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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Aggregate Demand, Aggregate Demand, Aggregate Supply, and Aggregate Supply, and
Modern Modern MacroeconomicsMacroeconomics
Chapter 9 – Part two
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Equilibrium in the Equilibrium in the Aggregate EconomyAggregate Economy Changes in the SAS, AD, and LAS curves
affect short-run and long-run equilibrium.
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Short-Run EquilibriumShort-Run Equilibrium
Short-run equilibrium is where the AS and AD curves intersect.
Increases (decreases) in AD lead to higher (lower) real output and higher (lower) price level.
Upward (downward) shift the SAS curve lead to lower (higher) real output and higher (lower) price level.
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Real output
Pric
e le
vel
Short-Run Equilibrium:Short-Run Equilibrium:Shift in Aggregate Shift in Aggregate DemandDemand
Y0 Y1
P1
P0 EF
AD0
AD1
SAS
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Real output
Pric
e le
vel
Short-Run Equilibrium:Short-Run Equilibrium:Shift in Aggregate Shift in Aggregate SupplySupply
Y1 Y0
P1
P0
E
G
AD
SAS1
SAS0
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Long-Run EquilibriumLong-Run Equilibrium
Long-run equilibrium is where AD and LAS intersect.
In the long run, output is fixed and the price level is variable.
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Long-Run EquilibriumLong-Run Equilibrium
AD determines the price level.
Increases (decreases) in AD lead to higher (lower) prices.
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Long-Run Equilibrium:Long-Run Equilibrium:Shift in Aggregate Shift in Aggregate DemandDemand
LAS
AD0
AD1
Real output
Price level
P0
Y0
E
HP1
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Integrating the Short-Integrating the Short-Run and Long-Run Run and Long-Run FrameworksFrameworks The economy is in both short-run and long-
run equilibrium when all three curves intersect in the same location.
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Integrating the Short-Integrating the Short-Run and Long-Run Run and Long-Run FrameworksFrameworks The ideal situation is for AD to grow at the
same rate as AS and potential output. Unemployment and growth are at their
target rates with no inflation.
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Long-Run EquilibriumLong-Run Equilibrium
AD
SAS
YP Real output
LAS
P0
E
Pric
e le
vel
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The Recessionary GapThe Recessionary Gap
A recessionary gap is the amount by which equilibrium output is below potential output.
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The Recessionary GapThe Recessionary Gap
If the economy remains at this level for a long time, there would be an excess supply of factors of production.
Costs and wages would tend to fall. As factor prices fall, the SAS curve will shift down to
eliminate the recessionary gap.
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Real output
Pric
e le
vel
The Recessionary GapThe Recessionary Gap
YPY1
LAS
AD
SAS0
SAS1
P0
A
P1
B
Recessionary gap
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The Inflationary GapThe Inflationary Gap
An inflationary gap occurs when the economy is above potential at the current price level.
Factor prices rise causing the SAS curve to shift up.
The price level rises, and the inflationary gap is eliminated.
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(c)
The Inflationary GapThe Inflationary Gap
Y2YPReal
output
LAS
SAS0AD
SAS2
P0
CP2
D
Inflationary gap
Pric
e le
vel
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The Economy Beyond The Economy Beyond PotentialPotential When the economy operates below its
potential, firms can hire additional factors of production without increasing production costs.
Once the economy reaches its potential output, that is no longer possible.
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The Economy Beyond The Economy Beyond PotentialPotential As firms compete for resources, costs rise
beyond productivity increases. The short-run AS curve shifts up and the price level rises. The economy will slow down by itself or government
adopt a policy to contract output and eliminate the inflationary gap.
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Aggregate Demand Aggregate Demand PolicyPolicy Fiscal policy – the deliberate change in
either government spending or taxes to stimulate or slow down the economy.
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Aggregate Demand Aggregate Demand PolicyPolicy Expansionary fiscal policy is appropriate if
aggregate income is too low. The deficit should be increased by
decreasing taxes or increasing government spending.
The AD curve shifts to the right.
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Aggregate Demand Aggregate Demand PolicyPolicy Contractionary fiscal policy is appropriate if
aggregate income is too high. The deficit should be decreased by
increasing taxes or decreasing government spending.
The AD curve shifts to the left.
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Real output
Pric
e le
vel
Expansionary Fiscal Expansionary Fiscal PolicyPolicy
YPY0
LAS
P1
P0
AD0
AD1
AS
A
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Contractionary Fiscal Contractionary Fiscal PolicyPolicy
Real output
Pric
e le
vel
YP Y2
LAS
ASP2
AD2
AD0
B
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Additional Policy Additional Policy ExamplesExamples Unemployment is 12 percent and there is
no inflation. What policy would you recommend? Use expansionary fiscal policy to shift the
AD curve out to its potential income.
