The big picture marcoeconomics 12e parkin chapter 10

Long-Run Aggregate Supply the relationship between the quantity of real GDP supplied and the price level in the long run when real GDP equals potential GDP.. Short-Run Aggregate Supply

W H AT I S E C O N O M I C S ? 8 5

T h e B i g P i c t u r e

Where we have been:

This chapter provides the work horse model, the aggregate supply-aggregate demand model, used to explore answers to the questions about short-run macroeconomic issues The chapter uses the fact established in Chapter 4,

that expenditure equals C + I + G + (X – M), to explain the forces that

determine aggregate demand It also draws on Chapter 3, demand and supply, for the crucial concepts of equilibrium and the distinction between shifts and movements along demand and supply curves

Where we are going:

This chapter provides a description of the AS-AD model The treatment

parallels that of the demand and supply model in Chapter 3 That is, the curves are defined and the reasons for their slopes and the factors that shift them are explained But the curves are not formally derived The next chapter more formally derives the aggregate demand curve from the aggregate expenditure curve It lays out the aggregate expenditure model, explains the multiplier effect of changes in investment, describes the adjustment process

that moves the economy toward the AD curve, and derives the AD curve from the AE equilibrium Then Chapters 12, 13, and 14 make use of the aggregate

supply-aggregate supply framework to explore business cycles and inflation, fiscal policy, and monetary policy

N e w i n t h e Tw e l f t h E d i t i o n

All the data are updated through 2014 and a discussion of the World Economy Headwinds in Economics in Action has been added The Economics In The News feature has a 2014 article about stronger than expected rebound in the U.S

economy, which applies the AD-AS model The Worked Problem presents

aggregate demand and short-run aggregate supply schedules and then asks the

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AGGREGATE SUPPLY AND AGGREGATE

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short-run equilibrium real GDP and price level It also asks the effect of an

increase in aggregate demand The solutions to the problems use both the

aggregate demand and short-run aggregate supply schedules and an AD-SAS

figure To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications These problems are in the MyEconLab and are called Extra Problems

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L e c t u r e N o t e s

Aggregate Supply and Aggregate Demand

 The aggregate supply-aggregate demand (AS-AD) model explains how real GDP and

the price level are determined

 The model also helps explains the factors that determine inflation and the business cycle

Tell students that there is heated debate among economists on the most important

influences in the macro economy and how to model those influences Economists as a

group are ambivalent about the aggregate supply-aggregate demand (AS-AD) model Real

business cycle theorists, who like to build their models from the base of production

functions and preferences, don’t use the model because the AS and AD curves are not independent Technological change shifts both the AS and AD curves simultaneously and in

complicated ways New Keynesian economists have dropped the model in favor of a

dynamic variant that places the inflation rate on the y-axis and the output gap (real GDP minus potential GDP as a percentage of potential GDP) on the x-axis Despite the

controversy, the AS-AD model is the key macroeconomic model for most economists The

model plays a similar role in the organization of the macroeconomics to that played by the

demand and supply model in microeconomics The author does a good job of using the

AS-AD model to explain various schools of thought.

The AS-AD model is the best model currently available for introducing students to

macroeconomics It enables them to gain insights into the way the economy works, to organize their study of the subject, and to understand the debates surrounding the effects

of policies designed to improve macroeconomic performance

Devoting at least a week of lecture time to the AS-AD model is worthwhile Your goal at this point in the course is to help them understand the components of the model intuitively and

to put the model to work using some of its more simple and obvious features

I Aggregate Supply

The quantity of real GDP supplied is the total quantity of goods and services, valued in constant dollar prices, that firms plan to produce in a given time period This amount depends on the quantity of labor employed, the capital stock, and the state of

technology In the short run, only the quantity of labor can vary, so fluctuations in employment lead to changes in real GDP

Long-Run Aggregate Supply

the relationship between the quantity of

real GDP supplied and the price level in

the long run when real GDP equals

potential GDP As illustrated in the figure,

the LAS curve is vertical at the level of

potential GDP ($13 trillion in the figure),

showing that potential GDP does not

depend on the specific price level

 In the long run, the wage rate and other

resource prices change in proportion to

the price level So moving along the LAS

curve both the price level and the money

wage rate change by the same

percentage

Short-Run Aggregate Supply

 The short-run aggregate supply curve is the relationship between the quantity

of real GDP supplied and the price level in the short run when the money wage rate, the prices of other resources, and potential GDP remain constant

