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Trisem 252022-23 BMT6111 TH VL2022230300008 Reference Material II 15-11-2022 AD AS 2
Mathematics
Sikkim Manipal University
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341
CHAPTER 12
❱ How the aggregate demand curve illustrates the relationship between the aggregate price level and the quantity of aggregate output demanded in the economy ❱ How the aggregate supply curve illustrates the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy ❱ Why the aggregate supply curve is different in the short run compared to the long run ❱ How the AD–AS model is used to analyze economic fluctuations ❱ How monetary policy and fiscal policy can stabilize the economy
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OMETIMES IT’S NOT EASY BEING BEN. In 2008 Ben Bernanke, a distinguished former Princeton economics professor, was chairman of the Federal Reserve— the institution that sets U. monetary policy, along with regulating the financial sector. The Federal Reserve’s job is to help the economy avoid the twin evils of high inflation and high unemployment. It does this, loosely speaking, either by pumping cash into the economy to fight unemployment or by pulling cash out of the economy to fight inflation. When the U. economy went into a recession in 2001, the Fed rushed cash into the system. It was an easy choice: unemployment was rising, and inflation was low and falling. In fact, for much of 2002 the Fed was actually worried about the possibility of deflation. For much of 2008, however, Bernanke faced a much more difficult problem. In fact, he faced the problem people in his position dread most: a combination of unacceptably high inflation and rising unemployment, often referred to as stagflation. Stagflation was the scourge of the 1970s: the two deep recessions of 1973–1975 and 1979–1982, the two deepest slumps since the Great Depression (until 2007–2009), were both accompanied by soaring inflation. And in the first half of 2008, the threat of stagfla- tion seemed to be back. Why did the economic difficulties of early 2008 look so different from those of 2001? Because they had a different cause. The lesson of stagflation in the 1970s was that recessions can have dif- ferent causes and that the appropriate policy response depends on the cause. Many recessions, from the great slump of 1929–1933 to the much milder recession of 2001, have been caused by a fall in investment and consumer spending. In these recessions high inflation isn’t a threat. In fact, the 1929–1933 slump was accompanied by a sharp fall in the aggre- gate price level. And because inflation isn’t a problem in such recessions, policy makers know what they must do: pump cash in, to fight rising unemployment. The recessions of the 1970s, however, were largely caused by events in the Middle East that led to sharp cuts in world oil production and soaring prices for oil and other fuels. Not coincidentally, soaring oil prices also contributed to the economic difficulties of early 2008. In both periods, high energy prices led to a combination of unemployment and high inflation. They also created a dilemma: should the Fed fight the slump by pump- ing cash into the economy, or should it fight inflation by pulling cash out of the economy? It’s worth noting, by the way, that in 2011 the Fed faced some of the same problems it faced in 2008, as rising oil and food prices led to rising inflation despite high unemployment. In 2011, however, the Fed was fairly sure that demand was the main problem. In the previous chapter we developed the income–expenditure model, which focuses on the determinants of aggre- gate spending. This model is extremely useful for understanding events like the recession of 2001 and the recovery that followed. However, the income– expenditure model takes the price level as given, and therefore it’s much less helpful for understanding the problems policy makers faced in 2008. In this chapter, we’ll develop a model that goes beyond the income – expenditure model and shows us how to distinguish between different types of short-run eco- nomic fluctuations—demand shocks, like those of the Great Depression and the 2001 recession, and supply shocks, like those of the 1970s and 2008. To develop this model, we’ll pro- ceed in three steps. First, we’ll develop the concept of aggregate demand. Then we’ll turn to the parallel concept of aggregate supply. Finally, we’ll put them together in the AD–AS model.
Aggregate Demand and
Aggregate Supply
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342 P A R T 5 S H O R T - R U N E C O N O M I C F L U C T U AT I O N S
Aggregate Demand
T
he Great Depression, the great majority of economists agree, was the result of a massive negative demand shock. What does that mean? In Chapter 3 we explained that when economists talk about a fall in the demand for a par- ticular good or service, they’re referring to a leftward shift of the demand curve. Similarly, when economists talk about a negative demand shock to the economy as a whole, they’re referring to a leftward shift of the aggregate demand curve, a curve that shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, firms, the government, and the rest of the world. Figure 12-1 shows what the aggregate demand curve may have looked like in 1933, at the end of the 1929–1933 recession. The horizontal axis shows the total quantity of domestic goods and services demanded, measured in 2005 dollars. We use real GDP to measure aggregate output and will often use the two terms inter- changeably. The vertical axis shows the aggregate price level, measured by the GDP deflator. With these variables on the axes, we can draw a curve, AD, showing how much aggregate output would have been demanded at any given aggregate price level. Since AD is meant to illustrate aggregate demand in 1933, one point on the curve corresponds to actual data for 1933, when the aggregate price level was 7 and the total quantity of domestic final goods and services purchased was $716 billion in 2005 dollars. As drawn in Figure 12-1, the aggregate demand curve is downward slop- ing, indicating a negative relationship between the aggregate price level and the quantity of aggregate output demanded. A higher aggregate price level, other things equal, reduces the quantity of aggregate output demanded; a lower aggregate price level, other things equal, increases the quantity of aggregate output demanded. According to Figure 12-1, if the price level in 1933 had been 4 instead of 7, the total quantity of domestic final goods and services demanded would have been $1,000 billion in 2005 dollars instead of $716 billion. The first key question about the aggregate demand curve is: why should the curve be downward sloping?
