THIRD EDITION and | Robin Wells

Chapter 12(27) and Aggregate • How the aggregate demand curve illustrates the relaonship between the aggregate level and the quanty of aggregate output demanded in the economy WHAT YOU • How the curve WILL LEARN illustrates the relaonship between the aggregate and the quanty of IN THIS aggregate output supplied in the CHAPTER economy • Debates regarding the short run and long run aggregate supply schedules • How the AS–AD model is used to analyze economic fluctuaons • How and fiscal policy can stabilize the economy Aggregate Demand

• The aggregate demand curve shows the relaonship between the aggregate price level and the quanty of aggregate output demanded by , businesses, the government and the rest of the world. The Aggregate Demand Curve Aggregate price level (GDP de!ator, 2005 = 100)

A movement down the AD curve leads to a lower aggregate price level and higher aggregate output. 1933 7.9

4.2

Aggregate demand curve, AD

0 716 1000 Real GDP (billions of 2005 dollars) The Aggregate Demand Curve

• It is downward-sloping for three reasons (Keynesian): § The first is the wealth effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households’ wealth and reduces consumer spending. § The second is the rate effect of a change in aggregate the price level—a higher aggregate price level, results in higher interest rates and a fall in and consumer spending. § The third is the foreign effect of a change in the aggregate price level – a higher price level reduces exports. • Quanty Theorec View (Monetarist): MV = PY § With MV fixed, P and Y are inversely related (hyperbola) The Aggregate Demand Curve and the Income-Expenditure Model

Planned 45-degree line aggregate spending E AE 2 Planned 2

AE AE Planned 1 Planned E 1

AE Planned

Y Y 1 2 Real GDP The Aggregate Demand Curve and the Income-Expenditure Model

Planned 45-degree line Aggregate Spending E AEPlanned2 (a) Change in 2 Income- AEPlanned1 Expenditure Equilibrium

E1

Real GDP Aggregate Price Level

P (b) Aggregate 1 Demand P2

AD

Y1 Y2 Real GDP Parameterizaon of Aggregate Demand 1

P

. exp AD = ƒ ( P | Wealth, Real r, expect, P , Y*, exch rate)

P1

AD

Shi Parameters: Y Wealth Real interest rates Expectaons / Animal Spirits Expected future inflaon Growth rate of Foreign GDP Exchange Rate Parametric Shis Aggregate Demand 2

P

. exp AD = ƒ ( P | Wealth, Real r, expect, P , Y*, exch rate)

P1

AD = C + I + G + NE

Shi Parameters: Y Wealth Incr W => Incr Qd @ P1 Real interest rates Incr r => Decr C, I => Decr Qd @ P1 Expectaons / Animal Spirits Improvement => Incr Qd @ P1 Expected future inflaon Expect future infl => Incr Qd @ P1 Now Growth rate of Foreign GDP Incr Foreign GDP => Incr Exports => Incr Qd Exchange Rate apprec => Decr Net Exports Shis of the Aggregate Demand Curve

(a) Rightward Shift (b) Leftward Shift

Aggregate Aggregate price level price level Decrease in aggregate demand

Increase in aggregate demand

P1 P1

AD AD AD AD 1 2 2 1

Real GDP Real GDP e.g. Factors that Shis the Aggregate Demand Curve

• Changes in expectaons • If consumers and firms become more opmisc, aggregate demand increases. • If consumers and firms become more pessimisc, aggregate demand decreases.

• Changes in wealth • If the real of assets rises, aggregate demand increases. • If the real value of household assets falls, aggregate demand decreases.

Factors that Shis the Aggregate Demand Curve

• • If the government increases spending or cuts taxes, aggregate demand increases. • If the government reduces spending or raises taxes, aggregate demand decreases.

• Monetary policy • If the increases the quanty of , aggregate demand increases. • If the central bank reduces the quanty of money, aggregate demand decreases Aggregate Supply

• The aggregate supply curve shows the relaonship between the aggregate price level and the quanty of aggregate output in the economy. The Short-Run Aggregate Supply Curve

• The short-run aggregate supply curve is upward-sloping because nominal are scky in the short run: § A higher aggregate price level leads to higher profits and increased aggregate output in the short run.

• The nominal is the dollar amount of the wage paid.

