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Chapter 22. Aggregate Demand and Supply Analysis. A ggregate D emand. Aggregate demand is made up of four component parts: C = consumption expenditure , the total demand for consumer goods and services

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### Chapter 22

Aggregate Demand and Supply Analysis

Aggregate Demand

• Aggregate demand is made up of four component parts:
• C= consumption expenditure, the total demand for consumer goods and services
• I = planned investment spending, the total planned spending by business firms on new machines, factories, and other capital goods, plus planned spending on new homes
• G = government purchases , spending by all levels of government (federal, state, and local) on goods and services
• NX = net exports, the net foreign spending on domestic goods and services

Aggregate Demand

• The Quantity Theory of Money (QTM) implies the aggregate demand curve is downward sloping.
• The QTM results when velocity is assumed to be constant in the equation of exchange:
• A constant money supply implies constant nominal aggregate spending
• A decrease in the price level is matched with an increase in real GDP.
• Recall that inflation is defined as follows:
• Hence, a rise in real GDP is associated with a decline in PLis, which causes p to fall for a given value of PLwas.

Aggregate Demand

QTM:

• The quantity of real GDP demanded decreases in p.

p

Y

Aggregate Demand

QTM:

• The quantity of real GDP demanded decreases in p.
• increases
• increases
• increases
• is increased
• is cut
• decreases
• Financial frictiondecreases

p

Y

Aggregate Demand

Aggregate Demand

Aggregate Demand

Aggregate Demand

• The Congress and President are in charge of fiscal policy.

Expansionary fiscal policy involves a cut in T and/or increase in G

Restrictive fiscal policy involves a raising T and/or cutting G

• The Federal Reserve (our central bank) is in charge of monetary policy

Expansionary monetary policy involves lowering the federal funds interest rate

Restrictive monetary policy involves raising the federal funds interest rate

Aggregate Demand

Aggregate Demand

• The Congress and President are in charge of fiscal policy.
• Expansionary fiscal policy involves a cut in T and/or increase in G

Restrictive fiscal policy involves a raising T and/or cutting G

• The Federal Reserve (our central bank) is in charge of monetary policy
• Expansionary monetary policy involves lowering the federal funds interest rate

Restrictive monetary policy involves raising the federal funds interest rate

Aggregate Demand

Aggregate Demand

• The Congress and President are in charge of fiscal policy.
• Expansionary fiscal policy involves a cut in T and/or increase in G
• Restrictive fiscal policy involves a raising T and/or cutting G
• The Federal Reserve (our central bank) is in charge of monetary policy
• Expansionary monetary policy involves lowering the federal funds interest rate
• Restrictive monetary policy involves raising the federal funds interest rate

Long Run Aggregate Supply

The Economy’s Production Function

• Example: Suppose the economy’s production function shows the volume of output that can be produced by its labor force of size L given levels of K units of capital, R units of resources and Z percent of the knowledge/talent that is contained in the universe.

Suppose resources, capital, & technology/talent are currently at R = 0.4 (trillion dollars of land, oil, coal, natural gas…), K = 2.5 (trillion dollars of machines, roads, networks…) and z = 1 (percent of all knowledge in the universe is known on Earth).

• What is the economy’s short-run production function?

Long Run Aggregate Supply

The Economy’s Production Function

• Example (continued):

2. Graph the economy’s short-run production function.

L

Long Run Aggregate Supply

The Economy’s Production Function

• Example (continued):

3. Suppose there are 9 million workers that are frictionally or structurally unemployed, and 135 million of the 144 million in the labor force are employed. Compute u, un, uc, real GDP, and Yp.

12

144

L

Long Run Aggregate Supply

The Economy’s Production Function

• Example (continued):
• Graph LRAS with AD. Yp = 12 PL = – 0.5 Y + 12.75

p

LRAS

12.75

6.75

0

Y

12

Long Run Aggregate Supply

The Economy’s Production Function

• Example (continued):

5. Suppose there are 9 million workers that are frictionally or structurally unemployed, and 112 million of the 144 million in the labor force are employed. Compute u, un, uc, real GDP, and Yp.

11

144

121

L

Long Run Aggregate Supply

The Economy’s Production Function

• Example (continued):

6. Suppose there are 9 million workers that are frictionally or structurally unemployed, and 135 million of the 144 million in the labor force are employed, with 50 million of them working 60 hours per week. Compute u, un, uc, real GDP, and Yp.

13

Since 50 million are working an extra 20 hours/wk, the effective size of the (fulltime) work force is

135 + 50/2 = 160

144

169

L

Long Run Aggregate Supply

The Economy’s Production Function

• Example (continued):

7. Suppose technology rises to 1.1 percent. Re-graph the economy’s production function, and re-compute full-employment output.