 As illustrated in the figure, the SAS curve is upward sloping This slope reflects that a

higher price level combined with a fixed money wage rate, lowers the real wage rate, thereby increasing the quantity of labor firms employ and hence increasing the real GDP firms produce

Difference between LAS and SAS: The distinction between the LAS and the SAS comes

about by assuming that resource and output prices adjust at different rates Ask the class,

“When there is an increase in demand, what do you think adjusts first, prices of goods on

the shelves at Wal-Mart or wages of employees at Wal-Mart?” By discussing out the

potential lag times in resource price adjustment, you have opened up a hotly contested

item among economists How long is that lag time? Tell the students that there are different schools of thought about this issue and during the term we will see how different

assumptions yield different answers

Movements Along the LAS and SAS Curves and Changes in Aggregate Supply

Movements Along the Curves

 When the price level, the money wage rate, and other resource prices change by the same percentage, real GDP remains at potential GDP and there is a movement along

the LAS curve.

 When the price level changes and the money wage rate and other resource prices

remain constant, real GDP departs from potential GDP and there is a movement

along the SAS curve.

Shifts in the Curves

 When potential GDP increases, both long-run and short-run aggregate supply

increase and the LAS and SAS curves shift rightward Potential GDP increases when

the full employment quantity of labor increases, the quantity of capital increases, or technology advances

 Short-run aggregate supply changes and the SAS curve shifts when there is a

change in the money wage rate or other resource prices A rise in the money wage

rate or other resource prices decreases short-run aggregate supply and shifts the SAS

curve leftward

The flavor of the Classical-Keynesian controversy If you want to convey the flavor of

one of the biggest controversies in macroeconomics, you can do so at this early stage of

the course by using only the aggregate supply curves The difference between the

upward-sloping SAS and the vertical LAS lies at the core of the disagreement between Classical

economists who believe that wages and prices are highly flexible and adjust rapidly and

Keynesian economists who believe that the money wage rate in particular adjusts very

slowly

Along the SAS curve: You cannot repeat yourself too many times about this topic:

Moving along the SAS curve, resource prices are fixed Point out that this is the same

assumption for the “micro” supply curve In particular, if there is an increase in the money wage rate at the Pepsi plant, the supply curve for Pepsi shifts leftward That same principle

gets applied to all goods and services in the AS-AD model so an increase in the money

wage rate shifts the SAS curve leftward.

Along the LAS curve: Students seem comfortable with the idea that the SAS curve has a

positive slope but they seem less at ease with the vertical LAS curve Emphasize (as the

textbook does) the crucial idea that along the LAS curve two sets of prices are changing —

the prices of output and the prices of resources, especially the money wage rate Once they get this point, students quickly catch on to the result that firms won’t be motivated to

change their production levels along the LAS curve The vertical LAS curve is both vital and

difficult and class time spent on this concept is well justified Though you do not “need” to

emphasize this point, what the LAS curve illustrates is that the real economy is

independent of money prices!

II Aggregate Demand

 The quantity of real GDP demanded is the sum of consumption expenditure (C), investment (I), government expenditure (G), and net exports (X  M), or Y = C + I +

G + (X  M).

 Buying plans depend on many factors including:

 The price level

 Expectations

 Fiscal policy and monetary policy

 The world economy

The Aggregate Demand Curve

 Other things remaining the same, the higher

the price level, the smaller is the quantity of

real GDP demanded The relationship

between the quantity of real GDP demanded

and the price level is called aggregate

demand As the figure shows, the AD curve

is downward sloping

 The negative relationship between the

price level and the quantity of real GDP

demanded reflects the wealth effect

(when the price level rises, real wealth

decreases and so people decrease

consumption) and substitution effects

(first, the intertemporal substitution

effect: when the price level rises, real money decreases and the interest rates rises so that consumption expenditure and investment decrease; and, second, the international price substitution effect: when the price level rises, domestic goods become more expensive relative to foreign goods so people decrease the quantity of domestic goods demanded)

