Chapter 19 Aggregate Demand Aggregate Supply 2005 Economic

Chapter 19 Aggregate Demand Aggregate Supply © 2005

Economic Principles The phases of the business cycle Gross Domestic Product (GDP) The CPI and GDP deflator Nominal and real GDP Aggregate demand aggregate supply © 2005 Gottheil - Principles of Economics, 4 e 2

Economic Principles Macroeconomic equilibrium Demand-pull and cost-push inflation © 2005 Gottheil - Principles of Economics, 4 e 3

Why Recession? Why Prosperity? Recession • A phase in the business cycle in which the decline in the economy’s real GDP persists for at least a half-year. A recession is marked by relatively high unemployment. © 2005 Gottheil - Principles of Economics, 4 e 4

Why Recession? Why Prosperity? Depression • Severe recession. © 2005 Gottheil - Principles of Economics, 4 e 5

Why Recession? Why Prosperity? Prosperity • A phase in the business cycle marked by a relatively high level of real GDP, full employment, and inflation. © 2005 Gottheil - Principles of Economics, 4 e 6

Why Recession? Why Prosperity? Inflation • An increase in the price level. © 2005 Gottheil - Principles of Economics, 4 e 7

Why Recession? Why Prosperity? Business cycle • Alternating periods of growth and decline in an economy’s GDP. © 2005 Gottheil - Principles of Economics, 4 e 8

Why Recession? Why Prosperity? Business cycle • No two business cycles are identical. The number of months in any given phase of the cycle varies from cycle to cycle. © 2005 Gottheil - Principles of Economics, 4 e 9

Why Recession? Why Prosperity? Trough • The bottom of a business cycle. © 2005 Gottheil - Principles of Economics, 4 e 10

Why Recession? Why Prosperity? Trough • This is the time period when the economy’s unemployment rate is greatest and output declines to the cycle’s minimum level. © 2005 Gottheil - Principles of Economics, 4 e 11

Why Recession? Why Prosperity? Recovery • A phase in the business cycle, following a recession, in which real GDP increases and unemployment declines. © 2005 Gottheil - Principles of Economics, 4 e 12

Why Recession? Why Prosperity? Peak • The top of a business cycle. © 2005 Gottheil - Principles of Economics, 4 e 13

Why Recession? Why Prosperity? Peak • This is the time period when output reaches its maximum level, the labor force is fully employed, and increasing pressure on prices is likely to generate inflation. © 2005 Gottheil - Principles of Economics, 4 e 14

Why Recession? Why Prosperity? Downturn • A phase in the business cycle in which real GDP declines, inflation moderates, and unemployment emerges. © 2005 Gottheil - Principles of Economics, 4 e 15

Why Recession? Why Prosperity? Trend lines trace the economy’s output performance over the course of a business cycle, measured either from recession to recession or from prosperity to prosperity. © 2005 Gottheil - Principles of Economics, 4 e 16

Why Recession? Why Prosperity? • Upward-sloping trend lines signify economic growth. • The steeper the trend line, the higher the economy’s rate of growth. • When no growth occurs, the trend line is horizontal. © 2005 Gottheil - Principles of Economics, 4 e 17

EXHIBIT 1 © 2005 THE BUSINESS CYCLE Gottheil - Principles of Economics, 4 e 18

Exhibit 1: The Business Cycle What does the trend line in Exhibit 1 tell us about the economy’s output performance? • The trend line shows that the economy is growing. © 2005 Gottheil - Principles of Economics, 4 e 19

Measuring the National Economy Gross Domestic Product (GDP) • Total value of all final goods and services, measured in current market prices, produced in the economy during a year. © 2005 Gottheil - Principles of Economics, 4 e 20

Measuring the National Economy Gross Domestic Product (GDP) • “Final goods and services” refers to everything produced that is not itself used to produce other goods and services. © 2005 Gottheil - Principles of Economics, 4 e 21

Measuring the National Economy Gross Domestic Product (GDP) • “During a given year” refers to a specific calendar year. © 2005 Gottheil - Principles of Economics, 4 e 22

Measuring the National Economy Gross Domestic Product (GDP) • “Produced in the economy” refers to any good or service produced in the United States, regardless of whether a US-owned or a foreign-owned company produced the good. © 2005 Gottheil - Principles of Economics, 4 e 23

Measuring the National Economy Gross Domestic Product (GDP) • Conversely, goods produced by US-owned firms in foreign countries are not included in GDP. © 2005 Gottheil - Principles of Economics, 4 e 24

Measuring the National Economy To compare GDP across years, we must devise some way of eliminating the effect of inflation. © 2005 Gottheil - Principles of Economics, 4 e 25

