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Principles of Economics, Ninth Edition N. Gregory Mankiw

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V. Andreea CHIRITESCU

Eastern Illinois University

N. Gregory Mankiw Principles Of Economics Ninth Edition

Chapter 33

Aggregate Demand and Aggregate Supply

Economic activity

Fluctuates from year to year

Recession

Economic contraction

Period of declining real incomes and rising unemployment

Depression

Severe recession

“You’re fired. Pass it on.”

Economic Fluctuations, Part 1

Economic Fluctuations, Part 2

Three key facts about economic fluctuations

Economic fluctuations are irregular and unpredictable

The business cycle

Most macroeconomic quantities fluctuate together

Recessions: economy-wide phenomena

As output falls, unemployment rises

Figure 1A Look at Short-Run Economic Fluctuations, Part 1

Figure 1A Look at Short-Run Economic Fluctuations, Part 2

Figure 1A Look at Short-Run Economic Fluctuations, Part 3

Short-Run Economic Fluctuations, Part 1

Classical dichotomy

Separation of variables into:

Real variables

Nominal variables

Monetary neutrality

Changes in the money supply

Affect nominal variables

Do not affect real variables

Short-Run Economic Fluctuations, Part 2

Classical theory holds in the long-run

Changes in money supply

Affect prices, and other nominal variables

Do not affect real GDP, unemployment, or other real variables

Short-Run Economic Fluctuations, Part 3

Short-run

Assumption of monetary neutrality: no longer appropriate

Real and nominal variables are highly intertwined

Changes in the money supply

Can temporarily push real GDP away from its long-run trend

Short-Run Economic Fluctuations, Part 4

AD-AS model

Model of aggregate demand (AD) and aggregate supply (AS)

Most economists use it to explain short-run fluctuations in economic activity

Around its long-run trend

Short-Run Economic Fluctuations, Part 5

Aggregate-demand curve

Shows the quantity of goods and services

That households, firms, the government, and customers abroad

Want to buy at each price level

Downward sloping

Short-Run Economic Fluctuations, Part 6

Aggregate-supply curve

Shows the quantity of goods and services

That firms choose to produce and sell

At each price level

Upward sloping

Figure 2 Aggregate Demand and Aggregate Supply

Economists use the model of aggregate demand and aggregate supply to analyze economic fluctuations. On the vertical axis is the overall level of prices. On the horizontal axis is the economy’s total output of goods and services.

Output and the price level adjust to the point at which the aggregate-supply and aggregate-demand curves intersect.

The Aggregate-Demand Curve, Part 1

Y = C + I + G + NX

Three effects explain why AD curve slopes downward:

Wealth effect (C )

Interest-rate effect (I)

Exchange-rate effect (NX)

Assumption: government spending (G)

Fixed by policy

The Aggregate-Demand Curve, Part 2

Price level and consumption (C): the wealth effect

Decrease in price level

Increase in the real value of money

Consumers are wealthier

Increase in consumer spending

Increase in quantity demanded of goods and services

The Aggregate-Demand Curve, Part 3

Price level and investment (I): the interest-rate effect

Decrease in price level

Decrease in the interest rate

Increase spending on investment goods

Increase in quantity demanded of goods and services

The Aggregate-Demand Curve, Part 4

Price level and net exports (NX): the exchange-rate effect

Decrease in U.S. price level

Decrease in the interest rate

U.S. dollar depreciates

Stimulates U.S. net exports

Increase in quantity demanded of goods and services

The Aggregate-Demand Curve, Part 5

Summary: a fall in price level

Increases quantity of goods and services demanded

Because:

Consumers are wealthier: stimulates the demand for consumption goods

Interest rates fall: stimulates the demand for investment goods

Currency depreciates: stimulates the demand for net exports

The Aggregate-Demand Curve, Part 6

Summary: a rise in price level

Decreases the quantity of goods and services demanded

Because:

Consumers are poorer: depress consumer spending

Higher interest rates fall: depress investment spending

Currency appreciates: depress net exports

Figure 3 The Aggregate-Demand Curve

The Aggregate-Demand Curve, Part 7

The AD curve might shift:

Changes in consumption, C

Changes in investment, I

Changes in government purchases, G

Changes in net exports, NX

The Aggregate-Demand Curve, Part 8

Changes in consumption, C

Events that change how much people want to consume at a given price level

Changes in taxes, wealth

Increase in consumer spending

Aggregate-demand curve: shift right

The Aggregate-Demand Curve, Part 9

Changes in investment, I

Events that change how much firms want to invest at a given price level

Better technology

Tax policy

Money supply

Increase in investment

Aggregate-demand curve: shift right

The Aggregate-Demand Curve, Part 10

Changes in government purchases, G

Policy makers – change government spending at a given price level

Build new roads

Increase in government purchases

Aggregate-demand curve: shift right

The Aggregate-Demand Curve, Part 11

Changes in net exports, NX

Events that change net exports for a given price level

Recession in Europe

International speculators – change in exchange rate

Increase in net exports

Aggregate-demand curve: shift right

Table 1 The Aggregate-Demand Curve: Summary, Part 1

Why Does the Aggregate-Demand Curve Slope Downward?