Keep it simple You know that the AD curve is a subtle object—an equilibrium relationship

derived from simultaneous equilibrium in the goods market and the money market This

description of the AD curve is not helpful to students in the principles course and is a topic

for the intermediate macro course At the same time that we want to simplify the

aggregate demand story, we also want to avoid being misleading The textbook walks that fine line, and we suggest that you stick closely to the textbook treatment and don’t try to convey the more subtle aspects of aggregate demand

A major problem with the AD curve is that a change in the price level that brings a

movement along the curve is not a strict ceteris paribus event A change in the price level

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changes the quantity of real money, which changes the interest rate Indeed, this chain of

events is one of the reasons for the negative slope of the AD curve In telling this story, we must be sensitive to the fact that the students don’t totally appreciate the ceteris paribus

condition We must provide intuition with stories such as the Maria stories in the textbook

Income equals expenditure on the AD curve Some instructors want to emphasize a

second and more subtle violation of ceteris paribus, that along the AD curve, aggregate

planned expenditure equals real GDP That is, the AD curve is not drawn for a given level of

income but for the varying level of income that equals the level of planned expenditure If

you want to make this point when you first introduce the AD curve, you must cover the AE

model in the next chapter before you cover this chapter (The material is written in a way

that permits this change of order.) If you do not want to derive the AD curve from the

equilibrium of the AE model, don’t even mention what’s going on with income along the AD

curve Silence is vastly better than confusion You can pull this rabbit out of the hat when

you get to the next chapter if you’re covering the material in the order presented in the

textbook

Changes in Aggregate Demand

 Any factor that influences buying plans other than the price level brings a change in aggregate demand and a shift in the aggregate demand curve Factors that change aggregate demand are:

 Expectations: Expectations of higher future income, expectations of higher future inflation, and expectations of higher future profits increase aggregate demand

and shift the AD curve rightward.

 Fiscal policy and monetary policy: The government’s attempt to influence the

economy by setting and changing taxes, making transfer payments, and

purchasing goods and services is called fiscal policy Tax cuts or increased

transfer payments increase disposable income (aggregate income minus tax

payments plus transfers) and thereby increase consumption expenditure and

aggregate demand Increased government expenditures increase aggregate

demand Monetary policy consists of changes in interest rates and in the

quantity of money in the economy An increase in the quantity of money and

lower interest rates increase aggregate demand

 The world economy: Exchange rates and foreign income affect net exports (X 

M) and, therefore, aggregate demand A decrease in the exchange rate or an

increase in foreign income increases aggregate demand

III Explaining Macroeconomic Trends and Fluctuations

Short-Run and Long-Run Macroeconomic Equilibrium

demanded equals the quantity of real GDP supplied This equilibrium is determined

where the AD and SAS curves intersect.

 If the quantity of real GDP supplied exceeds the quantity demanded, inventories pile up so that firms will cut production and prices

 If the quantity of real demanded exceeds the quantity supplied, inventories are

depleted so that firms will increase production and prices

Short-run macroeconomic equilibrium Emphasize that in short-run macroeconomic

equilibrium, firms are producing the quantities that maximize profit and everyone is

spending the amount that they want to spend Describe the convergence process using the mechanism laid out in the textbook In that process, firms always produce the

profit-maximizing quantities—the economy is on the SAS curve If they can’t sell everything they

produce, firms lower prices and cut production Similarly, they can’t keep up with sales and

inventories are falling, firms raise prices and increase production These adjustment

processes continues until firms are selling their profit-maximizing output

occurs when real GDP equals potential GDP—

equivalently, as the figure shows, when the

economy is on its long-run aggregate supply

curve The figure shows the long-run

macroeconomic equilibrium at a real GDP of

$16 trillion and a price level of 110

From the short run to the long run Explain that market forces move the money wage

rate to the long-run equilibrium level At money wage rates below the long-run equilibrium level, there is a shortage of labor, so the money wage rate rises and employment

decreases At money wage rates above the long-run equilibrium level, there is a surplus of labor, so the money wage rate falls and employment increases At the long-run equilibrium money wage rate, there is neither a shortage nor a surplus of labor and the money wage rate remains constant and employment is constant at its full employment level

