Aggregate Demand and Aggregate

33 Supply

PRINCIPLES OF

ECONOMICS
FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

In this chapter, look for the answers to
these questions:
 What are economic fluctuations? What are their
characteristics?
 How does the model of aggregate demand and
aggregate supply explain economic fluctuations?
 Why does the Aggregate-Demand curve slope
downward? What shifts the AD curve?
 What is the slope of the Aggregate-Supply curve
in the short run? In the long run?
What shifts the AS curve(s)?
CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 2
 Introduction
 Over the long run, real GDP grows about
3% per year on average.

 In the short run, GDP fluctuates around its trend.

• recessions: periods of falling real incomes
and rising unemployment
• depressions: severe recessions (very rare)

 Short-run economic fluctuations are often called

business cycles.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 3

 Three Facts About Economic Fluctuations
FACT
FACT 1:
1: Economic
Economic fluctuations
fluctuations are
are
irregular
irregular and
and unpredictable.
unpredictable.
$ 11,000
10,000 U.S.
U.S. real
real GDP,
GDP,
9,000 billions
billions of
of 2000
2000 dollars
dollars
8,000
7,000
6,000
The
The shaded
shaded
5,000
bars
bars are
are
4,000 recessions
recessions
3,000
2,000
1965 1970 1975 1980 1985 1990 1995 2000 2005
 Three Facts About Economic Fluctuations
FACT
FACT 2:
2: Most
Most macroeconomic
macroeconomic
quantities
quantities fluctuate
fluctuate together.
together.
$ 1,800

1,600 Investment
Investment spending,
spending,
1,400 billions
billions of
of 2000
2000 dollars
dollars
1,200
1,000
800
600
400
200
1965 1970 1975 1980 1985 1990 1995 2000 2005
Three Facts About Economic Fluctuations
FACT
FACT 3:
3: As
As output
output falls,
falls,
unemployment
unemployment rises.
rises.
12
Unemployment
Unemployment rate,
rate,
10
percent
percent of
of labor
labor force
force
8

0
1965 1970 1975 1980 1985 1990 1995 2000 2005
 Introduction, continued
 Explaining these fluctuations is difficult, and the
theory of economic fluctuations is controversial.
 Most economists use the model of
aggregate demand and aggregate supply
to study fluctuations.
 This model differs from the classical economic
theories economists use to explain the long run.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 7

 Classical Economics—A Recap
 The previous chapters are based on the ideas of
classical economics, especially:

 The Classical Dichotomy, the separation of

variables into two groups:
• real – quantities, relative prices
• nominal – measured in terms of money
 The neutrality of money:
Changes in the money supply affect nominal but
not real variables.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 8

 Classical Economics—A Recap
 Most economists believe classical theory
describes the world in the long run,
but not the short run.
 In the short run, changes in nominal variables
(like the money supply or P ) can affect
real variables (like Y or the u-rate).
 To study the short run, we use a new model.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 9

 The Model of Aggregate Demand and
Aggregate Supply
P
The price
level
SRAS

“Short-Run
The model P1 Aggregate
determines the Supply”
eq’m price level “Aggregate
Demand” AD

and the eq’m Y

Y1
level of output
(real GDP). Real GDP, the
quantity of output
CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 10
 The Aggregate-Demand (AD) Curve

P
The AD curve
shows the P2
quantity of
all g&s
demanded
in the economy P1
at any given AD
price level.
Y
Y2 Y1

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 11

 Why the AD Curve Slopes Downward
Y = C + I + G + NX P
C, I, G, NX are
the components P2
of agg. demand.
Assume G fixed
by govt policy.
P1
To understand
AD
the slope of AD,
must determine Y
how a change in P Y2 Y1
affects C, I, and NX.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 12

 The Wealth Effect (P and C )
 Suppose P rises.
 The dollars people hold buy fewer g&s,
so real wealth is lower.
 People feel poorer, so they spend less.
 Thus, an increase in P causes a fall in C
…which means a smaller quantity of g&s
demanded.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 13

