MacroEcomonics principles, application, and tools 7th edition by sullivan chapter 09

As the purchasing power of money changes, the aggregate demand curve is affected in three different ways: THE WEALTH EFFECT ● wealth effect The increase in spending that occurs because t

fails to grow and unemployment rises

2

What does the behavior of prices in consumer markets demonstrate about how quickly prices adjust in theU.S economy?

Measuring Price Stickiness in Consumer Markets

How can we determine what factors cause recessions?

Two Approaches to Determining the Causes of Recessions

Do changes in oil prices always hurt the U.S economy?

How the U.S Economy Has Coped with Oil Price Fluctuations

3

A P P L Y I N G T H E C O N C E P T S

● short run in macroeconomics

The period of time in which prices do not change or do not change very much

How Demand Determines Output in the Short Run

•For most firms, the biggest cost of doing business is wages If wages are sticky, firms’ overall costs will be sticky as well This means that firms’ product prices will remain sticky, too

•Sticky wages cause sticky prices and hamper the economy’s ability to bring demand and supply into balance in the short run

To analyze the behavior of retail prices, economist Anil Kashyap of the University

of Chicago examined prices in consumer catalogs

He looked at the prices of 12 selected goods from:

▪ L.L Bean

▪ Recreational Equipment, Inc (REI)

▪ The Orvis Company, Inc

The goods included shoes, blankets, chamois shirts, binoculars, and a fishing rod and fly

What did he find?

▪ Considerable price stickiness

▪ When prices did change, he observed a mixture of both large and small

APPLYING THE CONCEPTS #1: What does the behavior of prices

in consumer markets demonstrate about how quickly prices adjust

in the U.S economy?

● aggregate demand curve (AD)

A curve that shows the relationship between the level of prices and the quantity of real GDP demanded.

The Components of Aggregate Demand

 FIGURE 9.1

Aggregate Demand

The aggregate demand curve plots the total demand for real GDP as a function of the price level

The aggregate demand curve slopes downward, indicating that the quantity of aggregate

demand increases as the price level in the economy falls

As the purchasing power of money changes, the aggregate demand curve is

affected in three different ways:

THE WEALTH EFFECT

● wealth effect

The increase in spending that occurs because the real value of money increases when the price level falls

R E A L - N O M I N A L P R I N C I P L E

What matters to people is the real value of money or income—its purchasing power—not the face value of money or income.

Why the Aggregate Demand Curve Slopes Downward

THE INTEREST RATE EFFECT

THE INTERNATIONAL TRADE EFFECT

With a given supply of money in the economy, a lower price level will lead to

lower interest rates

With lower interest rates, both consumers and firms will find it cheaper to

borrow money to make purchases

As a consequence, the demand for goods in the economy (consumer

durables purchased by households and investment goods purchased by firms)

will increase

In an open economy, a lower price level will mean that domestic goods (goods

produced in the home country) become cheaper relative to foreign goods, so

the demand for domestic goods will increase

CHANGES IN TAXES

CHANGES IN GOVERNMENT SPENDING

CHANGES IN THE SUPPLY OF MONEY

An increase in the supply of money in the economy will increase aggregate

demand and shift the aggregate demand curve to the right

A decrease in taxes will increase aggregate demand and shift the aggregate

demand curve to the right

At any given price level, an increase in government spending will increase

aggregate demand and shift the aggregate demand curve to the right

Shifts in the Aggregate Demand Curve

ALL OTHER CHANGES IN DEMAND

 FIGURE 9.2

Shifting Aggregate Demand

Decreases in taxes, increases in

government spending, and an increase in

the supply of money all shift the aggregate

demand curve to the right.

