CHAPTER 22 Aggregate Demand and Aggregate Supply

1 Potential outputThe level of output aneconomy can achieve whenlabor is employed at itsnatural 22 Aggregate Demand andAggregate SupplySTART UP: THE GREAT WARNINGT hefirstwarningcamefromtheHarvardEconomic Society,anassociationofHarvardeconomicsp rofessors, ,fueledbysoaringinvestment, automobiles,publicpower,homeappliances,s yntheticfabrics,radio, momentum all its own. Prosperity was not about to end, no matter what a few economists might , , , history, the Great Depression, had ,realGDPhadfallen30%, ,andprices,measuredbytheimplicitpricedef lator,hadplunged23% ;itwasnotuntilWorldWarIIthatfullem-ploym ent was (realGDP),thepricelevel, ;greater detail, more examples, and more thorough explanations will follow in subsequent ,theremaybeactionsthatthegovernmentorthe centralbankcantaketopushtheeconomy toward it, and in this CHAPTER we will begin to consider the pros and cons of doing PDF created exclusively for ruthi aladjem demandThe relationship between thetotal quantity of goods andservices demanded (from allthe four sources of Demand )and the price level, all otherdeterminants of Demand curveA graphical representation ofaggregate DEMANDLEARNING potential output, also called the natural level of Aggregate Demand , represent it using a hypothetical Aggregate Demand curve, andidentify and explain the three effects that cause this curve to slope between a change in the Aggregate quantity of goods and services demanded anda change in Aggregate examples to explain how each component of Aggregate Demand can be a possible aggreg-ate Demand what a multiplier is and tell how to calculate.

2 Households(personalconsumption),otherfir ms(investment),gov-ernmentagencies(gover nmentpurchases),andforeignmarkets(netexp orts).Aggregatedemandistherelationshipbe tweenthetotalquantityofgoodsandservicesd emanded(fromallthefoursourcesofdemand)an dthepricelevel, curveis a graphical representation of Aggregate Slope of the Aggregate Demand CurveWewillusetheimplicitpricedeflatoras ourmeasureofthepricelevel; , ,$11,800billionworthofgoodsandserviceswi llbedemanded;atpointC, $12,000billion; and at point E, at a price level of , $12,200 billion will be DemandAn Aggregate Demand curve (AD) shows the relationship between the total quantity of output demanded(measured as real GDP) and the price level (measured as the implicit price deflator). At each price level, the totalquantity of goods and services demanded is the sum of the components of real GDP, as shown in the table. Thereis a negative relationship between the price level and the total quantity of goods and services demanded, all otherthings OF ECONOMICSP ersonal PDF created exclusively for ruthi aladjem effectThe tendency for a change inthe price level to affect realwealth and thus rate effectThe tendency for a change inthe price level to affect theinterest rate and thus toaffect the quantity ofinvestment trade effectThe tendency for a change inthe price level to affect in the aggregatequantity of goods andservices demandedMovement along anaggregate Demand ,alowerpriceinducespeopletosubstitutemor eofthegoodwhosepricehasfallenforothergoo ds, , quantity demanded thepricelevel ,butthepricesofwheat,sugar,tractors,stee l,andmostothergoodsorservicesproducedint heeco-nomy are likely to have fallen as , theirwages,therentstheymaychargeaslandlo rds,theinterestratestheyearn ,butincomesarelower, indeed,nochangeinrealincomewouldoc-cur.

3 If nominal incomes and prices all fall by 10%, for example, real incomes do not ,then,doestheaggregatedemandcurveslopedo wnward?Onereasonforthedownwardslopeofthe aggregatedemandcurveliesintherelationshi pbetweenrealwealth(thestocks,bonds,andot herassetsthatpeoplehaveaccumulated)andco nsumption(oneofthefourcomponentsofaggreg atedemand).Whenthepricelevelfalls,therea lvalueofwealthincreases ,ifthepricelevelfallsby25%,then$10, ;itsuggestsanegativerelation-ship between the price level and the real value of consumption , ,aswelearnedinstudyingdemandandsupply,ar eductioninthede-mandforsomething,allothe rthingsunchanged, ,the something , ,aBritisheconomistwhoseanalysisoftheGrea tDepressionandwhattodoaboutitledtothebir thofmodernmacroeconomics, ,the interest rate effect is sometimes called the Keynes , sgoodsmoreattractivetoforeignbuyers, sbuyers, trade effectis the tendency for a change in the price level to affect net ,then,afallinthepricelevelmeansthatthequ antitiesofconsumption,invest-ment, , ,thiscomponentofGDPdoesnotcontributetoth e downward slope of the ,achangeinthepricelevel,withallotherdete rminantsofaggregatedemandun-changed, is a response to a change in the price zero.