• Scky wages are nominal wages that are slow to fall even in the face of high and slow to rise even in the face of labor . Aggregate Supply – Short Run

J. Marthinsen Parameterizaon of Aggregate Supply 1

P . exp AS = ƒ ( P | Factor , P , Supply Shocks, Resource Supply, Q/L, Inst Eff ) (Labor, Capital, Energy) (Producvity)

P1

Shi Parameters: Yf Potenal GDP Factor Prices Expected Future Prices Pos/Neg Supply Shocks Resource Discovery, Depleon Producvity Instuonal Efficiencies Parametric Shis Aggregate Supply 2

P . exp AS = ƒ ( P | Factor Prices, P , Supply Shocks, Resource Supply, Q/L, Inst Eff ) (Labor, Capital, Energy) (Producvity)

P1

Shi Parameters: Y1 Y2 Yf Potenal GDP Factor Prices Expected Future Prices [Do Not impact Potenal GDP] Pos/Neg Supply Shocks Resource Discovery, Depleon Producvity [Factors that Do impact Potenal GDP] Instuonal Efficiencies Parametric Shis Aggregate Supply 3

P . exp AS = ƒ ( P | Factor Prices, P , Supply Shocks, Resource Supply, Q/L, Inst Eff ) (Labor, Capital, Energy) (Producvity)

P1

Shi Parameters: Y1 Yf Y2 Yf ‘ Potenal GDP Factor Prices Expected Future Prices [Factors that Do Not impact Potenal GDP] Pos/Neg Supply Shocks Resource Discovery, Depleon Producvity [Factors that Do impact Potenal GDP] Instuonal Efficiencies The Short-Run Aggregate Supply Curve Aggregate price level (GDP de!ator, 2005 = 100) Short-run aggregate supply curve, SRAS

10.6 1929 A movement down 7.9 the SRAS curve leads 1933 to de!ation and lower aggregate output.

0 716 976 Real GDP (billions of 2005 dollars) Shis of the Short-Run Aggregate Supply Curve

(a) Leftward Shift (b) Rightward Shift

Aggregate Aggregate price level price level SRAS SRAS 1 SRAS 2 SRAS 1 2

Increase in short-run Decrease in short-run aggregate supply aggregate supply

Real GDP Real GDP e.g. Factors that Shi Short-Run Aggregate Supply

• Changes in prices • If commodity prices fall, short-run aggregate supply increases. • If commodity prices rise, short-run aggregate supply decreases.

• Changes in nominal wages • If nominal wages fall, short-run aggregate supply increases. • If nominal wages rise, short-run aggregate supply decreases.

• Changes in producvity • If workers become more producve, short-run aggregate supply increases. • If workers become less producve, short-run aggregate supply decreases. AS-AD All Together

P . exp AS = ƒ ( P | Factor Prices, P , Supply Shocks, Resource Supply, Q/L, Inst Eff ) (Labor, Capital, Energy) (Producvity)

1 P1 . exp AD = ƒ ( P | Wealth, Real r, expect, P , Y*, exch rate)

AD = C + I + G + NE

Y1 Yf Potenal GDP

1 AD = AS Equilibrium P1, Y1 e.g. Collapse in Demand - AS-AD

P 1 AD = AS Inial Equilibrium P1, Y1 – Reducon in Demand => Qd is reduced at P1 to Pt 2. 2 AD < AS Disequilibrium - Prices Fall

Movement along AD 2 to 3 2 1 Movement along AS 1 to 3 P1 3 AD’ = AS New Equilibrium @ Pt. 3 P2 3 AD = C + I + G + NE

Y2 Y1 Yf Potenal GDP

Long-Run Aggregate Supply Curve

• The long-run aggregate supply curve shows the relaonship between the aggregate price level and the quanty of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible. Long-Run Aggregate Supply Curve

Aggregate price level Long-run aggregate (GDP de!ator, supply curve, LRAS 2005 = 100) 15.0 …leaves the quantity A fall in the of aggregate output aggregate supplied unchanged price level… in the long run.

7.5

0 $800 Potential Real GDP

output, YP (billions of 2005 dollars) Actual and Potenal Output Shis the LRAS Curve Rightward From the Short Run to the Long Run

(a) Leftward Shift of the Short-Run (b) Rightward Shift of the Short-Run Aggregate Supply Curve Aggregate Supply Curve

Aggregate price Aggregate price level level

L RAS L RAS SR AS 1 SR AS 2

SR AS 2 S RAS 1

A fall in nominal A1 A1 P wages shifts SRAS P1 1 rightward. A rise in nominal wages shifts SRAS leftward.

