Principles of Macroeconomics Aggregate Demand & Aggregate Supply PDF

N. Gregory Mankiw Principles of Macroeconomics Sixth Edition 20 Aggregate Demand and Aggregate Supply...

N. Gregory Mankiw Principles of Macroeconomics Sixth Edition 20 Aggregate Demand and Aggregate Supply Premium PowerPoint Slides by © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for Ron Cronovich use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  In this chapter, look for the answers to these questions: What are economic fluctuations? What are their characteristics? How does the model of aggregate demand and aggregate supply explain economic fluctuations? Why does the Aggregate-Demand curve slope downward? What shifts the AD curve? What is the slope of the Aggregate-Supply curve in the short run? In the long run? What shifts the AS curve(s)? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 2 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Introduction  Over the long run, real GDP grows about 3% per year on average.  In the short run, GDP fluctuates around its trend.  Recessions: periods of falling real incomes and rising unemployment  Depressions: severe recessions (very rare)  Short-run economic fluctuations are often called business cycles. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 3 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Phases of a typical Business Cycle © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 4 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Introduction, continued  Explaining these fluctuations is difficult, and the theory of economic fluctuations is controversial.  Most economists use the model of aggregate demand and aggregate supply to study fluctuations.  This model differs from the classical economic theories economists use to explain the long run. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 5 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Classical Economics—A Recap  The previous chapters are based on the ideas of classical economics, especially:  The Classical Dichotomy, the separation of variables into two groups:  Real – quantities, relative prices  Nominal – measured in terms of money  The neutrality of money: Changes in the money supply affect nominal but not real variables. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 6 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Classical Economics—A Recap  Most economists believe classical theory describes the world in the long run, but not the short run.  In the short run, changes in nominal variables (like the money supply or P ) can affect real variables (like Y or the u-rate).  To study the short run, we use a new model. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 7 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  The Model of Aggregate Demand and Aggregate Supply P The price level SRAS “Short-Run The model P1 Aggregate determines the Supply” eq’m price level “Aggregate Demand” AD and eq’m output Y Y1 (real GDP). Real GDP, the quantity of output © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 8 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  The Aggregate-Demand (AD) Curve P The AD curve shows the P2 quantity of all g&s demanded in the economy P1 at any given AD price level. Y Y2 Y1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 9 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Why the AD Curve Slopes Downward Y = C + I + G + NX P Assume G fixed P2 by govt policy. To understand the slope of AD, must determine P1 how a change in P AD affects C, I, and NX. Y Y2 Y1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 10 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  The Wealth Effect (P and C ) Suppose P rises.  The dollars people hold buy fewer g&s, so real wealth is lower.  People feel poorer. Result: C falls. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 11 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  The Interest-Rate Effect (P and I ) Suppose P rises.  Buying g&s requires more dollars.  To get these dollars, people sell bonds or other assets.  This drives up interest rates. Result: I falls.
(Recall, I depends negatively on interest rates.)
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 12 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  The Exchange-Rate Effect (P and NX ) Suppose P rises.  U.S. interest rates rise (the interest-rate effect).  Foreign investors desire more U.S. bonds.  Higher demand for $ in foreign exchange market.  U.S. exchange rate appreciates.  U.S. exports more expensive to people abroad, imports cheaper to U.S. residents. Result: NX falls. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 13 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  The Slope of the AD Curve: Summary An increase in P P reduces the quantity of g&s demanded P2 because:  the wealth effect (C falls) P1  the interest-rate AD effect (I falls)  the exchange-rate Y Y2 Y1 effect (NX falls) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 14 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Why the AD Curve Might Shift Any event that changes C, I, G, or NX—except P a change in P—will shift the AD curve. Example: P1 A stock market boom makes households feel wealthier, C rises, AD2 the AD curve shifts right. AD1 Y Y1 Y2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 15 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Why the AD Curve Might Shift  Changes in C  Stock market boom/crash  Preferences re: consumption/saving tradeoff  Tax hikes/cuts  Changes in I  Firms buy new computers, equipment, factories  Expectations, optimism/pessimism “animal spirits”  Interest rates, monetary policy  Investment Tax Credit or other tax incentives © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 16 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Why the AD Curve Might Shift  Changes in G  Federal spending, e.g., defense  State & local spending, e.g., roads, schools  Changes in NX  Booms/recessions in countries that buy our exports  Appreciation/depreciation resulting from international speculation in foreign exchange market © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 17 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  The Aggregate-Supply (AS ) Curves The AS curve shows P