CHAPTER OVERVIEW - SVSD



chapter twenty-nine

aggregate demand and aggregate supply

CHAPTER OVERVIEW

The aggregate expenditures model developed in Chapter 28 is a fixed-price-level model. Its focus is on changes in real GDP, not on changes in the price level. This chapter introduces a variable-price model in which it is possible to simultaneously analyze changes in real GDP and the price level. This distinction should be made explicit for those students who have covered Chapter 28. What students learn in this chapter will help organize their thoughts about equilibrium GDP, the price level, and government macroeconomic policies. The tools learned will be applied in later chapters.

The present chapter introduces the concepts of aggregate demand and aggregate supply, explaining the shapes of the aggregate demand and aggregate supply curves and the forces causing them to shift. The equilibrium levels of prices and real GDP are considered. Finally, the chapter analyzes the effects of shifts in the aggregate demand and/or aggregate supply curves on the price level and size of real GDP.

NOTES

I. Aggregate demand is a schedule or curve that shows the various amounts of real domestic output that domestic and foreign buyers will desire to purchase at each possible price level.

A. The aggregate demand curve is shown in Figure 29.1.

1. It shows an inverse relationship between price level and real domestic output.

2. The explanation of the inverse relationship is not the same as for demand for a single product, which centered on substitution and income effects.

a. Substitution effect doesn’t apply within the scope of domestically produced goods, since there is no substitute for “everything.”

b. Income effect also doesn’t apply in the aggregate case, since income now varies with aggregate output.

3. What is the explanation of the inverse relationship between price level and real output in aggregate demand?

a. Real balances effect: When price level falls, the purchasing power of existing financial balances rises, which can increase spending.

b. Interest-rate effect: A decline in price level means lower interest rates that can increase levels of certain types of spending.

c. Foreign purchases effect: When price level falls, other things being equal, U.S. prices will fall relative to foreign prices, which will tend to increase spending on U.S. exports and also decrease import spending in favor of U.S. products that compete with imports. (Similar to the substitution effect.)

B. Determinants of aggregate demand: Determinants are the “other things” (besides price level) that can cause a shift or change in demand (see Figure 29.2 in text). Effects of the following determinants are discussed in more detail in the text.

1. Changes in consumer spending, which can be caused by changes in several factors.

a. Consumer wealth,

b. Consumer expectations,

c. Household debt, and

d. Taxes.

2. Changes in investment spending, which can be caused by changes in several factors.

a. Interest rates, and

b. Expected returns, which are a function of

• Expected future business conditions

• Technology

• Degree of excess capacity

• Business taxes

3. Changes in government spending.

4. Changes in net export spending unrelated to price level, which may be caused by changes in other factors such as:

a. National income abroad, and

b. Exchange rates: Depreciation of the dollar encourages U.S. exports since U.S. products become less expensive when foreign buyers can obtain more dollars for their currency. Conversely, dollar depreciation discourages import buying in the U.S. because our dollars can’t be exchanged for as much foreign currency.

II. Aggregate supply is a schedule or curve showing the level of real domestic output available at each possible price level.

A. Aggregate supply in the long run (Figure 29.5)

1. In the long run the aggregate supply curve is vertical at the economy’s full-employment output.

2. The curve is vertical because in the long run resources prices adjust to changes in the price level, leaving no incentive for firms to change their output.

B. Aggregate supply in the short run (Figure 29.4)

1. The short run aggregate supply curve is upward sloping.

2. The lag between product prices and resource prices makes it profitable for firms to increase output when the price level rises.

3. To the left of full-employment output, the curve is relatively flat. The relative abundance of idle inputs means that firms can increase output without substantial increases in production costs.

4. To the right of full-employment output the curve is relatively steep. Shortages of inputs and production bottlenecks will require substantially higher prices to induce firms to produce.

5. References to “aggregate supply” in the remainder of the chapter apply to the short run curve unless otherwise noted.

C. Aggregate supply in the immediate short-run (Figure 29.3)

1. The aggregate supply curve is horizontal at a given price level due to the rigidity of prices

D. Determinants of aggregate supply: Determinants are the “other things” besides price level that cause changes or shifts in aggregate supply (see Figure 29.6 in text). The following determinants are discussed in more detail in the text.

