Aggregate Demand and Aggregate Long run v.s. short run 33 Supply ƒ Long run growth: what determines long-run output (and the related employment…)? Capital accumulation; P R I N C I P L E S O F • • Technological advancement. ECONOMICS ƒ Short run fluctuations: what determines short-run FOURTH EDITION output (and the related employment…)? Aggregate demand and aggregate supply. N. GREGORY MANKIW •

PowerPoint® Slides by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 1

Introduction In this chapter, look for the answers to these questions: ƒ Over the long run, real GDP grows about ƒ What are economic fluctuations? What are their 3% per year on average. characteristics? ƒ In the short run, GDP fluctuates around its trend. ƒ How does the model of aggregate demand and • recessions: periods of falling real incomes aggregate supply explain economic fluctuations? and rising unemployment ƒ Why does the Aggregate-Demand curve slope • depressions: severe recessions (very rare) downward? What shifts the AD curve? ƒ Short-run economic fluctuations are often called ƒ What is the slope of the Aggregate-Supply curve business cycles. in the short run? In the long run? What shifts the AS curve(s)?

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 2 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 3

Three Facts About Economic Fluctuations Three Facts About Economic Fluctuations

FACTFACT 11:: EconomicEconomic fluctuationsfluctuations areare FACTFACT 22:: MostMost macroeconomicmacroeconomic irregularirregular andand unpredictable.unpredictable. quantitiesquantities fluctuatefluctuate together.together.

$11,000 $1,800 10,000 U.S. real GDP, U.S. real GDP, 1,600 InvestmentInvestment spending,spending, 9,000 billions of 2000 dollars billions of 2000 dollars 1,400 billionsbillions ofof 20002000 dollarsdollars 8,000 1,200 7,000 1,000 6,000 TheThe shadedshaded 800 5,000 barsbars areare 600 4,000 recessionsrecessions 3,000 400 2,000 200 1965 1970 1975 1980 1985 1990 1995 2000 2005 1965 1970 1975 1980 1985 1990 1995 2000 2005

1 Three Facts About Economic Fluctuations Explaining the short-run fluctuations FACTFACT 33:: As As outputoutput falls,falls, unemploymentunemployment rises.rises. 12 UnemploymentUnemployment rate,rate, ƒ Warning! This chapter is very theoretical. 10 percentpercent ofof laborlabor forceforce 8

6

4

2

0 1965 1970 1975 1980 1985 1990 1995 2000 2005 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 7

Introduction, continued Classical Economics ƒ Explaining these fluctuations is difficult, and the ƒ The previous chapters are based on the ideas of theory of economic fluctuations is controversial. classical economics, especially: ƒ Most economists use the model of ƒ The Classical Dichotomy, the separation of aggregate demand and aggregate supply variables into two groups: to study fluctuations. • real – quantities, relative prices ƒ This model differs from the classical economic • nominal – measured in terms of money theories economists use to explain the long run. ƒ The neutrality of money: Changes in the money supply affect nominal but not real variables.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 8 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 9

The Model of Aggregate Demand and Classical Economics Aggregate Supply ƒ Most economists believe classical theory P describes the world in the long run, The price level but not the short run. SRAS ƒ In the short run, changes in nominal variables “Short-Run The model Aggregate (like the money supply or P ) can affect P1 real variables (like Y or the u-rate). determines the Supply” eq’m price level “Aggregate ƒ To study the short run, we use a new model. Demand” AD and the eq’m Y Y level of output 1 (real GDP). Real GDP, the quantity of output CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 10 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 11

2 The Aggregate-Demand (AD) Curve Why the AD Curve Slopes Downward

Y = C + I + G P P The AD curve C, I, G are shows the the components P2 P2 quantity of of agg. Demand for a closed economy. all g&s demanded Assume G fixed by govt policy. in the economy P1 P1 at any given AD To understand AD price level. the slope of AD, Y must determine Y Y2 Y1 how a change in P Y2 Y1 affects C, I, and NX.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 12 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 13