Economic Growth and Inflation

 Economic growth occurs when potential GDP increases so that the LAS curve shifts

rightward

 Inflation occurs when the AD curve continually shifts rightward at a faster rate than the LAS curve In the long run, only growth in the quantity of money makes the AD

curve continually shift rightward

The Business Cycle

The business cycle occurs because aggregate demand and aggregate supply fluctuate and the money wage rate does not adjust quickly enough to keep the economy at potential GDP

 A below full-employment equilibrium is a macroeconomic equilibrium in which

potential GDP exceeds real GDP The gap between real GDP and potential GDP is the

output gap With a below-full employment equilibrium, the gap is called a

recessionary gap A recessionary gap occurs when the SAS curve and the AD

curve intersect to the left of the LAS curve.

 An above full-employment equilibrium is a macroeconomic equilibrium in which

real GDP exceeds potential GDP The amount by which real GDP exceeds potential

GDP, the output gap, is called an inflationary gap An inflationary gap occurs

when the SAS curve and the AD curve intersect to the right of the LAS curve.

 A full-employment equilibrium is a macroeconomic equilibrium in which real GDP

equals potential GDP

 The figure below to the left shows a below-full employment equilibrium with a

recessionary gap of $1 trillion The figure on the right shows an above

full-employment equilibrium with an inflationary gap of $1 trillion

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Point out to the students that to simplify analysis of the business cycle, economists

typically abstract from the long-term persisting increases in the LAS curve and AD curve

that generate economic growth and inflation, respectively So, by fixing the LAS curve when

considering business cycle fluctuations, economists are looking at short-term movements

around a slower moving long-run equilibrium level of output Explain to the students that

one reason to abstract from these long-term movements is simply that the figures get very complicated if all the curves shift rather than just the immediately relevant ones A second

reason is the standard view that short-term movements around the LAS are driven by

different economic forces than the persisting long-run shifts in the LAS curve So

abstracting from long-term growth in order to focus on business cycle fluctuations

simplifies matters without any loss of relevant details

An Economics in Action feature discusses the

“World Economy Headwinds”—slowing real GDP

growth—that threaten to decrease U.S exports and

thereby leave a recessionary gap in the United

States

Fluctuations in Aggregate Demand

An increase in aggregate demand shifts the AD

curve rightward, as in the figure where the

aggregate demand curve shifts from AD0 to AD1 In

the short run, a rightward shift of the AD curve leads to movement along the SAS curve so

that both the price level and real GDP increase In the figure the economy moves from an

initial equilibrium at point a with real GDP equal to potential GDP of $16 trillion and a price level of 100 to point b with real GDP of $17 trillion and a price level of 105 But in the long

run, the higher price level and tight labor market lead to an increase in the money wage

rate Short-run aggregate supply decreases and the SAS curve shifts leftward, in the figure from SAS0 to SAS1 The long-run equilibrium is reached when the short-run aggregate supply has decreased enough so that the economy is back producing at potential GDP,

which in the figure occurs when the economy moves from b to point c In the long run, the

increase in aggregate demand has no effect on real GDP—it has returned to potential GDP,

$16 trillion in the figure and only results in a higher price level—which has risen from 100

to 110 in the figure

Shifting the SAS curve Reinforce the movement toward long-run equilibrium with a

curve-shifting exercise Take the case where the AD curve shifts rightward The fact that the initial equilibrium occurs where the new AD curve intersects the SAS curve is not difficult But the notion that the SAS curve shifts leftward as time passes is difficult for many

students The trick to making this idea clear is to spend enough time when initially

discussing the SAS so that the students realize that wages and other input prices remain constant along an SAS curve Once the students see this point, they can understand that,

as input prices increase in response to the higher level of (output) prices, the SAS curve

shifts leftward

Avoid confusing students by using “up” to correspond to a decrease in SAS But do point out that that when the SAS curve shifts leftward it is moving vertically upward, as input

prices rise to become consistent with potential GDP and the new long-run equilibrium price

level Most students find it easier to see why the SAS curve shifts leftward once they see

that rising input prices shift the curve vertically upward

In the figure above, instead of using identifying the short-run aggregate supply curve with