12-1 The Aggregate Demand Curve
The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded. The curve is downward sloping due to the wealth effect of a change in the aggregate price level and the interest rate effect of a change in the aggregate price level. Corresponding to the actual 1933 data, here the total quantity of goods and services demanded at an aggregate price level of 7. is $716 billion in 2005 dollars. According to our hypothetical curve, however, if the aggregate price level had been only 4, the quantity of aggregate output demanded would have risen to $1,000 billion. 4. 7. Aggregate price level (GDP deflator, 2005 = 100) Aggregate demand curve, AD 1933 A movement down the AD curve leads to a lower aggregate price level and higher aggregate output. 0 $716 1,000 Real GDP (billions of 2005 dollars) FIGURE The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, the government, and the rest of the world.
344 P A R T 5 S H O R T - R U N E C O N O M I C F L U C T U AT I O N S either by borrowing more or by selling assets such as bonds. This reduces the funds available for lending to other borrowers and drives interest rates up. In Chapter 10 we learned that a rise in the interest rate reduces investment spending because it makes the cost of borrowing higher. It also reduces consumer spending because households save more of their disposable income. So a rise in the aggregate price level depresses investment spending, I, and consumer spend- ing, C, through its effect on the purchasing power of money holdings, an effect known as the interest rate effect of a change in the aggregate price level. This also leads to a downward-sloping aggregate demand curve. We’ll have a lot more to say about money and interest rates in Chapter 15 on monetary policy. We’ll also see, in Chapter 19, which covers open- economy macroeconomics, that a higher interest rate indirectly tends to reduce exports (X) and increase imports (IM). For now, the important point is that the aggregate demand curve is downward sloping due to both the wealth effect and the interest rate effect of a change in the aggregate price level. The Aggregate Demand Curve and the Income–Expenditure Model In the preceding chapter we introduced the income –expenditure model, which shows how the economy arrives at income –expenditure equilibrium. Now we’ve introduced the aggregate demand curve, which relates the overall demand for goods and services to the overall price level. How do these concepts fit together? Recall that one of the assumptions of the income–expenditure model is that the aggregate price level is fixed. We now drop that assumption. We can still use the income–expenditure model, however, to ask what aggregate spending would be at any given aggregate price level, which is precisely what the aggregate demand curve shows. So the AD curve is actually derived from the income–expenditure model. Economists sometimes say that the income–expenditure model is “embedded” in the AD–AS model. Figure 12-2 shows, once again, how income –expenditure equilibrium is determined. Real GDP is on the horizontal axis; real planned aggregate spending The interest rate effect of a change in the aggregate price level is the effect on consumer spending and investment spending caused by the effect of a change in the aggregate price level on the purchasing power of consumers’ and firms’ money holdings. 12-2 How Changes in the Aggregate Price Level Affect Income–Expenditure Equilibrium Income–expenditure equilibrium occurs at the point where the curve AEPlanned , which shows real aggre- gate planned spending, crosses the 45-degree line. A fall in the aggregate price level causes the AEPlanned curve to shift from AEPlanned 1 to AEPlanned 2 , leading to a rise in income-expenditure equilibrium GDP from Y 1 to Y 2. Planned aggregate spending Y 1 Y 2 Real GDP E 1 E 2 AEPlanned AEPlanned AEPlanned 45-degree line 2 AEPlanned 1 FIGURE KrugWellsEC3e_Macro_CH12.inddKrugWellsEC3e_Macro_CH12 344344 4/4/124/4/12 12:44 PM12:44 PM
C H A P T E R 1 2 A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY 345 is on the vertical axis. Other things equal, planned aggregate spending, equal to consumer spending plus planned investment spending, rises with real GDP. This is illustrated by the upward-sloping lines AEPlanned 1 and AEPlanned 2. Income– expenditure equilibrium, as we learned in Chapter 11, is at the point where the line representing planned aggregate spending crosses the 45-degree line. For example, if AEPlanned 1 is the relationship between real GDP and planned aggre- gate spending, then income– expenditure equilibrium is at point E 1 , correspond- ing to a level of real GDP equal to Y 1. We’ve just seen, however, that changes in the aggregate price level change the level of planned aggregate spending at any given level of real GDP. This means that when the aggregate price level changes, the AEPlanned curve shifts. For example, suppose that the aggregate price level falls. As a result of both the wealth effect and the interest rate effect, the fall in the aggregate price level will lead to higher planned aggregate spending at any given level of real GDP. So the AEPlanned curve will shift up, as illustrated in Figure 12-2 by the shift from AEPlanned 1 to AEPlanned 2. The increase in planned aggregate spending leads to a multiplier process that moves the income– expenditure equilibrium from point E 1 to point E 2 , raising real GDP from Y 1 to Y 2. Figure 12-3 shows how this result can be used to derive the aggregate demand curve. In Figure 12-3, we show a fall in the aggregate price level from P 1 to P 2. We saw in Figure 12-2 that a fall in the aggregate price level would lead to an upward shift of the AEPlanned curve and hence a rise in real GDP. You can see this same result in Figure 12-3 as a movement along the AD curve: as the aggregate price level falls, real GDP rises from Y 1 to Y 2. So the aggregate demand curve doesn’t replace the income – expenditure model. Instead, it’s a way to summarize what the income –expenditure model says about the effects of changes in the aggregate price level. In practice, economists often use the income – expenditure model to analyze short-run economic fluctuations, even though strictly speaking it should be seen as a component of a more complete model. In the short run, in particular, this is usually a reasonable shortcut. 12-3 The Income–Expenditure Model and the Aggregate Demand Curve In Figure 12-2 we saw how a fall in the aggregate price level shifts the planned aggregate spending curve up, leading to a rise in real GDP. Here we show that same result as a movement along the aggregate demand curve. If the aggregate price level falls from P 1 to P 2 , real GDP rises from Y 1 to Y 2. The AD curve is therefore downward sloping. Aggregate price level Y 1 Y 2 Real GDP AD P 2 P 1 A movement down the AD curve leads to a lower aggregate price level and higher aggregate output. FIGURE