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Real output
Price level
Expansionary Fiscal Expansionary Fiscal PolicyPolicy
P1P0
SAS
AD0
Y0 YP
AD1
B
LAS
A
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Additional Policy Additional Policy ExamplesExamples Unemployment is at its target rate and it is
likely that consumer expenditures will rise. What policy would you recommend? Use contractionary fiscal policy to shift the
AD curve inward to counteract the expected increase in AD.
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Real output
Price level
Contractionary Fiscal Contractionary Fiscal PolicyPolicy
YP
LAS
AD0
SASP1
Y1
AD2
B
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Additional Policy Additional Policy ExamplesExamples What would have happened if the
government didn’t institute a contractionary fiscal policy?
There would be an inflationary gap which would increase factor prices.
The SAS curve would shift up until it intersects the AD curve at YP.
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Real output
Price level
Economy Above PotentialEconomy Above Potential
YP
LAS
AD1
SAS0
P0
Y1
AD0
D
SAS1
C
EP1
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Fiscal Policy in World Fiscal Policy in World War IIWar II The deficit increased greatly during World
War II. Real GDP grew by even more than the
increase in the deficit. Wartime wage and price controls
prevented the SAS curve from shifting up.
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Fiscal Policy in World Fiscal Policy in World War IIWar II Although World War II expanded the
economy, that doesn’t mean wars are good for the economy. The production of military goods
increased, but the production of consumer goods decreased.
Many people were killed or permanently disabled.
War Finance: War Finance: Expansionary Fiscal Expansionary Fiscal PolicyPolicy
Year
1937193819391940194119421943194419451946
GDP(billions of
1958 dollars)
$ 90849099
124157191210211208
Deficit(billions ofDollars)
$ -2.8-1.0-2.9-2.7-4.8
-19.4-53.8-46.1-45.0-18.2
Unemploymentrate
14.3%19.017.214.6
9.94.71.91.21.9
3.9
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Real output (in billions of dollars)
LAS
$90 $208
AD1
AD0
SAS
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U.S. Economic ExpansionU.S. Economic Expansion
The economy boomed during the late 1990s and early 2000s.
The budget went from a large deficit to a large surplus.
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U.S. Economic ExpansionU.S. Economic Expansion
Significant increases in consumer and investment spending offset the contractionary effect of the surplus.
The surplus was more due to a booming economy than due to contractionary policy.
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U.S. Economic ExpansionU.S. Economic Expansion
During 2000-2001, political pressures increased government spending and cut taxes which led to a shrinking surplus.
The tax cut came just at the right time because the economy moved into a recession in mid-2001.
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Macro Policy Is More Macro Policy Is More Complicated Than It Complicated Than It LooksLooks Using the AS/AD model to analyze the
economy is more complicated than it looks. Implementing fiscal policy. Estimating potential output. Effectiveness of fiscal policy.
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1. The Problem of 1. The Problem of Implementing Fiscal Implementing Fiscal PolicyPolicy There is no guarantee that government will
do what the economy needs to be done. Implementing government spending and
tax changes is a slow legislative process. Government spending and tax decisions
are made for political rather than for economic reasons.
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2. The Problem of 2. The Problem of Estimating Potential Estimating Potential OutputOutput Increasing AD when the economy is
operating at its potential will accelerate inflation by shifting up the SAS curve.
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2. The Problem of 2. The Problem of Estimating Potential Estimating Potential OutputOutput One way of estimating potential output is to
estimate the target rate of unemployment. Target rate of unemployment – the rate
below which inflation began to accelerate in the past.
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2. The Problem of 2. The Problem of Estimating Potential Estimating Potential OutputOutput Unfortunately, the target rate of
unemployment fluctuates and is difficult to predict.
For example, there is structural but no cyclical unemployment at potential output – it is difficult to differentiate between the two.
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2. The Problem of 2. The Problem of Estimating Potential Estimating Potential OutputOutput Another way to determine potential output
is to add the normal growth factor (3%) the economy’s previous level.
Estimating the economy’s potential from past growth rates is complicated by potentially dramatic changes in regulations, technology, and expectations.
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3. The Questionable 3. The Questionable Effectiveness of Fiscal Effectiveness of Fiscal PolicyPolicy The effectiveness of fiscal policy depends
on the government’s ability to perceive a problem and react appropriately to it.
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3. The Questionable 3. The Questionable Effectiveness of Fiscal Effectiveness of Fiscal PolicyPolicy Countercyclical fiscal policy – fiscal
policy in which the government offsets any change in aggregate expenditures that would create a business cycle.
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3. The Questionable 3. The Questionable Effectiveness of Fiscal Effectiveness of Fiscal PolicyPolicy Most economists agree that the
government is unable to fine tune the economy.
Fine tuning – fiscal policy designed to keep the economy always at its target or potential level of income.
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End of Chapter 9
Aggregate Demand, Aggregate Demand, Aggregate Supply, and Aggregate Supply, and
Modern Modern MacroeconomicsMacroeconomics