LEARNING OBJECTIVES

LEARNING OBJECTIVES After studying this chapter, you should be able to: Explain how the aggregate demand curve is derived. 17.1 Explain how the aggregate supply curve is derived. 17.2 Demonstrate macroeconomic equilibrium using the aggregate demand and aggregate supply model. 17.3 Use the aggregate demand and aggregate supply model to show the effects of monetary policy. 17.4

Why Was Unemployment So High for So Long? • “The Great Recession” began in December 2007 and ended in July 2009. Yet, the unemployment rate in November 2012 remained at 7.7%. • Economic growth is not predicted to be fast enough to bring these high unemployment rates down any time soon. • Many economists think that the financial crisis not only led to increased cyclical unemployment, but also to more structural unemployment, resulting in a higher natural rate of unemployment. • Economists have begun considering the “new normal,” in which unemployment rates might be stuck at higher levels for many years.

Key Issue and Question Issue: During the recovery from the financial crisis, the unemployment rate remained stubbornly high. Question: What explains the high unemployment rates during the economic expansion that began in 2009?

17.1 Learning Objective Explain how the aggregate demand curve is derived.

The Aggregate Demand Curve The Aggregate Demand Curve • C = spending by households on goods & services for consumption • I = planned spending by firms on capital goods, and by households on new homes • G = local, state, and federal government purchases of goods & services • NX = Net exports, i.e., spending by foreign firms and households on goods & services produced domestically minus spending by domestic firms and households on goods & services produced in other countries

The Aggregate Demand Curve Figure 17.1 The Aggregate Demand Curve The aggregate demand (AD) curve shows the relationship between the price level and the level of aggregate expenditure.•

The Aggregate Demand Curve The Market for Money and the Aggregate Demand Curve The market for money involves the interaction between the demand for M1 by households and firms and the supply of M1, as controlled by the Fed. The analysis of the market for money is also called the liquidity preference theory (coined by John Maynard Keynes). Real money balancesis the value of money held by households and firms, adjusted for changes in the price level. The primary reason for the demand for money is called the transactions motive—to hold money as a medium of exchange. Households and firms face a trade-off: The higher the interest rate on short-term assets (e.g., Treasury bills), the more households and firms give up when they hold large money balances. So, the short-term nominal interest rate is the opportunity cost of holding money.

The Aggregate Demand Curve The Market for Money Figure 17.2 Panel (a) shows the demand for real balances and the supply of real balances. Panel (b) shows that an increase in the price level causes the supply curve for real balances to shift from (M/P)S to (M/P)S, thereby increasing the equilibrium interest rate from i1 to i2.•

The Aggregate Demand Curve Shifts of the Aggregate Demand Curve Variables That Shifts the Aggregate Demand Curve Table 17.1

The Aggregate Demand Curve Shifts of the Aggregate Demand Curve Variables That Shifts the Aggregate Demand Curve (continued) Table 17.1

17.2 Learning Objective Explain how the aggregate supply curve is derived.

The Aggregate Supply Curve The Aggregate Supply Curve Aggregate supplyis the total quantity of output, or GDP, that firms are willing to supply at a given price level. Short-run aggregate supply (SRAS) curveis a curve that shows the relationship in the short run between the price level and the quantity of aggregate output supplied by firms. Although the short-run aggregate supply curve slopes upward like the supply curve facing an individual firm, it represents different behavior. Next, we examine the new classical and new Keynesian views that attempt to explain why the SRAS curve slopes upward.

The Aggregate Supply Curve The Short-Run Aggregate Supply (SRAS) Curve

The Aggregate Supply Curve • John Maynard Keynes provided an alternative explanation for the upward slope of the SRAS curve: • prices adjust slowly in the short run in response to changes in aggregate demand, i.e., prices are sticky in the short run. • In the most extreme view of price stickiness, the SRAS curve is horizontal: firms adjust their production levels to meet changes in demand without changing their prices. • Contemporary followers of Keynes’s view (new Keynesian view) have sought reasons for the failure of prices to adjust in the short run using real-world market characteristics: rigidity of long-term contracts and imperfect competition. • New Keynesian economists argue that prices will adjust only gradually in monopolistically competitive markets when there are costs to changing prices (menu costs).

The Aggregate Supply Curve The Long-Run Aggregate Supply (LRAS) Curve Long-run aggregate supply (LRAS) curve is a curve that shows the relationship in the long run between the price level and the quantity of aggregate output supplied by firms. The long-run aggregate supply (LRAS) curve is vertical at YP. In the new Keynesian view, in the short run many input costs are fixed, so firms can expand output without experiencing an increase in input cost that is proportional to the increase in their output prices. Over time, though, input costs increase in line with the price level, so all firms adjust their prices in response to a change in demand in the long run. As with the new classical view, the LRAS curve is vertical at potential GDP, or Y = YP.

The Aggregate Supply Curve Figure 17.3 The Short-Run and Long-Run Aggregate Supply Curves The SRAS curve is upward sloping. The LRAS curve is vertical at potential GDP,YP.