Y Y YP Y1 Real GDP 1 P Real GDP Pialls

Are We There Yet? What the Long Run Really Means

• We’ve used the term long run in two different contexts. § In an earlier chapter, we focused on long-run economic growth: growth that takes place over decades. § In this chapter, we introduced the long-run aggregate supply curve, which depicts the economy’s potenal output: the level of aggregate output that the economy would produce if all prices, including nominal wages, were fully flexible.

• It might seem that we’re using the same term, long run, for two different concepts. § But we aren’t: these two concepts are really the same thing. Pialls

Are We There Yet? What the Long Run Really Means

• Because the economy always tends to return to potenal output in the long run, actual aggregate output fluctuates around potenal output, rarely geng too far from it. • As a result, the economy’s rate of growth over long periods —say, decades—is very close to the rate of growth of potenal output. • And potenal output growth is determined by the factors we analyzed in the chapter on long-run economic growth. So, that means that the “long run” of long-run growth and the “long run” of the long-run aggregate supply curve coincide. ECONOMICS IN ACTION The AS–AD Model

• The AS–AD model uses the aggregate supply curve and the aggregate demand curve together to analyze economic fluctuaons.

Short-Run Macroeconomic Equilibrium

• The economy is in short-run macroeconomic equilibrium when the quanty of aggregate output supplied is equal to the quanty demanded.

• The short-run equilibrium aggregate price level is the aggregate price level in the short-run macroeconomic equilibrium.

• Short-run equilibrium aggregate output is the quanty of aggregate output produced in the short-run macroeconomic equilibrium. The AS–AD Model

Aggregate price level

S R AS

P E Short-run E SR macroeconomic equilibrium

AD

Y E Real GDP Shis of Aggregate Demand: Short-Run Effects

(a) A Negative (b) A Positive Demand Shock

Aggregate Aggregate price level price level A negative demand A positive demand shock... shock...

SRAS SRAS

...leads to a higher P P E 1 E1 2 2 aggregate price ...leads to a lower P level and higher 2 aggregate price level P E 1 E1 aggregate output. 2 and lower aggregate AD AD1 output. 2 AD 2 AD1 Y Y Y Y 2 1 1 2 Real GDP Real GDP Shis of the SRAS Curve

(a) A Negative Supply Shock (b) A Positive Supply Shock

Aggregate Aggregate price price level level

A negative supply A positive supply shock... shock...

SRAS SRAS 2 1 SRAS 1 SRAS 2 E E 2 1 P P 2 1 ...leads to a higher ...leads to a lower aggregate output P E1 aggregate output P E 2 1 2 and lower aggregate and a higher price level. AD aggregate price AD level.

Y Y Y Y 2 1 Real GDP 1 2 Real GDP GLOBAL COMPARISON: The Supply Shock of the Twenty-first Century Long-Run Macroeconomic Equilibrium

• The economy is in long-run macroeconomic equilibrium when the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve. Long-Run Macroeconomic Equilibrium

Aggregate price level L R AS

S R AS

Long-run P E E LR macroeconomic equilibrium

AD

Y P Real GDP Potential output Short-Run versus Long-Run Effects of a Negave Demand Shock

2. …reduces the aggregate price Aggregate level and aggregate output and price level leads to higher unemployment in the short run…

L R AS S R AS 1

SRAS 2

P E 1 1 1. An initial 3. …until an eventual P 2 negative fall in nominal wages E demand 2 in the long run increases shock… short-run aggregate supply P E and moves the economy 3 3 AD 1 back to potential output. AD 2

Y Y 2 1 Potential Real GDP output Recessionary gap Short-Run versus Long-Run Effects of a Negave Demand Shock Aggregate 3. … reducing both the 1. Originally the price level aggregate price level and economy is at E . aggregate output and LRAS 1 leading to higher

unemployment in the SRAS1 short run.