1. A change in input prices, which can be caused by changes in several factors.

a. Domestic resource prices

b. Prices of imported resources, and

c. Market power in certain industries.

2. Changes in productivity (productivity = real output / input) can cause changes in per-unit production cost (production cost per unit = total input cost / units of output). If productivity rises, unit production costs will fall. This can shift aggregate supply to the right and lower prices. The reverse is true when productivity falls. Productivity improvement is very important in business efforts to reduce costs.

3. Change in legal-institutional environment, which can be caused by changes in other factors.

a. Business taxes and/or subsidies, and

b. Government regulation.

III. Equilibrium: Real Output and the Price Level

A. Equilibrium price and quantity are found where the aggregate demand and supply curves intersect. (See Key Graph 29.7 for illustration of why quantity will seek equilibrium where curves intersect.) (Key Questions 4 and 7)

B. Try Quick Quiz 29.7.

C. Increases in aggregate demand cause demand-pull inflation (Figure 29.8).

1. Increases in aggregate demand increase real output and create upward pressure on prices, especially when the economy operates at or above its full employment level of output.

2. The multiplier effect weakens the further right the aggregate demand curve moves along the aggregate supply curve. More of the increase in spending is absorbed into price increases instead of generating greater real output.

D. Decreases in AD: If AD decreases, recession and cyclical unemployment may result. See Figure 29.9. Prices don’t fall easily.

1. Fear of price wars keeps prices from being reduced.

2. Menu costs discourage repeated price changes.

3. Wage contracts are not flexible so businesses can’t afford to reduce prices.

4. Employers are reluctant to cut wages because of impact on employee effort, etc. Employers seek to pay efficiency wages – wages that maximize work effort and productivity, minimizing cost.

5. Minimum wage laws keep wages above that level.

6. CONSIDER THIS … Ratchet Effect

E. Shifting aggregate supply occurs when a supply determinant changes. (See Key Questions 5, 6, 7):

1. Leftward shift in curve illustrates cost-push inflation (see Figure 29.10).

2. Rightward shift in curve will cause a decline in price level (see Figure 29.11). See text for discussion of this desirable outcome.

3. In the late 1990s, despite strong increases in aggregate demand, prices remained relatively stable (low inflation) as aggregate supply shifted right (productivity gains).

IV. LAST WORD: Has the Impact of Oil Prices Diminished?

A. In the mid- and late 1970s, oil price shocks caused cost-push inflation, rising unemployment, and a negative GDP gap (stagflation).

B. In the late 1980s and through most of the 1990s, oil prices fell, prompting OPEC (along with Mexico, Norway, and Russia) to restrict output and raise prices (up to $34 per barrel in March 2000). This price shock did not cause the cost-push inflation and recessionary conditions as with previous shocks.

C. In 2005, conflict in the Middle East, combined with rapidly rising demand for oil in India and China, pushed oil prices above $60 per barrel (and over $70 per barrel in July 2006). U.S. inflation rose in 2005, but not core inflation (inflation rate minus price changes in food and energy).

D. A number of reasons explain why oil price shocks have had less of an impact:

1. Lower production costs from productivity increases have offset inflationary pressures from oil price increases.

2. The amount of gas and oil used to produce each dollar of output has declined by about 50 percent since 1970. (from 14,000 BTUs to 7,000 BTUs per dollar of GDP).

3. Federal reserve monetary policy helped keep oil price increases from becoming generalized.

APPENDIX TO CHAPTER 29

I. The Relationship of the Aggregate Demand Curve to the Aggregate Expenditures Model

A. Deriving AD-curve from aggregate expenditures model. (See Appendix Figure 1)

1. Both models measure real GDP on horizontal axis.

2. Suppose initial price level is P1 and aggregate expenditures AE1 as shown in Appendix Figure 1a. Equilibrium real domestic output is Q1. There will be a corresponding point on the aggregate demand curve (Point 1 on Appendix Figure 1b).

3. If price rises to P2, aggregate expenditures will fall to AE2 because purchasing power of wealth falls, interest rates may rise, and net exports fall. (See Appendix Figure 1a.) Then new equilibrium is at Q2. That generates a point (Point 2) up and to the left of Point 1 on Appendix Figure 1b.