13.2

Yp= 13.2 (trillion \$)

144

L

Long Run Aggregate Supply

The Economy’s Production Function

• Example (continued):

8. Graph the initial LRAS with AD and final LRAS

p

LRAS

LRAS’

12.75

6.75

0

Y

12

13.2

Short Run Aggregate Supply

SRAS is the relationship between the quantity of real GDP supplied and p when all other influences on production plans remain the same

• SRAS shifts upward (decreases) when
• Expected inflation rises
• Workers expecting the PL to rise will demand one-for-one adjustments in w

Dp e = Dw

• In the short-run, w is the most important factor to producing products
• Inflation increases one-for-one in expected inflation
• a price shock (up) occurs due to the nominal price of a resource like energy (r).
• Government permanently changes the supply-side tax rate (t )
• Output gap Y – Yp widens
• workers are being offered higher w and better benefits due to u being too low
• In the short-run, it is believed this pushes inflation higher due to firms raising their prices.
• This makes SRAS upward sloping.

p = p e + r +t+ g (Y – Yp)

p = g Y + pe+ r +t– g Yp

Short Run Aggregate Supply

• Example: In addition to R = 0.4 (trillion dollars of land…), K =2.5 (trillion dollars of machines…), Z = 1 (percent of all knowledge is known to man), Un = 9 (million frictionally or structurally unemployed workers), E = 135 (million), and L = 144 (million), suppose the sensitivity of inflation to the output gap is 0.5, expected inflation is 1 (percent), price shock is 0, and the supply-side tax rate is 5 (percent).

1. Graph the potential GDP you computed in part (3) with AD

Yp = 12

p = g Y + p e+ r +t– g Yp

Short Run Aggregate Supply

• Example: In addition to R = 0.4 (trillion dollars of land…), K =2.5 (trillion dollars of machines…), Z = 1 (percent of all knowledge is known to man), Un = 9 (million frictionally or structurally unemployed workers), E = 135 (million), and L = 144 (million), suppose the sensitivity of inflation to the output gap is 0.5, expected inflation is 1 (percent), price shock is 0, and the supply-side tax rate is 5 (percent).

1. Graph the potential GDP you computed in part (3) with AD

Yp = 12

p = g Y + p e+ r +t– g 12

Short Run Aggregate Supply

• Example: In addition to R = 0.4 (trillion dollars of land…), K =2.5 (trillion dollars of machines…), Z = 1 (percent of all knowledge is known to man), Un = 9 (million frictionally or structurally unemployed workers), E = 135 (million), and L = 144 (million), suppose the sensitivity of inflation to the output gap is 0.5, expected inflation is 1 (percent), price shock is 0, and the supply-side tax rate is 5 (percent).

1. Graph the potential GDP you computed in part (3) with AD

Yp = 12

p = 0.5Y + p e+ r +t– 6

Short Run Aggregate Supply

• Example: In addition to R = 0.4 (trillion dollars of land…), K =2.5 (trillion dollars of machines…), Z = 1 (percent of all knowledge is known to man), Un = 9 (million frictionally or structurally unemployed workers), E = 135 (million), and L = 144 (million), suppose the sensitivity of inflation to the output gap is 0.5, expected inflation is 1 (percent), price shock is 0, and the supply-side tax rate is 5 (percent).

1. Graph the potential GDP you computed in part (3) with AD

Yp = 12

p = 0.5Y + 1+ r +t– 6

Short Run Aggregate Supply

• Example: In addition to R = 0.4 (trillion dollars of land…), K =2.5 (trillion dollars of machines…), Z = 1 (percent of all knowledge is known to man), Un = 9 (million frictionally or structurally unemployed workers), E = 135 (million), and L = 144 (million), suppose the sensitivity of inflation to the output gap is 0.5, expected inflation is 1 (percent), price shock is 0, and the supply-side tax rate is 5 (percent).

1. Graph the potential GDP you computed in part (3) with AD

Yp = 12

p = 0.5Y + 1+ 0 +t– 6

Short Run Aggregate Supply

• Example: In addition to R = 0.4 (trillion dollars of land…), K =2.5 (trillion dollars of machines…), Z = 1 (percent of all knowledge is known to man), Un = 9 (million frictionally or structurally unemployed workers), E = 135 (million), and L = 144 (million), suppose the sensitivity of inflation to the output gap is 0.5, expected inflation is 1 (percent), price shock is 0, and the supply-side tax rate is 5 (percent).

