1 of 29. Aggregate Demand and Aggregate Supply. Economics: Principles, Applications, and Tools O Sullivan, Sheffrin, Perez 6/e.

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1 1 of 29 2 of 29 As we explained in previous chapters, recessions occur when output fails to grow and unemployment rises. P R E P A R E D B Y FERNANDO QUIJANO, YVONN QUIJANO, AND XIAO XUAN XU 3 of 29 1

2 A P P L Y I N G T H E C O N C E P T S What does the behavior of prices in retail catalogs demonstrate about how quickly prices adjust in the U.S. economy? Price Stickiness in Retail Catalogs How can we determine what factors cause recessions? The Causes of Recessions in U.S. Economic History Do changes in oil prices always hurt the U.S. economy? How the U.S. Economy Has Coped with Oil Price Fluctuations 4 of STICKY PRICES AND THEIR MACROECONOMIC CONSEQUENCES Flexible and Sticky Prices For most firms, the biggest cost of doing business is wages. If wages are sticky, firms overall costs will be sticky as well. This means that firms product prices will remain sticky, too. Sticky wages cause sticky prices and hamper the economy s ability to bring demand and supply into balance in the short run. How Demand Determines Output in the Short Run short run in macroeconomics The period of time in which prices do not change or do not change very much. 5 of 29 A P P L I C A T I O N 1 PRICE STICKINESS IN RETAIL CATALOGS APPLYING THE CONCEPTS #1: What does the behavior of prices in retail catalogs demonstrate about how quickly prices adjust in the U.S. economy? To analyze the behavior of retail prices, economist Anil Kashyap of the University of Chicago examined prices in consumer catalogs. He looked at the prices of 12 selected goods from: L.L. Bean Recreational Equipment, Inc. (REI) The Orvis Company, Inc. The goods included shoes, blankets, chamois shirts, binoculars, and a fishing rod and fly. What did he find? Considerable price stickiness. When prices did change, he observed a mixture of both large and small changes. During periods of high inflation, prices tended to change more frequently. 6 of 29 2

3 What Is the Curve? aggregate demand curve (AD) A curve that shows the relationship between the level of prices and the quantity of real GDP demanded. 7 of 29 The Components of FIGURE 9.1 The aggregate demand curve plots the total demand for real GDP as a function of the price level. The aggregate demand curve slopes downward, indicating that the quantity of aggregate demand increases as the price level in the economy falls. 8 of 29 Why the Curve Slopes Downward As the purchasing power of money changes, the aggregate demand curve is affected in three different ways: THE WEALTH EFFECT wealth effect The increase in spending that occurs because the real value of money increases when the price level falls. 9 of 29 3

4 Why the Curve Slopes Downward THE INTEREST RATE EFFECT With a given supply of money in the economy, a lower price level will lead to lower interest rates. With lower interest rates, both consumers and firms will find it cheaper to borrow money to make purchases. As a consequence, the demand for goods in the economy (consumer durables purchased by households and investment goods purchased by firms) will increase. THE INTERNATIONAL TRADE EFFECT In an open economy, a lower price level will mean that domestic goods (goods produced in the home country) become cheaper relative to foreign goods, so the demand for domestic goods will increase. 10 of 29 Shifts in the Curve CHANGES IN THE SUPPLY OF MONEY An increase in the supply of money in the economy will increase aggregate demand and shift the aggregate demand curve to the right. CHANGES IN TAXES A decrease in taxes will increase aggregate demand and shift the aggregate demand curve to the right. CHANGES IN GOVERNMENT SPENDING At any given price level, an increase in government spending will increase aggregate demand and shift the aggregate demand curve to the right. 11 of 29 Shifts in the Curve ALL OTHER CHANGES IN DEMAND FIGURE Shifting Decreases in taxes, increases in government spending, and an increase in the supply of money all shift the aggregate demand curve to the right. Higher taxes, lower government spending, and a lower supply of money shift the curve to the left. 12 of 29 4

5 How the Multiplier Makes the Shift Bigger FIGURE The Multiplier Initially, an increase in desired spending will shift the aggregate demand curve horizontally to the right from a to b. The total shift from a to c will be larger. The ratio of the total shift to the initial shift is known as the multiplier. 13 of 29 How the Multiplier Makes the Shift Bigger multiplier The ratio of the total shift in aggregate demand to the initial shift in aggregate demand. consumption function The relationship between the level of income and consumer spending. C = C a + by 14 of 29 How the Multiplier Makes the Shift Bigger autonomous consumption spending The part of consumption spending that does not depend on income. marginal propensity to consume (MPC) The fraction of additional income that is spent. marginal propensity to save (MPS) The fraction of additional income that is saved. 15 of 29 5