The Wealth Effect: A lower price level increases real wealth, which stimulates spending on consumption.

The Interest-Rate Effect: A lower price level reduces the interest rate, which stimulates spending on investment.

The Exchange-Rate Effect: A lower price level causes the real exchange rate to depreciate, which stimulates spending on net exports.

Why Might the Aggregate-Demand Curve Shift?

Shifts Arising from Changes in Consumption: An event that causes consumers to spend more at a given price level (a tax cut, a stock market boom) shifts the aggregate-demand curve to the right. An event that causes consumers to spend less at a given price level (a tax hike, a stock market decline) shifts the aggregate-demand curve to the left.

Shifts Arising from Changes in Investment: An event that causes firms to invest more at a given price level (optimism about the future, a fall in interest rates due to an increase in the money supply) shifts the aggregate-demand curve to the right. An event that causes firms to invest less at a given price level (pessimism about the future, a rise in interest rates due to a decrease in the money supply) shifts the aggregate-demand curve to the left.

Shifts Arising from Changes in Government Purchases: An increase in government purchases of goods and services (greater spending on defense or highway construction) shifts the aggregate-demand curve to the right. A decrease in government purchases on goods and services (a cutback in defense or highway spending) shifts the aggregate demand curve to the left.

Shifts Arising from Changes in Net Exports: An event that raises spending on net exports at a given price level (a boom overseas, speculation that causes an exchange rate depreciation) shifts the aggregate-demand curve to the right. An event that reduces spending on net exports at a given price level (a recession overseas, speculation that causes an exchange-rate appreciation) shifts the aggregate-demand curve to the left.

Table 1 The Aggregate-Demand Curve: Summary, Part 2

The Aggregate-Supply Curve, Part 1

Long run aggregate-supply curve is vertical, LRAS

Price level does not affect the long-run determinants of GDP:

Supplies of labor, capital, and natural resources

Available technology

Short run

Aggregate-supply curve is upward sloping

Figure 4 The Long-Run Aggregate-Supply Curve

The Aggregate-Supply Curve, Part 2

Natural level of output

Production of goods and services

That an economy achieves in the long run

When unemployment is at its normal rate

Potential output

Full-employment output

The LRAS curve might shift:

Any change in natural level of output

Changes in labor

Changes in capital

Changes in natural resources

Changes in technological knowledge

The Aggregate-Supply Curve, Part 3

Changes in labor

Quantity of labor – increases

Aggregate-supply curve: shifts right

Natural rate of unemployment – increases

Aggregate-supply curve: shifts left

Changes in capital

Capital stock – increase

Aggregate-supply curve: shifts right

Physical and human capital

The Aggregate-Supply Curve, Part 4

Changes in natural resources

New discovery of natural resource

Aggregate-supply curve: shifts right

Weather

Availability of natural resources

The Aggregate-Supply Curve, Part 5

Changes in technology

New technology, for given labor, capital and natural resources

Aggregate-supply curve: shifts right

International trade

Government regulation

The Aggregate-Supply Curve, Part 6

Long-Run Growth and Inflation

Long run: both AD and LRAS curves shift

Continual shifts of LRAS curve to right

Technological progress

AD curve shifts to right

Monetary policy

The Fed increases money supply over time

Result:

Continuing growth in output

Continuing inflation

Figure 5 Long-Run Growth and Inflation in the Model of Aggregate Demand and Aggregate Supply

The Aggregate-Supply Curve, Part 7

Aggregate supply curve slopes upward in the short-run:

Price level affects the economy’s output

Increase in overall level of prices in economy

Tends to raise the quantity of goods and services supplied

Decrease in level of prices

Tends to reduce quantity of goods and services supplied

Figure 6 The Short-Run Aggregate-Supply Curve

Theories that explain why the AS curve slopes upward in short-run:

Sticky-wage theory

Sticky-price theory

Misperceptions theory

The Aggregate-Supply Curve, Part 8

Sticky-wage theory

Nominal wages - slow to adjust to changing economic conditions

Long-term contracts: workers and firms

Slowly changing social norms

Notions of fairness - influence wage setting

Nominal wages - based on expected prices

Don’t respond immediately when actual price level – different from what was expected

