Aggregate Demand and Aggregate Supply

CHAPTER ELEVEN AGGREGATE DEMAND AND AGGREGATE SUPPLY

LECTURE NOTES
I. Introduction to AD-AS Model A. AD-AS model is a variable price model. The aggregate expenditures model in Chapters 9 and 10 assumed constant price. B. AD-AS model provides insights on inflation, unemployment and economic growth. II. Aggregate demand is a schedule 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 11-1. 1. It shows an inverse relationship between price level and 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 doesnt apply in the aggregate case, since there is no substitute for everything. b. Income effect also doesnt apply in the aggregate case, since income now varies with aggregate output. 3. What is the explanation of 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 which 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. B. Deriving AD-curve from aggregate expenditures model. (See Figure 11-2) 1. Both models measure real GDP on horizontal axis. 2. Suppose initial price level is P 1 and aggregate expenditures AE1 as shown in Figure 11-2a. Then equilibrium GDP is GDP1. This is shown in Figure 11-2b. 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 Figure 11-2a) Then new equilibrium is at GDP2 shown also in Figure 11-2b. 4. If price rises to P3, real asset balance value falls, interest rates rise again, net exports fall and new equilibrium is at GDP3. Again see Figures 11-2a and 11-2b.

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Aggregate Demand and Aggregate Supply C. Determinants of aggregate demand: Determinants are the other things (besides price level) that can cause a shift or change in demand (see Figure 11-3 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. Consumer indebtedness, and d. Taxes. 2. Changes in investment spending, which can be caused by changes in several factors. a. Interest rates, b. Profit expectations, c. Business taxes, d. Technology, and e. Amount of excess capacity. 3. A change in government spending is another determinant. 4. Changes in net export spending unrelated to price level, which may be caused by changes in other factors such as: a. 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 cant be exchanged for as much foreign currency. C. Aggregate demand shifts and the aggregate expenditures model: 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 Figure 11-4. 2. If price level remains constant, then a change in aggregate expenditures is multiplied and the real output rises by more than the initial change in spending (see the lower part of Figure 11-4). The text illustrates the multiplier effect of a change in investment spending. III. Aggregate supply is a schedule showing level of real domestic output available at each possible price level. A. Aggregate supply curve may be viewed as having three distinct segments. See Figure 11-5. 1. Horizontal range: where the price level remains constant with substantial output variation. In this range substantial unemployment and excess capacity exist. Economy is far below full-employment output level. 2. Intermediate (upsloping) range: where the expansion of real output is accompanied by rising price level, near to where the full-employment level of output exists. Per unit production costs rise in this stage because as resource markets near full employment their prices will be bid up and, therefore, producer costs rise.

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Aggregate Demand and Aggregate Supply 3. Vertical range: where absolute full capacity is assumed, and any attempt to increase output will bid up resource and product prices. We assume full-employment occurs at the natural rate of unemployment. B. Determinants of aggregate supply: Determinants are the other things besides price level that cause changes or shifts in aggregate supply (see Figure 11-6 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. Availability of resources (land, labor, capital, entrepreneurial ability), b. Prices of imported resources, and c. Market power in certain industries. 2. Change 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, b. Government regulation. IV. 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 11-7a,b for illustration of why quantity will seek equilibrium where curves intersect.) (Key Questions 4 and 7) B. Try Quick Quiz 11-7. C. Shifting aggregate demand when a determinant changes will change the equilibrium. 1. Demand-pull inflation: Shifts in the intermediate and vertical ranges will cause demand-pull inflation with an increase in aggregate demand (Figures 11-8b and c). 2. Shifts in the horizontal range will cause quantity changes but not price level (Figure 118a). D. The multiplier effect is weakened with price level changes in intermediate and vertical ranges of aggregate supply. Real GDP does not change as much in Figure 11-8c as it does in Figures 11-8a even though the aggregate demand shifts are of equal magnitude. Figure 11-9 combines the effects of Figures 11-8a and b. Conclusion: The more price level increases, the less effect any increase in aggregate demand will have in increasing real GDP. E. Decreases in AD: If AD decreases, recession and cyclical unemployment may result. See Figure 11-10. Prices dont fall easily. 1. Wage contracts are not flexible so businesses cant afford to reduce prices. 2. Also, employers are reluctant to cut wages because of impact on employee effort, etc. 3. Minimum wage laws keep wages above that level. 4. So-called menu costs are difficult to change. 5. Fear of price wars keep prices from being reduced also.
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Aggregate Demand and Aggregate Supply F. Shifting aggregate supply occurs when a supply determinant changes. (See Key Questions 5, 7, 8): 1. Leftward shift in curve illustrates cost-push inflation (see Figure 11-11). 2. Rightward shift in curve will cause a decline in price level (see Figure 11-12). See text for discussion of this desirable outcome. V. LAST WORD: Why Is Unemployment in Europe So High? A. Several European economies have had high rates of unemployment in the past several years, even before their recessions. 1. In 2000: France, 9.7 percent; Italy, 10.7 percent; Germany, 8.3 percent. 2. These rates compare to a 4.0 percent unemployment rate at the same time in U.S. B. Reasons for high European unemployment rates: 1. High natural rates of unemployment exist due to frictional and structural unemployment. This results from government policies and union contracts, which increase the costs of hiring and reduce the cost of being unemployed. a. High minimum wages exist. b. Generous welfare benefits exist for unemployed. c. Restrictions against firings discourage employment. d. Thirty to forty days of paid vacation and holidays boost the cost of hiring. e. High worker absenteeism reduces productivity. f. High employer cost of fringe benefits discourages hiring. 2. Deficient aggregate demand may also be a cause as shown in Figure 11-7b. European governments have feared inflation and have not undertaken expansionary monetary or fiscal policies. If they did, aggregate demand would expand, and unemployment rates might drop without inflation. 3. Conclusion: Economists in Europe are not sure whether aggregate demand is near fullemployment (Figure 11-7a) or is below full employment.