Making the Connection “Fracking” Transforms Energy Markets in the United States Falling natural gas prices between 2010 and 2012 were the result of the growing use of hydraulic fracturing (“fracking”) technology in the United States. Natural gas has long been a source of energy for manufacturing and for long-haul trucking transportation. Reductions in energy costs have caused the SRAS curve for the United States to shift to the right. Despite the economic benefits of the new fracking technology, policymakers are concerned about its drawbacks, including water contamination at production sites. The Effects of Monetary Policy

The Aggregate Supply Curve Shifts in the Short-Run Aggregate Supply (SRAS) Curve • Supply shock is an unexpected change in production costs or in technology that causes the short-run aggregate supply curve to shift. • There are three main factors that cause the short-run aggregate supply curve to shift: • 1. Changes in labor costs. • 2. Changes in other input costs. • 3. Changes in the expected price level. • Shifts in the Long-Run Aggregate Supply (LRAS) Curve • The LRAS curve shifts over time to reflect growth in the potential level of output. Sources of this economic growth include: • increases in capital and labor inputs • increases in productivity growth (output produced per unit of input)

The Aggregate Supply Curve Table 17.2 Variables That Shift the Short-Run and Long-Run Aggregate Supply Curves

The Aggregate Supply Curve Table 17.2 Variables That Shift the Short-Run and Long-Run Aggregate Supply Curves (continued)

17.3 Learning Objective Demonstrate macroeconomic equilibrium using the aggregate demand and aggregate supply model.

Equilibrium in the Aggregate Demand and Aggregate Supply Model Equilibrium in the Aggregate Demand and Aggregate Supply Model Short-Run Equilibrium Figure 17.4 Short-Run Equilibrium The economy’s short-run equilibrium is represented by the intersection of the AD and SRAS curves at E1. Higher price levels are associated with an excess supply of output, and lower price levels are associated with excess demand for output.

Equilibrium in the Aggregate Demand and Aggregate Supply Model Long-Run Equilibrium Figure 17.5 Adjustment to Long-Run Equilibrium From an initial equilibrium at E1, an increase in aggregate demand shifts the AD curve from AD1 to AD2, increasing output from YP to Y2. Because Y is greater than YP, prices rise, shifting the SRAS curve from SRAS1 to SRAS2. The economy’s new equilibrium is at E3. Output has returned to YP, but the price level has risen to P2.

Equilibrium in the Aggregate Demand and Aggregate Supply Model • Because the LRAS curve is vertical, economists generally agree that in the long run changes in aggregate demand affect the price level but not the output level. • Monetary neutrality is the proposition that changes in the money supply have no effect on output in the long run. • An increase (decrease) in the money supply raises (lowers) the price level in the long run but does not change the equilibrium level of output.

Equilibrium in the Aggregate Demand and Aggregate Supply Model Economic Fluctuations in the United States Shocks to Aggregate Demand, 1964–1969 During the Vietnam War, the Fed was concerned that the rise in aggregate demand caused by increases in government purchases would increase money demand and the interest rate. To avoid an increase in the interest rate, the Fed pursued an expansionary monetary policy. Because fiscal and monetary expansion continued for several years, AD–AS analysis confirms that output growth and inflation should have risen from 1964 through 1969.

Equilibrium in the Aggregate Demand and Aggregate Supply Model Supply Shocks, 1973–1975 and After 1995 The early 1970s was a period of stagflation (rising inflation and falling output) as a result of two negative supply shocks: a sharp reduction in the supply of oil and poor crop harvests around the world. The negative supply shocks shift the SRAS curve to the left, raising the price level and reducing output. A similar pattern occurred as a result of negative supply shocks caused by rising oil prices in the 1978–1980 period. In the late 1990s and 2000s, the U.S. economy experienced favorable supply shocks, such as the acceleration in productivity growth.

Equilibrium in the Aggregate Demand and Aggregate Supply Model Credit Crunch and Aggregate Demand, 1990–1991 The credit crunch was a result of stringent bank regulation and declines in real estate values. Because households and businesses weren’t able to replace bank credit with funds from other sources, consumer spending fell. In AD–AS analysis, the decline in spending reduces AD and puts downward pressure on prices, shifting the SRAS curve down. In fact, output growth fell during the 1990–1991 recession and inflation declined from 4.3% in 1989 to 2.9% in 1992.

Equilibrium in the Aggregate Demand and Aggregate Supply Model Investment and the 2001 Recession The brief recession of 2001 began as a result of a decline in business investment. In the late 1990s, many firms invested heavily in information technology. The U.S. economy accumulated more capital than businesses desired when expectations of future profitability declined after 2000. In AD–AS analysis, the decline in planned investment shifts the AD curve to the left, reducing both output growth and inflation. High productivity growth during this period led to a rightward shift of the SRAS and LRAS curves and cushioned the decline in output.

Equilibrium in the Aggregate Demand and Aggregate Supply Model Are Investment Incentives Inflationary? In the late 1990s, many economists and policymakers urged tax reforms that would stimulate business investment through increasing investment demand and output of capital goods. Would they also increase inflation? In AD–AS analysis, the stimulus to investment increases aggregate demand, shifting the AD curve to the right. However, investment in new plant and equipment would also increase the economy’s capacity, so that the SRAS and LRAS curves shift to the right, reducing the inflationary pressure from the tax reform. Recent evidence suggests that the supply response is substantial and investment incentives are unlikely to be inflationary.

