Chapter 32 - Aggregate Demand and Aggregate Supply PDF

economics McConnell Brue Flynn Chapter 32 Aggregate Demand and Aggregate Supply © McGraw Hill LLC. All rights reserved. No reproduction or distribution wi...

economics McConnell Brue Flynn Chapter 32 Aggregate Demand and Aggregate Supply © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Chapter Contents Aggregate Demand Changes in Aggregate Demand Aggregate Supply Changes in Aggregate Supply Equilibrium in the AD-AS Model Demand-pull Inflation & Cost-push Inflation in AD-AS Model 32-2 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Aggregate Demand Aggregate demand – a demand curve that shows the total quantity of goods and services that would be demanded at various price levels. 32-3 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Aggregate Demand This graph shows an inverse (negative) relationship between price and real domestic output. The negative relationship can be explained by the THREE effects: (1)Real balances effect: P ↓, the purchasing power (real value) of existing financial balances ↑, which can ↑ spending. (2)Interest rate effect: Price level ↓, lower interest rates, ↑ certain types of spending. (3)Foreign purchases effect: Price level ↓, ↑ spending on U.S. exports, U.S. import products ↓. 32-4 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Changes in Aggregate Demand Graphed 32-5 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Changes in Aggregate Demand Determinants of aggregate demand are as follows.: Change in one of the determinants (C, I, G, Xn) § Changes in consumer spending – e.g., consumer wealth, consumer expectations § Changes in investment spending – e.g., changes in real interest rates § Changes in government spending § Changes in net export spending – changes in national income abroad, exchange rates 32-6 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  (1) Consumer Spending Consumer wealth – spending more when asset values increase and spending less when asset values decrease. Consumer expectations – expect higher (low) incomes in future will increase (decrease) current household spending. Household borrowing – if household reduces spending to pay off household debt, AD decrease. Personal taxes – reduce (↑) personal income taxes, increase (↓) disposable income, and increase (↓ )spending by household, AD ↑ (↓). 32-7 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  (2) Investment Spending Investment spending is spending on capital goods (e.g., ↑ in investment spending, ↑ AD. Real interest rates ↑ , the cost of borrowing ↑, less investment spending, less money spent, AD ↓. Expected returns: § Expectations about future business conditions: if business is optimistic about future expected returns, spend more now, AD ↑. § Technology: new technology enhance future expected returns, spend money on new technology, AD ↑. 32-8 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  (2) Investment Spending (Cont.) § Degree of excess capacity: if excess capacity ↑, ↓ businesses current spending, AD ↓ (excess capacity – no demand for a product, a firm produces less output in the market causes to excess capacity occurs). § Business taxes: ↑ in business taxes, ↓ amount of after- tax income for business, ↓ amount of spending businesses are capable, AD ↓. 32-9 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  (3) Government Spending Government spending increases (e.g., more transportation projects), AD ↑. (4) Net Export Spending National income abroad: if the national incomes abroad ↑, it encourages people living abroad to buy more products that produced by U.S., U.S. net export ↑, AD ↑. Dollar appreciation (depreciation): discourages (encourages) U.S. exports because U.S. goods are relatively more (less) expensive since (foreign buyers obtain more dollars for their currency) it take more of the foreign currency to buy the U.S. dollar, encourage (discourages) more import spending since U.S. dollar can (can’t exchange much foreign currency) buy more of another nation’s currency. Exports decline (↑), AD ↓ (AD ↑). 32-10 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Aggregate Supply Aggregate supply– a supply curve that shows the relationship between a nation’s price level and the amount of real domestic output that firms produce. This relationship depends on time horizon: Immediate short run Short run Long run 32-11 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Aggregate Supply in the Immediate Short Run In the immediate short run, the aggregate supply curve, ASISR, is horizontal at the economy’s current price level, P1. With output prices fixed, firms collectively supply at the different level of output that is demanded at fixed prices. Conclude: ASISR – Price level fixed, while output change 32-12 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Aggregate Supply Curve in the Short Run The aggregate supply curve in the short run shows the upsloping aggregate supply curve (ASSR), indicates a positive relationship between the price level and the amount of real output that firms produce. AS slopes upward, rising (decrease) prices à increase (decrease) real profits. Conclude: ASSR – Both price level and output will change 32-13 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Aggregate Supply in the Long Run The long-run aggregate supply curve (ASLR) shows a vertical line. In the long run (vertical curve), the economy will produce the full- employment output level no matter what the price level is. Conclude: ASLR – Price level change, while output no change 32-14 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Changes in Aggregate Supply Determinants of aggregate supply: Shift the aggregate supply curve such as (1) input prices; (2) productivity; and (3) legal-institutional environment. 