LRAS the total quantity of g&s firms produce SRAS and sell at any given price level. AS is:  upward-sloping in short run Y  vertical in long run © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 18 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website The Long-Run Aggregate-Supply Curve (LRAS) The natural rate of P LRAS output (YN) is the amount of output the economy produces when unemployment is at its natural rate. YN is also called potential output or Y full-employment YN output. (this is from chapter 12) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 19 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Why LRAS Is Vertical YN determined by the P LRAS economy’s stocks of labor, capital, and natural resources, and on the level of P2 technology. P1 An increase in P does not affect any of these, Y so it does not YN affect YN. (Classical dichotomy) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 20 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Why the LRAS Curve Might Shift P LRAS1 LRAS2 Any event that changes any of the determinants of YN will shift LRAS. Example: Immigration increases L, causing YN to rise. Y YN YN’ © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 21 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Why the LRAS Curve Might Shift  Changes in L or natural rate of unemployment  Immigration  Baby-boomers retire  Govt policies reduce natural u-rate  Changes in K or H  Investment in factories, equipment  More people get college degrees  Factories destroyed by a hurricane © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 22 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Why the LRAS Curve Might Shift  Changes in natural resources (N)  Discovery of new mineral deposits  Reduction in supply of imported oil  Changing weather patterns that affect agricultural production  Changes in technology (A)  Productivity improvements from technological progress © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 23 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Using AD & AS to Depict Long-Run Growth and Inflation LRAS2010 Over the long run, P LRAS2000 tech. progress shifts LRAS1990 LRAS to the right and growth in the P2010 money supply shifts P2000 AD to the right. AD2010 P1990 Result: ongoing inflation AD2000 and growth in AD1990 Y output. Y1990 Y2000 Y2010 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 24 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Short Run Aggregate Supply (SRAS) The SRAS curve P is upward sloping: SRAS Over the period of 1–2 years, P2 an increase in P causes an P1 increase in the quantity of g & s supplied. Y Y1 Y2 The positive slope of the SRAS is the key to understanding short-run fluctuations. 25 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Why the Slope of SRAS Matters LRAS P If AS is vertical, fluctuations in AD Phi SRAS do not cause Phi fluctuations in output or employment. ADhi Plo If AS slopes up, then shifts in AD AD1 Plo do affect output ADlo Y and employment. Ylo Y1 Yhi © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 26 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Three Theories of SRAS In each,  some type of market imperfection (maybe better, some type of confusion)  result: Output deviates from its natural rate when the actual price level deviates from the price level people expected. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 27 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  1. The Sticky-Wage Theory  Imperfection: Nominal wages are sticky in the short run,
they adjust sluggishly.  Due to labor contracts, social norms  Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 28 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  1. The Sticky-Wage Theory  If P > PE, revenue is higher, but labor cost is not. Production is more profitable, so firms increase output and employment.  Hence, higher P causes higher Y, so the SRAS curve slopes upward. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 29 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  2. The Sticky-Price Theory  Imperfection: Many prices are sticky in the short run.  Due to menu costs, the costs of adjusting prices.  Examples: cost of printing new menus, the time required to change price tags  Firms set sticky prices in advance based on PE. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 30 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  3. The Misperceptions Theory  Imperfection: Firms may confuse changes in P with changes in the relative price of the products they sell.  If P rises above PE, a firm sees its price rise before realizing all prices are rising. The firm may believe its relative price is rising, and may increase output and employment.  So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 31 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  What the 3 Theories Have in Common: In all 3 theories, Y deviates from YN when P deviates from PE. Y = YN + a (P – PE) Output Expected price level Natural rate of output a > 0, Actual (long-run) measures price level how much Y responds to unexpected changes in P © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 32 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  What the 3 Theories Have in Common: Y = YN + a ( P – PE ) P SRAS When P > PE the expected PE price level When P < PE Y YN Y < YN Y > YN © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 33 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  SRAS and LRAS Y = YN + a ( P – PE ) P LRAS SRAS In the long run, PE = P PE and Y = YN. Y YN © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 34 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Why the SRAS Curve Might Shift Everything that shifts LRAS shifts SRAS, too. P LRAS Also, PE shifts SRAS: SRAS SRAS If PE rises, PE workers & firms set higher wages. PE At each P, production is less profitable, Y falls, SRAS shifts left. Y YN © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 35 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  The Effects of a Shift in AD Event: Stock market crash 1. Affects C, AD curve P LRAS 2. C falls, so AD shifts left SRAS1 3. SR eq’m at B. P and Y lower,
P1 A SRAS2 unemp higher P2 B 4. Over time, PE falls, AD1 SRAS shifts right,
P3 C until LR eq’m at C.