C H A P T E R 1 2 A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY 347 their planned investment spending not only on current conditions but also on the sales they expect to make in the future. As a result, changes in expectations can push consumer spending and planned investment spending up or down. If consumers and firms become more optimistic, aggregate spending rises; if they become more pessimistic, aggregate spending falls. In fact, short-run economic TABLE 12-1 Factors That Shift Aggregate Demand When this... aggregate happens,... demand increases: But when this... aggregate happens,... demand decreases: Changes in expectations: Changes in wealth: Size of the existing stock of physical capital: Fiscal policy: Monetary policy: When consumers and firms become more optimistic,... ... aggregate demand increases. Price Quantity When the real value of household assets rises,... ... aggregate demand increases. Price Quantity When the existing stock of physical capital is relatively small,... ... aggregate demand increases. Price Quantity When the government increases spending or cuts taxes,... ... aggregate demand increases. Price Quantity When the central bank increases the quantity of money,... ... aggregate demand increases. Price Quantity When consumers and firms become more pessimistic,... ... aggregate demand decreases. Price Quantity When the real value of household assets falls,... ... aggregate demand decreases. Price Quantity When the existing stock of physical capital is relatively large,... ... aggregate demand decreases. Price Quantity When the government reduces spending or raises taxes,... ... aggregate demand decreases. Price Quantity When the central bank reduces the quantity of money,... ... aggregate demand decreases. Price Quantity KrugWellsEC3e_Macro_CH12.inddKrugWellsEC3e_Macro_CH12 347347 4/4/124/4/12 12:49 PM12:49 PM
348 P A R T 5 S H O R T - R U N E C O N O M I C F L U C T U AT I O N S forecasters pay careful attention to surveys of consumer and business sentiment. In particu- lar, forecasters watch the Consumer Confidence Index, a monthly measure calculated by the Conference Board, and the Michigan Consumer Sentiment Index, a similar measure calculated by the University of Michigan. Changes in Wealth Consumer spending depends in part on the value of household assets. When the real value of these assets rises, the purchasing power they embody also rises, leading to an increase in aggregate spending. For example, in the 1990s there was a sig- nificant rise in the stock market that increased aggregate demand. And when the real value of household assets falls—for example, because of a stock market crash—the purchasing power they embody is reduced and aggregate demand also falls. The stock market crash of 1929 was a significant factor leading to the Great Depression. Similarly, a sharp decline in real estate values was a major factor depressing consumer spend- ing during the 2007–2009 recession. Size of the Existing Stock of Physical Capital Firms engage in planned investment spending to add to their stock of physical capital. Their incentive to spend depends in part on how much physical capital they already have: the more they have, the less they will feel a need to add more, other things equal. The same applies to other types of investment spending—for example, if a large number of houses have been built in recent years, this will depress the demand for new houses and as a result also tend to reduce residential investment spending. In fact, that’s part of the reason for the deep slump in residential investment spending that began in 2006. The housing boom of the previous few years had created an oversupply of houses: by spring 2009, the inventory of unsold houses on the market was equal to more than 14 months of sales, and prices of new homes had fallen more than 25% from their peak. This gave the construction industry little incentive to build even more homes. Government Policies and Aggregate Demand One of the key insights of macroeconomics is that the government can have a powerful influence on aggregate demand and that, in some circumstances, this influence can be used to improve eco- nomic performance. The two main ways the government can influence the aggregate demand curve are through fiscal policy and monetary policy. We’ll briefly discuss their influence on aggregate demand, leaving a full- length discussion for upcoming chapters. Fiscal Policy As we learned in Chapter 6, fiscal policy is the use of either government spending—government purchases of final goods and services and government transfers—or tax policy to stabilize the economy. In practice, governments often respond to recessions by increasing spending, cutting taxes, or both. They often respond to inflation by reducing spending or increasing taxes. ““CONSUMER CONFIDENCE CRISIS IN AISLE 3 !” Jim Borgman PITFALLS CHANGES IN WEALTH: A MOVEMENT ALONG VERSUS A SHIFT OF THE AGGREGATE DEMAND CURVE In the last section we explained that one reason the AD curve is downward sloping is due to the wealth effect of a change in the aggregate price level: a higher aggregate price level reduces the purchasing power of households’ assets and leads to a fall in consumer spending, C. But in this section we’ve just explained that changes in wealth lead to a shift of the AD curve. Aren’t those two explanations contra- dictory? Which one is it—does a change in wealth move the economy along the AD curve or does it shift the AD curve? The answer is both: it depends on the source of the change in wealth. A move- ment along the AD curve occurs when a change in the aggregate price level changes the purchasing power of consumers’ existing wealth (the real value of their assets). This is the wealth effect of a change in the aggregate price level—a change in the aggregate price level is the source of the change in wealth. For example, a fall in the aggregate price level increases the purchasing power of consum- ers’ assets and leads to a movement down the AD curve. In contrast, a change in wealth independent of a change in the aggregate price level shifts the AD curve. For example, a rise in the stock market or a rise in real estate values leads to an increase in the real value of consumers’ assets at any given aggregate price level. In this case, the source of the change in wealth is a change in the values of assets without any change in the aggregate price level— that is, a change in asset values holding the prices of all final goods and services constant.