 The Interest-Rate Effect (P and I )
 Suppose P rises.
 Buying g&s requires more dollars.
 To get these dollars, people sell some of their bonds
or other assets, which drives up interest rates.
…which increases the cost of borrowing to fund
investment projects.
 Thus, an increase in P causes a decrease in I
…which means a smaller quantity of g&s demanded.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 14

The Exchange-Rate Effect (P and NX )
 Suppose P rises.
 Interest rates go up (the interest-rate effect).
 U.S. bonds more attractive relative to foreign bonds.
 Foreign investors purchase more U.S. bonds,
but first must convert their currency into $
…which appreciates the U.S. exchange rate.
 Makes U.S. exports more expensive to people
abroad, imports cheaper to U.S. residents.
 Thus, an increase in P causes a decrease in NX
…which means a smaller quantity of g&s
demanded.
15
The Slope of the AD Curve: Summary
An increase in P P
reduces the quantity
of g&s demanded P2
because:
• the wealth effect
(C falls)
P1
• the interest-rate
AD
effect (I falls)
• the exchange-rate Y2 Y1
Y
effect (NX falls)

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 16

 Why the AD Curve Might Shift
Any event that changes
C, I, G, or NX P
– except a change in P –
will shift the AD curve.

Example: P1
A stock market boom
makes households feel
wealthier, C rises, AD2
the AD curve shifts right. AD1
Y
Y1 Y2

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 17

 AD Shifts Arising from Changes in C
 people decide to save more:
C falls, AD shifts left
 stock market crash:
C falls, AD shifts left
 tax cut:
C rises, AD shifts right

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 18

 AD Shifts Arising from Changes in I
 Firms decide to upgrade their computers:
I rises, AD shifts right
 Firms become pessimistic about future demand:
I falls, AD shifts left
 Central bank uses monetary policy to reduce
interest rates:
I rises, AD shifts right
 Investment Tax Credit or other tax incentive:
I rises, AD shifts right

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 19

 AD Shifts Arising from Changes in G
 Congress increases spending on homeland
security:
G rises, AD shifts right
 State govts cut spending on road construction:
G falls, AD shifts left

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 20

 AD Shifts Arising from Changes in NX
 A boom overseas increases foreign demand for
our exports:
NX rises, AD shifts right
 International speculators cause exchange rate to
appreciate:
NX falls, AD shifts left

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 21

A C T I V E L E A R N I N G 1:
Exercise
Try this without looking at your notes.
What happens to the AD curve in each of the
following scenarios?
A. A ten-year-old investment tax credit expires.
B. The U.S. exchange rate falls.
C. A fall in prices increases the real value of
consumers’ wealth.
D. State governments replace their sales taxes
with new taxes on interest, dividends, and
capital gains.
22
A C T I V E L E A R N I N G 1:
Answers
A. A ten-year-old investment tax credit expires.
I falls, AD curve shifts left.
B. The U.S. exchange rate falls.
NX rises, AD curve shifts right.
C. A fall in prices increases the real value of
consumers’ wealth.
Move down along AD curve (wealth-effect).
D. State governments replace sales taxes with new
taxes on interest, dividends, and capital gains.
C rises, AD shifts right.
23
 The Aggregate-Supply (AS) Curves

The AS curve shows P LRAS

the total quantity of
g&s firms produce SRAS
and sell at any given
price level.
In the short run,
AS is
upward-sloping.
In the long run, Y
AS is vertical.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 24

The Long-Run Aggregate-Supply Curve (LRAS)

The natural rate of P LRAS

output (YN) is the
amount of output
the economy produces
when unemployment
is at its natural rate.
YN is also called
potential output
or Y
full-employment YN
output.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 25