4. If price rises to P3, real asset balance value falls, interest rates rise again, net exports fall and new equilibrium is at Q3. Again see Appendix Figures 1a and 1b.

5. Technically, the aggregate demand curve is found by drawing a line (or curve) through Points 1, 2, and 3 on Appendix Figure 1b.

B. Aggregate demand shifts and the aggregate expenditures model (Appendix Figure 2):

1. When there is a change in one of the determinants of aggregate demand, there will be a change in the aggregate expenditures as well. Look at Appendix Figure 2a.

2. The change in aggregate expenditures is multiplied and aggregate demand shifts by more than the initial change in spending (see Appendix Figure 2b). The text illustrates the multiplier effect of a change in investment spending.

3. Shift of AD curve = initial change in spending x multiplier

4. The effect of the shift on real domestic output and the price level will depend on the starting point relative to full-employment output, as well as the relative steepness of the aggregate supply curve.

ANSWERS TO END-OF-CHAPTER QUESTIONS

29-1 Why is the aggregate demand curve downsloping? Specify how your explanation differs from the explanation for the downsloping demand curve for a single product. What role does the multiplier play in shifts of the aggregate demand curve?

The aggregate demand (AD) curve shows that as the price level drops, purchases of real domestic output increase. The AD curve slopes downward for three reasons. The first is the interest-rate effect. We assume the supply of money to be fixed. When the price level increases, more money is needed to make purchases and pay for inputs. With the money supply fixed, the increased demand for it will drive up its price, the rate of interest. These higher rates will decrease the buying of goods with borrowed money, thus decreasing the amount of real output demanded.

The second reason is the real balances effect. As the price level rises, the real value—the purchasing power—of money and other accumulated financial assets (bonds, for instance) will decrease. People will therefore become poorer in real terms and decrease the quantity demanded of real output.

The third reason is the foreign purchases effect. As the United States’ price level rises relative to other countries, Americans will buy more abroad in preference to their own output. At the same time foreigners, finding American goods and services relatively more expensive, will decrease their buying of American exports. Thus, with increased imports and decreased exports, American net exports decrease and so, therefore, does the quantity demanded of American real output.

These reasons for the downsloping AD curve have nothing to do with the reasons for the downsloping single-product demand curve. In the case of the dropping price of a single product, the consumer with a constant money income substitutes more of the now relatively cheaper product for those whose prices have not changed. Also, the consumer has become richer in real terms, because of the lower price of the one product, and can buy more of it and all other products. But with the AD curve, moving down the curve means all prices are dropping—the price level is dropping. Therefore, the single-product substitution effect does not apply. Also, whereas when dealing with the demand for a single product the consumer’s income is assumed to be fixed, the AD curve specifically excludes this assumption. Movement down the AD curve indicates lower prices but, with regard to the circular flow of economic activity, it also indicates lower incomes. If prices are dropping, so must the receipts or revenues or incomes of the sellers. Thus, a decline in the price level does not necessarily imply an increase in the nominal income of the economy as a whole.

The multiplier acts on an “initial change in spending” to generate an even greater shift in the aggregate demand curve. (Figure 29.2)

29-2 Distinguish between “real-balances effect” and “wealth effect,” as the terms are used in this chapter. How does each relate to the aggregate demand curve?

The “real balances effect” refers to the impact of price level on the purchasing power of asset balances. If prices decline, the purchasing power of assets will rise, so spending at each income level should rise because people’s assets are more valuable. The reverse outcome would occur at higher price levels. The “real balances effect” is one explanation of the inverse relationship between price level and quantity of expenditures.

The “wealth effect” assumes the price level is constant, but a change in consumer wealth causes a shift in consumer spending; the aggregate expenditures curve will shift right. For example, the value of stock market shares may rise and cause people to feel wealthier and spend more. A stock decline can cause a decline in consumer spending.

29-3 What assumptions cause the immediate short-run aggregate supple curve to be horizontal? Why is the long-run aggregate supply curve vertical? Explain the shape of the short-run aggregate supply curve. Why is the short-run curve relatively flat to the left of the full employment output and relatively steep to the right?