4 Such a phenomenon has never been 22 Aggregate Demand AND Aggregate SUPPLY547 Personal PDF created exclusively for ruthi aladjem in aggregatedemandChange in the aggregatequantity of goods andservices demanded at everyprice in Aggregate ,forexample, , and decreases in Aggregate Demand are shown inFigure in Aggregate DemandAn increase in consumption, investment, government purchases, or net exports shifts the Aggregate Demand curveAD1to the right as shown in Panel (a). A reduction in one of the components of Aggregate Demand shifts the curveto the left, as shown in Panel (b).Whatfactorsmightcausetheaggregatedem andcurvetoshift? in the components of Aggregate Demand and thus shift the Aggregate Demand in , , ,adecreaseinconsumptionwouldaccompanydim inishedconsumerexpectationsandadecreasei nconsumerconfidence, of the , ,1981,1986,1997,and2003; ,anothergovernmentpolicyaimedatincreasin gconsumptionandthusag-gregatedemandhasbe entheuseofrebatesinwhichtaxpayersaresimp lysentchecksinhopesthat548 PRINCIPLES OF ECONOMICSP ersonal PDF created exclusively for ruthi aladjem rateThe price of a currency interms of another currency ,2001, , , ,anincreaseintransferpaymentsraisesconsu mptionandaggregatedemand, and a reduction lowers consumption and Aggregate in , at each price level; it increases Aggregate , ; examine reasons interest rates might change in another ,suchasahouseorafactory,sellstheassetfor morethanitspurchaseprice(lessanydeprecia tionclaimedinearlieryears).

5 Thelowercapitalgainstaxcouldstimulateinv estment,becausetheownersofsuchassetsknow thattheywillloselesstotaxeswhentheysellt hoseassets,thusmaking assets subject to the tax more in Government PurchasesAnychangeingovernmentpurchases, allotherthingsunchanged, ;adecreaseingovernmentpurchasesde-crease s Aggregate , World War II accounted in large part for the rapid recovery from the Great in Net sgoodsandservices; snetexportsandaggregatedemand; , reduced exports and tended to reduce Aggregate , ,forexample, , , ; , , exchange rate tends to increase net exports, increasing Aggregate ,whenforeignpricelevelsfallrelativetothe pricelevelintheUnitedStates, , the opposite of goods and services from India, for example, would increase net exports in 22 Aggregate Demand AND Aggregate SUPPLY549 Personal PDF created exclusively for ruthi aladjem ratio of the change in thequantity of real GDPdemanded at each price levelto the initial change in one ormore components ofaggregate Demand thatproduced ,theag-gregatedemandcurveshiftsbymoretha ntheamountbywhichthecomponentinitiallyca usingittoshift ,acountry ,incomeswillrise, ,theaggregatedemandcurvewillshiftbymoret hantheinitialshiftcaused by the initial increase in net the initial change in one or more components of Aggregate Demand that produced it:EQUATION (realGDPdemandedateachpricelevel)initial (componentofAD)WeusethecapitalGreeklette rdelta( )tomean changein.

6 Intheaggregatedemand aggregatesupplymodelpresentedinthischapt er, , price level:EQUATION (realGDPdemandedateachpricelevel)=multip lier initial (componentofAD)Supposethattheinitialincr easeinnetexportsis$100billionandthatthei nitial$100-billionin-creasegeneratesaddi tionalconsumptionof$ (a) ,theaggregatedemandcurveshiftstotheright by$200billion $200billion(theinitial$100-billionincrea seinnetexportsplusthe$100-billionincreas ethatitgener-atedinconsumption) $ ,adecreaseinnetexportsof$100billionleads toadecreaseinaggregatedemandof$200billio nat each price level, as shown in Panel (b).FIGURE MultiplierA change in one component of Aggregate Demand shifts the Aggregate Demand curve by more than the initialchange. In Panel (a), an initial increase of $100 billion of net exports shifts the Aggregate Demand curve to the rightby $200 billion at each price level. In Panel (b), a decrease of net exports of $100 billion shifts the aggregatedemand curve to the left by $200 billion. In this example, the multiplier is OF ECONOMICSP ersonal PDF created exclusively for ruthi aladjem TAKEAWAYS<Potential output is the level of output an economy can achieve when labor is employed at its natural an economy fails to produce at its potential, the government or the central bank may try to pushthe economy toward its potential.