350 P A R T 5 S H O R T - R U N E C O N O M I C F L U C T U AT I O N S the quantity of money slowly. The aggregate price level was rising steeply, but the quantity of money circulating in the economy was growing slowly. The net result was that the purchasing power of the quantity of money in circulation fell. This led to an increase in the demand for borrowing and a surge in interest rates. The prime rate, which is the interest rate banks charge their best customers, climbed above 20%. High interest rates, in turn, caused both consumer spending and investment spending to fall: in 1980 purchases of durable consumer goods like cars fell by 5% and real investment spending fell by 8%. In other words, in 1979–1980 the economy responded just as we’d expect if it were moving upward along the aggregate demand curve from right to left: due to the wealth effect and the interest rate effect of a change in the aggregate price level, the quantity of aggregate output demanded fell as the aggregate price level rose. This does not explain, of course, why the aggregate price level rose. But as we’ll see in the section “The AD–AS Model,” the answer to that question lies in the behavior of the short-run aggregate supply curve.
CHECK YOUR UNDERSTANDING 12-
- Determine the effect on aggregate demand of each of the following events. Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward). a. A rise in the interest rate caused by a change in monetary policy b. A fall in the real value of money in the economy due to a higher aggregate price level c. News of a worse-than-expected job market next year d. A fall in tax rates e. A rise in the real value of assets in the economy due to a lower aggregate price level f. A rise in the real value of assets in the economy due to a surge in real estate values Solutions appear at back of book.
Aggregate Supply
B
etween 1929 and 1933, there was a sharp fall in aggregate demand—a reduction in the quantity of goods and services demanded at any given price level. One consequence of the economy-wide decline in demand was a fall in the prices of most goods and services. By 1933, the GDP deflator (one of the price indexes we defined in Chapter 7) was 26% below its 1929 level, and other indexes were down by similar amounts. A second consequence was a decline in the output of most goods and services: by 1933, real GDP was 27% below its 1929 level. A third consequence, closely tied to the fall in real GDP, was a surge in the unemployment rate from 3% to 25%. The association between the plunge in real GDP and the plunge in prices wasn’t an accident. Between 1929 and 1933, the U. economy was moving down its aggre- gate supply curve, which shows the relationship between the economy’s aggregate price level (the overall price level of final goods and services in the economy) and the total quantity of final goods and services, or aggregate output, producers are willing to supply. (As you will recall, we use real GDP to measure aggregate output. So we’ll often use the two terms interchangeably.) More specifically, between 1929 and 1933 the U. economy moved down its short-run aggregate supply curve.
The Short-Run Aggregate Supply Curve
The period from 1929 to 1933 demonstrated that there is a positive relationship in the short run between the aggregate price level and the quantity of aggregate output supplied. That is, a rise in the aggregate price level is associated with a
• The aggregate demand curve is
downward sloping because of the wealth effect of a change in the aggregate price level and the interest rate effect of a change in the aggregate price level.
• The aggregate demand curve shows
how income – expenditure equilib- rium GDP changes when the aggre- gate price level changes.
• Changes in consumer spending
caused by changes in wealth and expectations about the future shift the aggregate demand curve. Changes in investment spending caused by changes in expectations and by the size of the existing stock of physical capital also shift the aggregate demand curve.
• Fiscal policy affects aggregate
demand directly through govern- ment purchases and indirectly through changes in taxes or govern- ment transfers. Monetary policy affects aggregate demand indirectly through changes in the interest rate.
Quick Review
The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy.
