Introduction to Economics - Presentation

INTRODUCTION TO ECONOMICS SECOND EDITION TRUST 40 35 З m.m Chapter 17 Aggregate Demand and Aggregate Supply INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL CHAPTER 17/AGGREGATE DEMAND AND AGGREGATE SUPPLY ©2005, South-Western/Thomson Learning Slides by John F. Hall Animations by Anthony Zambelli Figure 1: The Two-Way Relationship Between Output and the Price Level Price Level Lieberman & Hall; Introduction to Economics, 2005 Aggregate Demand Curve Aggregate Supply Curve Real GDP 2 The Price Level and The Money Market First effect of a change in the price level occurs in the money market Rise in the price increases the demand for money and shifts the money demand curve rightward It makes purchases more expensive Drop in the price level • Makes purchases cheaper 이 Decreases the demand for money Shifts the money demand curve leftward Rise in the price level causes the interest rate to rise and interest-sensitive spending to fall Equilibrium GDP decreases by a multiple of the decrease in interest-sensitive spending Lieberman & Hall; Introduction to Economics, 2005 3 The Price Level and Net Exports The second effect of a higher price level brings in the foreign sector A rise in the price level causes Net exports to drop and Equilibrium GDP to decrease by a multiple of the drop in net exports Lieberman & Hall; Introduction to Economics, 2005 4 Deriving The Aggregate Demand (AD) Curve Figure 2 plots the price level on a vertical axis and the economy's real GDP on the horizontal axis If we continued to change the price level to other values we would find that each different price level results in a different equilibrium GDP The aggregate demand (AD) curve tells us the equilibrium real GDP at any price level Lieberman & Hall; Introduction to Economics, 2005 5 Figure 2: Deriving the Aggregate Demand Curve Price Level 140 K 100 Lieberman & Hall; Introduction to Economics, 2005 AD 6 10 Real GDP ($ Trillions) 6 Movements Along The AD Curve A variety of events can cause the price level to change, and move us along the AD curve It's important to understand what happens in the economy as we make such a move Increase in money demand ↑ a and / P1 Relative price of U.S. goods ↑ Net exports↓ Multiplier effect Multiplier effect Equilibrium GDP Opposite sequence of events will occur if the price level falls, moving us rightward along the AD curve Decrease in money demand r a and I↑ Multiplier effect Equilibrium GDP ↑ 1d Relative price of U.S. goods↓ Net exports ↑ Lieberman & Hall; Introduction to Economics, 2005 Multiplier effect 7 Shifts of The AD Curve The distinction between movements along the AD curve and shifts of the curve itself is very important Always keep the following rule in mind When a change in the price level causes equilibrium GDP to change, we move along the AD curve • Whenever anything other than the price level causes equilibrium GDP to change, the AD curve itself shifts What are these other influences on GDP? Equilibrium GDP will change whenever there is a change in any of the following Government spending Taxes Autonomous consumption spending Investment spending The money supply curve The money demand curve Lieberman & Hall; Introduction to Economics, 2005 8 Spending Shocks Spending shocks initially affect the economy by changing total spending And then changing output by a multiple of that original change in spending The AD curve shifts rightward when government purchases, investment spending, autonomous consumption spending, or net exports increase, or when taxes decrease The AD curve shifts leftward when government purchases, investment spending, autonomous consumption spending, or net exports decrease, or when taxes increase Lieberman & Hall; Introduction to Economics, 2005 Figure 3: A Spending Shock Shifts the AD Curve Price Level 100- E AD AD2 Lieberman & Hall; Introduction to Economics, 2005 10 15 Real GDP ($ Trillions) 10 Changes in the Money Market Changes that originate in the money market will also shift the aggregate demand curve An increase in the money supply shifts the AD curve rightward ■ A decrease in the money supply shifts the AD curve leftward Lieberman & Hall; Introduction to Economics, 2005 11 Figure 4(a): Effects of Key Changes on the Aggregate Demand Curve Price Level Pa P (a) Price level ↑ moves us leftward along the AD curve Price level ↓ moves us rightward along the AD curve P2 Lieberman & Hall; Introduction to Economics, 2005 AD Q3 Q Q2 Real GDP 12 Figure 4(b): Effects of Key Changes on the Aggregate Demand Curve Price Level (b) Entire AD curve shifts rightward if: a, IP, G, or NX increases Net taxes decrease The money supply increases Lieberman & Hall; Introduction to Economics, 2005 AD2 AD1 Real GDP 13 Figure 4(c): Effects of Key Changes on the Aggregate Demand Curve Price Level (c) Entire AD curve shifts leftward if: a, IP, G, or NX decreases Net taxes increase The money supply decreases Lieberman & Hall; Introduction to Economics, 2005 AD1 AD2 Real GDP 14 The Aggregate Supply Curve On the one hand, changes in the price level affect output On the other hand, changes in output affect the price level This relationshipsummarized by the aggregate supply curve-is the focus of this section The effect of changes in output on the price level is complex, involving a variety of forces Lieberman & Hall; Introduction to Economics, 2005 15 Costs and Prices Price level in economy results from pricing behavior of millions of individual business firms In any given year, some of these firms will raise their prices, and some will lower them Often, all firms in the economy are affected by the same