Principles of Economics Twelfth Edition Chapter 26 PDF
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2017
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This document is chapter 26 of a textbook titled Principles of Economics, twelfth edition. It introduces aggregate supply and demand, and explores the determination of aggregate output, price levels, and interest rates.
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Principles of Economics Twelfth Edition Chapter 26 The Determination of Aggregate Output, the Price Level, and the...
Principles of Economics Twelfth Edition Chapter 26 The Determination of Aggregate Output, the Price Level, and the Interest Rate Copyright©©2017 Copyright 2017Pearson PearsonEducation, Education,Inc. Inc. 26-1 Copyright Copyright © 2017 Pearson Education, Inc. 26-2 Chapter Outline and Learning Objectives (1 of 2) 26.1 The Aggregate Supply (AS) Curve Define the aggregate supply curve and discuss shifts in the short-run AS curve. 26.2 The Aggregate Demand (AD) Curve Derive the aggregate demand curve and explain why the AD curve is downward sloping. 26.3 The Final Equilibrium Explain why the intersection of the AD and AS curves is an equilibrium point. Copyright©©2017 Copyright 2017Pearson PearsonEducation, Education,Inc. Inc. 26-3 Chapter Outline and Learning Objectives (2 of 2) 26.4 Other Reasons for a Downward-Sloping AD Curve Give two additional reasons why the AD curve may slope down. 26.5 The Long-Run AS Curve Discuss the shape of the long-run aggregate supply curve and explain long-run market adjustment to potential GDP. Copyright©©2017 Copyright 2017Pearson PearsonEducation, Education,Inc. Inc. 26-4 Chapter 26 The Determination of Aggregate Output, the Price Level, and the Interest Rate We are now ready to bring together the three pieces of the economy—output, the price level, and the interest rate. This chapter and the next one will give you the ability to think about the key issues policy makers face in trying to manage the economy. Copyright © 2017 Pearson Education, Inc. 26-5 The Aggregate Supply (AS) Curve (1 of 3) aggregate supply The total supply of all goods and services in an economy. aggregate supply (AS) curve A graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level. It is better thought of as a “price/output response” curve: a curve that traces out the price decisions and output decisions of all firms in the economy under different levels of aggregate demand. Copyright © 2017 Pearson Education, Inc. 26-6 Aggregate Supply in the Short Run FIGURE 26.1 The Short-Run Aggregate Supply Curve In the short run, the aggregate supply curve (the price/output response curve) has a positive slope. At low levels of aggregate output, the curve is fairly flat. As the economy approaches capacity, the curve becomes nearly vertical. At capacity, Ȳ, the curve is vertical. Copyright © 2017 Pearson Education, Inc. 26-7 The Aggregate Supply (AS) Curve (2 of 3) Why an Upward Slope Wages are a large fraction of total costs, and wage changes lag behind price changes. This gives us an upward-sloping short-run AS curve. Copyright © 2017 Pearson Education, Inc. 26-8 The Aggregate Supply (AS) Curve (3 of 3) Why the Particular Shape? As the overall economy is using all its capital and all the labor that wants to work at the market wage at Ȳ, increased demand for labor and output can be met only by increased prices. At low levels of output, the AS curve is flatter. Small price increases may be associated with relatively large output responses. Copyright © 2017 Pearson Education, Inc. 26-9 Shifts of the Short-Run Aggregate Supply Curve The vertical part of the short-run AS curve represents the economy’s maximum (capacity) output, as determined by existing resources. New discoveries of oil or problems in the production of energy can shift the AS curve through effects on the marginal cost of production. cost shock, or supply shock A change in costs that shifts the short-run aggregate supply (AS) curve. Copyright © 2017 Pearson Education, Inc. 26-10 FIGURE 26.2 Shifts of the Short-Run Aggregate Supply Curve Copyright © 2017 Pearson Education, Inc. 26-11 The Aggregate Demand (AD) Curve The AD curve is derived from the model of the goods market in Chapters 23 and 24 and from the behavior of the Fed. Planned Aggregate Expenditure and the Interest Rate As the interest rate rises (falls), I falls, thus total planned spending rises (falls) as well. Copyright © 2017 Pearson Education, Inc. 26-12 FIGURE 26.3 The Effect of an Interest Rate Increase on Planned Aggregate Expenditure and Equilibrium Output An increase in the interest rate from 3% to 6% lowers planned aggregate expenditure and thus reduces equilibrium output from Y0 to Y1. Copyright © 2017 Pearson Education, Inc. 26-13 Planned Aggregate Expenditure and the Interest Rate (1 of 2) Recall: The effects of a change in the interest rate: A high interest rate (r) discourages planned investment (I). Planned aggregate expenditure (AE) at every level of income falls. A decrease in AE lowers equilibrium output (income) (Y) by a multiple of the initial decrease in I. Copyright © 2017 Pearson Education, Inc. 26-14 Planned Aggregate Expenditure and the Interest Rate (2 of 2) IS curve Relationship between aggregate output and the interest rate in the goods market. With the interest rate fixed, an increase in government spending (G) increases AE and thus Y in equilibrium. Copyright © 2017 Pearson Education, Inc. 26-15 FIGURE 26.4 The IS Curve In the goods market, there is a negative relationship between output and the interest rate because planned investment depends negatively on the interest rate. Any point on the IS curve is an equilibrium in the goods market for the given interest rate. Copyright © 2017 Pearson Education, Inc. 26-16 FIGURE 26.5 Shift of the IS Curve An increase in government spending (G) with the interest rate fixed increases output (Y), which is a shift of the IS curve to the right. Copyright © 2017 Pearson Education, Inc. 26-17 The Behavior of the Fed Output (Y) and inflation (P) are two main inputs into the Fed’s interest rate decision. Fed rule Equation that shows how the Fed’s interest rate decision depends on the state of the economy. where Z includes economic factors (other than Y and P) that lie outside our model and are likely to vary from period to period in ways that are hard to predict. Copyright © 2017 Pearson Education, Inc. 26-18 ECONOMICS IN PRACTICE The Federal Reserve Bank Gets a New Chair, Janet Yellen On January 6, 2014, Janet Yellen began her term as the Chair of the Board of Governors of the Federal Reserve System. Yellen came to the Chair position from a mix of academic and public sector experience. She had served as the Fed’s Vice Chair and President of the San Francisco Fed and a member of the Council of Economic Advisors. THINKING PRACTICALLY 1. The Fed Chair is sometimes said to be the second most powerful person in the United States after the president. Why might this be so? Copyright © 2017 Pearson Education, Inc. 26-19 FIGURE 26.6 Equilibrium Values of the Interest Rate and Output In the Fed rule, the Fed raises the interest rate as output increases, other things being equal. Along the IS curve, output falls as the interest rate increases because planned investment depends negatively on the interest rate. The intersection of the two curves gives the equilibrium values of output and the interest rate for given values of government spending (G), the price level (P), and the factors in Z. Copyright © 2017 Pearson Education, Inc. 26-20 Deriving the AD Curve The AD curve is not a market demand curve, and it is not the sum of all market demand curves in the economy. Because many prices rise together when the overall price level rises, we cannot use the ceteris paribus assumption to draw the AD curve. AD falls when P increases because the higher P leads the Fed to raise r, which decreases I and thus Y. The higher interest rate causes aggregate output to fall. Copyright © 2017 Pearson Education, Inc. 26-21 FIGURE 26.7 The Aggregate Demand (AD) Curve The AD curve is derived from Figure 26.6. Each point on the AD curve is an equilibrium point in Figure 26.6 for a given value of P. When P increases, the Fed raises the interest rate (the Fed rule in Figure 26.6 shifts to the left), which has a negative effect on planned investment and thus on Y. The AD curve reflects this negative relationship between P and Y. Copyright © 2017 Pearson Education, Inc. 26-22 ECONOMICS IN PRACTICE How Does the Fed Look at Inflation? In monetary policy decisions, the Fed pays most attention to a price index called the Core Personal Consumption Expenditures (PCE), which eliminates most food and energy goods due to their volatility. Some economists have criticized the Fed’s use of the Core PCE price index because it includes import prices that the Fed cannot influence. THINKING PRACTICALLY 1. How do you think Fed policy might change if it included energy and food prices in its measure of the price level? Copyright © 2017 Pearson Education, Inc. 26-23 The Final Equilibrium FIGURE 26.8 Equilibrium Output and the Price Level Aggregate output and the aggregate price level are determined by the intersection of the AS and AD curves. These two curves embed within them decisions of households, firms, and the government Copyright © 2017 Pearson Education, Inc. 26-24 Other Reasons for a Downward-Sloping AD Curve The AD curve slopes down because the Fed raises the interest rate (r) when P increases and because I depends negatively on r. A real wealth effect on consumption also contributes to a downward-sloping AD curve. real wealth effect The change in consumption brought about by a change in real wealth that results from a change in the price level. Copyright © 2017 Pearson Education, Inc. 26-25 The Long-Run AS Curve FIGURE 26.9 The Long-Run Aggregate Supply Curve When the AD curve shifts from AD0 to AD1, the equilibrium price level initially rises from P0 to P1 and output rises from Y0 to Y1. Wages respond in the longer run, shifting the AS curve from AS0 to AS1. If wages fully adjust, output will be back to Y0. Y0 is sometimes called potential GDP. Copyright © 2017 Pearson Education, Inc. 26-26 Potential GDP (1 of 2) The vertical portion of the short-run AS curve exists because there are physical limits to the amount that an economy can produce in any given time period. potential output, or potential GDP The level of aggregate output that can be sustained in the long run without inflation. Copyright © 2017 Pearson Education, Inc. 26-27 Potential GDP (2 of 2) Short-Run Equilibrium below Potential Output Economists have different opinions on how to determine whether an economy is operating at or above potential output. Those who believe the AS curve is vertical in the long run believe that output will tend to rise when wages fall with high unemployment. Copyright © 2017 Pearson Education, Inc. 26-28 ECONOMICS IN PRACTICE The Simple “Keynesian” Aggregate Supply Curve With planned aggregate expenditure of AE1 and aggregate demand of AD1, equilibrium output is Y1. A shift of planned aggregate expenditure to AE2, corresponding to a shift of the AD curve to AD2, causes output to rise but the price level to remain at P1. If AE and AD exceed YF, however, there is an inflationary gap and the price level rises to P3. THINKING PRACTICALLY 1. Why is the distance between AE3 and AE2 called an inflationary gap? Copyright © 2017 Pearson Education, Inc. 26-29 REVIEW TERMS AND CONCEPTS aggregate supply aggregate supply curve cost shock, or supply shock Fed rule IS curve potential output, or potential GDP real wealth effect Equations: Copyright © 2017 Pearson Education, Inc. 26-30