SAS0 you might use SASW=$10 with the explanation that along this SAS curve the money wage rate, W, is fixed at $10/hour Then, rather than label the new short-run aggregate supply curve SAS1, can identify it as SASW=$11 You can now show your students the

qualitative point that the money wage rate has increased and you can show them the quantitative point that the 10 percent increase in the price level (from 100 to 110) lead to

a 10 percent increase in the money wage rate

Fluctuations in Aggregate Supply

Some business cycle fluctuations are driven by shifts in short-run aggregate supply An

increase in energy prices decreases the short-run aggregate supply and shifts the SAS

curve leftward The price level increases and real GDP decreases The combination of

recession and higher inflation is called stagflation and occurred in the United States in the

1970s as a result of the oil price shocks

IV Macroeconomic Schools of Thought

There is a fair degree of consensus among mainstream economists about economic growth and inflation, although there is still immense debate about the business cycle The

importance of macroeconomic issues and the complexities of economic systems mean that there are strong incentives to speak knowledgeably about macroeconomics, but it is

difficult for most people to evaluate whether the speaker is truly knowledgeable or a

charlatan Mainstream economic theories are completely thought out and fully articulated Thus, one should be wary of anyone who confidently rejects that one of these mainstream theories as “just plain wrong.”

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The Classical View

 A classical macroeconomist believes that the economy is self-regulating and that it

is always at full employment A new classical view is that business cycle

fluctuations are the efficient responses of a well-functioning market economy that is bombarded by shocks that arise from the uneven pace of technological change

 The uneven pace of technological advancement are the main source of business

cycle fluctuations There is no distinct short-run aggregate supply curve because the economy is always producing at potential GDP

 Classical economists emphasize that taxes blunt people’s incentives to work, so the most the government should do to affect the business cycle is to keep taxes low

The Keynesian View

 A Keynesian macroeconomist believes that left alone, the economy would rarely

operate at full employment and that to achieve and maintain full employment,

active help from fiscal policy and monetary policy is required

 Aggregate demand fluctuations driven by changes in expectations (“animal spirits”) about business conditions and profits are the main source of business cycle

fluctuations Because money wages are sticky (slow to adjust), especially in the

downward direction, the economy can remain mired in a recession

 A modern version of the Keynesian view known as the new Keynesian view holds

that not only is the money wage rate sticky but that the prices of some goods and

services are also sticky

 Keynesians believe that fiscal policy and monetary policy should be used actively to stimulate demand to end recessions and restore full employment

Although Keynes agreed that the economy would return to its potential in the long run, he

stated, “In the long run, we are all dead” Keynes believed that because of the interaction

between financial markets, the price level, and the labor market, there was no inherent

tendency of the market system to return quick enough to potential GDP following an

aggregate demand shock The role of the government, in Keynes’ view, was not to replace

markets with central planning, but to use stabilization policies to help the macroeconomy

find equilibrium at potential GDP Keynes’ analogy was that market capitalism in the Great Depression was like a car with a broken alternator Fiscal policy would give the economy a

jump-start when aggregate demand was inadequate Keynes worried that without active

aggregate demand management, high unemployment would lead to a breakdown of

capitalism, with revolution leading to totalitarianism in the form of communism or fascism

The Monetarist View

 A monetarist macroeconomist believes that the economy is self-regulating and that

it will normally operate at full employment provided that monetary policy is not

erratic and that the pace of money growth is kept steady

 Aggregate demand fluctuations driven by monetary policy mistakes are the main

source of business cycle fluctuations

 There is a short-run aggregate supply curve because money wages are sticky

 The monetarist view of policy is that tax rates should be kept low and the quantity of money should be kept growing on a steady path Beyond these policies, however, the government should not undertake active stabilization policy

The Economics in the News detail discusses real GDP growth in the second quarter of 2014 This growth was more rapid than expected, which is analyzed in terms using the AD-AS

model