17.4 Learning Objective Use the aggregate demand and aggregate supply model to show the effects of monetary policy.

The Effects of Monetary Policy The Effects of Monetary Policy Business cycle is alternating periods of economic expansion and economic recession. Stabilization policy is a monetary policy or fiscal policy intended to reduce the severity of the business cycle and stabilize the economy.

The Effects of Monetary Policy An Expansionary Monetary Policy Figure 17.6 (1 of 2) Effects of Monetary Policy At an initial full-employment equilibrium of E1, an aggregate demand shock shifts the AD curve from AD1 to AD2, and output falls from YP to Y2. At E2, the economy is in a recession. Over time, the price level adjusts downward, restoring the economy’s full employment equilibrium at E3.

The Effects of Monetary Policy An Expansionary Monetary Policy Figure 17.6 (2 of 2) Effects of Monetary Policy At an initial full-employment equilibrium of E1, an aggregate demand shock shifts the AD curve from AD1 to AD2. At E2, the economy is in a recession. The Fed’s expansionary monetary policy shifts the AD curve back from AD2 to AD1. Relative to the nonintervention case, the economy recovers more quickly back to full employment, but with a higher long-run price level.

Solved Problem 17.4 Dealing with Shocks to Aggregate Demand and Aggregate Supply Assume that the economy is initially in equilibrium at full employment. Then suppose that the economy is hit simultaneously with negative aggregate demand and aggregate supply shocks. a. Draw an AD-AS graph to illustrate the initial equilibrium and the short-run equilibrium after the shocks. Do we know with certainty whether the price level will be higher or lower in the new equilibrium? b. Suppose that the Fed decides not to intervene with an expansionary monetary policy. Show how the economy will adjust back to its long-run equilibrium. c. Now suppose that the Fed decides to intervene with an expansionary monetary policy. If the Fed’s policy is successful, show how the economy adjusts back to its long-run equilibrium. The Effects of Monetary Policy

Solved Problem Solved Problem 17.4 Dealing with Shocks to Aggregate Demand and Aggregate Supply Step 1Review the chapter material. Step 2 Answer part (a) by drawing the appropriate graph and explaining whether we know whether the price level will rise or fall. The Effects of Monetary Policy

Solved Problem Solved Problem 17.4 Dealing with Shocks to Aggregate Demand and Aggregate Supply Step 3Answer part (b) by drawing the appropriate graph. The Effects of Monetary Policy

Solved Problem Solved Problem 17.4 Dealing with Shocks to Aggregate Demand and Aggregate Supply Step 4Answer part (c) by redrawing the appropriate graph. The Effects of Monetary Policy

The Effects of Monetary Policy Was Monetary Policy Ineffective during the 2007–2009 Recession? In late 2012, the U.S. unemployment rate remained high, and increases in real GDP were disappointingly modest. Do these facts indicate that monetary policy had failed? Certainly, the Fed was unable to pull off a rapid and smooth return to full employment of the type illustrated in panel (b) of Figure 17.6. However, recessions started by financial crises are almost always very severe. The 2007–2009 recession was not a temporary decline in aggregate demand but the result of structural, perhaps permanent, changes in the economy. Some economists believe that large negative shifts in AD actually reduce the full employment level of output in a process known as hysteresis.

The Effects of Monetary Policy Persistently high rates of unemployment in many European countries during the 1980s and 1990s may reflect hysteresis. Government policies (e.g., generous unemployment insurance benefits, high tax rates, and hiring and firing restrictions) may also help to explain why employment growth was sluggish in these countries. Fed Chairman Ben Bernanke referred to the problems with aggregate supply as the “unusual uncertainty.” Conventional expansionary monetary policy would be effective only if the main problem facing the economy was insufficient AD. Since the economy was sailing in largely uncharted waters, it was unclear whether AD or AS was the bigger problem.

Making the Connection Have Recent Years Been Like the 1930s? Do the events from the Great Depression provide an insight into the recession of 2007–2009? Problems with aggregate supply included substantial increases in tax rates; a sharp increase in unionization, strikes, and labor unrest; and an apparent undermining of private property rights. Hysteresis and “regime uncertainty” are some of the possible explanations for insufficient aggregate demand. Economists will continue to explore the parallels between the U.S. economy of the 1930s and that following the beginning of the financial crisis in 2007. The Effects of Monetary Policy

Answering the Key Question At the beginning of this chapter, we asked the question: “What explains the high unemployment rates during the economic expansion that began in 2009?” In late 2012, the unemployment rate remained at nearly 8%. Economists disagreed about why the unemployment rate was so high. Some economists believed that it was due to insufficient aggregate demand and so they called for conventional macroeconomic stabilization policies. Other economists saw problems with aggregate supply, either because of potentially long-lived declines in the residential construction and automobile industries, or because of increased economic uncertainty.

LEARNING OBJECTIVES