1. Graph the potential GDP you computed in part (3) with AD

Yp = 12

p = 0.5Y + 1+ 0+ 5 – 6

Short Run Aggregate Supply

• Example: In addition to R = 0.4 (trillion dollars of land…), K =2.5 (trillion dollars of machines…), Z = 1 (percent of all knowledge is known to man), Un = 9 (million frictionally or structurally unemployed workers), E = 135 (million), and L = 144 (million), suppose the sensitivity of inflation to the output gap is 0.5, expected inflation is 1 (percent), price shock is 0, and the supply-side tax rate is 5 (percent).

1. Graph the potential GDP you computed in part (3) with AD

Yp = 12

p = 0.5Y

Short Run Aggregate Supply

• Example (continued):

2. Graph SRAS: p = 0.5Y

p

SRAS

6

12

Y

Short Run Aggregate Supply

• Example (continued):

3. What happens if government cuts supply-side taxes by 1 percentage point?

p =0.5Y +1+ 0 + 5 – 6

4

p

SRAS

SRAS’

Supply-side tax cuts increase SRAS.

6

-5

12

Y

13

Short Run Aggregate Supply

p = g Y + p e + r +t– g Yp

Short Run Aggregate Supply

• p = g Y + p e + r +t– g Yp
• The Congress and President are in charge of fiscal policy.
• Expansionary supply-side fiscal policy involves cutting t
• Restrictive supply-side fiscal policy involves raising t
• The Federal Reserve (our central bank) is in charge of monetary policy
• Expansionary monetary policy lowers the federal funds interest rate
• Restrictive monetary policy raises the federal funds interest rate

Short Run Aggregate Supply

• p = g Y + p e + r +t– g Yp
• The Congress and President are in charge of fiscal policy.
• Expansionary supply-side fiscal policy involves cutting t
• Restrictive supply-side fiscal policy involves raising t
• The Federal Reserve (our central bank) is in charge of monetary policy
• Expansionary monetary policy lowers the federal funds interest rate
• Restrictive monetary policy raises the federal funds interest rate

Aggregate Market Model

Equilibrium

• Example (continued):

4. Graph LRAS with SRAS: Yp= 12p= 0.5Y

p

LRAS

SRAS

6

12

Y

Aggregate Market Model

Equilibrium

• Example (continued):
• Suppose technology/talent increases by 0.1 percentage points. Show the effect of this on LRAS and SRAS.

p

LRAS

LRAS’

SRAS

Yp= 13.2 (trillion \$)

6

12

13.2

Y

Aggregate Market Model

Equilibrium

• Example (continued):
• Suppose technology/talent increases by 0.1 percentage points. Show the effect of this on LRAS and SRAS.

p

LRAS

LRAS’

SRAS

SRAS’

Yp= 13.2 (trillion \$)

6

p =0.5Y + 1 + 0 + 5 – 0.5 · 12

p =0.5Y – 0.6

-0.6

12

13.2

Y

Aggregate Market Model

Equilibrium

• Example (continued):

6. Graph LRAS, AD & SRAS: Yp= 12 p= 0.5Yp= 12 – 0.5 Y

p

LRAS

SRAS

6

12

Y

Aggregate Market Model

Equilibrium

• Example (continued):

7. Graph LRAS, AD & SRAS: Yp= 12 p= 0.5Yp= 11 – 0.5 Y

p

LRAS

SRAS

5.5

12

Y

11

Aggregate Market Model

Equilibrium

• Example (continued):

7. Graph LRAS, AD & SRAS: Yp= 12 p= 0.5Yp= 11 – 0.5 Y

p = g Y + p e + r +t– g Yp

p

LRAS

SRAS

5.5

12

Y

11

Aggregate Market Model

Equilibrium

• Example (continued):

7. Graph LRAS, AD & SRAS: Yp= 12 p= 0.5Yp= 11 – 0.5 Y

p = g Y + p e + r +t– g Yp

p

LRAS

SRAS

• Wages are inflexible, particularly downward
• Need for active government policy

5.5

5.2

12

Y

11

Aggregate Market Model

Equilibrium

• Example (continued):

7. Graph LRAS, AD & SRAS: Yp= 12 p= 0.5Yp= 11 – 0.5 Y

p = g Y + p e + r +t– g Yp

p

LRAS

• Wages are inflexible, particularly downward
• Need for active government policy

SRAS

5.2

12

Y

Aggregate Market Model

Equilibrium

• Example (continued):

8. Graph LRAS, AD & SRAS: Yp= 12 p= 0.5Yp= 13 – 0.5 Y

p

LRAS

SRAS

6.5

12

Y

13

Aggregate Market Model

Equilibrium

• Example (continued):