 Why LRAS Is Vertical
YN depends on the P LRAS
economy’s stocks of
labor, capital, and
natural resources,
and on the level of P2
technology.
P1
An increase in P
does not affect
any of these,
Y
so it does not YN
affect YN.
(Classical dichotomy)
CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 26
 Why the LRAS Curve Might Shift

P LRAS1 LRAS2
Any event that
changes any of the
determinants of YN
will shift LRAS.
Example:
Immigration
increases L,
causing YN to rise.
Y
YN Y’N

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 27

 LRAS Shifts Arising from Changes in L
 The Baby Boom generation retires:
L falls, LRAS shifts left
 New govt policies reduce the natural rate of
unemployment:
the % of the labor force normally employed
rises, LRAS shifts right

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 28

 LRAS Shifts Arising from Changes in
Physical or Human Capital
 Investment in factories or equipment:
K rises, LRAS shifts right
 More people get college degrees:
Human capital rises, LRAS shifts right
 Earthquakes or hurricanes destroy factories:
K falls, LRAS shifts left

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 29

 LRAS Shifts Arising from Changes in
Natural Resources
 A change in weather patterns makes farming
more difficult:
LRAS shifts left
 Discovery of new mineral deposits:
LRAS shifts right
 Reduction in supply of imported oil or other
resources:
LRAS shifts right

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 30

 LRAS Shifts Arising from Changes in
Technology
 Technological advances allow more output to be
produced from a given bundle of inputs:
LRAS shifts right.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 31

 Using AD & AS to Depict LR Growth and
Inflation
LRAS2000
Over the long run, P LRAS1990
tech. progress shifts LRAS1980
LRAS to the right
and growth in the P2000
money supply shifts
P1990
AD to the right.
AD2000
P1980
Result:
ongoing inflation AD1990
and growth in AD1980
Y
output. Y1980 Y1990 Y2000

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 32

 Short Run Aggregate Supply (SRAS)

The SRAS curve P

is upward sloping:
SRAS
Over the period
of 1-2 years, P2
an increase in P
causes an P1
increase in the
quantity of g & s
supplied.
Y
Y1 Y2

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 33

 Why the Slope of SRAS Matters

P LRAS
If AS is vertical,
fluctuations in AD Phi
SRAS
do not cause Phi
fluctuations in output
or employment.
ADhi
Plo
If AS slopes up,
then shifts in AD AD1
Plo
do affect output ADlo
Y
and employment. Ylo Y1 Yhi

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 34

 Three Theories of SRAS
In each,
• some type of market imperfection
• result:
Output deviates from its natural rate
when the actual price level deviates
from the price level people expected.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 35

 Three Theories of SRAS
P

SRAS
When P > PE

the expected
PE
price level

When P < PE

Y
YN
Y < YN Y > YN

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 36

 1. The Sticky-Wage Theory
 Imperfection:
Nominal wages are sticky in the short run,
they adjust sluggishly.
• Due to labor contracts, social norms.
 Firms and workers set the nominal wage in
advance based on PE, the price level they
expect to prevail.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 37

 1. The Sticky-Wage Theory
 If P > PE,
revenue is higher, but labor cost is not.
Production is more profitable,
so firms increase output and employment.
 Hence, higher P causes higher Y,
so the SRAS curve slopes upward.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 38

 2. The Sticky-Price Theory
 Imperfection:
Many prices are sticky in the short run.
• Due to menu costs, the costs of adjusting
prices.
• Examples: cost of printing new menus,
the time required to change price tags.
 Firms set sticky prices in advance based
on PE.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 39

 2. The Sticky-Price Theory
 Suppose the Fed increases the money supply
unexpectedly. In the long run, P will rise.
 In the short run, firms without menu costs can
raise their prices immediately.
 Firms with menu costs wait to raise prices.
Meantime, their prices are relatively low,
which increases demand for their products,
so they increase output and employment.
 Hence, higher P is associated with higher Y,
so the SRAS curve slopes upward.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 40

 3. The Misperceptions Theory
 Imperfection:
Firms may confuse changes in P with changes
in the relative price of the products they sell.
 If P rises above PE, a firm sees its price rise
before realizing all prices are rising.
The firm may believe its relative price is rising,
and may increase output and employment.
 So, an increase in P can cause an increase in Y,

making the SRAS curve upward-sloping.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 41

 What the 3 Theories Have in Common:
Each of the 3 theories implies Y deviates from YN
when P deviates from PE.

