until full employment is restored 51

Some Important Provisos About the AS Curve • Upward-sloping aggregate supply curve we’ve presented in this chapter gives a realistic picture of how economy behaves after a demand shock • However, the story we have told about what happens as we move along AS curve is somewhat incomplete – Made assumption that prices are completely flexible—that they can change freely over short periods of time • In fact, however, some prices take time to adjust, just as wages take time to adjust – Assumed that wages are completely inflexible in short-run • But in some industries, wages respond quickly – More to process of recovering from a shock than adjustment of prices and wages 52

Using the Theory: The Recession of 1990 -91 • Story of 1990 -91 recession begins in mid 1990, when Iraq invaded Kuwait – During this conflict, Kuwait’s oil was taken off world market, as was Iraq’s – Reduction in oil supplies resulted in a rapid and substantial increase in price of oil 53

Using the Theory: The Recession of 2001 • Story of 2001 recession was quite different – This time, there was no spike in oil prices and no other significant supply shock to plague economy – Rather, there was a demand shock, and a Federal reserve policy during the year before the recession that might have made it a bit worse • During late 1990 s, Fed had become concerned that investment boom and consumer optimism were shifting AD curve rightward too rapidly – Creating a danger that we would overshoot potential GDP and set off higher inflation – Fed responded by tightening money supply and raising interest rate – Effects of this policy may have continued into early 2001, exacerbating decrease in investment that was occurring for other reasons • In this way, rate hikes themselves may have contributed to a further leftward shift of AD curve 54

Figure 14 a: An AD and AS analysis of Two Recessions 1. In 1990, a supply shock from (a)higher oil prices shifted the AS curve leftward. . . Price Level AS 1991 AS 1990 P 2 R E P 1 2. causing output to fall. . . AD 1990 3. and the price level to rise. Y 2 YFE Real GDP 55

Figure 14 b: An AD and AS analysis of Two Recessions 4. In 2001, a demand shock from(b) several factors caused the AD curve to shift leftward. . . AS 2000 Price Level P 2 E R P 1 5. causing output to fall. . . AD 2000 6. and the price level to fall. AD 2001 Y 2 YFE Real GDP 56

Figure 15 a/b: GDP and the Price Level in Two Recessions The 1990 -91 Recession (b) Real GDP ($ Trillions) (a) 6. 75 CPI 140 6. 72 135 6. 69 6. 66 130 6. 63 125 6. 60 120 1989: 3 1990: 2 1991: 1 Year and Quarter 57

Figure 15 c/d: GDP and the Price Level in Two Recessions The 2001 Recession (d) Real GDP ($ Trillions) (c) 9. 35 CPI 178 9. 30 176 9. 25 9. 20 174 9. 15 172 9. 10 2000: 1 2001: 1 Year and Quarter 58

Using the Theory: Jobless Expansions • After a recession, economy enters expansion phase of business cycle – Employment usually grows rapidly during this period as well • But in our two most recent recessions, economy experienced abnormal, prolonged periods during which employment did not grow at all • Figure 16 illustrates behavior of employment during our two most recent recession – Called trough of recession • Vertical axis shows an employment index—employment divided by employment at the trough • Blue line shows that employment falls during the contraction phase of average cycle – Rises rapidly during the first year of the expansion phase • But red and pink lines show what happened in first year of our most recent expansions—during 1992 and 2002 – In both cases, employment drifted slightly downward, telling us that total number of jobs decreased during year 59

Figure 16: The Average Expansion Versus Two Recent Jobless Expansions Employment 1. 04 Index (Trough = 1) 1. 03 After Average Recession 1. 02 After 2001 Recession 1. 01 1. 00 After 1991 Recession 0. 99 -6 -4 -2 0 +2 +4 +6 +8 +10 +12 Months Before and After the Trough 60

Explaining Jobless Expansions • Since story is similar for both of these expansions, let’s focus on period from late 2001 to late 2002— the first year of expansion after our most recent recession – Using equation for economic growth • Real GDP = productivity x average hours x (emp / pop) x population • But equation can be used in different ways – Now we’re using equation to account for deviations in employment away from full employment in short-run • For this purpose, we’ll need to make some adjustments to equation – Real GDP = productivity x average hours x employment 61

Explaining Jobless Expansions • Let’s convert equation to percentage changes – %Δ real GDP = %Δ productivity + %Δ employment • Finally, rearranging – %Δ employment (-0. 3%) = %Δ real GDP (2. 9%) - %Δ productivity (3. 2%) • Numbers in parentheses show actual percentage changes for each of these variables during 2002 62

Explaining Jobless Expansions • Why didn’t real GDP growth keep up with productivity? – Because growth in real GDP was unusually low – Productivity grew at about the same rate as average expansion, in spite of the low growth in output – Throughout period, firms were reluctant to hire full-time, permanent workers • Created uncertainty about strength and duration of expansion • Instead, business expanded output by hiring part-time and temporary workers • Why would this boost productivity? – Enabled firms to adjust their workforce more easily to fluctuations in production • Phrase “jobless expansion” refers to just part of expansion phase – Eventually, employment catches up—even to higher levels of output made possible by productivity growth 63