8. Graph LRAS, AD & SRAS: Yp= 12 p= 0.5Yp= 13 – 0.5 Y

p= g Y + p e + r +t– g Yp

p

LRAS

SRAS

6.5

12

Y

13

Aggregate Market Model

Equilibrium

• Example (continued):

8. Graph LRAS, AD & SRAS: Yp= 12 p= 0.5Yp= 13 – 0.5 Y

p= g Y + p e + r +t– g Yp

p

LRAS

SRAS

7.5

6.5

• Wages and prices are flexible

12

Y

13

Aggregate Market Model

Equilibrium

• Example (continued):

8. Graph LRAS, AD & SRAS: Yp= 12 p= 0.5Yp= 13 – 0.5 Y

p= g Y + p e + r +t– g Yp

p

LRAS

SRAS

7.5

• Wages and prices are flexible

12

Y

Positive Demand Shock

AD can shift from temporary demand shocks in which the LRAS and SRAS do not shift

Positive Demand Shock

AD can shift from temporary demand shocks in which the LRAS and SRAS do not shift

p

LRAS

SRAS

3

2

13

12

Y

Positive Demand Shock

AD can shift from temporary demand shocks in which the LRAS and SRAS do not shift

p

LRAS

SRAS

3.5

3

2

13

12

Y

Negative Demand Shock

AD can shift from temporary demand shocks in which the LRAS and SRAS do not shift

p

LRAS

SRAS

2

1.5

11

12

Y

Negative Demand Shock

AD can shift from temporary demand shocks in which the LRAS and SRAS do not shift

p

LRAS

SRAS

2

1.5

1.25

11

12

Y

Negative Demand Shock

The Volcker Disinflation

p

LRAS

SRAS

13.5

10.3

6.2

3.6

1.9

Yp

Y

Negative Demand Shock

The Volcker Disinflation

p

LRAS

SRAS

13.5

10.3

6.2

3.6

1.9

Yp

Y

Negative Demand Shock

2001-2004

p

LRAS

SRAS

4.5

3.1

11

12

Y

Negative Demand Shock

2001-2004

p

LRAS

SRAS

4.5

3.1

1.6

11

12

Y

Source: Economic Report of the President.

Supply Shock

• Temporary supply shock
• SRAS shifts
• LRAS does not shift
• Permanent supply shock
• SRAS shifts
• LRAS shifts
• E.g., permanent negative supply shock occurs when ill-advised regulations that cause the economy to be less efficient are adopted
• Real business cycle theory(Edward Prescott of ASU) says that business cycle fluctuations result from permanent supply shocks

Temporary Negative Supply Shock

1973-1980

p

LRAS

SRAS

6

5

11

12

Y

Permanent Positive Supply Shock

1995–1999

p

LRAS

SRAS

5

4

13

12

Y

Negative Demand and Supply Shocks

2007–2009

LRAS

p

SRAS

4

3

0

11

12

Y

Negative Demand and Supply Shocks

2007–2009

LRAS

p

SRAS

4

3

0

-1

11

11

12

Y

The Phillips Curve and the SRAS

Figure 1

Source: Economic Report of the President. www.gpoaccess.gov/eop/.

The Phillips Curve and the SRAS

LRPC

p

SRPC

4

p = u – un

b0 + b1( )

2

4.15

5

u

u – un

The Phillips Curve and the SRAS

LRPC

p

SRPC

4

p = u – un

b0 + b1( )

2

4.15

5

u

u – un

= a(Y – Yp)

The Phillips Curve and the SRAS

LRPC

p

SRPC

4

p =

b0 + b1( )

a(Y – Yp)

2

4.15

5

u

u – un

= a(Y – Yp)

The Phillips Curve and the SRAS

LRPC

p

SRPC

4

p =

b0 + g ( )

Y – Yp

2

4.15

5

u

u – un

= a(Y – Yp)

The Phillips Curve and the SRAS

LRAS

p

SRAS

4

p =

b0 + g ( )

Y – Yp

2

15.5

15

Y

Y – Yp

Okun’s Law

Figure 3 (1960–2010)

Source: Unemployment, quarterly, 1960–2010 and real GDP growth, quarterly, 1960–2010. Bureau of Labor Statistics and Bureau of Economic Analysis.

Conclusions

Aggregate demand and supply analysis yields the following conclusions:

1. A shift in the aggregate demand curve affects output only in the short run and has no effect in the long run

• A temporary supply shock affects output and inflation only in the short run and has no effect in the long run (holding the aggregate demand curve constant)

3. A permanent supply shock affects output and inflation both in the short and the long run

4. The economy has a self-correcting mechanism that returns it to potential output and the natural rate of unemployment over time