The Wealth Effect (P and C ) The Interest-Rate Effect (P and I ) ƒ Suppose P rises. ƒ Suppose P rises. ƒ The dollars people hold buy fewer g&s, ƒ Buying g&s requires more dollars. so real wealth is lower. ƒ To get these dollars, people sell some of their bonds ƒ People feel poorer, so they spend less. or other assets, which drives up interest rates. …which increases the cost of borrowing to fund ƒ Thus, an increase in P causes a fall in C investment projects. …which means a smaller quantity of g&s demanded. ƒ Thus, an increase in P causes a decrease in I …which means a smaller quantity of g&s demanded.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 14 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 15

The Slope of the AD Curve: Summary Why the AD Curve Might Shift

An increase in P P Any event that changes reduces the quantity C, I, G – except a change P of g&s demanded in P – will shift the AD P2 because: curve. • the wealth effect Example: P1 (C falls) A stock market boom P1 makes households feel • the interest-rate AD wealthier, consume AD2 effect (I falls) more, AD1 Y and the AD curve shifts Y2 Y1 Y right. Y1 Y2

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 16 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 17

3 AD Shifts arising from things affecting C: AD Shifts Arising from things affecting I ƒ The world becomes more uncertain, people ƒ Firms decide to upgrade their computers: decide to save more: I rises, AD shifts right C falls, AD shifts left ƒ Firms become pessimistic about future demand: ƒ The stock market crashes, the consumer I falls, AD shifts left confidence drops: ƒ Central bank uses monetary policy to reduce C falls, AD shifts left interest rates: ƒ tax cut: I rises, AD shifts right C falls, AD shifts right ƒ Investment Tax Credit or other tax incentive: I rises, AD shifts right

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 18 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 19

AD Shifts Arising from Changes in G A C T I V E L E A R N I N G 1: Exercise ƒ Congress increases spending on homeland security: Try this without looking at your notes. G rises, AD shifts right What happens to the AD curve in each of the following scenarios? ƒ State govts cut spending on road construction: G falls, AD shifts left A. A ten-year-old investment tax credit expires. B. A fall in prices increases the real value of consumers’ wealth. C. State governments eliminates sales taxes.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 20 21

A C T I V E L E A R N I N G 1: The Aggregate-Supply (AS) Curves Answers The AS curve shows P LRAS A. A ten-year-old investment tax credit the total quantity of expires. g&s firms produce SRAS I falls, AD curve shifts left. and sell at any given price level. B. A fall in prices increases the real value of In the short run, consumers’ wealth. AS is Move down along AD curve (wealth- upward-sloping. effect). In the long run, Y C. State governments eliminates sales AS is vertical. taxes. C rises, AD shifts right. 22 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 23

4 The Long-Run Aggregate-Supply Curve (LRAS) Why LRAS Is Vertical

The natural rate of P LRAS YN depends on the P LRAS economy’s stocks of output (YN) is the amount of output labor, capital, and the economy produces natural resources, P when unemployment and on the level of 2 is at its natural rate. technology. P1 An increase in P YN is also called potential output does not affect or any of these, Y so it does not Y full-employment YN YN output. affect YN. (Classical dichotomy) CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 24 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 25

Why the LRAS Curve Might Shift LRAS Shifts Arising from Changes in L The Baby Boom generation retires: P LRAS LRAS ƒ Any event that 1 2 L falls, LRAS shifts left changes any of the New govt policies reduce the natural rate of determinants of YN ƒ will shift LRAS. unemployment: Example: the % of the labor force normally employed Immigration rises, LRAS shifts right increases L,

causing YN to rise. Y YN Y’N

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 26 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 27

LRAS Shifts Arising from Changes in LRAS Shifts Arising from Changes in Physical or Human Capital Natural Resources ƒ Investment in factories or equipment: ƒ A change in weather patterns makes farming K rises, LRAS shifts right more difficult: LRAS shifts left ƒ More people get college degrees: Human capital rises, LRAS shifts right ƒ Discovery of new mineral deposits: LRAS shifts right ƒ Earthquakes or hurricanes destroy factories: K falls, LRAS shifts left ƒ Reduction in supply of imported oil or other resources: LRAS shifts right

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 28 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 29

5 LRAS Shifts Arising from Changes in In short: Technology ƒ Technological advances allow more output to be produced from a given bundle of inputs: LRAS shifts right. ƒ Anything that affects growth shifts LRAS!