The immediate short-run supply curve is horizontal because of contractual agreements. These ‘contracts’ for both input and output prices imply that prices do not change along the immediate short-run aggregate supply curve.

The long-run aggregate supply curve is vertical (at the full-employment or potential output) because the economy’s potential output is determined by the availability and productivity of real resources, not by the price level. The availability and productivity of real resources is reflected in the prices of inputs, and in the long run these input prices (including wages) adjust to match changes in the price level. Firms have no incentive to increase production to take advantage of higher prices if they simultaneously face equally higher resource prices.

The shape of the short-run supply curve is upsloping. Wages and other input prices adjust more slowly than the price level, leaving room for firms to take advantage of these higher prices (temporarily) by increasing output. Firms face increasing per unit production costs as they increase output, making higher prices necessary to induce them to produce more.

To the left of full-employment output the curve is relatively flat because of the large amounts of unused capacity and idle human resources. Under such conditions, per-unit production costs rise slowly because of the relative abundance of available inputs. Additional resources are easily brought into production, as the suppliers of these resources (especially labor) are anxious to employ them and are happy to accept current prices.

To the right of full-employment output the curve is relatively steep because most resources are already employed. Those resources that are not yet in production require higher prices to induce them, or generate higher per-unit production costs because they are less productive than currently employed inputs. Firms trying to increase production bid up input prices as they attempt to attract resources away from other firms. Even if the firm succeeds in pulling resources from another firm, the aggregate increase in output is minimal at best, as resources are merely shifted from one productive process to another.

29-4 (Key Question) Suppose that aggregate demand and supply for a hypothetical economy are as shown:

| | | |

|Amount of | |Amount of |

|real domestic | |real domestic |

|output demanded, |Price level |output supplied, |

|billions |(price index) |billions |

| | | | | |

| | | | | |

|$100 | |300 |$450 | |

|200 | |250 |400 | |

|300 | |200 |300 | |

|400 | |150 |200 | |

|500 | |100 |100 | |

| | | | | |

a. Use these sets of data to graph the aggregate demand and aggregate supply curves. What is the equilibrium price level and the equilibrium level of real output in this hypothetical economy? Is the equilibrium real output also necessarily the full-capacity real output? Explain.

b. Why will a price level of 150 not be an equilibrium price level in this economy? Why not 250?

c. Suppose that buyers desire to purchase $200 billion of extra real domestic output at each price level. Sketch in the new aggregate demand curve as AD1. What factors might cause this change in aggregate demand? What is the new equilibrium price level and level of real output?

(a) See the graph. Equilibrium price level = 200. Equilibrium real output = $300 billion. No, the full-capacity level of GDP is more likely at $400 billion, where the AS curve starts to become steeper.

(b) At a price level of 150, real GDP supplied is a maximum of $200 billion, less than the real GDP demanded of $400 billion. The shortage of real output will drive the price level up. At a price level of 250, real GDP supplied is $400 billion, which is more than the real GDP demanded of $200 billion. The surplus of real output will drive down the price level. Equilibrium occurs at the price level at which AS and AD intersect.

(c) See the graph. Increases in consumer, investment, government, or net export spending might shift the AD curve rightward. New equilibrium price level = 250. New equilibrium GDP = $400 billion.

[pic]

29-5 (Key Question) Suppose that a hypothetical economy has the following relationship between its real output and the input quantities necessary for producing that level of output:

| | |

|Input | |

|quantity |Real GDP |

| | | | |

| | | | |

|150.0 | |400 | |

|112.5 | |300 | |

|75.0 | |200 | |

| | | | |

a. What is productivity in this economy?

b. What is the per-unit cost of production if the price of each input is $2?

c. Assume that the input price increases from $2 to $3 with no accompanying change in productivity. What is the new per-unit cost of production? In what direction did the $1 increase in input price push the economy’s aggregate supply curve? What effect would this shift in aggregate supply have upon the price level and the level of real output?

d. Suppose that the increase in input price does not occur but instead that productivity increases by 100 percent. What would be the new per-unit cost of production? What effect would this change in per unit production cost have on the aggregate supply curve? What effect would this shift in aggregate supply have on the price level and the level of real output?