Y = YN + a (P – PE)
Output Expected
price level
Natural rate
of output
a > 0,
measures Actual
(long-run) price level
how much Y
responds to
unexpected
changes in P

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 42

 SRAS and LRAS
 The imperfections in these theories are
temporary. Over time,
• sticky wages and prices become flexible
• misperceptions are corrected
 In the LR,
• PE = P
• AS curve is vertical

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 43

 SRAS
and LRAS Y = YN + a (P – PE)

P LRAS

In the long run, SRAS

PE = P
and PE
Y = YN.

Y
YN
CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 44
 Why the SRAS Curve Might Shift
Everything that shifts
LRAS shifts SRAS, too.
P LRAS
Also, PE shifts SRAS: SRAS
SRAS
If PE rises,
workers & firms set PE
higher wages.
PE
At each P,
production is less
profitable, Y falls,
SRAS shifts left. Y
YN

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 45

 The Long-Run Equilibrium

In the long-run P LRAS

equilibrium,
SRAS
PE = P,
Y = YN ,
PE
and unemployment
is at its natural rate.
AD
Y
YN

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 46

 Economic Fluctuations
 Caused by events that shift the AD and/or
AS curves.
 Four steps to analyzing economic fluctuations:
1. Determine whether the event shifts AD or AS.
2. Determine whether curve shifts left or right.
3. Use AD-AS diagram to see how the shift
changes Y and P in the short run.
4. Use AD-AS diagram to see how economy
moves from new SR eq’m to new LR eq’m.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 47

 The Effects of a Shift in AD
Event: stock market crash
1. affects C, AD curve P LRAS
2. C falls, so AD shifts left SRAS1
3. SR eq’m at B.
P and Y lower, P1 A SRAS2
unemp higher
P2 B
4. Over time, PE falls, AD1
SRAS shifts right, P3 C
until LR eq’m at C. AD2
Y and unemp back Y
Y2 YN
at initial levels.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 48

 Two Big AD Shifts:
1. The Great Depression
From 1929-1933, U.S. Real GDP,
billions of 2000 dollars
• money supply fell 900
28% due to problems 850
in banking system 800

• stock prices fell 90%, 750

700
reducing C and I
650
• Y fell 27%
600
• P fell 22% 550
•

1932

1933

1934
1929

1930

1931
unemp rose
from 3% to 25%
CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 49
 Two Big AD Shifts:
2. The World War II Boom
U.S. Real GDP,
From 1939-1944,
billions of 2000 dollars
• govt outlays rose 2,000

from $9.1 billion 1,800

to $91.3 billion 1,600

• Y rose 90% 1,400

• P rose 20% 1,200

• unemp fell 1,000

from 17% to 1% 800

1941

1943
1939

1940

1942

1944
CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 50
A C T I V E L E A R N I N G 2:
Exercise
 Draw the AD-SRAS-LRAS diagram
for the U.S. economy,
starting in a long-run equilibrium.
 A boom occurs in Canada.
Use your diagram to determine
the SR and LR effects on U.S. GDP,
the price level, and unemployment.