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 30 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 31

Using AD & AS to Depict LR Growth and Short Run Aggregate Supply (SRAS) Inflation The SRAS curve P LRAS2000 Over the long run, P LRAS1990 LRAS is upward sloping: tech. progress shifts 1980 SRAS LRAS to the right Over the period of 1-2 years, P2 and growth in the P2000 an increase in P aggregate demand P1990 causes an P shifts AD to the 1 AD2000 increase in the right. P1980 quantity of g & s Result: AD1990 supplied. ongoing inflation Y AD1980 Y Y and growth in Y 1 2 Y Y Y2000 output. 1980 1990

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 32 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 33

Why the Slope of SRAS Matters Three Theories of SRAS In each, P LRAS If AS is vertical, some type of market imperfection P • fluctuations in AD hi SRAS do not cause • result: Phi fluctuations in output Output deviates from its natural rate or employment. when the actual price level deviates AD from the price level people expected. P hi If AS slopes up, lo then shifts in AD AD1 Plo do affect output ADlo Y and employment. Ylo Y1 Yhi

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 34 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 35

6 Three Theories of SRAS The Sticky-Wage Theory

P ƒ Imperfection: Nominal wages are sticky in the short run, SRAS they adjust sluggishly. When P > PE • Due to labor contracts, social norms. the expected P price level E ƒ Firms and workers set the nominal wage in advance based on PE, the price level they When P < PE expect to prevail.

Y YN

Y < YN Y > YN

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 36 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 37

The Sticky-Wage Theory The Sticky-Wage Theory

ƒ The labor contract sets nominal wages The sticky wage theory implies Y deviates from YN according to expected prices. when P deviates from PE. ƒ If P > P , E Y = YN + a(P – PE) revenue is higher, but labor cost is not. Output Expected Production is more profitable, price level Natural rate so firms increase output and employment. > 0, of output a measures Actual ƒ Hence, higher P causes higher Y, (long-run) price level so the SRAS curve slopes upward. how much Y responds to unexpected changes in P

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 38 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 39

SRAS and LRAS SRAS

ƒ The imperfections in these theories are and LRAS Y = YN + a(P – PE) temporary. Over time, • sticky wages and prices become flexible P LRAS misperceptions are corrected • In the long run, SRAS

ƒ In the LR, PE = P • P = P and E PE • AS curve is vertical Y = YN.

Y YN

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 40 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 41

7 Why the SRAS Curve Might Shift The Long-Run Equilibrium Everything that shifts In the long-run P LRAS LRAS shifts SRAS, too. P LRAS equilibrium, Also, P shifts SRAS: SRAS E SRAS P = P, SRAS E If PE rises, Y = YN , workers & firms set PE PE and unemployment higher wages. is at its natural rate. PE At each P, AD production is less profitable, Y falls, Y YN SRAS shifts left. Y YN

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 42 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 43

Economic Fluctuations The Effects of a Shift in AD ƒ Caused by events that shift the AD and/or Event: stock market crash AS curves. 1. affects C, AD curve P LRAS 2. C falls, so AD shifts left ƒ Four steps to analyzing economic fluctuations: SRAS1 1. Determine whether the event shifts AD or AS. 3. SR eq’m at B. P and Y lower, P1 A SRAS 2. Determine whether curve shifts left or right. unemp higher 2 P 3. Use AD-AS diagram to see how the shift 2 B 4. Over time, PE falls, AD1 changes Y and P in the short run. SRAS shifts right, P3 C 4. Use AD-AS diagram to see how economy until LR eq’m at C. AD2 Y and unemp back Y moves from new SR eq’m to new LR eq’m. Y Y at initial levels. 2 N

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 44 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 45

Two Big AD Shifts: Two Big AD Shifts: 1. The Great Depression 2. The World War II Boom

U.S. Real GDP, U.S. Real GDP, From 1929-1933, From 1939-1944, billions of 2000 dollars billions of 2000 dollars • money supply fell 900 • govt outlays rose 2,000 28% due to problems 850 from $9.1 billion 1,800 in banking system 800 to $91.3 billion 1,600 • stock prices fell 90%, 750 • Y rose 90% 1,400 reducing C and I 700 650 • P rose 20% 1,200 • Y fell 27% 600 • unemp fell 1,000 • P fell 22% 550 from 17% to 1% 800 • unemp rose 1929 1930 1931 1932 1933 1934 from 3% to 25% 1939 1940 1941 1942 1943 1944

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 46 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 47