Measuring the National Economy Nominal GDP • GDP measured in terms of current market prices—that is, the price level at the time of measurement. (It is not adjusted for inflation. ) © 2005 Gottheil - Principles of Economics, 4 e 26

Measuring the National Economy Real GDP • GDP adjusted for changes in the price level. © 2005 Gottheil - Principles of Economics, 4 e 27

Measuring the National Economy • Price indices are designed to remove the effect of price changes. • The consumer price index and the GDP deflator are the two indices most commonly used. © 2005 Gottheil - Principles of Economics, 4 e 28

Measuring the National Economy Consumer Price Index (CPI) • A measure comparing the prices of consumer goods and services that a household typically purchases to the prices of those goods and services purchased in a base year. © 2005 Gottheil - Principles of Economics, 4 e 29

Measuring the National Economy Base year • The reference year with which prices in other years are compared in a price index. © 2005 Gottheil - Principles of Economics, 4 e 30

Measuring the National Economy Price level • A measure of prices in one year expressed in relation to prices in a base year. © 2005 Gottheil - Principles of Economics, 4 e 31

Measuring the National Economy Example: Suppose in 1998 (the base year) a basket of goods including such things as food, clothing, and fuel cost $350. The $350 converts to a price level index of 100, P = 100. © 2005 Gottheil - Principles of Economics, 4 e 32

Measuring the National Economy Example: Suppose in the next year, 1999, the same basket of goods cost $385. The 1999 CPI, measured against the 1998 base year of 100, is 110. P = ($385/$350) × 100 = 110. © 2005 Gottheil - Principles of Economics, 4 e 33

Measuring the National Economy Example: A 1999 P = 110 indicates that from 1998 to 1999 the cost of goods and services that consumers typically buy increased by 10 percent. © 2005 Gottheil - Principles of Economics, 4 e 34

Measuring the National Economy GDP deflator • A measure comparing the prices of all goods and services produced in the economy during a given year to the prices of those goods and services purchased in a base year. © 2005 Gottheil - Principles of Economics, 4 e 35

Measuring the National Economy GDP deflator • This price index includes not only consumer goods and services, but also producer goods, investment goods, exports and imports, and goods and services purchased by government. © 2005 Gottheil - Principles of Economics, 4 e 36

Measuring the National Economy GDP deflator • This price index is used to convert nominal GDP to real GDP. © 2005 Gottheil - Principles of Economics, 4 e 37

Measuring the National Economy The formula to convert from nominal GDP to real GDP is: • Real GDP = (nominal GDP × 100)/ GDP deflator. © 2005 Gottheil - Principles of Economics, 4 e 38

EXHIBIT 2 CONVERTING NOMINAL GDP TO REAL GDP: 1995– 2002 ($ BILLIONS, 1996 = 100) Source: U. S. Department of Commerce, Bureau of Economic Analysis. © 2005 Gottheil - Principles of Economics, 4 e 39

Exhibit 2: Converting Nominal GDP to Real GDP: 1995 -2000 1. What is the nominal difference between GDP in 1996 and 1997? • The nominal difference = $8, 318. 4 billion - $7, 813. 2 billion = $505. 2 billion. © 2005 Gottheil - Principles of Economics, 4 e 40

Exhibit 2: Converting Nominal GDP to Real GDP: 1995 -2000 2. What is the real difference between GDP in 1996 and 1997? • Real GDP in 1996 is = ($7, 813. 2 billion × 100)/100. 00 = $7, 813. 2 billion. © 2005 Gottheil - Principles of Economics, 4 e 41

Exhibit 2: Converting Nominal GDP to Real GDP: 1995 -2000 2. What is the real difference between GDP in 1996 and 1997? • Real GDP in 1997 = ($8, 318. 4 billion × 100)/101. 95 = $8, 159. 5 billion. © 2005 Gottheil - Principles of Economics, 4 e 42

Exhibit 2: Converting Nominal GDP to Real GDP: 1995 -2000 2. What is the real difference between GDP in 1996 and 1997? • The real difference = $8, 159. 5 billion - $7, 813. 2 billion = $346. 3 billion. © 2005 Gottheil - Principles of Economics, 4 e 43

Deriving Equilibrium GDP in the Aggregate Demand Supply Model The aggregate demand aggregate supply model is one model used to explain how GDP is determined. © 2005 Gottheil - Principles of Economics, 4 e 44

Deriving Equilibrium GDP in the Aggregate Demand Supply Model Aggregate supply • The total quantity of goods and services that firms in the economy are willing to supply at varying price levels. © 2005 Gottheil - Principles of Economics, 4 e 45