51
A C T I V E L E A R N I N G 2:
Answers
Event: boom in Canada
P LRAS
1. affects NX, AD curve SRAS2

2. shifts AD right
3. SR eq’m at point B. P3 C SRAS1
P and Y higher, P2 B
unemp lower
P1 A AD2
4. Over time, PE rises,
SRAS shifts left, AD1
until LR eq’m at C. Y
YN Y2
Y and unemp back
at initial levels.
52
 The Effects of a Shift in SRAS
Event: oil prices rise
1. increases costs, P LRAS
shifts SRAS
(assume LRAS constant) SRAS2
2. SRAS shifts left SRAS1
3. SR eq’m at point B. B
P2
P higher, Y lower,
unemp higher P1 A
From A to B,
stagflation, AD1
a period of Y
falling output Y2 YN
and rising prices.
CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 53
Accommodating an Adverse Shift in SRAS
If policymakers do nothing,
4. Low employment P LRAS
causes wages to fall, SRAS2
SRAS shifts right,
until LR eq’m at A. P3 C SRAS1
B
Or, policymakers P2
could use fiscal or P1 A
monetary policy to AD2
increase AD and
AD1
accommodate the AS
Y
shift: Y2 YN
Y back to YN, but
PCHAPTER
permanently higher.
33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 54
The 1970s Oil Shocks and Their Effects

1973-75 1978-80

Real oil prices + 138% + 99%

CPI + 21% + 26%

Real GDP – 0.7% + 2.9%

# of unemployed + 3.5 + 1.4

persons million million

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 55

 John Maynard Keynes, 1883-1946
• The General Theory of Employment,
Interest, and Money, 1936
• Argued recessions and depressions
can result from inadequate demand;
policymakers should shift AD.
• Famous critique of classical theory:
The long run is a misleading guide
to current affairs. In the long run,
we are all dead. Economists set themselves
too easy, too useless a task if in tempestuous seasons
they can only tell us when the storm is long past,
the ocean will be flat.
CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 56
 CONCLUSION
 This chapter has introduced the model of
aggregate demand and aggregate supply,
which helps explain economic fluctuations.
 Keep in mind: these fluctuations are deviations
from the long-run trends explained by the
models we learned in previous chapters.
 In the next chapter, we will learn how
policymakers can affect aggregate demand
with fiscal and monetary policy.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 57

CHAPTER SUMMARY
 Short-run fluctuations in GDP and other
macroeconomic quantities are irregular and
unpredictable. Recessions are periods of falling real
GDP and rising unemployment.
 Economists analyze fluctuations using the model of
aggregate demand and aggregate supply.
 The aggregate demand curve slopes downward
because a change in the price level has a wealth effect
on consumption, an interest-rate effect on investment,
and an exchange-rate effect on net exports.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 58

CHAPTER SUMMARY
 Anything that changes C, I, G, or NX
– except a change in the price level –
will shift the aggregate demand curve.
 The long-run aggregate supply curve is vertical,
because changes in the price level do not affect
output in the long run.
 In the long run, output is determined by labor,
capital, natural resources, and technology;
changes in any of these will shift the
long-run aggregate supply curve.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 59

CHAPTER SUMMARY
 In the short run, output deviates from its natural
rate when the price level is different than
expected, leading to an upward-sloping short-run
aggregate supply curve. The three theories
proposed to explain this upward slope are the
sticky wage theory, the sticky price theory, and the
misperceptions theory.
 The short-run aggregate-supply curve shifts in
response to changes in the expected price level
and to anything that shifts the long-run aggregate
supply curve.
CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 60
CHAPTER SUMMARY
 Economic fluctuations are caused by shifts in
aggregate demand and aggregate supply.
 When aggregate demand falls, output and the
price level fall in the short run. Over time, a
change in expectations causes wages, prices, and
perceptions to adjust, and the short-run aggregate
supply curve shifts rightward. In the long run, the
economy returns to the natural rates of output and
unemployment, but with a lower price level.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 61

CHAPTER SUMMARY
 A fall in aggregate supply results in stagflation –
falling output and rising prices.
Wages, prices, and perceptions adjust over time,
and the economy recovers.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 62