ANSWERS TO END-OF-CHAPTER QUESTIONS

11-1 Why is the aggregate demand curve downsloping? Specify how your explanation differs from the explanation for the downsloping demand curve for a single product. 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 wealth or real balances effect. As the price level rises, the real value the purchasing powerof 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
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Aggregate Demand and Aggregate Supply 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 droppingthe 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 consumers 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. 11-2 Explain the shape of the aggregate supply curve, and account for the horizontal, intermediate, and vertical ranges of the curve. In the horizontal range of the aggregate supply (AS) curve, the economy is in a severe recession, so that there is a large GDP gapmuch excess capacitybecause of deficient aggregate demand (AD). In these circumstances, AD can increase without pulling the price level upward. In the intermediate, or upsloping, range of the AS curve, the economy is clearly in the recovery phase of the business cycle and the price level moves up more and more as AD increases. The economy as a whole nears the full employment level of output, as some firms, some industries, are at or close enough to their capacity production that they believe they canor are forced to raise their prices to equate the quantity they supply with increasing demand. Moreover, some essential inputs are fully employedsome skilled labor, certain raw materialsand firms must bid against each other in order to increase their production. Thus, costsand pricesstart to rise in the economy, pushing up the price level as full employment is reached. In the vertical range of the AS curve, absolute full capacity has been reached; the economy, by definition, cannot produce any more (not until, through economic growth, the potential output of the economy has increased). Since the economy has attained its potential, any further increase in AD cannot be met by an increase in output. Therefore, the increase in AD results only in pure demand-pull inflation. 11-3 (Optional Section Question) Explain: 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. Figure 11-2 graphically illustrates the relationship between the two models. 11-4 (Key Question) Suppose that aggregate demand and supply for a hypothetical economy are as shown:

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Aggregate Demand and Aggregate Supply

Amount of real domestic output demanded, billions $100 200 300 400 500

Price level (price index) 300 250 200 150 150

Amount of real domestic output supplied, billions $400 400 300 200 100

a. Use these sets of data to graph the aggregate demand and supply curves. What will be the equilibrium price level and level of real domestic output in this hypothetical economy? Is the equilibrium real output also the absolute 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. What factors might cause this change in aggregate demand? What is the new equilibrium price level and level of real output? Over which range of the aggregate supply curvehorizontal, intermediate, or verticalhas equilibrium changed? (a) See the graph. Equilibrium price level = 200. Equilibrium real output = $300 billion. No, the full-capacity level of GDP is $400 billion, where the AS curve becomes vertical (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. 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. The intermediate range.

11-5

(Key Question) Suppose that the hypothetical economy in question 4 had the following relationship between its real domestic output and the input quantities necessary for producing that level of output:

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Aggregate Demand and Aggregate Supply 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 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? Input quantity 150.0 112.5 75.0 (a) Productivi ty = 2.67 ( = 300 / 112 .5). (b) Pre - unit cost of production
= $. 75 ( = $2 112 .5 / 300 ).

Real domestic output 400 300 200

(c) New per unit production cost = $1.13 . 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 ( = $2 112 .5 / 600 ). AS curve shifts to the right; price level declines and real output increases. 11.6 Distinguish between the real-balances effect and the 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 peoples 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. 11-7 (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 large purchase of U.S. wheat by Russia. c. A $1 increase in the excise tax on cigarettes. d. A reduction in interest rates at each price level.

