THIRD EDITION ECONOMICS and MACROECONOMICS Paul Krugman | Robin Wells Chapter 12(27) Aggregate Demand and Aggregate Supply • How the aggregate demand curve illustrates the relaonship between the aggregate price level and the quan@ty of aggregate output demanded in the economy WHAT YOU • How the aggregate supply curve WILL LEARN illustrates the relaonship between the aggregate price level and the quan@ty 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 monetary policy and fiscal policy can stabilize the economy Aggregate Demand • The aggregate demand curve shows the relaonship between the aggregate price level and the quan@ty of aggregate output demanded by households, 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 interest rate effect of a change in aggregate the price level—a higher aggregate price level, results in higher interest rates and a fall in investment and consumer spending. § The third is the foreign trade effect of a change in the aggregate price level – a higher price level reduces net exports. • Quan@ty Theore@c 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 ParameterizaSon of Aggregate Demand 1 P . exp AD = ƒ ( P | Wealth, Real r, expect, P , Y*, exch rate) P1 AD Shia Parameters: Y Wealth Real interest rates Expectaons / Animal Spirits Expected future inflaon Growth rate of Foreign GDP Exchange Rate Parametric ShiTs Aggregate Demand 2 P . exp AD = ƒ ( P | Wealth, Real r, expect, P , Y*, exch rate) P1 AD = C + I + G + NE Shia 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 Currency apprec => Decr Net Exports ShiTs 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 ShiTs the Aggregate Demand Curve • Changes in expectaons • If consumers and firms become more op@mis@c, aggregate demand increases. • If consumers and firms become more pessimis@c, aggregate demand decreases. • Changes in wealth • If the real value of household assets rises, aggregate demand increases. • If the real value of household assets falls, aggregate demand decreases. Factors that ShiTs the Aggregate Demand Curve • Fiscal policy • 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 central bank increases the quan@ty of money, aggregate demand increases. • If the central bank reduces the quan@ty of money, aggregate demand decreases Aggregate Supply • The aggregate supply curve shows the relaonship between the aggregate price level and the quan@ty of aggregate output in the economy. The Short-Run Aggregate Supply Curve • The short-run aggregate supply curve is upward-sloping because nominal wages are s@cky in the short run: § A higher aggregate price level leads to higher profits and increased aggregate output in the short run. • The nominal wage is the dollar amount of the wage paid. • SScky wages are nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages. Aggregate Supply – Short Run J. Marthinsen ParameterizaSon of Aggregate Supply 1 P . exp AS = ƒ ( P | Factor Prices, P , Supply Shocks, Resource Supply, Q/L, Ins@t Eff ) (Labor, Capital, Energy) (Produc@vity) P1 Shia Parameters: Yf Poten@al GDP Factor Prices Expected Future Prices Pos/Neg Supply Shocks Resource Discovery, Deple@on Produc@vity Ins@tu@onal Efficiencies Parametric ShiTs Aggregate Supply 2 P . exp AS = ƒ ( P | Factor Prices, P , Supply Shocks, Resource Supply, Q/L, Ins@t Eff ) (Labor, Capital, Energy) (Produc@vity) P1 Shia Parameters: Y1 Y2 Yf Poten@al GDP Factor Prices Expected Future Prices [Do Not impact Poten@al GDP] Pos/Neg Supply Shocks Resource Discovery, Deple@on Produc@vity [Factors that Do impact Poten@al GDP] Ins@tu@onal Efficiencies Parametric ShiTs Aggregate Supply 3 P . exp AS = ƒ ( P | Factor Prices, P , Supply Shocks, Resource Supply, Q/L, Ins@t Eff ) (Labor, Capital, Energy) (Produc@vity) P1 Shia Parameters: Y1 Yf Y2 Yf ‘ Poten@al GDP Factor Prices Expected Future Prices [Factors that Do Not impact Poten@al GDP] Pos/Neg Supply Shocks Resource Discovery, Deple@on Produc@vity [Factors that Do impact Poten@al GDP] Ins@tu@onal 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) ShiTs 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 ShiT Short-Run Aggregate Supply • Changes in commodity 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 produc@ve, short-run aggregate supply increases. • If workers become less produc@ve, short-run aggregate supply decreases. AS-AD All Together P . exp AS = ƒ ( P | Factor Prices, P , Supply Shocks, Resource Supply, Q/L, Ins@t Eff ) (Labor, Capital, Energy) (Produc@vity) 1 P1 . exp AD = ƒ ( P | Wealth, Real r, expect, P , Y*, exch rate) AD = C + I + G + NE Y1 Yf Poten@al GDP 1 AD = AS Equilibrium P1, Y1 e.g. Collapse in Demand - AS-AD P 1 AD = AS Ini@al Equilibrium P1, Y1 Shock – Reduc@on 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 Poten@al GDP Long-Run Aggregate Supply Curve • The long-run aggregate supply curve shows the relaonship between the aggregate price level and the quan@ty 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 PotenSal Output Economic Growth 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 poten@al 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 poten@al output in the long run, actual aggregate output fluctuates around poten@al 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 poten@al output.