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  1. Chapter 19 Aggregate Demand and Aggregate Supply

  2. Economic Principles • The phases of the business cycle • Gross Domestic Product (GDP) • The CPI and GDP deflator • Nominal and real GDP • Aggregate demand and aggregate supply Gottheil - Principles of Economics, 4e

  3. Economic Principles • Macroeconomic equilibrium • Demand-pull and cost-push inflation Gottheil - Principles of Economics, 4e

  4. Why Recession? Why Prosperity? Recession • A phase in the business cycle in which the decline in the economy’s real GDP persists for at least a half-year. A recession is marked by relatively high unemployment. Gottheil - Principles of Economics, 4e

  5. Why Recession? Why Prosperity? Depression • Severe recession. Gottheil - Principles of Economics, 4e

  6. Why Recession? Why Prosperity? Prosperity • A phase in the business cycle marked by a relatively high level of real GDP, full employment, and inflation. Gottheil - Principles of Economics, 4e

  7. Why Recession? Why Prosperity? Inflation • An increase in the price level. Gottheil - Principles of Economics, 4e

  8. Why Recession? Why Prosperity? Business cycle • Alternating periods of growth and decline in an economy’s GDP. Gottheil - Principles of Economics, 4e

  9. Why Recession? Why Prosperity? Business cycle • No two business cycles are identical. The number of months in any given phase of the cycle varies from cycle to cycle. Gottheil - Principles of Economics, 4e

  10. Why Recession? Why Prosperity? Trough • The bottom of a business cycle. Gottheil - Principles of Economics, 4e

  11. Why Recession? Why Prosperity? Trough • This is the time period when the economy’s unemployment rate is greatest and output declines to the cycle’s minimum level. Gottheil - Principles of Economics, 4e

  12. Why Recession? Why Prosperity? Recovery • A phase in the business cycle, following a recession, in which real GDP increases and unemployment declines. Gottheil - Principles of Economics, 4e

  13. Why Recession? Why Prosperity? Peak • The top of a business cycle. Gottheil - Principles of Economics, 4e

  14. Why Recession? Why Prosperity? Peak • This is the time period when output reaches its maximum level, the labor force is fully employed, and increasing pressure on prices is likely to generate inflation. Gottheil - Principles of Economics, 4e

  15. Why Recession? Why Prosperity? Downturn • A phase in the business cycle in which real GDP declines, inflation moderates, and unemployment emerges. Gottheil - Principles of Economics, 4e

  16. Why Recession? Why Prosperity? Trend lines trace the economy’s output performance over the course of a business cycle, measured either from recession to recession or from prosperity to prosperity. Gottheil - Principles of Economics, 4e

  17. Why Recession? Why Prosperity? • Upward-sloping trend lines signify economic growth. • The steeper the trend line, the higher the economy’s rate of growth. • When no growth occurs, the trend line is horizontal. Gottheil - Principles of Economics, 4e

  18. EXHIBIT 1 THE BUSINESS CYCLE Gottheil - Principles of Economics, 4e

  19. Exhibit 1: The Business Cycle What does the trend line in Exhibit 1 tell us about the economy’s output performance? • The trend line shows that the economy is growing. Gottheil - Principles of Economics, 4e

  20. Measuring the National Economy Gross Domestic Product (GDP) • Total value of all final goods and services, measured in current market prices, produced in the economy during a year. Gottheil - Principles of Economics, 4e

  21. Measuring the National Economy Gross Domestic Product (GDP) • “Final goods and services” refers to everything produced that is not itself used to produce other goods and services. Gottheil - Principles of Economics, 4e

  22. Measuring the National Economy Gross Domestic Product (GDP) • “During a given year” refers to a specific calendar year. Gottheil - Principles of Economics, 4e

  23. Measuring the National Economy Gross Domestic Product (GDP) • “Produced in the economy” refers to any good or service produced in the United States, regardless of whether a US-owned or a foreign-owned company produced the good. Gottheil - Principles of Economics, 4e

  24. Measuring the National Economy Gross Domestic Product (GDP) • Conversely, goods produced by US-owned firms in foreign countries are not included in GDP. Gottheil - Principles of Economics, 4e

  25. Measuring the National Economy To compare GDP across years, we must devise some way of eliminating the effect of inflation. Gottheil - Principles of Economics, 4e

  26. Measuring the National Economy Nominal GDP • GDP measured in terms of current market prices—that is, the price level at the time of measurement. (It is not adjusted for inflation.) Gottheil - Principles of Economics, 4e

  27. Measuring the National Economy Real GDP • GDP adjusted for changes in the price level. Gottheil - Principles of Economics, 4e

  28. Measuring the National Economy • Price indices are designed to remove the effect of price changes. • The consumer price index and the GDP deflator are the two indices most commonly used. Gottheil - Principles of Economics, 4e