(a) Productivity = 2.67 (= 400/150; = 300/112.5; = 200/75.0)

b) Per-unit cost of production = $.75 (= $2 x 112.5/300)

c) New per-unit production cost = $1.13 (= $3 x 75/200). The AS curve would shift leftward. The price level would rise and real output would decrease.

(d) New per-unit cost of production = $0.375 (= $2 x 112.5/600). AS curve shifts to the right; price level declines and real output increases.

29-6 (Key Question) What effects would each of the following have on aggregate demand or aggregate supply? In each case use a diagram to show the expected effects on the equilibrium price level and level of real output. Assume that all other things remain constant.

a. A widespread fear of depression on the part of consumers.

b. A $2 increase in the excise tax on a pack of cigarettes.

c. A reduction in interest rates at each price level.

d. A major increase in Federal spending for health care.

e. The expectation of rapid inflation.

f. The complete disintegration of OPEC, causing oil prices to fall by one-half.

g. A 10 percent reduction in personal income tax rates.

h. A sizable increase in labor productivity (with no change in nominal wages).

i. A 12 percent increase in nominal wages (with no change in productivity).

j. Depreciation in the international value of the dollar.

(a) AD curve left, output down and price level down (assuming no ratchet effect).

(b) AS curve left, output down and price level up.

(c) AD curve right, output and price level up.

(d) AD curve right, output and price level up (any real improvements in health care resulting from the spending would eventually increase productivity and shift AS right).

(e) AD curve right, output and price level up.

(f) AS curve right, output up and price level down.

(g) AD curve right, output and price level up.

(h) AS curve right, output up and price level down.

(i) AS curve left, output down and price level up.

(j) AD curve right (increased net exports); AS curve left (higher input prices)

29-7 (Key Question) Assume that (a) the price level is flexible upward but not downward and (b) the economy is currently operating at its full-employment output. Other things equal, how will each of the following affect the equilibrium price level and equilibrium level of real output in the short run?

a. An increase in aggregate demand.

b. A decrease in aggregate supply, with no change in aggregate demand.

c. Equal increases in aggregate demand and aggregate supply.

d. A decrease in aggregate demand.

e. An increase in aggregate demand that exceeds an increase in aggregate supply.

(a) Price level rises rapidly and little change in real output.

(b) Price level rises and real output decreases.

(c) Price level does not change, but real output increases.

(d) Price level does not change, but real output declines.

(e) Price level increases somewhat, as does real output.

29-8 Explain how an upsloping aggregate supply curve weakens the realized multiplier effect.

An upward sloping aggregate supply curve weakens the effect of the multiplier because any increase in aggregate demand will have both a price and an output effect. For example, if aggregate demand grows by $110 million, this could represent an increase of $100 million in real output and $10 million in higher prices if the inflation rate averages 10 percent. The multiplier is weakened because some of the increase in aggregate demand is absorbed by the higher prices and real output does not change by the full extent of the change in aggregate demand.

29-9 Why does a reduction in aggregate demand reduce real output, rather than the price level? Why might a full-strength multiplier apply to a decrease in aggregate supply?

A reduction in aggregate demand causes a decline in real output rather than the price level because prices are inflexible downward (“sticky”). If we assume prices are completely inflexible downward, then a reduction in demand is essentially moving leftward and the aggregate supply curve is flat (horizontal), which means reduced output at a constant price. To say prices are completely inflexible downward may exaggerate but prices don’t fall easily for several reasons: wage contracts, minimum wage laws, employee morale, fear of price wars and the “menu cost” notion.

Without price changes to mitigate the effects of an aggregate demand change, the multiplier is at full strength. If price were flexible downward, the decrease in spending would lower prices, encouraging some individuals within the macroeconomy to spend more, dampening the multiplier effects.

29-10 Explain: “Unemployment can be caused by a decrease of aggregate demand or a decrease of aggregate supply.” In each case, specify price-level outcomes.