SRAS2

4. Eventually in the long P1 E1 run, the fall in nominal wages increases the P2 E2 SRAS curve and moves the economy back to

P3 E3 potenal output. 2. A negave demand AD shock shis the AD 1 curve to the le, … AD2

Y2 Y1 Potenal Real GDP output Recessionary gap Short-Run versus Long-Run Effects of a Posive Demand Shock

3. …until an eventual rise in nominal Aggregate wages in the long run reduces short-run price level aggregate supply and moves the 1. An initial positive economy back to potential output. demand shock… L R AS S R AS 2 S R AS 1 E 3 P 3

P E 2. …increases the 2 2 E1 aggregate price level P and aggregate output 1 AD and reduces unemployment 2 in the short run… AD 1 Y Y Potential 1 2 Real GDP output In!ationary gap Short-Run versus Long-Run Effects of a Posive Demand Shock Aggregate 4. Eventually in the long run, the rise in price level nominal wages decreases the SRAS curve 2. A posive demand LRAS and moves the economy back to shock shis the AD potenal output.

curve to the right, … SRAS2

SRAS1

3. … raising both the P3 E3 aggregate price level and aggregate output and E P2 2 leading to lower unemployment in the P1 E1 short run.

1. Originally the AD2 economy is at E1. AD1

Potenal Y1 Y2 Real GDP output Inflaonary gap Gap Recap

• There is a recessionary gap when aggregate output is below potenal output.

• There is an inflaonary gap when aggregate output is above potenal output.

• The output gap is the percentage difference between actual aggregate output and potenal output. Gap Recap

• The economy is self-correcng when shocks to aggregate demand affect aggregate output in the short run, but not the long run. FOR INQUIRING MINDS

Where’s the Deflaon?

• The AD–AS model says that either a negave demand shock or a posive supply shock should lead to a fall in the aggregate price level—that is, deflaon. § In fact, however, the United States hasn’t experienced an actual fall in the aggregate price level since 1949. FOR INQUIRING MINDS

Where’s the Deflaon?

• What happened to the deflaon? The basic answer is that since World War II economic fluctuaons have taken place around a long-run inflaonary trend. § Before the war, it was common for prices to fall during , but since then negave demand shocks have been reflected in a decline in the rate of inflaon rather than an actual fall in prices.

• A very severe negave demand shock could sll bring deflaon, which is what happened in Japan. Negave Supply Shocks • Negave supply shocks pose a policy dilemma: a policy that stabilizes aggregate output by increasing aggregate demand will lead to inflaon, but a policy that stabilizes prices by reducing aggregate demand will deepen the output slump. ECONOMICS IN ACTION

Supply Shocks versus Demand Shocks in Pracce

• Recessions are mainly caused by demand shocks. But when a negave supply shock does happen, the resulng tends to be parcularly severe.

• There’s a reason the aermath of a supply shock tends to be parcularly severe for the economy: macroeconomic policy has a much harder me dealing with supply shocks than with demand shocks. ECONOMICS IN ACTION

Supply Shocks versus Demand Shocks in Pracce

• The reason the Federal Reserve was having a hard me in 2008, as described in the opening story, was the fact that in early 2008 the U.S. economy was in a recession parally caused by a supply shock (although it was also facing a demand shock). ECONOMICS IN ACTION Macroeconomic Policy

• Economy is self-correcng in the long run.

• Most think it takes a decade or longer!

• : “In the long run we are all dead.”

• Stabilizaon policy is the use of government policy to reduce the severity of recessions and rein in excessively strong expansions. FOR INQUIRING MINDS

Keynes and the Long Run

• The Brish Sir John Maynard Keynes (1883– 1946), probably more than any other single economist, created the modern field of macroeconomics.

• In 1923, Keynes published A Tract on Monetary Reform, a small book on the economic problems of Europe aer World War I. FOR INQUIRING MINDS

Keynes and the Long Run

• In it, he decried the tendency of many of his colleagues to focus on how things work out in the long run: “This long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the sea is flat again.” Macroeconomic Policy

• The high cost — in terms of unemployment — of a recessionary gap and the future adverse consequences of an inflaonary gap à Acve stabilizaon policy, using fiscal or monetary policy to offset shocks.

Macroeconomic Policy

• Policy in the face of supply shocks: § There are no easy policies to shi the short-run aggregate supply curve. § Policy dilemma: a policy that counteracts the fall in aggregate output by increasing aggregate demand will lead to higher inflaon, but a policy that counteracts inflaon by reducing aggregate demand will deepen the output slump. ECONOMICS IN ACTION

Is Stabilizaon Policy Stabilizing?

• Has the economy actually become more stable since the government began trying to stabilize it?