6 How the Multiplier Makes the Shift Bigger multiplier 1 (1 MPC) 16 of 29 aggregate supply curve (AS) A curve that shows the relationship between the level of prices and the quantity of output supplied. The Long-Run Aggregate Supply Curve long-run aggregate supply curve A vertical aggregate supply curve that represents the idea that in the long run, output is determined solely by the factors of production. 17 of 29 The Long-Run Aggregate Supply Curve FIGURE 9.4 Long-Run Aggregate Supply In the long run, the level of output, y p, is independent of the price level. 18 of 29 6

7 The Long-Run Aggregate Supply Curve DETERMINING OUTPUT AND THE PRICE LEVEL FIGURE 9.5 and the Long-Run Aggregate Supply Output and prices are determined at the intersection of AD and AS. An increase in aggregate demand leads to a higher price level. 19 of 29 The Short-Run Aggregate Supply Curve short-run aggregate supply curve A relatively flat aggregate supply curve that represents the idea that prices do not change very much in the short run and that firms adjust production to meet demand. 20 of 29 The Short-Run Aggregate Supply Curve FIGURE 9.6 and Short-Run Aggregate Supply With a short-run aggregate supply curve, shifts in aggregate demand lead to large changes in output but small changes in price. 21 of 29 7

8 The Short-Run Aggregate Supply Curve What factors determine the costs firms must incur to produce output? The key factors are Input prices (wages and materials) The state of technology Taxes, subsidies, or economic regulations 22 of 29 Supply Shocks supply shocks External events that shift the aggregate supply curve. FIGURE 9.7 Supply Shock An adverse supply shock, such as an increase in the price of oil, will cause the AS curve to shift upward. The result will be higher prices and a lower level of output. stagflation A decrease in real output with increasing prices. 23 of 29 A P P L I C A T I O N 2 THE CAUSES OF RECESSIONS IN U.S. ECONOMIC HISTORY APPLYING THE CONCEPTS #2: How can we determine what factors cause recessions? Economists have used the basic framework of aggregate demand and supply analysis to explain recessions. Recessions can occur either when there is a sharp decrease in demand or a decrease in aggregate supply. Economic historian Peter Temin looked back at all recessionary episodes from 1893 to 1990 to try to determine their ultimate causes. According to his analysis, recessions were caused by many different factors. Sometimes, as in 1929, they were caused by shifts in aggregate demand from the private sector, as consumers cut back their spending. Other times, as in 1981, the government cut back on aggregate demand to reduce inflation. Supply shocks were the cause of the recessions in 1973 and The most severe shock hit the U.S. economy in 1931 and converted an economic downturn into the Great Depression. Professor Temin believes that foreign monetary developments were the ultimate source of this shock to the U.S. economy. 24 of 29 8

9 A P P L I C A T I O N 3 HOW THE U.S. ECONOMY HAS COPED WITH OIL PRICE FLUCTUATIONS APPLYING THE CONCEPTS #3: Do changes in oil prices always hurt the U.S. economy? During the 1970s, the world economy was hit with unfavorable supply shocks that raised prices and lowered output, including spikes in oil prices. Increases in oil prices shift the aggregate supply curve. However, they also have an adverse effect on aggregate demand. Because the United States is a net importer of foreign oil, an increase in oil prices is just like a tax that decreases the income of consumers. An increase in taxes will shift the aggregate demand curve to the left. Between 1997 and 1998, the price of oil on the world market fell from $22 a barrel to less than $13 a barrel. The result: gasoline prices were lower than they had been in over 50 years. In 2008, oil prices shot up to $145 a barrel. Reason: increased demand throughout the world, particularly in fast-growing countries such as China and India. The economy had been weak prior to these increases, and policymakers feared the negative effects this major supply disturbance would have both on inflation and GDP. 25 of FROM THE SHORT RUN TO THE LONG RUN FIGURE 9.8 The Economy in the Short Run In the short run, the economy produces at y 0, which exceeds potential output y p. 26 of FROM THE SHORT RUN TO THE LONG RUN FIGURE 9.9 Adjusting to the Long Run With output exceeding potential, the short-run AS curve shifts upward over time. The economy adjusts to the long-run equilibrium at a of 29 9

10 9.4 FROM THE SHORT RUN TO THE LONG RUN Looking Ahead The aggregate demand and aggregate supply model in this chapter provides an overview of how demand affects output and prices in both the short run and the long run. The next several chapters explore more closely how aggregate demand determines output in the short run. 28 of 29 K E Y T E R M S aggregate demand curve (AD) aggregate supply curve (AS) autonomous consumption spending consumption function long-run aggregate supply curve marginal propensity to consume (MPC) multiplier short-run aggregate supply curve short run in macroeconomics stagflation supply shocks wealth effect marginal propensity to save (MPS) 29 of 29 10