Higher taxes, lower government spending,

and a lower supply of money shift the curve

to the left

 FIGURE 9.3

The Multiplier

Initially, an increase in desired

spending will shift the

aggregate demand curve

horizontally to the right from a

to b

The total shift from a to c will

be larger The ratio of the total

shift to the initial shift is

known as the multiplier

How the Multiplier Makes the Shift Bigger

The relationship between the level

of income and consumer spending

C = Ca + by

● autonomous consumption spending

The part of consumption spending that does not depend on income

● marginal propensity to consume (MPC)

The fraction of additional income that is spent

● marginal propensity to save (MPS)

The fraction of additional income that is saved

How the Multiplier Makes the Shift Bigger

multiplier

The Long-Run Aggregate Supply Curve

● aggregate supply curve (AS)

A curve that shows the relationship between the level of prices and the quantity of output supplied

● long-run aggregate supply curve

A vertical aggregate supply curve that represents the idea that in the long run, output is determined solely by the

factors of production

The Long-Run Aggregate Supply Curve

 FIGURE 9.4

Long-Run Aggregate Supply

In the long run, the level of

output, y p, is independent of the

price level

 FIGURE 9.5

Aggregate Demand and the

Long-Run Aggregate Supply

Output and prices are

determined at the intersection

The Short-Run Aggregate Supply Curve

● short-run aggregate supply curve

A relatively flat aggregate supply curve that represents the idea that prices do not change very much in the short run and that firms adjust production to meet demand.

 FIGURE 9.6

Aggregate Demand and

Short-Run Aggregate Supply

With a short-run aggregate

supply curve, shifts in

aggregate demand lead to

large changes in output but

small changes in price.

The Short-Run Aggregate Supply Curve

What factors determine the costs firms must incur to produce output? The key

factors are

• Input prices (wages and materials)

• The state of technology

• Taxes, subsidies, or economic regulations

Economists have used the basic framework of aggregate demand and supply

analysis to explain recessions Recessions can occur either when there is a sharp

decrease in demand or a decrease in aggregate supply

Economic historian Peter Temin looked at all recessions from 1893 to 1990 to

determine their causes He found, recessions were caused by many different

factors

• Sometimes, as in 1929, they were caused by shifts in aggregate demand from

the private sector, as consumers cut back their spending

• Other times, as in 1981, the government cut back on aggregate demand to

reduce inflation

• Supply shocks were the cause of the recessions in 1973 and 1979

• The most severe shock hit the U.S economy in 1931 and converted an

economic downturn into the Great Depression He believes that foreign monetary developments were the ultimate source of this shock to the U.S

During the 1970s, the world economy was hit with unfavorable supply shocks that

raised prices and lowered output, including spikes in oil prices

• Increases in oil prices shift the aggregate supply curve However, they also have an adverse effect on aggregate demand

• Because the United States is a net importer of foreign oil, an increase in oil prices is just like a tax that decreases the income of consumers

• An increase in taxes will shift the aggregate demand curve to the left

Between 1997 and 1998, the price of oil on the world market fell from $22 a barrel to less than $13 a barrel The result: gasoline prices adjusted for inflation were lower

than they had been in over 50 years

In 2008, oil prices shot up to $145 a barrel

• Reason: increased demand throughout the world, particularly in fast-growing countries such as China and India

U.S economy?

External events that shift the aggregate supply curve.

 FIGURE 9.7

Supply Shock

An adverse supply shock, such

as an increase in the price of oil,

will cause the AS curve to shift

upward

The result will be higher prices

and a lower level of output

 FIGURE 9.9

Adjusting to the

Long Run

With output exceeding

potential, the short-run

AS curve shifts

upward over time.

The economy adjusts

to the long-run

equilibrium at a1

Looking Ahead

•The aggregate demand and aggregate supply model in this chapter provides an

overview of how demand affects output and prices in both the short run and the

long run

•The next several chapters explore more closely how aggregate demand

determines output in the short run

aggregate demand curve (AD)

aggregate supply curve (AS)

autonomous consumption spending

consumption function

long-run aggregate supply curve

marginal propensity to consume (MPC)

marginal propensity to save (MPS)

multiplier short-run aggregate supply curve short run in macroeconomics stagflation

supply shocks wealth effect