C H A P T E R 1 2 A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY 351 rise in the quantity of aggregate output supplied, other things equal; a fall in the aggregate price level is associated with a fall in the quantity of aggregate output supplied, other things equal. To understand why this positive relationship exists, consider the most basic question facing a producer: is producing a unit of output profitable or not? Let’s define profit per unit: (12-2) Profit per unit of output = Price per unit of output − Production cost per unit of output Thus, the answer to the question depends on whether the price the pro- ducer receives for a unit of output is greater or less than the cost of produc- ing that unit of output. At any given point in time, many of the costs producers face are fixed per unit of output and can’t be changed for an extended period of time. Typically, the largest source of inflexible production cost is the wages paid to workers. Wages here refers to all forms of worker compensa- tion, such as employer - paid health care and retirement benefits in addition to earnings. Wages are typically an inflexible production cost because the dollar amount of any given wage paid, called the nominal wage, is often determined by con- tracts that were signed some time ago. And even when there are no formal con- tracts, there are often informal agreements between management and workers, making companies reluctant to change wages in response to economic condi- tions. For example, companies usually will not reduce wages during poor eco- nomic times—unless the downturn has been particularly long and severe—for fear of generating worker resentment. Correspondingly, they typically won’t raise wages during better economic times—until they are at risk of losing workers to competitors—because they don’t want to encourage workers to routinely demand higher wages. As a result of both formal and informal agreements, then, the economy is characterized by sticky wages: nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages. It’s important to note, however, that nominal wages cannot be sticky forever: ultimately, formal contracts and informal agreements will be renegotiated to take into account changed economic circumstances. As the Pitfalls at the end of this section explains, how long it takes for nominal wages to become flex- ible is an integral component of what distinguishes the short run from the long run. To understand how the fact that many costs are fixed in nominal terms gives rise to an upward-sloping short-run aggregate supply curve, it’s helpful to know that prices are set somewhat differently in different kinds of markets. In perfectly competitive markets, producers take prices as given; in imperfectly competitive markets, producers have some ability to choose the prices they charge. In both kinds of markets, there is a short-run positive relationship between prices and output, but for slightly different reasons. Let’s start with the behavior of producers in perfectly competitive markets; remember, they take the price as given. Imagine that, for some reason, the aggregate price level falls, which means that the price received by the typical producer of a final good or service falls. Because many production costs are fixed in the short run, production cost per unit of output doesn’t fall by the same proportion as the fall in the price of output. So the profit per unit of output declines, leading perfectly competitive producers to reduce the quantity sup- plied in the short run. On the other hand, suppose that for some reason the aggregate price level rises. As a result, the typical producer receives a higher price for its final good or service. Again, many production costs are fixed in the short run, so production cost per unit of output doesn’t rise by the same proportion as the rise in the price The nominal wage is the dollar amount of the wage paid. Sticky wages are nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages.
C H A P T E R 1 2 A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY 353 Shifts of the Short-Run Aggregate Supply Curve Figure 12-5 shows a movement along the short-run aggregate supply curve, as the aggregate price level and aggregate output fell from 1929 to 1933. But there can also be shifts of the short-run aggregate supply curve, as shown in Figure 12-6. Panel (a) shows a decrease in short-run aggregate supply—a leftward shift of the short-run aggre- gate supply curve. Aggregate supply decreases when producers reduce the quantity of aggregate output they are willing to supply at any given aggregate price level. Panel (b) Most macroeconomists agree that the basic picture shown in Figure 12-5 is correct: there is, other things equal, a positive short-run relationship between the aggregate price level and aggregate output. But many would argue that the details are a bit more complicated. So far we’ve stressed a difference in the behavior of the aggregate price level and the behavior of nominal wages. That is, we’ve said that the aggregate price level is flexible but nominal wages are sticky in the short run. Although this assumption is a good way to explain why the short-run aggregate supply curve is upward slop- ing, empirical data on wages and prices don’t wholly support a sharp distinction between flexible prices of final goods and services and sticky nominal wages. On one side, some nominal wages are in fact flexible even in the short run because some workers are not covered by a contract or informal agreement with their employers. Since some nominal wages are sticky but others are flexible, we observe that the average nominal wage—the nomi- nal wage averaged over all workers in the economy—falls when there is a steep rise in unemployment. For example, nominal wages fell substantially in the early years of the Great Depression. On the other side, some prices of final goods and services are sticky rather than flexible. For example, some firms, particularly the makers of luxury or name-brand goods, are reluctant to cut prices even when demand falls. Instead they prefer to cut output even if their profit per unit hasn’t declined. These complications, as we’ve said, don’t change the basic picture. When the aggregate price level falls, some produc- ers cut output because the nominal wages they pay are sticky. And some producers don’t cut their prices in the face of a falling aggregate price level, preferring instead to reduce their output. In both cases, the positive relationship between the aggregate price level and aggregate output is main- tained. So, in the end, the short-run aggre- gate supply curve is still upward sloping. FOR INQUIRING MINDS WHAT’S TRULY FLEXIBLE, WHAT’S TRULY STICKY F FIGURE 12-6 Shifts of the Short-Run Aggregate Supply Curve Real GDP Aggregate price level (a) Leftward Shift SRAS 2 SRAS 1 SRAS 1 SRAS 2 Real GDP Aggregate price level (b) Rightward Shift Decrease in short-run aggregate supply Increase in short-run aggregate supply Panel (a) shows a decrease in short-run aggregate sup- ply: the short-run aggregate supply curve shifts leftward from SRAS 1 to SRAS 2 , and the quantity of aggregate output supplied at any given aggregate price level falls. Panel (b) shows an increase in short-run aggregate sup- ply: the short-run aggregate supply curve shifts rightward from SRAS 1 to SRAS 2 , and the quantity of aggregate output supplied at any given aggregate price level rises.