7 <The Aggregate Demand curve represents the total of consumption, investment, government purchases,and net exports at each price level in any period. It slopes downward because of the wealth effect onconsumption, the interest rate effect on investment, and the international trade effect on net exports.<The Aggregate Demand curve shifts when the quantity of real GDP demanded at each price level changes.<The multiplier is the number by which we multiply an initial change in Aggregate Demand to obtain theamount by which the Aggregate Demand curve shifts at each price level as a result of the initial IT!Explain the effect of each of the following on the Aggregate Demand curve for the United decrease in consumer increase in real GDP in the countries that buy increase in the price increase in government spending on highwaysCase in Point: The Multiplied Economic Impact of SARS on China s EconomySevereAcuteRespiratorySyndrome(SARS),anatypicalpneumonia-likedisease, ,theWorldHealthOrganization(WHO)issueditsfirstworldwidealertandamonthlateritsfirsttraveladvisory,whichrecommendedthattravelersavoidHongKongandthesouthernprovinceofChina, ,additionaltraveladvisorieswereissuedforotherpartsofCh-ina, Taiwan, and briefly for Toronto, Canada.

8 By the end of June, all WHO travel advisories had been ,economistsWenHai,ZhongZhao,andJianWanto fPekingUniversity sChinaCenterforEconomicResearchconducted asurveyofBeijing ,theyprojectedthetourismsectorofChinaasa wholewouldlose$ ofwhich$ $6billionfromcurtaileddomestictourism,as holidaycelebrationswerecancelledand domestic travel restrictions seconomy, , be $ billion smaller in 2003 as a result of SARS:Source:WenHai,ZhongZhao,andJianWan, TheShort-TermImpactofSARS ontheChineseEconomy, AsianEconomicPapers3, (Winter2004): 57 22 Aggregate Demand AND Aggregate SUPPLY551 Personal PDF created exclusively for ruthi aladjem runIn macroeconomic analysis, aperiod in which wages andsome other prices are stickyand do not respond tochanges in priceA price that is slow to adjustto its equilibrium level,creating sustained periods ofshortage or runIn macroeconomic analysis, aperiod in which wages andprices are TO TRY IT! decline in consumer optimism would cause the Aggregate Demand curve to shift to the left.

9 Ifconsumers are more pessimistic about the future, they are likely to cut purchases, especially of increase in the real GDP of other countries would increase the Demand for exports and cause theaggregate Demand curve to shift to the right. Higher incomes in other countries will make consumers inthose countries more willing and able to buy increase in the price level corresponds to a movement up along the unchanged Aggregate demandcurve. At the higher price level, the consumption, investment, and net export components of aggregatedemand will all fall; that is, there will be a reduction in the total quantity of goods and services demanded,but not a shift of the Aggregate Demand curve increase in government spending on highways means an increase in government purchases. Theaggregate Demand curve would shift to the Demand AND Aggregate Supply :THE LONG RUN AND THE SHORT RUNLEARNING between the short run and the long run, as these terms are used a hypothetical long-run Aggregate Supply curve and explain what it shows about the nat-ural levels of employment and output at various price levels, given changes in a hypothetical short-run Aggregate Supply curve, explain why it slopes upward, and ex-plain why it may shift.

10 That is, distinguish between a change in the Aggregate quantity of goodsand services supplied and a change in short-run Aggregate various explanations for wage and price and illustrate what is meant by equilibrium in the short run and relate the equilibriumto potential ,weseektounderstandtwotypesofequilibria, ,aseconomicconditionschange,prices(inclu dingwages) , , ,employ-ment will move to its natural level and real GDP to , ,intheshortrun, the section on short-run macroeconomic Long RunAsexplainedinapreviouschapter, , , OF ECONOMICSP ersonal PDF created exclusively for ruthi aladjem Aggregate Supply (LRAS) curveA graphical representationthat relates the level ofoutput produced by firms tothe price level in the long Aggregate SupplyThelong-runaggregatesupply(LRAS) (b) ,thelong-runaggregatesupplycurveisaverti callineattheeconomy (a) ,onlyarealwageof ,however, ,forexample,thattheequilibriumrealwage(t heratioofwagestothepricelevel) , , ,and so Employment and Long-Run Aggregate SupplyWhen the economy achieves its natural level of employment, as shown in Panel (a) at the intersection of thedemand and Supply curves for labor, it achieves its potential output, as shown in Panel (b) by the vertical long-runaggregate Supply (b) to create a real wage of e, and flexible nominal wages would achieve that in the long ,then, ,thelong-runaggregatesupplycurveisaverti callineattheeconomy spotential level of output Levels of Price and Output in the Long RunTheintersectionoftheeconomy ,realGDPis$12, ,long-runequilibriumwillbereestablisheda trealGDPof$12,000billionperyear, ,long-runequilibriumwillstillbeatrealGDP of $12,000 billion per year, but with the now lower price level of 22 Aggregate Demand AND Aggregate SUPPLY553 Personal PDF created exclusively for ruthi aladjem EquilibriumLong-run equilibrium occurs at the intersection of the Aggregate Demand curve and the long-run Aggregate supplycurve.