• Yes. Data from the pre–World War II era are less reliable than more modern data, but there sll seems to be a clear reducon in the size of economic fluctuaons.

• It’s possible that the greater stability of the economy reflects good luck rather than policy.

• But on the face of it, the evidence suggests that stabilizaon policy is indeed stabilizing.

ECONOMICS IN ACTION VIDEO

§ “Fear the Boom and Bust”: Hayek versus Keynes Rap Anthem

§ hp://www.youtube.com/watch?v=XKEv8J2KQDU Summary

1. The aggregate demand curve shows the relaonship between the aggregate price level and the quanty of aggregate output demanded.

2. The aggregate demand curve is downward sloping for two reasons. The first is the wealth effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households’ wealth and reduces consumer spending. The second is the effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households’ and firms’ money holdings, leading to a rise in interest rates and a fall in investment spending and consumer spending. Summary

3. The aggregate demand curve shis because of changes in expectaons, changes in wealth not due to changes in the aggregate price level, and the effect of the size of the exisng stock of physical capital.

Policy makers can use fiscal policy and monetary policy to shi the aggregate demand curve.

4. The aggregate supply curve shows the relaonship between the aggregate price level and the quanty of aggregate output supplied. Summary

5. The short-run aggregate supply curve is upward sloping because nominal wages are scky in the short run: a higher aggregate price level leads to higher profit per unit of output and increased aggregate output in the short run.

6. Changes in commodity prices, nominal wages, and producvity lead to changes in producers’ profits and shi the short-run aggregate supply curve. Summary

7. In the long run, all prices are flexible and the economy produces at its potenal output.

If actual aggregate output exceeds potenal output, nominal wages will eventually rise in response to low unemployment and aggregate output will fall.

If potenal output exceeds actual aggregate output, nominal wages will eventually fall in response to high unemployment and aggregate output will rise.

So the long-run aggregate supply curve is vercal at potenal output. Summary

8. In the AD–AS model, the intersecon of the short-run aggregate supply curve and the aggregate demand curve is the point of short-run macroeconomic equilibrium. It determines the short-run equilibrium aggregate price level and the level of short-run equilibrium aggregate output. Summary

9. Economic fluctuaons occur because of a shi of the aggregate demand curve (a demand shock) or the short-run aggregate supply curve (a supply shock).

A demand shock causes the aggregate price level and aggregate output to move in the same direcon as the economy moves along the short-run aggregate supply curve.

A supply shock causes them to move in opposite direcons as the economy moves along the aggregate demand curve.

A parcularly nasty occurrence is stagflaon—inflaon and falling aggregate output—which is caused by a negave supply shock. Summary

10. Demand shocks have only short-run effects on aggregate output because the economy is self-correcng in the long run. In a recessionary gap, an eventual fall in nominal wages moves the economy to long-run macroeconomic equilibrium, where aggregate output is equal to potenal output. In an inflaonary gap, an eventual rise in nominal wages moves the economy to long-run macroeconomic equilibrium.

We can use the output gap, the percentage difference between actual aggregate output and potenal output, to summarize how the economy responds to recessionary and inflaonary gaps. Because the economy tends to be self-correcng in the long run, the output gap always tends toward zero. Summary

11. The high cost—in terms of unemployment—of a recessionary gap and the future adverse consequences of an inflaonary gap lead many economists to advocate acve stabilizaon policy: using fiscal or monetary policy to offset demand shocks.

There can be drawbacks, however, because such policies may contribute to a long-term rise in the budget deficit and crowding out of private investment, leading to lower long- run growth. Also, poorly med policies can increase economic instability. Summary

12. Negave supply shocks pose a policy dilemma: a policy that counteracts the fall in aggregate output by increasing aggregate demand will lead to higher inflaon, but a policy that counteracts inflaon by reducing aggregate demand will deepen the output slump. Key Terms

• Aggregate demand curve • Short-run equilibrium aggregate • Wealth effect of a change in the output aggregate price level • Demand shock • Interest rate effect of a change in • Supply shock the aggregate price level • Stagflaon • Aggregate supply curve • Long-run macroeconomic • Nominal wage equilibrium • Scky wages • Recessionary gap • Short-run aggregate supply curve • Inflaonary gap • Long - run aggregate supply curve • Output gap • Potenal output • Self-correcng • AD–AS model • Stabilizaon policy • Short-run macroeconomic equilibrium • Short-run equilibrium aggregate price level