354 P A R T 5 S H O R T - R U N E C O N O M I C F L U C T U AT I O N S shows an increase in short-run aggregate supply—a rightward shift of the short-run aggregate supply curve. Aggregate supply increases when producers increase the quan- tity of aggregate output they are willing to supply at any given aggregate price level. To understand why the short-run aggregate supply curve can shift, it’s impor- tant to recall that producers make output decisions based on their profit per unit of output. The short-run aggregate supply curve illustrates the relationship between the aggregate price level and aggregate output: because some production costs are fixed in the short run, a change in the aggregate price level leads to a change in producers’ profit per unit of output and, in turn, leads to a change in aggregate output. But other factors besides the aggregate price level can affect profit per unit and, in turn, aggregate output. It is changes in these other factors that will shift the short-run aggregate supply curve. To develop some intuition, suppose that something happens that raises pro- duction costs—say, an increase in the price of oil. At any given price of output, a producer now earns a smaller profit per unit of output. As a result, producers reduce the quantity supplied at any given aggregate price level, and the short-run aggregate supply curve shifts to the left. If, in contrast, something happens that lowers production costs—say, a fall in the nominal wage—a producer now earns a higher profit per unit of output at any given price of output. This leads produc- ers to increase the quantity of aggregate output supplied at any given aggregate price level, and the short-run aggregate supply curve shifts to the right. Now we’ll discuss some of the important factors that affect producers’ profit per unit and so can lead to shifts of the short-run aggregate supply curve. Changes in Commodity Prices In this chapter’s opening story, we described how a surge in the price of oil caused problems for the U. economy in the 1970s, early in 2008, and again in 2011. Oil is a commodity, a standardized input bought and sold in bulk quantities. An increase in the price of a commodity—oil—raised production costs across the economy and reduced the quantity of aggregate out- put supplied at any given aggregate price level, shifting the short-run aggregate supply curve to the left. Conversely, a decline in commodity prices reduces pro- duction costs, leading to an increase in the quantity supplied at any given aggre- gate price level and a rightward shift of the short-run aggregate supply curve. Why isn’t the influence of commodity prices already captured by the short-run aggregate supply curve? Because commodities—unlike, say, soft drinks—are not a final good, their prices are not included in the calculation of the aggregate price level. Further, commodities represent a significant cost of production to most suppliers, just like nominal wages do. So changes in commodity prices have large impacts on production costs. And in contrast to noncommodities, the prices of commodities can sometimes change drastically due to industry-specific shocks to supply—such as wars in the Middle East or rising Chinese demand that leaves less oil for the United States. Changes in Nominal Wages At any given point in time, the dollar wages of many workers are fixed because they are set by contracts or informal agreements made in the past. Nominal wages can change, however, once enough time has passed for contracts and informal agreements to be renegotiated. Suppose, for example, that there is an economy-wide rise in the cost of health care insurance premiums paid by employers as part of employees’ wages. From the employers’ perspective, this is equivalent to a rise in nominal wages because it is an increase in employer-paid compensation. So this rise in nominal wages increases produc- tion costs and shifts the short-run aggregate supply curve to the left. Conversely, suppose there is an economy-wide fall in the cost of such premiums. This is equiv- alent to a fall in nominal wages from the point of view of employers; it reduces production costs and shifts the short-run aggregate supply curve to the right. An important historical fact is that during the 1970s the surge in the price of oil had the indirect effect of also raising nominal wages. This “knock- on” effect occurred because many wage contracts included cost- of-living allowances
356 P A R T 5 S H O R T - R U N E C O N O M I C F L U C T U AT I O N S The Long-Run Aggregate Supply Curve We’ve just seen that in the short run a fall in the aggregate price level leads to a decline in the quantity of aggregate output supplied because nominal wages are sticky in the short run. But, as we mentioned earlier, contracts and informal agreements are renegotiated in the long run. So in the long run, nominal wages— like the aggregate price level—are flexible, not sticky. This fact greatly alters the long-run relationship between the aggregate price level and aggregate supply. In fact, in the long run the aggregate price level has no effect on the quantity of aggregate output supplied. To see why, let’s conduct a thought experiment. Imagine that you could wave a magic wand—or maybe a magic bar- code scanner—and cut all prices in the economy in half at the same time. By “all prices” we mean the prices of all inputs, including nominal wages, as well as the prices of final goods and services. What would happen to