Deriving Equilibrium GDP in the Aggregate Demand Supply Model There are three distinct segments of the aggregate supply curve: 1. Horizontal segment. Real GDP increases without affecting the economy’s price level. © 2005 Gottheil - Principles of Economics, 4 e 46

Deriving Equilibrium GDP in the Aggregate Demand Supply Model There are three distinct segments of the aggregate supply curve: 2. Upward-sloping segment. A positive relationship between real GDP and price level. © 2005 Gottheil - Principles of Economics, 4 e 47

Deriving Equilibrium GDP in the Aggregate Demand Supply Model There are three distinct segments of the aggregate supply curve: 3. Vertical segment. All resources are fully employed, so that real GDP cannot increase. © 2005 Gottheil - Principles of Economics, 4 e 48

Deriving Equilibrium GDP in the Aggregate Demand Supply Model Aggregate demand • The total quantity of goods and services demanded by households, firms, foreigners, and government at varying price levels. © 2005 Gottheil - Principles of Economics, 4 e 49

Deriving Equilibrium GDP in the Aggregate Demand Supply Model Increases in the price level affect people’s real wealth, their lending and borrowing activity, and the nation’s trade with other nations. © 2005 Gottheil - Principles of Economics, 4 e 50

Deriving Equilibrium GDP in the Aggregate Demand Supply Model The quantity of goods and services demanded in the economy declines when price levels increase. © 2005 Gottheil - Principles of Economics, 4 e 51

EXHIBIT 3 © 2005 AGGREGATE SUPPLY AND AGGREGATE DEMAND Gottheil - Principles of Economics, 4 e 52

Exhibit 3: Aggregate Supply and Aggregate Demand At what real GDP value is fullemployment of resources realized in Exhibit 3? • Full-employment real GDP is $9. 5 trillion. © 2005 Gottheil - Principles of Economics, 4 e 53

Deriving Equilibrium GDP in the Aggregate Demand Supply Model • The aggregate demand curve shifts when there is a change in the quantity of goods and services demanded at a particular price level. • Government spending, income levels, and expectations about the future all factors that can cause the curve to shift. © 2005 Gottheil - Principles of Economics, 4 e 54

Deriving Equilibrium GDP in the Aggregate Demand Supply Model The aggregate supply curve shifts due to factors such as changes in resource availability and resource prices. © 2005 Gottheil - Principles of Economics, 4 e 55

EXHIBIT 4 © 2005 SHIFTS IN AGGREGATE DEMAND AGGREGATE SUPPLY Gottheil - Principles of Economics, 4 e 56

Exhibit 4: Shifts in Aggregate Demand Aggregate Supply What might cause the aggregate demand curve in panel a of Exhibit 4 to shift to the right? • Increases in government spending, increases in incomes, and optimistic expectations could all cause the aggregate demand curve to shift to the right. © 2005 Gottheil - Principles of Economics, 4 e 57

Macroeconomic Equilibrium Macroequilibrium • The level of real GDP and the price level that equate the aggregate quantity demanded and the aggregate quantity supplied. © 2005 Gottheil - Principles of Economics, 4 e 58

EXHIBIT 5 © 2005 ACHIEVING MACROECONOMIC EQUILIBRIUM Gottheil - Principles of Economics, 4 e 59

Exhibit 5: Achieving Macroeconomic Equilibrium 1. At what price level and real GDP is macroequilibrium achieved in Exhibit 5? • Macroequilibrium is achieved at P = 101. 95 and real GDP = $8. 1595 trillion. © 2005 Gottheil - Principles of Economics, 4 e 60

Exhibit 5: Achieving Macroeconomic Equilibrium 2. What happens when the price level increases to P = 110? • At P = 110, the aggregate quantity demanded falls to $5 trillion and the aggregate quantity supplied increases to $9 trillion. © 2005 Gottheil - Principles of Economics, 4 e 61

Equilibrium, Inflation, and Unemployment • The Depression of the 1930 s produced one of the poorest GDP performance records in our economic history. • Real GDP fell by 30 percent in the first four years of the decade. © 2005 Gottheil - Principles of Economics, 4 e 62

Time Line on Equilibrium, Inflation, and Unemployment The U. S. commitment to support England during World War II changed the pace and direction of our national economy significantly. © 2005 Gottheil - Principles of Economics, 4 e 63

Time Line on Equilibrium, Inflation, and Unemployment • Government war-related spending shifted the aggregate demand curve to the right. • With millions of men and women joining the armed forces, the size of the civilian labor pool declined and the aggregate supply curve shifted to the left. © 2005 Gottheil - Principles of Economics, 4 e 64