32-15 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  (1) Input Prices A change in input prices either domestic/imported resource price will impact aggregate supply. Domestic resource prices: Labor – ↓ supply of labor due to older workers retiring à wages and per-unit production costs ↑ à AS shift to the left., while, ↑ supply of labor, AS shift to the right Capital If the prices fall (increase), AS would shift right (left) Land 32-16 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  (1) Input Prices (Cont.) Prices of imported resources: Imported oil - ↑ in the price of import resources (e.g., oil) à ↑ per-unit production costs à AS shift left. Exchange rates – dollar appreciates à U.S. producers purchase imported resources more cheaply à ↓ per-unit production costs à AS shift right. 32-17 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  (2) Productivity Changes in productivity can cause changes in per-unit production cost. Increases in productivity (AS curve shift right), reduce production costs. Decrease in productivity (AS curve shift left), increase production costs. 32-18 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  (3) Legal-Institutional Environment Legal changes can change per-unit production costs and AS: Business taxes and subsidies – higher business taxes, ↑ costs of businesses, ↓ short-run AS, while, business subsidies can ↓ production costs, ↑ short- run AS. Government regulation – more regulation, ↑ per- unit production costs, AS shift left. 32-19 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  The Equilibrium Price Level and Equilibrium Real GDP Real Output Real Output Demanded Price Level Supplied (Billions) (Index Number) (Billions) $506 108 $513 508 104 512 510 100 510 512 96 507 514 92 502 32-20 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  An Increase in Aggregate Demand That Causes Demand- Pull Inflation The increase in aggregate demand from AD1 to AD2 causes demand-pull inflation, shown as the rise in the price level from P1 to P2. Increase in demand expands output from the full employment level Qf to Q1. It also causes an inflationary GDP gap of Q1 minus Qf (Positive GDP). If the price level had remained at P1, the increase in aggregate demand from AD1 to AD2 would increase output from Qf to Q2. 32-21 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  A Recession Resulting from a Leftward Shift of Aggregate Demand When the Price Level Is Downwardly Inflexible A decline of aggregate demand from AD1 to AD2 will move the economy leftward from a to b along the horizontal broken-line segment and reduce real GDP from Qf to Q1. This causes to empty production capacity, cyclical unemployment, and a recessionary GDP gap (Q1 – Qf). If the price level were flexible downward (from P1 to P2), the decline in aggregate demand would move the economy from a to c. 32-22 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Decreases in AD: Recession and Cyclical Unemployment Price are downwardly inflexible: Fear of price wars – if business reduce their price, their rival may reduce their price even more, causes to price war. Menu costs – discourage repeated price changes. Menu costs in businesses like printing catalogs/new price lists. Firms will wait and see if the decline in AD is permanent. Wage contracts – legal agreement between an employer and employee, which involves doing work for a stated sum of money. Efficiency wages – employers reluctant to cut wages because the impact on employee morale, effort and productivity. Minimum wage law – legal minimum wage for low-skilled labor and firm cannot reduce them when AD declines. 32-23 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Global Perspective 32.1 The graph shows the GDP gap between potential output and actual output in 2020. GDP gaps were negative in most countries, reflecting the COVID-19 pandemic. Source: OECD Economic Outlook, Organisation for Economic Co-operation and Development (OECD). 32-24 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  A Decrease in Aggregate Supply That Causes Cost-Push Inflation A decrease in aggregate supply that causes cost-push inflation. A leftward shift of aggregate supply from AS1 to AS2 raises the price level from P1 to P2 and produces cost- push inflation. Real output declines, and a recessionary occurs (negative GDP) 32-25 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Growth, Full-Employment, and Relative Price Stability This figure illustrates growth, full employment, and relative price stability. An increase in aggregate demand from AD1 to AD2 would move the economy from a to b along AS1. Real output would expand to Q2, and inflation would result (P1 to P3). However, increases in productivity shifted the aggregate supply curve from AS1 to AS2. The economy moved from a to c rather than from a to b. It experienced strong economic growth (Q1 to Q3), full employment, and only very mild inflation (P1 to P2). 32-26 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.