macroeconomic event ■ Causing prices to rise or fall throughout the economy To understand how macroeconomic events affect the price level, we begin with a very simple assumption A firm sets price of its products as a markup over cost per unit Lieberman & Hall; Introduction to Economics, 2005 16 Costs and Prices Percentage markup in any particular industry will depend on degree of competition there In macroeconomics, we are not concerned with how the markup differs in different industries But rather with average percentage markup in economy Determined by competitive conditions Competitive structure changes very slowly, so average percentage markup should be somewhat stable from year-to-year But a stable markup does not necessarily mean a stable price level, because unit costs can change In short-run, price level rises when there is an economy-wide increase in unit costs • Price level falls when there is an economy-wide decrease in unit costs Lieberman & Hall; Introduction to Economics, 2005 17 GDP, Costs, and the Price Level Why should a change in output affect unit costs and price level? As total output increases . . Greater amounts of inputs may be needed to produce a unit of output Price of non-labor inputs rise Nominal wage rate rises A decrease in output affects unit costs through the same three forces, but with opposite result Lieberman & Hall; Introduction to Economics, 2005 18 The Short Run All three of our reasons are important in explaining why a change in output affects price level They operate within different time frames Our third explanation-changes in nominal wage rate-is a different story For a year or more after a change in output, changes in average nominal wage are less important than other forces that change unit costs Lieberman & Hall; Introduction to Economics, 2005 19 The Short Run Some of the more important reasons why wages in many industries respond so slowly to changes in output Many firms have union contracts that specify wages for up to three years Wages in many large corporations are set by slowmoving bureaucracies ■ Wage changes in either direction can be costly to firms Firms may benefit from developing reputations for paying stable wages Lieberman & Hall; Introduction to Economics, 2005 20 The Short Run Nominal wage rate is fixed in short-run We assume that changes in output have no effect on nominal wage rate in short-runu Since we assume a constant nominal wage in short-run, a change in output will affect unit costs through the other two factors In short-run, a rise (fall) in real GDP, by causing unit costs to increase (decrease), will also cause a rise (decrease) in price level Lieberman & Hall; Introduction to Economics, 2005 21 Deriving the Aggregate Supply Curve Figure 5 summarizes discussion about effect of output on price level in short-run Each time we change level of output, there will be new price level in short-run Giving us another point on the figure ■ If we connect all of these points, we obtain economy's aggregate supply curve Tells us price level consistent with firms' unit costs and their percentage markup at any level of output over short-run A more accurate name for AS curve would be "short-run-price-level-at-each-output-level" curve a Lieberman & Hall; Introduction to Economics, 2005 22 Figure 5: The Aggregate Supply Curve Price Level 130- 100- 80- C Lieberman & Hall; Introduction to Economics, 2005 B A AS Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises. Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price level falls. 6 10 13.5 Real GDP ($ Trillions) 23 Movements Along the AS Curve When a change in output causes price level to change, we move along economy's AS curve What happens in economy as we make such a move? As we move upward along AS curve, we can represent what happens as follows Input requirements per unit of output Real GDP Lieberman & Hall; Introduction to Economics, 2005 Unit costs Price level Prices of nonlabor inputs 24 Shifts of the AS Curve Figure 5 assumed that a number of important variables remained unchanged Unit costs sometimes change for reasons other than a change in output In general, we distinguish between a movement along AS curve, and a shift of curve itself, as follows When a change in real GDP causes the price level to change, move along AS curve we • When anything other than a change in real GDP causes price level to change, AS curve itself shifts What can cause unit costs to change at any given level of output? Changes in world oil prices Changes in the weather Technological change Nominal wage, etc. Lieberman & Hall; Introduction to Economics, 2005 25 Figure 6: Shifts of the Aggregate Supply Curve Price Level L 140- 100 A Lieberman & Hall; Introduction to Economics, 2005 AS2 AS When unit costs rise at any given real GDP, the AS curve shifts upward-e.g., an increase in world oil prices or bad weather for farm production. 10 Real GDP ($ Trillions) 26 Figure 7(a): Effects of Key Changes on the Aggregate Supply Curve (a) Price Level AS Real GDP ↑ moves us rightward along the AS curve P3 Real GDP↓ moves us leftward along the AS curve P P2 Lieberman & Hall; Introduction to Economics, 2005 Q2 Q1 Real GDP Q3 27 Figure 7(b): Effects of Key Changes on the Aggregate Supply Curve Price Level (b) AS2 AS Entire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP Lieberman & Hall; Introduction to Economics, 2005 Real GDP 28 Figure 7(c): Effects of Key Changes on the Aggregate Supply Curve (c) Price Level Entire AS curve shifts downward if unit costs↓ for any reason besides an decrease in real GDP Lieberman & Hall; Introduction to Economics, 2005 AS1 AS2 Real GDP 29 AD and AS Together: Short-Run Equilibrium Where will the economy settle in short-run? Where is our short-run macroeconomic equilibrium? 