chap12pp

© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.

Fernando & Yvonn Quijano

Prepared by:

Chapter

12

Aggregate Demand and Aggregate Supply Analysis

© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 47

The Fortunes of FedEx Follow the Business Cycle

12.1 Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve.

12.2 Identify the determinants of aggregate supply and distinguish between a movement along the short- run aggregate supply curve and a shift of the curve.

12.3 Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium.

12.4 Use the dynamic aggregate demand and aggregate supply model to analyze macroeconomic conditions.

APPENDIX Understand macroeconomic schools of thought.

Learning Objectives

To understand why FedEx and other firms are affected by the business cycle, we need to explore the effects that recessions and expansions have on production, employment, and prices.

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Aggregate Demand

Learning Objective 12.1

Aggregate demand and aggregate supply model A model that explains short-run fluctuations in real GDP and the price level.

FIGURE 12.1

Aggregate Demand and Aggregate Supply

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Aggregate Demand


Aggregate demand curve A curve that shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government.

Short-run aggregate supply curve A curve that shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms.

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Aggregate Demand


GDP has four components: consumption (C), investment (I), government purchases (G), and net exports (NX). If we let Y stand for GDP, we can write the following:

Y = C + I + G + NX

Why Is the Aggregate Demand Curve Downward Sloping?

The Wealth Effect: How a Change in the Price Level Affects Consumption

The impact of the price level on consumption is called the wealth effect.

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Aggregate Demand


The impact of the price level on investment is known as the interest-rate effect.

Why Is the Aggregate Demand Curve Downward Sloping?

The International-Trade Effect: How a Change in the Price Level Affects Net Exports

The impact of the price level on net exports is known as the international-trade effect.

The Interest-Rate Effect: How a Change in the Price Level Affects Investment

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Aggregate Demand


An important point to remember is that the aggregate demand curve tells us the relationship between the price level and the quantity of real GDP demanded, holding everything else constant.

Shifts of the Aggregate Demand Curve versusMovements Along It

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Aggregate Demand


• Changes in government policies

• Changes in the expectations of households and firms

• Changes in foreign variables

The Variables That Shift the Aggregate Demand Curve

Don’t Let This Happen to YOU!Be Clear Why the Aggregate Demand Curve Is Downward Sloping

The variables that cause the aggregate demand curve to shift fall into three categories:

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Aggregate Demand


Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives.


Changes in Government Policies

Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as high employment, price stability, and high rates of economic growth.

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Aggregate Demand


If households become more optimistic about their future incomes, they are likely to increase their current consumption.


Changes in the Expectations of Households and Firms

If firms and households in other countries buy fewer U.S. goods or if firms and households in the United States buy more foreign goods, net exports will fall, and the aggregate demand curve will shift to the left.

Changes in Foreign Variables

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In a Global Economy, How Can You Tell the Imports from the Domestic Goods?

Makingthe

Connection

Is the Toyota Sienna as American as apple pie?

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Solved Problem 12-1Movements along the Aggregate Demand Curve versus Shifts of the Aggregate Demand Curve


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Aggregate Demand



Changes in Foreign VariablesTable 12-1

Variables That Shift the Aggregate Demand Curve

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Aggregate Demand



Changes in Foreign VariablesTable 12-1

Variables That Shift the Aggregate Demand Curve (continued)

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Aggregate Supply


Long-run aggregate supply curve A curve that shows the relationship in the long run between the price level and the quantity of real GDP supplied.

The Long-Run Aggregate Supply Curve

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Aggregate Supply


The Long-Run Aggregate Supply CurveFIGURE 12.2

The Long-Run Aggregate

Supply Curve

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Aggregate Supply


1 Contracts make some wages and prices “sticky.”

2 Firms are often slow to adjust wages.

3 Menu costs make some prices sticky.

The Short-Run Aggregate Supply Curve

The three most common explanations as to why a short-run aggregate supply curve slopes upward include:

Menu costs The costs to firms of changing prices.

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Aggregate Supply


Shifts of the Short-Run Aggregate Supply Curve versus Movements Along It

It is important to remember the difference between a shift in a curve and a movement along a curve.

Increases in the Labor Force and in the Capital Stock

Variables That Shift the Short-Run Aggregate Supply Curve

Technological Change

Expected Changes in the Future Price Level

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Aggregate Supply



Expected Changes in the Future Price Level

FIGURE 12.3

How Expectations of the Future Price Level Affect the Short-Run Aggregate Supply

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Aggregate Supply



Adjustments of Workers and Firms to Errors in Past Expectations about the Price Level

Unexpected Changes in the Price of an Important Natural Resource

Supply shock An unexpected event that causes the short-run aggregate supply curve to shift.

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Aggregate Supply


Variables That Shift the Short-Run Aggregate Supply CurveUnexpected Changes in the Price of an Important Natural Resource

Table 12-2


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Aggregate Supply


Variables That Shift the Short-Run Aggregate Supply CurveUnexpected Changes in the Price of an Important Natural Resource

Table 12-2

Variables That Shift the Short-Run Aggregate Supply Curve (continued)

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Macroeconomic Equilibriumin the Long Run and the Short Run


FIGURE 12.4

Long-Run Macroeconomic Equilibrium

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1 The economy has not been experiencing any inflation. The price level is currently 100, and workers and firms expect it to remain at 100 in the future.

