Aggregate
Supply and Demand
Chapter 11
Copyright
© 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.
McGraw-Hill/Irwin
11-2
Macro
Outcomes
- Macroeconomics is the study
of the aggregate economy
- Macro outcomes include:
- Output–the
total volume of goods and services produced (real GDP).
- Jobs–the levels
of employment and unemployment.
- Prices–the
average prices of goods and services.
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Figure 11.1
11-4
- Macro outcomes include:
- Growth–the
year-to-year expansion in production capacity.
- International balances–the
international value of the dollar; trade and payment balances with other
countries.
Macro
Outcomes
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Macro
Determinants
- The determinants of macro
performance include:
- Internal market forces–population
growth, spending behavior, invention and innovation, and the like.
- External shocks–wars,
natural disasters, terrorist attacks, trade disruptions, and so on.
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- The determinants of macro
performance include:
- Policy levers–tax
policy, government spending, changes in interest rates, credit availability
and money, trade policy, immigration policy, and regulation.
Macro
Determinants
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Classical
Theory and
Self-Adjustment
- According to the classical
view, the economy self-adjusts to deviations from its long-term
growth trend.
- Classical theory was the predominant
theory prior to the 1930s.
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Flexible
Prices
and Wages
- The cornerstones of the Classical
Theory were flexible wages and flexible prices.
- Flexible prices virtually
guarantee that all output can be sold.
- No one would lose a job because
of weak consumer demand.
- Flexible wages would ensure
that everyone who wants a job would have a job.
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Say��s
Law
- According to Say��s
Law, ��supply creates its own demand.��
- Unsold goods will ultimately
be sold when buyers and sellers find an acceptable price.
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The
Keynesian
Revolution
- The Great Depression was a
stunning blow to Classical economists.
- John Maynard Keynes provided
an alternative to the Classical Theory.
- Keynes argued that the Great
Depression was not a unique event.
- It would recur if reliance
on the market to ��self-adjust�� continued.
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No
Self-Adjustment
- Keynes asserted that the
private economy was inherently unstable.
- The inherent instability
of the marketplace required government intervention.
- Policy levers were both effective
and necessary.
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Aggregate
Supply-Demand Model:
Aggregate Demand
- Any influence on macro outcomes
must be transmitted through supply or demand.
- Aggregate demand
is the total quantity of output demanded at alternative price levels
in a given time period, ceteris paribus.
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Real
GDP (Output)
- Real GDP is the inflation-adjusted
value of GDP—the value of output in constant prices.
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Price
Level
- The aggregate demand curve
illustrates how the volume of purchases varies with average prices:
- With a given (constant) level
of income, people will buy more goods and services at lower prices.
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Aggregate
Demand Curve
- The Aggregate Demand curve
is downward sloping for three reasons:
- Real balances effect
- Foreign trade effect
- Interest-rate effect
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Figure 11.3
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Real
Balances Effect
- The real value of money is
measured by how many goods and services each dollar will buy.
- As prices fall, money can
purchase more goods and services.
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Foreign
Trade Effect
- If domestic prices decline,
consumers demand more domestic output and fewer imports.
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Interest-Rate
Effect
- At lower price levels, interest
rates fall as consumers borrow less.
- Lower interest rates stimulate
more borrowing and loan-financed purchases.
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Aggregate
Supply
- Aggregate supply
is the total quantity of output producers are willing and able to supply
at alternative price levels in a given time period, ceteris paribus.
- The aggregate supply curve
is upward-sloping
- We expect the rate of output
to increase when the price level rises.
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Figure 11.4
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Profit
Margins
- Producers�� short-run costs,
like rent and negotiated wages, are relatively constant.
- Higher product prices tend
to widen their profit margins, so producers will want to produce and
sell more goods.
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Costs
- Production costs tend to
increase as producers try to produce more.
- They must acquire more resources
and use existing plant and equipment more intensively.
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- The aggregate supply curve
is relatively flat when capacity is underutilized.
- It becomes steeper as producers
approach capacity.
Costs
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Macro
Equilibrium
- Aggregate supply and demand
curves summarize the market activity of the whole (macro) economy.
- Macro equilibrium–the
unique combination of price level and real output compatible with aggregate
demand and aggregate supply.
- It is the only price-output
combination mutually compatible with both buyers�� and sellers�� intentions.