이 이 In equilibrium, economy must be at some point on AD curve Short-run equilibrium requires economy be operating on its AS curve Only when economy is at point E-on both curves-will we have reached a sustainable level of real GDP and the price level Lieberman & Hall; Introduction to Economics, 2005 30 Figure 8: Short-Run Macroeconomic Equilibrium Price Level 140 100 Lieberman & Hall; Introduction to Economics, 2005 E B AS F AD 6 10 14 Real GDP ($ Trillions) 31 What Happens When Things Change? Our short-run equilibrium will change when either AD curve, AS curve, or both, shift Π An event that causes AD curve to shift is called a demand shock An event that causes AS curve to shift is called a supply shock In earlier chapters, we've used phrase spending shock A change in spending by one or more sectors that ultimately affects entire economy Demand shocks and supply shocks are just two different categories of spending shocks Lieberman & Hall; Introduction to Economics, 2005 32 An Increase in Government Purchases Shifts AD curve rightward Can see how it affects economy in short-run Process we've just described is not entirely realistic Assumes that when government purchases rise, first output increases, and then price level rises In reality, output and price level tend to rise together Lieberman & Hall; Introduction to Economics, 2005 33 Figure 9: The Effect of a Demand Shock Price Level 130 115 100 E Lieberman & Hall; Introduction to Economics, 2005 ال AS AD2 AD1 10 13.5 Real GDP($ Trillions) 12.5 34 An Increase in Government Purchases Can summarize impact of price-level changes When government purchases increase, horizontal shift of AD curve measures how much real GDP would increase if price level remained constant . But because price level rises, real GDP rises by less than horizontal shift in AD curve Unit costs AD cuive shifts rightward Movement along newAD cuve GDP Money demand Interest rate a and P GDP Movement along AS curve Net Effect: GDP, but by less due to effect of pt Lieberman & Hall; Introduction to Economics, 2005 35 An Decrease in Government Purchases Unit costs to AD cuve shifts leftward GDP Movement along new AD curve Money demand Interest rate a and GDP Movement along AS curve Net Effect: GDP, but by less due to effect of P Lieberman & Hall; Introduction to Economics, 2005 36 An Increase in the Money Supply Although monetary policy stimulates economy through a different channel than fiscal policy Once we arrive at AD and AS diagram, two look very much alike Can represent situation as follows Money supply Rightward shift ofAD curve a and P GDP Movement along new AD curve Unit costs DA Money demand Interest rate a and GDP Movement alongAS curve Net Effect: GDP, but by less due to effect of P Lieberman & Hall; Introduction to Economics, 2005 37 Other Demand Shocks A positive demand shock-shifts AD curve rightward Increases both real GDP and price level in shortrun A negative demand shock-shifts AD curve leftward Decreases both real GDP and price level in short-run Lieberman & Hall; Introduction to Economics, 2005 38 An Example: The Great Depression U.S. economy collapsed far more seriously during 1929 through 1933-the onset of the Great Depression-than it did at any other time What do we know about demand shocks that caused Great Depression? Fall of 1929, bubble of optimism burst Stock market crashed, and investment and consumption spending plummeted Demand for products exported by United States fell Fed reacted by cutting money supply sharply • Each of these events contributed to a leftward shift of AD curve Causing both output and price level to fall Lieberman & Hall; Introduction to Economics, 2005 39 Demand Shocks: Adjusting to the Long-Run In Figure 9, point H shows new equilibrium after a positive demand shock in short-run-a year or so after the shock But point H is not necessarily where economy will end up in long-run In short-run, we treat wage rate as given But in long-run, wage rate can change When output is above full employment, wage rate will rise, shifting AS curve upward When output is below full employment, wage rate will fall, shifting AS curve downward Lieberman & Hall; Introduction to Economics, 2005 40 Demand Shocks: Adjusting to the Long Run Increase in government purchases has no effect on equilibrium GDP in long-run Economy returns to full employment, which is just where it started This is why long-run adjustment process is often called economy's self-correcting mechanism If a demand shock pulls economy away from full employment Change in wage rate and price level will eventually cause economy to correct itself and return to full-employment output Lieberman & Hall; Introduction to Economics, 2005 41 Figure 10: The Long-Run Adjustment Process Price Level AS2 AS P K Pa J P2 H P E Lieberman & Hall; Introduction to Economics, 2005 AD2 AD YFEY3 Y2 Real GDP 42 Demand Shocks: Adjusting to the Long Run For a positive demand shock that shifts AD curve rightward, self-correcting mechanism works like this Change in short-run equilibrium Positive demand shock Pand Y Wage Y> YE rate Unit costs PA Yuntil Y = YFE Lieberman & Hall; Introduction to Economics, 2005 Long-run adjustment process 43 Figure 11: Long-Run Adjustment After a Negative Demand Shock Price Level P E P P3 M Lieberman & Hall; Introduction to Economics, 2005 AS1 AS2 AD1 AD2 Real GDP Y2 YFE 44 Demand Shocks: Adjusting to the Long Run Complete sequence of events after a negative demand shock looks like this Change in short-run equilibrium Negative demand shock P and Y Y