8 A C T I V E L E A R N I N G 2: A C T I V E L E A R N I N G 2: Exercise Answers ƒ Draw the AD-SRAS-LRAS diagram Event: a tax cut P LRAS for the U.S. economy, 1. affects C, AD curve SRAS2 starting in a long-run equilibrium. 2. shifts AD right

ƒ A boom occurs in Canada. 3. SR eq’m at point B. P3 C SRAS1 Use your diagram to determine P and Y higher, P B the SR and LR effects on U.S. GDP, unemp lower 2 P A the price level, and unemployment. 1 AD2 4. Over time, PE rises, SRAS shifts left, AD1 until LR eq’m at C. Y Y and unemp back YN Y2 at initial levels. 48 49

The Effects of a Shift in SRAS Accommodating an Adverse Shift in SRAS Event: oil prices rise If policymakers do nothing, 1. increases costs, P LRAS 4. Low employment P LRAS shifts SRAS SRAS causes wages to fall, SRAS (assume LRAS constant) 2 SRAS shifts right, 2 2. SRAS shifts left P3 C SRAS1 until LR eq’m at A. SRAS1 3. SR eq’m at point B. B B P2 Or, policymakers could P2 P higher, Y lower, A use fiscal or monetary A unemp higher P1 P1 AD policy to increase AD 2 From A to B, and accommodate the stagflation, AD AD 1 AS shift: 1 a period of Y Y falling output Y2 YN Y back to YN, but Y2 YN and rising prices. P permanently higher.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 50 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 51

The 1970s Oil Shocks and Their Effects John Maynard Keynes, 1883-1946 • The General Theory of Employment, 1973-75 1978-80 Interest, and Money, 1936 • Argued recessions and depressions Real oil prices + 138% + 99% can result from inadequate demand; policymakers should shift AD. CPI + 21% + 26% • Famous critique of classical theory: The long run is a misleading guide Real GDP –0.7% + 2.9% to current affairs. In the long run, # of unemployed + 3.5 + 1.4 we are all dead. Economists set themselves persons million million too easy, too useless a task if in tempestuous seasons they can only tell us when the storm is long past, the ocean will be flat. CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 52 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 53

9 CONCLUSION CHAPTER SUMMARY ƒ This chapter has introduced the model of ƒ Short-run fluctuations in GDP and other aggregate demand and aggregate supply, macroeconomic quantities are irregular and which helps explain economic fluctuations. unpredictable. Recessions are periods of falling ƒ Keep in mind: these fluctuations are deviations real GDP and rising unemployment. from the long-run trends explained by the ƒ Economists analyze fluctuations using the model models we learned in previous chapters. of aggregate demand and aggregate supply. ƒ In the next chapter, we will learn how ƒ The aggregate demand curve slopes downward policymakers can affect aggregate demand because a change in the price level has a wealth with fiscal and monetary policy. effect on consumption, an interest-rate effect on investment, and an exchange-rate effect on net exports. CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 54 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 55

CHAPTER SUMMARY CHAPTER SUMMARY ƒ Anything that changes C, I, G, or NX ƒ In the short run, output deviates from its natural – except a change in the price level – rate when the price level is different than will shift the aggregate demand curve. expected, leading to an upward-sloping short-run aggregate supply curve. The three theories ƒ The long-run aggregate supply curve is vertical, proposed to explain this upward slope are the because changes in the price level do not affect sticky wage theory, the sticky price theory, and the output in the long run. misperceptions theory. ƒ In the long run, output is determined by labor, ƒ The short-run aggregate-supply curve shifts in capital, natural resources, and technology; response to changes in the expected price level changes in any of these will shift the and to anything that shifts the long-run aggregate long-run aggregate supply curve. supply curve.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 56 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 57

CHAPTER SUMMARY CHAPTER SUMMARY ƒ Economic fluctuations are caused by shifts in ƒ A fall in aggregate supply results in stagflation – aggregate demand and aggregate supply. falling output and rising prices. ƒ When aggregate demand falls, output and the Wages, prices, and perceptions adjust over time, price level fall in the short run. Over time, a and the economy recovers. change in expectations causes wages, prices, and perceptions to adjust, and the short-run aggregate supply curve shifts rightward. In the long run, the economy returns to the natural rates of output and unemployment, but with a lower price level.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 58 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 59

10