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Aggregate Demand and Aggregate Supply e. A major cut in Federal spending for health care. f. The expectation of a rapid rise in the price level. g. The complete disintegration of OPEC, causing oil prices to fall by one-half. h. A 10 percent reduction in personal income tax rates. i. j. l. An increase in labor productivity. A 12 percent increase in nominal wages. A sharp decline in the national incomes of our western European trading partners.

k. Depreciation in the international value of the dollar. m. A sizable increase in U.S. immigration. (a) AD curve left (b) AD curve right (c) AS curve left (d) AD curve right (e) AD curve left (f) AD curve right (g) AS curve right (h) AD curve right (i) AS curve right (j) AS curve left (k) AD curve right; AS curve left (l) AD curve left (m) AS curve right. 11-8 (Key Question) Other things being equal, what effect will each of the following have on the equilibrium price level and level of real output: a. An increase in aggregate demand in the vertical range of aggregate supply. b. An increase in aggregate supply with no change in aggregate demand (assume prices and wages are flexible). c. Equal increases in aggregate demand and aggregate supply. d. A reduction in aggregate demand in the horizontal range of aggregate supply. e. An increase in aggregate demand and a decrease in aggregate supply. f. A decrease in aggregate demand in the intermediate range of aggregate supply (a) Price level rises and no change in real output (b) Price level drops and real output increases (c) Price level does not change, but real output rises (d) Price level does not change, but real output declines (e) Price level increases, but the change in real output is indeterminate

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Aggregate Demand and Aggregate Supply (f) Price level may not change, but real output declines (if prices are flexible downward, then output will decline but not as much as if prices stay high) 11-9 (Optional Section Question) Suppose that the price level is constant and investment spending increases sharply. How would you show this increase in the aggregate expenditures model? What would be the outcome? How would you show this rise in investment in the aggregate demand-aggregate supply model? What range of the aggregate supply curve is involved? An increase in investment spending represents an increase in aggregate expenditures and an upward shift in the aggregate expenditures curve. The outcome would be a new, greater equilibrium output level. This rise 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. Because we are assuming the price level is constant with increased aggregate demand, the shift in aggregate demand occurs in the horizontal range of the aggregate supply curve. It would be a rightward shift of aggregate demand, and the new equilibrium output would fall to the right of the original equilibrium by the full extent of the shift in aggregate demand. 11-10 (Optional Section Question) Explain how an upsloping aggregate supply curve might weaken the multiplier. 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. 11.11 Why does a reduction in aggregate demand reduce real output, rather than the price level?

A reduction in aggregate demand causes a decline in real output rather than the price level because prices are sticky or inflexible downward. If we assume prices are completely inflexible downward, then a reduction in demand is essentially moving leftward in the horizontal range of aggregate supply, which means reduced output at a constant price. To say prices are completely inflexible downward may exaggerate but prices dont fall easily for several reasons: wage contracts, minimum wage laws, employee morale, fear of price wars and the menu cost notion. 11-12 Unemployment can be caused by a decrease in aggregate demand or a decrease in aggregate supply. Do you agree? Explain. In each case specify price-level effects. Assuming the economy was not operating in the vertical range of the AS curve, the statement is true. In either case, the new point of intersection is to the left of the previous position, denoting a decrease in real domestic output and, therefore, assuming no change in productivity, necessarily an increase in unemployment. However, assuming complete flexibility of prices and wages, the decrease in AD will result in a lower price level, whereas the decrease in AS will result in a higher price level. From the point of view of price stability, therefore, the decrease in AD is preferable. If the economy were in the horizontal range initially, there would be no price changes in either case. 11-13 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 positive wealth effect could cause demand-pull inflation even though productivity growth in surging; and (c) how a strong negative wealth effect from say, a precipitous drop in the stock market, could cause a recession even though productivity is surging.

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Aggregate Demand and Aggregate Supply (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 both AD and AS shift right, but AD increases by more so that the increase in AD ends up in vertical range of AS. (c) 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 11-10 shows how this could happen even if AS shifted to the right. 11-14 (Last Word) State the alternative views on why unemployment in Europe has recently been so high. Discuss the policy implications of each view. There are two views on this question. One is that there is a high natural rate of unemployment in each of the European countries in question. This view holds that there are high levels of frictional and structural unemployment which accompany the full-employment level of output. Any increase in aggregate demand would cause demand-pull inflation. The sources of the high frictional and structural unemployment are government policies and union contracts, which increase the costs of hiring and reduce the costs of not having a job. For example, there are high minimum wages; generous welfare benefits; restrictions against firing, which discourage firms from employing workers; thirty to forty days of paid vacation per year; high worker absenteeism, which reduces productivity; and high employer costs of health, pension, disability, and other benefits. The second explanation disagrees with the first and sees the major problem as being deficient aggregate demand. Those economists who hold this view point to government policies that are aimed at preventing inflation and not at increasing aggregate demand. In this view, the European economies are operating in the horizontal range of their aggregate supply curves and, increases in aggregate demand would not be inflationary but would, instead, increase output and employment.

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