aggregate output, given that the aggregate price level has been halved and all input prices, including nominal wages, have been halved? The answer is: nothing. Consider Equation 12-2 again: each producer would receive a lower price for its product, but costs would fall by the same proportion. As a result, every unit of output profitable to produce before the change in prices would still be profitable to produce after the change in prices. So a halving of all prices in the economy has no effect on the economy’s aggregate output. In other words, changes in the aggregate price level now have no effect on the quantity of aggregate output supplied. In reality, of course, no one can change all prices by the same proportion at the same time. But now, we’ll consider the long run, the period of time over which all prices are fully flexible. In the long run, inflation or deflation has the same effect as someone changing all prices by the same proportion. As a result, changes in the aggre- gate price level do not change the quantity of aggregate output supplied in the long run. That’s because changes in the aggregate price level will, in the long run, be accom- panied by equal proportional changes in all input prices, including nominal wages. The long-run aggregate supply curve, illustrated in Figure 12-7 by the curve LRAS, shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including The long - run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible. 12-7 The Long-Run Aggregate Supply Curve The long-run aggregate sup- ply curve shows the quantity of aggregate output supplied when all prices, including nominal wages, are flexible. It is vertical at potential output, YP, because in the long run a change in the aggregate price level has no effect on the quantity of aggregate output supplied. 15. 7. Aggregate price level (GDP deflator, 2005 = 100) Long-run aggregate supply curve, LRAS .. the quantity of aggregate output supplied unchanged in the long run. A fall in the aggregate price level... Potential output, YP 0 $800 Real GDP (billions of 2005 dollars) FIGURE
C H A P T E R 1 2 A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY 357 nominal wages, were fully flexible. The long-run aggregate supply curve is verti- cal because changes in the aggregate price level have no effect on aggregate out- put in the long run. At an aggregate price level of 15, the quantity of aggregate output supplied is $800 billion in 2005 dollars. If the aggregate price level falls by 50% to 7, the quantity of aggregate output supplied is unchanged in the long run at $800 billion in 2005 dollars. It’s important to understand not only that the LRAS curve is vertical but also that its position along the horizontal axis represents a significant measure. The horizon- tal intercept in Figure 12-7, where LRAS touches the horizontal axis ($800 billion in 2005 dollars), is the economy’s potential output, YP: the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible. In reality, the actual level of real GDP is almost always either above or below potential output. We’ll see why later in this chapter, when we discuss the AD–AS model. Still, an economy’s potential output is an important number because it defines the trend around which actual aggregate output fluctuates from year to year. In the United States, the Congressional Budget Office, or CBO, estimates annu- al potential output for the purpose of federal budget analysis. In Figure 12-8, the CBO’s estimates of U. potential output from 1990 to 2011 are represented by the orange line and the actual values of U. real GDP over the same period are repre- sented by the blue line. Years shaded purple on the horizontal axis correspond to periods in which actual aggregate output fell short of potential output, years shad- ed green to periods in which actual aggregate output exceeded potential output. Potential output is the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible. FIGURE 12-8 Actual and Potential Output from 1990 to 2011 Actual aggregate output $15, 14, 13, 12, 11, 10, 9, 8, 7, Real GDP (billions of 2005 dollars) Year 19901991 1993 1995 19971998 2000 2002 20042005 2007 2009 2011 Potential Actual aggregate output output exceeds potential output. Potential output exceeds actual aggregate output. Actual aggregate output roughly equals potential output. This figure shows the performance of actual and potential output in the United States from 1990 to 2011. The orange line shows estimates of U. potential output, produced by the Congressional Budget Office, and the blue line shows actual aggregate output. The purple-shaded years are periods in which actual aggre- gate output fell below potential output, and the green-shaded years are periods in which actual aggregate output exceeded potential output. As shown, significant shortfalls occurred in the recessions of the early 1990s and after 2000. Actual aggregate output was significantly above potential output in the boom of the late 1990s, and a huge shortfall occurred after the recession of 2007–2009. Sources: Congressional Budget Office; Bureau of Economic Analysis.
C H A P T E R 1 2 A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY 359 are scarce, nominal wages will fall over time, shifting the short-run aggregate supply curve gradually to the right. Eventually it will be in a new position, such as SRAS 2. We’ll see shortly that these shifts of the short-run aggregate supply curve will return the economy to potential output in the long run.