2 The economy is not experiencing any long-run growth. Potential real GDP is $10.0 trillion and will remain at that level in the future.

Recessions, Expansions, and Supply Shocks

Because the full analysis of the aggregate demand and aggregate supply model can be complicated, we begin with a simplified case, using two assumptions:

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Recession

FIGURE 12.5

The Short-Run and Long-Run Effects of a Decrease in Aggregate Demand

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Expansion

FIGURE 12.6

The Short-Run and Long- run Effects of an Increase in Aggregate Demand

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Stagflation A combination of inflation and recession, usually resulting from a supply shock.

Supply Shock

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Supply ShockFIGURE 12.7

The Short-Run and Long-Run Effects of a Supply Shock


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A Dynamic Aggregate Demandand Aggregate Supply Model


• Potential real GDP increases continually, shifting the long-run aggregate supply curve to the right.

• During most years, the aggregate demand curve will be shifting to the right.

• Except during periods when workers and firms expect high rates of inflation, the short-run aggregate supply curve will be shifting to the right.

We can create a dynamic aggregate demand and aggregate supply model by making three changes to the basic model.

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FIGURE 12.8

A Dynamic Aggregate Demand and Aggregate Supply Model

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FIGURE 12.9

Using Dynamic Aggregate Demand and Aggregate Supply to Understand Inflation

What Is the Usual Cause of Inflation?

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• The end of the stock market “bubble.”

The Slow Recovery from the Recession of 2001

• Excessive investment in information technology.

• The terrorist attacks of September 11, 2001.

• The corporate accounting scandals.

The recession of 2001 was caused by a decline in aggregate demand. Several factors contributed to this decline:

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The Slow Recovery from the Recession of 2001

FIGURE 12.10

Using Dynamic Aggregate Demand and Aggregate Supply to Understand the Recovery from the 2001 Recession

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Does Rising Productivity Growth Reduce Employment?

Makingthe

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The More Rapid Recovery of 2003–2004

FIGURE 12.11

Using Dynamic Aggregate Demand and Aggregate Supply to Understand the More Rapid Recovery of 2003–2004

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In late 2007, economists were divided over whether the twin blows of higher oil prices and a declining housing sector would be sufficient to push the economy into a recession.

The majority of economists forecast that growth in real GDP would slow but that the economy would not tip into recession.

The Economy in 2007: Continuing Expansion or Looming Recession?

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Solved Problem 12-4Showing the Oil Shock of 1974–1975 on a Dynamic Aggregate Demand and Aggregate Supply Graph


ACTUALREAL GDP

POTENTIAL REAL GDP

PRICE LEVEL

1974$4.32 trillion

$4.35 trillion 34.7

1975$4.31 trillion

$4.50 trillion 38.0

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Do Oil Shocks Still Cause Recessions?Making

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FedEx’s trucks and jets have become more fuel efficient.

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An Inside LOOK Profits at UPS Signal Slow Growth in the U.S. Economy

Freight Carrier Weakness Shows Retailer Uncertainty

The U.S. economic expansion from the first quarter of 2006 to the first quarter of 2007.

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Aggregate demand and aggregate supply model

Aggregate demand curve

Fiscal policyLong-run aggregate supply curve

Menu costs

Monetary policy

Short-run aggregate supply curve

Stagflation

Supply shock

K e y T e r m s

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Macroeconomic Schools of Thought

Appendix

Keynesian revolution The name given to the widespread acceptance during the 1930s and 1940s of John Maynard Keynes’s macroeconomic model.

1 The monetarist model

2 The new classical model

3 The real business cycle model

These alternative schools of thought use models that differ significantly from the standard aggregate demand and aggregate supply model. We can briefly consider each of the three major alternative models:

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Appendix

The Monetarist Model

Monetary growth rule A plan for increasing the quantity of money at a fixed rate that does not respond to changes in economic conditions.

Monetarism The macroeconomic theories of Milton Friedman and his followers; particularly the idea that the quantity of money should be increased at a constant rate.

The monetarist model—also known as the neo-Quantity Theory of Money model—was developed beginning in the 1940s by Milton Friedman, an economist at the University of Chicago who was awarded the Nobel Prize in Economics in 1976.

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Appendix

The New Classical Model

New classical macroeconomics The macroeconomic theories of Robert Lucas and others, particularly the idea that workers and firms have rational expectations.

The new classical model was developed in the mid-1970s by a group of economists including Nobel laureate Robert Lucas of the University of Chicago, Thomas Sargent of New York University, and Robert Barro of Harvard University.

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Appendix

The Real Business Cycle Model

Real business cycle model A macroeconomic model that focuses on real, rather than monetary, causes of the business cycle.

Beginning in the 1980s, some economists, including Nobel laureates Finn Kydland of Carnegie Mellon University and Edward Prescott of Arizona State University, argued that Lucas was correct in assuming that workers and firms formed their expectations rationally and that wages and prices adjust quickly to supply and demand but wrong about the source of fluctuations in real GDP.

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Karl Marx: Capitalism’s Severest CriticMaking

the

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Karl Marx predicted that a final economic crisis would lead to the collapse of the market system.

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Keynesian revolution

Monetarism

Monetary growth rule

New classical macroeconomics

Real business cycle model

K e y T e r m s

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dynamic aggregate demand

real gdp supplied

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