Time Line on Equilibrium, Inflation, and Unemployment • The same basic shifts in aggregate demand supply occurred during the Vietnam War. • Unlike the poor economic condition prior to WWII, however, the economy was already relatively vigorous prior to the Vietnam war. Inflation resulted. © 2005 Gottheil - Principles of Economics, 4 e 65

Time Line on Equilibrium, Inflation, and Unemployment Demand-pull inflation • Inflation caused primarily by an increase in aggregate demand. © 2005 Gottheil - Principles of Economics, 4 e 66

Equilibrium, Inflation, and Unemployment Stagflation • A period of stagnating real GDP, rapid inflation, and relatively high levels of unemployment. © 2005 Gottheil - Principles of Economics, 4 e 67

Time Line on Equilibrium, Inflation, and Unemployment The oil price increases imposed by OPEC during the 1970 s caused the cost of producing nearly everything in the economy to increase. The aggregate supply curve shifted to the left. GDP declined while the price level increased. © 2005 Gottheil - Principles of Economics, 4 e 68

Time Line on Equilibrium, Inflation, and Unemployment Cost-push inflation • Inflation caused primarily by a decrease in aggregate supply. © 2005 Gottheil - Principles of Economics, 4 e 69

EXHIBIT 6 AGGREGATE DEMAND AGGREGATE SUPPLY DURING THE DEPRESSION AND WAR PERIOD AND THE OIL PRICE INCREASES © 2005 Gottheil - Principles of Economics, 4 e 70

Exhibit 6: Aggregate Demand Aggregate Supply During the Depression and War Period and the Oil Price Increases How does macroeconomic equilibrium change before and after OPEC in panel b of Exhibit 6? • The aggregate supply curve shifts to the left after OPEC. © 2005 Gottheil - Principles of Economics, 4 e 71

Exhibit 6: Aggregate Demand Aggregate Supply During the Depression and War Period and the Oil Price Increases How does macroeconomic equilibrium change before and after OPEC in panel b of Exhibit 6? • A new equilibrium is obtained at a lower level of real GDP and at a higher price level. 72 © 2005 Gottheil - Principles of Economics, 4 e

Time Line on Equilibrium, Inflation, and Unemployment • During the second half of the 1980 s, the economy was performing about as well as it ever had in the last quarter century. • Tax reforms, ready credit, leveraged buyouts, a commercial real estate boom, and optimistic expectations contributed to the already strong aggregate demand. © 2005 Gottheil - Principles of Economics, 4 e 73

Time Line on Equilibrium, Inflation, and Unemployment Leveraged buyout • A primarily debt-financed purchase of all the stock or assets of a company. © 2005 Gottheil - Principles of Economics, 4 e 74

Time Line on Equilibrium, Inflation, and Unemployment The recession of 1990 -91 was caused by an inward shift in aggregate demand. Reduced federal revenue sharing with states, downsized government budgets, cuts in demand for military goods, and high levels of debt acquired during the 1980 s are all to blame. © 2005 Gottheil - Principles of Economics, 4 e 75

The Longest Prosperity Phase: 1992 -2000 Economists attribute the boom to supply-side factors: • A rise in the nation’s productivity caused by the diffusion of computer technology throughout the economy. • The absence of rising inflation. © 2005 Gottheil - Principles of Economics, 4 e 76

The 2001 -02 Recession and 9/11 • The 1992 -2000 buying spree left consumers without the means to keep the spree alive. • Terrorist attacks created a heightened sense of economic uncertainty. © 2005 Gottheil - Principles of Economics, 4 e 77

Can We Avoid Unemployment and Inflation? Although the desired macroequilibrium outcome would occur at a real GDP level consistent with full employment and no inflation, this level is not always achieved. © 2005 Gottheil - Principles of Economics, 4 e 78

Can We Avoid Unemployment and Inflation? Some economists believe government should act in ways to help shift macroequilibrium to this position. © 2005 Gottheil - Principles of Economics, 4 e 79

Can We Avoid Unemployment and Inflation? Increasing or decreasing government spending and income taxes are two methods government can use to attempt to shift the aggregate demand curve. © 2005 Gottheil - Principles of Economics, 4 e 80

EXHIBIT 7 OBTAINING FULL-EMPLOYMENT GDP WITHOUT INFLATION © 2005 Gottheil - Principles of Economics, 4 e 81

Exhibit 7: Obtaining Full. Employment GDP Without Inflation How might government shift the aggregate demand curve from AD to AD′ in Exhibit 7? • Government could increase spending and reduce income taxes in order to shift the demand curve to the right. © 2005 Gottheil - Principles of Economics, 4 e 82