####### ECONOMICS ➤ IN ACTION
PRICES AND OUTPUT DURING THE GREAT DEPRESSION
F
igure 12-10 shows the actual track of the aggregate price level, as measured by the GDP deflator, and real GDP, from 1929 to 1942. As you can see, aggregate output and the aggregate price level fell together from 1929 to 1933 and rose together from 1933 to 1937. This is what we’d expect to see if the economy was mov- ing down the short-run aggregate supply curve from 1929 to 1933 and moving up it (with a brief reversal in 1937–1938) thereafter. But even in 1942 the aggregate price level was still lower than it was in 1929; yet real GDP was much higher. What happened? The answer is that the short- run aggregate sup- ply curve shifted to the right over time. This shift partly reflected rising productivity—a rightward shift of the underlying long- run aggregate supply curve. FIGURE 12-9 From the Short Run to the Long Run YP Y 1 Real GDP P 1 Aggregate price level SRAS 2 LRAS SRAS 1 A 1 A rise in nominal wages shifts SRAS leftward. Y 1 YP Real GDP P 1 Aggregate price level LRAS SRAS 1 SRAS 2 A 1 A fall in nominal wages shifts SRAS rightward. (a) Leftward Shift of the Short-Run Aggregate Supply Curve (b) Rightward Shift of the Short-Run Aggregate Supply Curve In panel (a), the initial short-run aggregate supply curve is SRAS 1. At the aggregate price level, P 1 , the quantity of aggregate output supplied, Y 1 , exceeds potential output, YP. Eventually, low unemployment will cause nominal wages to rise, leading to a leftward shift of the short-run aggregate supply curve from SRAS 1 to SRAS 2. In panel (b), the reverse happens: at the aggre- gate price level, P 1 , the quantity of aggregate output supplied is less than potential output. High unemploy- ment eventually leads to a fall in nominal wages over time and a rightward shift of the short-run aggregate supply curve. 11 10 9 8 7 Aggregate price level (GDP deflator, 2005 = 100) Real GDP (billions of 2005 dollars) 1942 1941 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 0 $600 700800900 1,0001,1001,2001,3001,4001,5001,6001,7001, FIGURE 12- Prices and Output During the Great Depression
360 P A R T 5 S H O R T - R U N E C O N O M I C F L U C T U AT I O N S But since the U. economy was producing below potential output and had high unemployment during this period, the rightward shift of the short- run aggregate supply curve also reflected the adjustment process shown in panel (b) of Figure 12-9. So the movement of aggregate output from 1929 to 1942 reflected both movements along and shifts of the short- run aggregate supply curve.
CHECK YOUR UNDERSTANDING 12-
- Determine the effect on short-run aggregate supply of each of the following events. Explain whether it represents a movement along the SRAS curve or a shift of the SRAS curve. a. A rise in the consumer price index (CPI) leads producers to increase output. b. A fall in the price of oil leads producers to increase output. c. A rise in legally mandated retirement benefits paid to workers leads producers to reduce output.
- Suppose the economy is initially at potential output and the quantity of aggregate output supplied increases. What information would you need to determine whether this was due to a movement along the SRAS curve or a shift of the LRAS curve? Solutions appear at back of book.
The AD–AS Model
F
rom 1929 to 1933, the U. economy moved down the short-run aggregate supply curve as the aggregate price level fell. In contrast, from 1979 to 1980 the U. economy moved up the aggregate demand curve as the aggregate price level rose. In each case, the cause of the movement along the curve was a shift of the other curve. In 1929–1933, it was a leftward shift of the aggregate demand curve—a major fall in consumer spending. In 1979–1980, it was a left- ward shift of the short-run aggregate supply curve—a dramatic fall in short-run aggregate supply caused by the oil price shock. So to understand the behavior of the economy, we must put the aggregate supply curve and the aggregate demand curve together. The result is the AD–AS model, the basic model we use to understand economic fluctuations.
Short-Run Macroeconomic Equilibrium
We’ll begin our analysis by focusing on the short run. Figure 12-11 shows the aggregate demand curve and the short-run aggregate supply curve on the same diagram. The point at which the AD and SRAS curves intersect, ESR, is the short- run macroeconomic equilibrium: the point at which the quantity of aggregate output supplied is equal to the quantity demanded by domestic households, busi- nesses, the government, and the rest of the world. The aggregate price level at ESR, PE, is the short-run equilibrium aggregate price level. The level of aggregate output at ESR , YE, is the short-run equilibrium aggregate output. In the supply and demand model of Chapter 3 we saw that a shortage of any individual good causes its market price to rise but a surplus of the good causes its market price to fall. These forces ensure that the market reaches equilib- rium. The same logic applies to short-run macroeconomic equilibrium. If the aggregate price level is above its equilibrium level, the quantity of aggregate output supplied exceeds the quantity of aggregate output demanded. This leads to a fall in the aggregate price level and pushes it toward its equilibrium level. If
• The aggregate supply curve illus-
trates the relationship between the aggregate price level and the quan- tity of aggregate output supplied.
• The short-run aggregate supply
curve is upward sloping: a higher aggregate price level leads to higher aggregate output given that nominal wages are sticky.
• Changes in commodity prices, nomi-
nal wages, and productivity shift the short-run aggregate supply curve.
• In the long run, all prices are flexible,
and changes in the aggregate price level have no effect on aggregate out- put. The long-run aggregate supply curve is vertical at potential output.
• If actual aggregate output exceeds
potential output, nominal wages even- tually rise and the short-run aggregate supply curve shifts leftward. If poten- tial output exceeds actual aggregate output, nominal wages eventually fall and the short-run aggregate supply curve shifts rightward.
Quick Review
In the AD–AS model, the aggregate supply curve and the aggregate demand curve are used together to analyze economic fluctuations. The economy is in short-run macroeconomic equilibrium when the quantity of aggregate output supplied is equal to the quantity demanded. The short-run equilibrium aggregate price level is the aggregate price level in the short-run macroeconomic equilibrium. Short-run equilibrium aggregate output is the quantity of aggregate output produced in the short-run macroeconomic equilibrium.
Trisem 252022-23 BMT6111 TH VL2022230300008 Reference Material II 15-11-2022 AD AS 2
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