Chapter 12: Aggregate Demand And Aggregate Supply Analysis

Chapter 12: Aggregate Demand and AggregateSupply AnalysisYulei LuoSEF of HKUMarch 13, 2012

Learning Objectives1. Identify the determinants of aggregate demand anddistinguish between a movement along the aggregate demandcurve and a shift of the curve.2. Identify the determinants of aggregate supply and distinguishbetween a movement along the short-run aggregate supplycurve and a shift of the curve.3. Use the aggregate demand and aggregate supply model toillustrate the di erence between short-run and long-runmacroeconomic equilibrium.4. Use the dynamic aggregate demand and aggregate supplymodel to analyze macroeconomic conditions.

Aggregate DemandIIn the short-run, real GDP ‡uctuates around the long-runupward trend because of business cycles (BC). Real GDP andemployment co-move during BC.IThe BC also causes changes in prices and wages. Some rmsreact to a decline in sales by cutting back on production, butthey may also cut the prices they charge and the wages theypay.IAggregate demand and aggregate supply model: A model thatexplains short-run ‡uctuations in real GDP and the price level.This model will help us analyze the e ects of recessions andexpansions on production, employment, and prices.

I(Cont.) Aggregate demand curve (AD): A curve showing therelationship between the price level (PL) and the quantity ofreal GDP demanded by households, rms, and thegovernment.IShort-run aggregate supply curve (SRAS): A curve showingthe relationship in the short run between the PL and thequantity of real GDP supplied by rms.IFluctuations in real GDP and the PL are caused by shifts inthe AD curve or the AS curve.

12.1 LEARNING OBJECTIVEAggregate DemandIdentify the determinants of aggregatedemand and distinguish between amovement along the aggregatedemand curve and a shift of the curve.Aggregate demand and aggregate supply modelA model that explains short-run fluctuations in realGDP and the price level.Chapter 12: Aggregate Demand and Aggregate Supply AnalysisFIGURE 12-1Aggregate Demand andAggregate SupplyIn the short run, real GDP and theprice level are determined by theintersection of the aggregatedemand curve and the short-runaggregate supply curve.In the figure, real GDP is measuredon the horizontal axis, and the pricelevel is measured on the verticalaxis by the GDP deflator.In this example, the equilibrium realGDP is 14.0 trillion, and theequilibrium price level is 100.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.5 of 48

Why Is the Aggregate Demand Curve Downward Sloping?IBecause a fall in the PL increases the quantity of real GDPdemanded.Y C I G NX(1)IThe wealth e ect: How a change in the PL a ectsconsumption?IIAs the PL falls, the real value of HH wealth rises, and so willconsumption because consumption is positively correlated withreal wealth.This e ect of the PL on consumption is called the wealthe ect.

I(Cont.) The interest rate e ect: How a change in the PLa ects investment?IIWhen prices rise, HHs and rms need more money to nancebuying and selling; consequently, they try to increase theamount of money they hold by withdrawing funds from banks,borrowing from banks, or selling bonds. These actions willincrease the interest rate (IR) charged on loans and bonds.A higher IR raises the cost of borrowing for rms and HHs(e.g., borrow less to build new buildings, new houses, orautos). Investment and consumption will therefore be reduced.

I(Cont.) The international-trade e ect: How a change in thePL a ects net exports?IIIf the PL in the US rises relative to the PLs in other countries,US exports will become relatively more expensive and foreignimports will become relatively less expensive.Consequently, some consumers in foreign countries will shiftfrom buying US products to buying domestic products, andsome US consumers will also shift from buying US products tobuying imported products, US exports will fall and US importswill rise, causing NXs to fall.

Shifts of the AD Curve versus Movements Along ItINote that the AD curve tells the relationship bw the PL andthe quantity of real GDP demanded, holding everything elseconstant.IIf the PL changes, but other variables that a ect thewillingness of HHs, rms, and gov. to spend are unchanged,the economy will move up or down a stationary AD curve.IIf any variable changes other than the PL, the AD curve willshift. E.g., if gov spending increases and the PL remainsunchanged, the AD curve will shift to the right at every PL.

Three Variables That Shift the AD CurveIChanges in government policies (Monetary and scal policies)IIIIMonetary policy (MP): The actions the Federal Reserve takesto manage the money supply and interest rates to pursuemacroeconomic policy objectives. Fiscal policy (FP): Changesin federal taxes and purchases that are intended to achievemacroeconomic policy objectives.Gov uses monetary and scal policies to shift the AD curve.Lower IRs lower the cost to rms and HHs of borrowing.Lower borrowing costs increase consumption and investment,which shifts the AD to the right. An increase in gov.purchases also shifts the AD to the right because they are onecomponent of AD.An increase in personal income taxes reduce consumptionspending and shift the AD curve to the left. Increases inbusiness taxes reduce the pro tability and shift the AD to theleft.