AD2 Y and unemp back Y Y2 YN at initial levels. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 36 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  The Effects of a Shift in SRAS Event: Oil prices rise 1. Increases costs, P LRAS shifts SRAS
(assume LRAS constant) SRAS2 2. SRAS shifts left SRAS1 3. SR eq’m at point B. B P2 P higher, Y lower,
unemp higher P1 A From A to B, stagflation, a period of AD1 falling output Y and rising prices. Y2 YN © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 37 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  Accommodating an Adverse Shift in SRAS If policymakers do nothing, 4. Low employment P LRAS causes wages to fall, SRAS SRAS2 shifts right,
until LR eq’m at A. P3 C SRAS1 B Or, policymakers could P2 use fiscal or monetary A P1 AD2 policy to increase AD and accommodate the AS shift: AD1 Y Y back to YN, but
Y2 YN P permanently higher. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 38 use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website  S UMM A RY Short-run fluctuations in GDP and other macroeconomic quantities are irregular and unpredictable. Recessions are periods of falling real GDP and rising unemployment. Economists analyze fluctuations using the model of aggregate demand and aggregate supply. The aggregate demand curve slopes downward because a change in the price level has a wealth effect on consumption, an interest-rate effect on investment, and an exchange-rate effect on net exports. © 2012©Cengage 2012 Cengage Learning.Learning. All Rights All Reserved. Rights Reserved. May notMay be copied, not be copied, scanned, scanned, or duplicated, or duplicated, in wholein or whole in part, or in except part, except for for 39 use as use permitted as permitted in a license in a license distributed distributed with a certain with a certain productproduct or service or service or otherwise or otherwise on a password-protected on a password-protected websitewebsite  S UMM A RY Anything that changes C, I, G, or NX—except a change in the price level—will shift the aggregate demand curve. The long-run aggregate supply curve is vertical because changes in the price level do not affect output in the long run. In the long run, output is determined by labor, capital, natural resources, and technology; changes in any of these will shift the long-run aggregate supply curve. © 2012©Cengage 2012 Cengage Learning.Learning. All Rights All Reserved. Rights Reserved. May notMay be copied, not be copied, scanned, scanned, or duplicated, or duplicated, in wholein or whole in part, or in except part, except for for 40 use as use permitted as permitted in a license in a license distributed distributed with a certain with a certain productproduct or service or service or otherwise or otherwise on a password-protected on a password-protected websitewebsite  S UMM A RY In the short run, output deviates from its natural rate when the price level is different than expected, leading to an upward-sloping short-run aggregate supply curve. The three theories proposed to explain this upward slope are the sticky wage theory, the sticky price theory, and the misperceptions theory. The short-run aggregate-supply curve shifts in response to changes in the expected price level and to anything that shifts the long-run aggregate supply curve. © 2012©Cengage 2012 Cengage Learning.Learning. All Rights All Reserved. Rights Reserved. May notMay be copied, not be copied, scanned, scanned, or duplicated, or duplicated, in wholein or whole in part, or in except part, except for for 41 use as use permitted as permitted in a license in a license distributed distributed with a certain with a certain productproduct or service or service or otherwise or otherwise on a password-protected on a password-protected websitewebsite  S UMM A RY Economic fluctuations are caused by shifts in aggregate demand and aggregate supply. When aggregate demand falls, output and the price level fall in the short run. Over time, a change in expectations causes wages, prices, and perceptions to adjust, and the short-run aggregate supply curve shifts rightward. In the long run, the economy returns to the natural rates of output and unemployment, but with a lower price level. © 2012©Cengage 2012 Cengage Learning.Learning. All Rights All Reserved. Rights Reserved. May notMay be copied, not be copied, scanned, scanned, or duplicated, or duplicated, in wholein or whole in part, or in except part, except for for 42 use as use permitted as permitted in a license in a license distributed distributed with a certain with a certain productproduct or service or service or otherwise or otherwise on a password-protected on a password-protected websitewebsite  S UMM A RY A fall in aggregate supply results in stagflation—falling output and rising prices. Wages, prices, and perceptions adjust over time, and the economy recovers. © 2012©Cengage 2012 Cengage Learning.Learning. All Rights All Reserved. Rights Reserved. May notMay be copied, not be copied, scanned, scanned, or duplicated, or duplicated, in wholein or whole in part, or in except part, except for for 43 use as use permitted as permitted in a license in a license distributed distributed with a certain with a certain productproduct or service or service or otherwise or otherwise on a password-protected on a password-protected websitewebsite