The Aggregate-Supply Curve, Part 9

Sticky-wage theory

If price level < expected

Firms – incentive to produce less output

If price level > expected

Firms – incentive to produce more output

The Aggregate-Supply Curve, Part 10

Sticky-price theory

Prices of some goods and services

Slow to adjust to changing economic conditions

Menu costs: costs to adjusting prices

The Aggregate-Supply Curve, Part 11

The Aggregate-Supply Curve, Part 12

Misperceptions theory

Changes in the overall price level

Can temporarily mislead suppliers

About changes in individual markets

Changes in relative prices

Suppliers - respond to changes in level of prices

Change - quantity supplied of goods and services

The Aggregate-Supply Curve, Part 13

Quantity of output supplied =

= Natural level of output +

+ a(Actual price level – Expected price level)

Where a - number that determines how much output responds to unexpected changes in the price level

The Aggregate-Supply Curve, Part 14

The short-run AS curve might shift:

Changes in labor, capital, natural resources, or technological knowledge

Expected price level increases

Aggregate-supply curve: shifts left

Table 2 Short-Run Aggregate-Supply Curve: Summary, Part 1

Why Does the Short-Run Aggregate-Supply Curve Slope Upward?

The Sticky-Wage Theory: An unexpectedly low price level raises the real wage, which causes firms to hire fewer workers and produce a smaller quantity of goods and services.

The Sticky-Price Theory: An unexpectedly low price level leaves some firms with higher than desired prices, which depresses their sales and leads them to cut back production.

The Misperceptions Theory: An unexpectedly low price level leads some suppliers to think their relative prices have fallen, which induces a fall in production.

Table 2 Short-Run Aggregate-Supply Curve: Summary, Part 2

Why Might the Short-Run Aggregate-Supply Curve Shift?

Shifts Arising from Changes in Labor: An increase in the quantity of labor available (perhaps due to a fall in the natural rate of unemployment) shifts the aggregate supply curve to the right. A decrease in the quantity of labor available (perhaps due to a rise in the natural rate of unemployment) shifts the aggregate-supply curve to the left.

Shifts Arising from Changes in Capital: An increase in physical or human capital shifts the aggregate-supply curve to the right. A decrease in physical or human capital shifts the aggregate-supply curve to the left.

Shifts Arising from Changes in Natural Resources: An increase in the availability of natural resources shifts the aggregate-supply curve to the right. A decrease in the availability of natural resources shifts the aggregate-supply curve to the left.

Shifts Arising from Changes in Technology: An advance in technological knowledge shifts the aggregate-supply curve to the right. A decrease in the available technology (perhaps due to government regulation) shifts the aggregate-supply curve to the left.

Shifts Arising from Changes in the Expected Price Level: A decrease in the expected price level shifts the short-run aggregate-supply curve to the right. An increase in the expected price level shifts the short-run aggregate-supply curve to the left.

Causes of Economic Fluctuations, Part 1

Assumption

Economy begins in long-run equilibrium

Long-run equilibrium:

Intersection of AD and LRAS curves

Natural level of output

Actual price level

Intersection of AD and short-run AS curve

Expected price level = Actual price level

Figure 7 The Long-Run Equilibrium

Causes of Economic Fluctuations, Part 2

Shift in aggregate demand

Wave of pessimism: AD shifts left

Short-run

Output falls

Price level falls

Long-run

Short-run aggregate-supply curve shifts right

Output – natural level

Price level – falls

Table 3 Four Steps for Analyzing Macroeconomic Fluctuations

Decide whether the event shifts the aggregate-demand curve or the aggregate-supply curve (or perhaps both).

Decide the direction in which the curve shifts.

Use the diagram of aggregate demand and aggregate supply to determine the impact on output and the price level in the short run.

Use the diagram of aggregate demand and aggregate supply to analyze how the economy moves from its new short-run equilibrium to its new long-run equilibrium.