I(Cont.) Changes in the expectations of households and rmsIIIIf HHs and rms become more optimistic (pessimistic) abouttheir future incomes, they are likely to increase (reduce) theircurrent consumption spending, which will increase (reduce)AD.Similarly, if rms become more optimistic (pessimistic) abouttheir future pro tability of investment spending, the AD curvewill shift to the right.Changes in foreign variables: If rms and HHs in othercountries buy fewer U.S. goods or if rms and households inthe U.S. buy more foreign goods, net exports will fall, and theAD curve will shift to the left.IIIIf real GDP in the US increases faster than the real GDP inother countries, US imports will increase faster than USexports, and NXs will decline.If the exchange rate bw. the dollar and foreign currencies rises,NXs will also fall.Both changes will shift the AD curve to the left.

12.1 LEARNING OBJECTIVEAggregate DemandThe Variables That Shift theAggregate Demand CurveIdentify the determinants of aggregatedemand and distinguish between amovement along the aggregatedemand curve and a shift of the curve.Table 12-1Chapter 12: Aggregate Demand and Aggregate Supply AnalysisVariables That Shift the Aggregate Demand CurveCopyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.14 of 48

12.1 LEARNING OBJECTIVEAggregate DemandThe Variables That Shift theAggregate Demand CurveIdentify the determinants of aggregatedemand and distinguish between amovement along the aggregatedemand curve and a shift of the curve.Table 12-1Chapter 12: Aggregate Demand and Aggregate Supply AnalysisVariables That Shift the Aggregate Demand Curve (continued)Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.15 of 48

12.1 LEARNING OBJECTIVEAggregate DemandThe Variables That Shift theAggregate Demand CurveIdentify the determinants of aggregatedemand and distinguish between amovement along the aggregatedemand curve and a shift of the curve.Table 12-1Chapter 12: Aggregate Demand and Aggregate Supply AnalysisVariables That Shift the Aggregate Demand Curve (continued)Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.16 of 48

12.1 LEARNING OBJECTIVEAggregate DemandThe Variables That Shift theAggregate Demand CurveIdentify the determinants of aggregatedemand and distinguish between amovement along the aggregatedemand curve and a shift of the curve.Table 12-1Chapter 12: Aggregate Demand and Aggregate Supply AnalysisVariables That Shift the Aggregate Demand Curve (continued)Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.17 of 48

The Long-Run Aggregate Supply CurveIThe e ect of change in the PL on aggregate supply (i.e., thequantity of GS that rms are willing and able to supply) isvery di erent in the short run (SR) than in the long run (LR),so we need two AS curves: one for SR and one for LR.ILong-run aggregate supply (LRAS) A curve showing therelationship in the long run between the PL and the quantityof real GDP supplied.IIn the LR the level of real GDP is determined by the numberof workers, the capital stock, and the technology.IIn the LR changes in the PL doesn’t a ect real GDP becauseit doesn’t a ect the number of workers, the capital stock, andtechnology.INote that the level of real GDP in the LR is called potentialGDP or full employment GDP. There is no reason for thisnormal level of capacity to change just because the PL haschanged.

12.2 LEARNING OBJECTIVEAggregate SupplyThe Long-Run Aggregate Supply CurveIdentify the determinants ofaggregate supply and distinguishbetween a movement along theshort-run aggregate supply curveand a shift of the curve.FIGURE 12-2Chapter 12: Aggregate Demand and Aggregate Supply AnalysisThe Long-Run AggregateSupply CurveChanges in the price level do notaffect the level of aggregatesupply in the long run. Therefore,the long-run aggregate supplycurve, labeled LRAS, is a verticalline at the potential level of realGDP.For instance, the price level was109 in 2009, and potential realGDP was 13.9 trillion.If the price level had been 119, orif it had been 99, long-runaggregate supply would still havebeen a constant 13.9 trillion.Each year, the long-run aggregatesupply curve shifts to the right, asthe number of workers in theeconomy increases, moremachinery and equipment areaccumulated, and technologicalchange occurs.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.19 of 48

The Short-Run Aggregate Supply CurveIThe SRAS is upward sloping because over the SR, as the PLincreases, the quantity of G&S rms are willing to supply willincrease.IThe main reason: As prices of nal G&S rise, prices of inputs(such as the wages or the prices of natural resources) risemore slowly. Pro ts rise when the prices of the G&S rms sellrise more rapidly than the prices they pay for inputs.Therefore, a higher PL leads to higher pro ts and increasesthe willingness of rms to supply more G&S.ISecondary reason: As the PL rises or falls, some rms are slowto adjust their prices. A rm that is slow to raise (reduce) itsprices when the PL is increasing (decreasing) may nd itssales increasing (falling) and therefore will increase (decrease)production.

I(Cont.) Next questions are:IIIWhy some rms adjust prices more slowly than others?Why might the wages and the prices of other inputs changemore slowly than the prices of nal G&S?Most economists believe the explanation is that some rmsand workers fail to predict accurately changes in the PL. Thethree most common reasons:1. Contracts make some wages and prices “sticky”: Prices andwages are said to be “sticky” when they don’t respond quicklyto changes in demand or supply. Consider the Ford Motorcompany case. Suppose their managers negotiate a 3-yearcontract with the Labor union. Suppose that after thecontract is signed, the demand starts to increase rapidly andprices rise. Producing more is pro table because they canincrease prices and wages are xed by contract.