  29. Measuring the National Economy Consumer Price Index (CPI) • A measure comparing the prices of consumer goods and services that a household typically purchases to the prices of those goods and services purchased in a base year. Gottheil - Principles of Economics, 4e

  30. Measuring the National Economy Base year • The reference year with which prices in other years are compared in a price index. Gottheil - Principles of Economics, 4e

  31. Measuring the National Economy Price level • A measure of prices in one year expressed in relation to prices in a base year. Gottheil - Principles of Economics, 4e

  32. Measuring the National Economy Example: Suppose in 1998 (the base year) a basket of goods including such things as food, clothing, and fuel cost $350. The $350 converts to a price level index of 100, P = 100. Gottheil - Principles of Economics, 4e

  33. Measuring the National Economy Example: Suppose in the next year, 1999, the same basket of goods cost $385. The 1999 CPI, measured against the 1998 base year of 100, is 110. P = ($385/$350) × 100 = 110. Gottheil - Principles of Economics, 4e

  34. Measuring the National Economy Example: A 1999 P = 110 indicates that from 1998 to 1999 the cost of goods and services that consumers typically buy increased by 10 percent. Gottheil - Principles of Economics, 4e

  35. Measuring the National Economy GDP deflator • A measure comparing the prices of all goods and services produced in the economy during a given year to the prices of those goods and services purchased in a base year. Gottheil - Principles of Economics, 4e

  36. Measuring the National Economy GDP deflator • This price index includes not only consumer goods and services, but also producer goods, investment goods, exports and imports, and goods and services purchased by government. Gottheil - Principles of Economics, 4e

  37. Measuring the National Economy GDP deflator • This price index is used to convert nominal GDP to real GDP. Gottheil - Principles of Economics, 4e

  38. Measuring the National Economy The formula to convert from nominal GDP to real GDP is: • Real GDP = (nominal GDP × 100)/GDP deflator. Gottheil - Principles of Economics, 4e

  39. EXHIBIT 2 CONVERTING NOMINAL GDP TO REAL GDP: 1995–2002 ($ BILLIONS, 1996 = 100) Source: U.S. Department of Commerce, Bureau of Economic Analysis. Gottheil - Principles of Economics, 4e

  40. Exhibit 2: Converting Nominal GDP to Real GDP: 1995-2000 1. What is the nominal difference between GDP in 1996 and 1997? • The nominal difference = $8,318.4 billion - $7,813.2 billion = $505.2 billion. Gottheil - Principles of Economics, 4e

  41. Exhibit 2: Converting Nominal GDP to Real GDP: 1995-2000 2. What is the real difference between GDP in 1996 and 1997? • Real GDP in 1996 is = ($7,813.2 billion × 100)/100.00 = $7,813.2 billion. Gottheil - Principles of Economics, 4e

  42. Exhibit 2: Converting Nominal GDP to Real GDP: 1995-2000 2. What is the real difference between GDP in 1996 and 1997? • Real GDP in 1997 = ($8,318.4 billion × 100)/101.95 = $8,159.5 billion. Gottheil - Principles of Economics, 4e

  43. Exhibit 2: Converting Nominal GDP to Real GDP: 1995-2000 2. What is the real difference between GDP in 1996 and 1997? • The real difference = $8,159.5 billion - $7,813.2 billion = $346.3 billion. Gottheil - Principles of Economics, 4e

  44. Deriving Equilibrium GDP in the Aggregate Demand and Supply Model The aggregate demand and aggregate supply model is one model used to explain how GDP is determined. Gottheil - Principles of Economics, 4e

  45. Deriving Equilibrium GDP in the Aggregate Demand and Supply Model Aggregate supply • The total quantity of goods and services that firms in the economy are willing to supply at varying price levels. Gottheil - Principles of Economics, 4e

  46. Deriving Equilibrium GDP in the Aggregate Demand and Supply Model There are three distinct segments of the aggregate supply curve: 1. Horizontal segment. Real GDP increases without affecting the economy’s price level. Gottheil - Principles of Economics, 4e

  47. Deriving Equilibrium GDP in the Aggregate Demand and Supply Model There are three distinct segments of the aggregate supply curve: 2. Upward-sloping segment. A positive relationship between real GDP and price level. Gottheil - Principles of Economics, 4e

  48. Deriving Equilibrium GDP in the Aggregate Demand and Supply Model There are three distinct segments of the aggregate supply curve: 3. Vertical segment. All resources are fully employed, so that real GDP cannot increase. Gottheil - Principles of Economics, 4e

  49. Deriving Equilibrium GDP in the Aggregate Demand and Supply Model Aggregate demand • The total quantity of goods and services demanded by households, firms, foreigners, and government at varying price levels. Gottheil - Principles of Economics, 4e

  50. Deriving Equilibrium GDP in the Aggregate Demand and Supply Model Increases in the price level affect people’s real wealth, their lending and borrowing activity, and the nation’s trade with other nations. Gottheil - Principles of Economics, 4e