Figure 8 A Contraction in Aggregate Demand

Two Big Shifts in Aggregate Demand: The Great Depression and World War II, Part 1

Early 1930s: large drop in real GDP

The Great Depression

Largest economic downturn in U.S. history

From 1929 to 1933

Real GDP fell by 27%

Unemployment rose from 3 to 25%

Price level fell by 22%

Two Big Shifts in Aggregate Demand: The Great Depression and World War II, Part 2

Early 1930s: large drop in real GDP

Cause: decrease in aggregate demand

Decline in money supply (by 28%)

Decreasing: C and I

The outcome of a massive decrease in aggregate demand

Two Big Shifts in Aggregate Demand: The Great Depression and World War II, Part 3

Early 1940s: large increase in real GDP

Economic boom

World War II

More resources to the military

Government purchases increased

Aggregate demand – increased 1939 to 1944

Doubled the economy’s production of goods and services

20% increase in the price level

Unemployment fell from 17 to 1%

Figure 9 U.S. Real GDP Growth since 1900

The Great Recession of 2008–2009, Part 1

2008-2009, financial crisis, severe downturn in economic activity

Worst macroeconomic event in more than half a century

A few years earlier: a substantial boom in the housing market

Fueled by low interest rates

Rise in housing prices

Developments in the mortgage market

Other issues

The Great Recession of 2008–2009, Part 2

Developments in the mortgage market

Easier for subprime borrowers to get loans

Borrowers with a higher risk of default (income and credit history)

Securitization

Process by which a financial institution (mortgage originator) makes loan

Then (investment bank) bundles them together mortgage-backed securities

The Great Recession of 2008–2009, Part 3

Developments in the mortgage market

Mortgage-backed securities

Sold to other institutions, which may not have fully appreciated the risks in these securities

Other issues

Inadequate regulation for these high-risk loans

Misguided government policy

Encouraged this high-risk lending

The Great Recession of 2008–2009, Part 4

1995-2006

Increase in housing demand

Increase in housing prices

More than doubled

2006-2009, housing prices fell 30%

Substantial rise in mortgage defaults and home foreclosures

Financial institutions that owned mortgage-backed securities

Huge losses

The Great Recession of 2008–2009, Part 5

Large contractionary shift in AD

Real GDP fell sharply

By 4.2% between the forth quarter of 2007 and the second quarter of 2009

Employment fell sharply

Unemployment rate rose from 4.4% in May 2007 to 10.0% in October 2009

The Great Recession of 2008–2009, Part 6

Three policy actions aimed in part at returning AD to its previous level

The Fed

Cut its target for the federal funds rate

From 5.25% in September 2007 to about zero in December 2008

Started buying mortgage-backed securities and other private loans

In open-market operations

Provided banks with additional funds

The Great Recession of 2008–2009, Part 7

October 2008, Congress appropriated $700 billion

For the Treasury to use to rescue the financial system

To stem the financial crisis on Wall Street

To make loans easier to obtain

Equity injections into banks

U.S. government – temporarily became a part owner of these banks

The Great Recession of 2008–2009, Part 8

January 2009, Barack Obama

Large increase in government spending

$787 billion stimulus bill, February 17, 2009

June 2009, the meager recovery began

Second quarter of 2009 to fourth quarter of 2015

Real GDP growth averaged only 2.1% per year

The Great Recession of 2008–2009, Part 9

Unemployment fell to 5.0% by 2016

Much of the decline: individuals leaving the labor force

In December 2015, employment-to-population ratio

Only 1.3 percentage points higher than at its trough during the Great Recession

More than 3 percentage points lower than before the downturn began

Causes of Economic Fluctuations, Part 3

Shift in aggregate supply

Firms – increase in production costs

Aggregate-supply curve: shifts left

Short-run - stagflation

Output falls, price level rises

Long-run, if AD is held constant

Short-run AS shifts back to right

Output – natural level

Price level - falls

Figure 10 An Adverse Shift in Aggregate Supply

Causes of Economic Fluctuations, Part 4

Shift in aggregate supply

Firms – increase in production costs

Aggregate-supply curve: shifts left

Short-run

Output falls

Price level rises

Long-run, policymakers – shift AD to right

Output – natural level

Price level – rises

Figure 11 Accommodating an Adverse Shift in Aggregate Supply

Oil and the Economy, Part 1

Economic fluctuations in the U.S.

Since 1970, originated in the oil fields of the Middle East

Some event - reduces the supply of crude oil flowing from Middle East

Price of oil rises around the world

Aggregate-supply curve shifts left

Stagflation

Mid-1970s

Late-1970s

Oil and the Economy, Part 2

Increase the supply of crude oil from Middle East, 1986

Squabbling among members of OPEC

Prices fell by about half

Aggregate-supply curve – shifts right

Output – rapid growth

Unemployment – falls

Inflation rate – falls

Changes in Middle East oil production are one source of U.S. economic fluctuations.

Oil and the Economy, Part 3

Recent years

World market for oil – not an important source of economic fluctuations

Conservation efforts

Changes in technology

Availability of alternative energy sources

Amount of oil used to produce a unit of real GDP

Declined by more than 50% since the OPEC shocks of the 1970s