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Figure 11.5
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Disequilibrium
- If the price level is higher
than at equilibrium, buyers will want to buy less than producers want
to produce and sell.
- This is a disequilibrium
situation, in which the intentions of buyers and sellers are incompatible.
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Macro
Failure
- There are two potential problems
with macro equilibrium: undesirability and instability.
- Undesirability–the
price-output relationship at equilibrium may not satisfy our macroeconomic
goals.
- Instability–even
if the designated macro equilibrium is optimal, it may be displaced
by macro disturbances.
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Undesirable
Outcomes
- Full-employment GDP–the
rate of real output (GDP) produced at full employment
- Unemployment–the
inability of labor-force participants to find jobs.
- Inflation–an
increase in the average level of prices of goods and services.
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Shifts
of AS and AD
- A leftward shift of the aggregate
supply curve results in higher price levels and less output.
- A leftward shift of the aggregate
demand curve results in lower price levels and less output.
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Recurrent
Shifts
- Business cycles result from
recurrent shifts of the aggregate supply and demand curves:
- Business cycles
are alternating periods of economic growth and contraction.
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Figure 11.7
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Shift
Factors:
Demand Shifts
- The aggregate demand curve
might shift as a result of changes in:
- Consumer sentiment.
- Taxes on consumer income.
- Interest rates.
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Shift
Factors:
Supply Shifts
- The aggregate supply curve
might shift as a result of changes in:
- The price or availability
of raw materials.
- Business taxes.
- Environmental or workplace
regulations.
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Demand-Side
Theories
- Keynesian Theory
- Monetary Theory
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Keynesian
Theory
- Keynes argued that if people
demand a product, producers will supply it.
- If aggregate spending isn't
sufficient, some goods will remain unsold and some production capacity
will be idled.
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- Keynesian theory urges increased
government spending or tax cuts as mechanisms for increasing aggregate
demand (shifting the AD curve to the right).
Keynesian
Theory
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Monetary
Theory
- Monetary theories focus on
the control of money and interest rates as mechanisms for shifting the
aggregate demand curve.
- Money and credit affect the
ability and willingness of people to buy goods and services.
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- If the right amount of money
is not available, aggregate demand may be too small.
- High interest rates decrease
aggregate demand.
Monetary
Theory
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Supply-Side
Theories
- A decline in aggregate supply
causes output and employment to decline.
- The focus of supply-side
theory is to get more output by shifting the AS curve to the right.
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Figure 11.8
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Eclectic
Explanations
- Shifts in both supply
and demand curves may occur.
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Policy
Options
- Essentially, the government
has three policy options:
- Shift the aggregate demand
curve.
- Shift the aggregate supply
curve.
- Do nothing.
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Fiscal
Policy
- Fiscal policy
is the use of government taxes and spending to alter macro-economic
outcomes.
- Fiscal policy is conducted
by Congress and the President.
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Monetary
Policy
- Monetary policy
is the use of money and credit controls to influence macro-economic
activity.
- The Federal Reserve is the
regulatory body that controls the supply of money.
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Supply-Side
Policy
- Supply-side policy
is the use of tax rates, (de)regulation, and other mechanisms to increase
the ability and willingness to produce goods and services.
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The
Changing Choice
of Policy Levers
- The ��do nothing�� approach
prevailed until the Great Depression.
- The Great Depression spurred
a desire for a more active government role.
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The
Changing of Policy
Levers: 1970s-80s
- Monetary policy dominated
macro policy in the 1970s.
- The heavy reliance on monetary
policy ended with a recession in the late 1970s.
- Supply-side policies prevailed
in the 1980s with President Ronald Reagan.
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The
Changing Choice of
Policy Levers: 1990s
- The George H. Bush administration
pursued a less activist approach in the early 1990s.
- Bill Clinton pursued a contractionary
fiscal policy in the mid-1990s.
- This fiscal policy retreat
cleared the way for the reemergence of monetary policy.
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The
Changing Choice of
Policy Levers: 2000s
- The fiscal restraint of the
late 1990s helped the federal budget move from deficits to surpluses.
- In 2001, ��02, and ��03,
Congress cut taxes in an attempt to deal with a recession (shifting
AD curve to the right).
- Starting in 2007, the Fed
cut interest rates, and in 2009 President Obama pushed hard on the fiscal-policy
lever.
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End
of Chapter 11