The statement is true, although the magnitude of the effect on unemployment can vary considerably, particularly with decreases in aggregate demand. A decrease in aggregate supply will unambiguously increase the price level and reduce real output. With the decrease in output we would expect unemployment to rise. If the economy is operating above its full-employment output, a decrease in aggregate demand will have more modest effects on unemployment, having its strongest impact on the price level (reducing it). If aggregate demand falls while the economy is operating to the left of full-employment output, the increases in unemployment will be more substantial, and the effects on the price level weaker.

29-11 Use shifts in the AD and AS curves to explain (a) the U.S. experience of strong economic growth, full employment, and price stability in the late 1990s and early 2000s; (b) how a strong negative wealth effect from, say, a precipitous drop in the stock market could cause a recession even though productivity is surging.

(a) While AD is increasing and shifting to right, AS is shifting rightward as well, because of productivity increasing and growing labor force. Thus, both output and employment can rise while price level remains constant. The equilibrium shifts rightward, not upward because AS and AD shift by similar magnitudes.

(b) In this situation AD shifts left while AS shifts right. Price level may even decline, but real output could decline if the reduction in AD exceeds the increase is AS. Figure 10-10 shows how this could happen even if AS shifted to the right.

29-12 In early 2001 investment spending sharply declined in the United States. In the 2 months following the September 11, 2001, attacks on the United States, consumption also declined. Use AD-AS analysis to show the two impacts on real GDP.

Both events would be represented by a leftward shift in aggregate demand, and the initial declines in spending would be multiplied. (See Figure 29-2, shift from AD1 to AD3.) This would cause real GDP to drop and, assuming flexible prices, a drop in the price level. To the extent the drop in investment spending affected productivity, it could have either shifted AS left (if productivity dropped) or slowed the rightward movement of AS that occurred through much of the 1990s and into the early 2000s.

29-13 (Last Word) Go to the OPEC website, , and find the current “OPEC basket price” of oil. By clicking on that amount, you will find the annual prices of oil for the past 5 years. By what percentage is the current price higher or lower than five years ago? Next, go to the Bureau of Economic Analysis website, , and use the interactive feature to find U.S. real GDP for the past years. By what percentage is real GDP higher or lower than it was five years ago? What, if anything, can you conclude about the relationship between the price of oil and the level of real GDP in the United States?

Answers will vary depending on when this question is assigned. As of late July 2006, prices were about 155 percent higher than in 2002 ($62.07 in 2006, $24.36 in 2002). The percentage increase in real GDP from 2001 to 2005 (the latest year for which data were available) was about 12.6 percent. (A comparison of oil prices from 2001 to 2005 reveals a 119 percent increase). Despite the rapid increase in oil prices over the past 5 years, real GDP has continued to grow at a healthy pace, especially considering the non-oil induced recession of 2001.

Chapter 29 Appendix

29A-1 Explain carefully: “A change in the price level shifts the aggregate expenditures curve but not the aggregate demand curve.”

A change in the price level does not shift the aggregate demand curve. It simply represents a movement along the curve, because there is an inverse relationship between the price level and aggregate quantity demanded.

However, a change in the price level will shift the aggregate expenditures curve, which responds to the wealth, interest-rate, and foreign purchases effects occurring with a change in price level. When the price level declines, aggregate expenditures will rise, and when the price level rises, aggregate expenditures will fall. The aggregate expenditures model assumes a constant price level, so it is expressed in “real” terms. Appendix Figures 1 and 2 graphically illustrates the relationship between the two models.

29A-2 Suppose that the price level is constant and that investment decreases sharply. How would you show this decrease in the aggregate expenditures model? What would be the outcome for real GDP? How would you show this fall in investment in the aggregate demand-aggregate supply model, assuming the economy is operating in what, in effect, is a horizontal range of the aggregate supply curve?

A decrease in investment spending represents a decrease in aggregate expenditures and a downward shift in the aggregate expenditures curve. The outcome would be a new, lower equilibrium output level. This fall in output would be equal to a multiple of the initial change in investment spending based on the multiplier effect. The multiplier is 1/MPS in this model.

It would be a leftward shift of aggregate demand, and the new equilibrium output would fall to the left of the original equilibrium by the full extent of the shift in aggregate demand. The price level (assumed by using the AE model) will not change. See figure below.

Appendix Question 29A-2

AS

Price

Level

AD1

AD2

Q2 Q1

Real GDP

................
................

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