Lecture Principles of economics (Brief edition, 2e): Chapter 20 - Robert H. Frank, Ben S. Bernanke

Chapter 20: Aggregate Demand, Aggregate
Supply, and Stabilization Policy
1. Define the aggregate demand curve, explain why
it slopes downward, and explain why it shifts
2. Define the aggregate supply curve, explain why it
slopes upward, and explain why it shifts
3. Show how the aggregate demand and supply
curves determine output and the price level in
both the short run and the long run
4. Analyze how the economy adjusts to
expansionary and recessionary gaps, and relate
this to the concept of a self-correcting economy
5. Explain how stabilization policy can be used to
close output gaps
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Aggregate Demand and
Aggregate Supply

Price level P

• Analyze fluctuations in both output and the price level
– Short run and long run analysis
• Price level and output on the axis
• AD shows the relationship
between planned spending
and the price level
Aggregate

• AS shows how output
Supply (AS)
produced by firms depends
Aggregate
on the price level
Demand (AD)
• Potential output is shown
Y* Output Y
to measure output gaps
20­2


Long-Run Equilibrium

Price level P

• In the long run,
– Actual output equals potential output
– Actual price level equals expected price level
• Long-run equilibrium
occurs at the intersection of
– Aggregate demand
Aggregate
Supply AS
– Aggregate supply and
– Potential output
Aggregate
Demand AD

Y* Output Y

20­3


Short-Run Equilibrium
• Short-run equilibrium occurs when the AD and
AS curves intersect at a level of output
different from Y*
• Short-run equilibrium is
temporary
• Caused by a shift in
• either AD or AS

Price level P

– Point A in the graph

AS

P1

A
AD

Y* Y1

Output Y
20­4


The Aggregate Demand Curve

• The aggregate demand curve shows the
amount of output consumers, firms,
government, and customers abroad want to
purchase at each price level
– All else the same
– Slopes downwards
– A higher price level reduces planned aggregate
expenditure which reduces output via the
multiplier effect

20­5


The Aggregate Demand Curve

Price level P

• An increase in the price level reduces planned
aggregate expenditure for three reasons:
– The wealth effect
– The interest rate effect
– The exchange rate effect
• According to the wealth effect
a higher price level reduces the
real value of assets
– Financial assets
AD
– Durable assets like houses
Output Y
20­6

The Aggregate Demand Curve
• According to the interest rate effect a higher
price level causes
– An increase in money demand
– An increase in the interest rate given money
supply is fixed
– A decrease in planned consumption and planned
investment

20­7


The Aggregate Demand Curve
• According to the exchange rate effect a
higher price level causes
– Higher interest rates which make our financial
assets more attractive
– An increase in the demand for dollars
– An increase in the value of the dollar
– A decrease in net exports

20­8


Shifts in the Aggregate Demand
Curve
• A shift of the aggregate demand curve is called
a change in aggregate demand

• At the given price level, something causes
output to rise (an increase in aggregate
demand) or fall (a decrease in aggregate
demand)
• Two main causes:
– Demand shocks
– Stabilization policy

20­9


Shifts in the Aggregate Demand
Curve

–
–
–
–

Consumer confidence
Consumer wealth
Business confidence
Opportunities for firms
to purchase new
technologies
– Foreign demand for
US goods

Price level P

• Demand shocks are changes in planned
spending not caused by a change in output or
a change in price level

AD

AD'

Output (Y)
20­10


Shifts in the Aggregate Demand
Curve

– Change in government
spending or taxes

• Monetary policy
– Change in the nominal
money supply which
changes the interest
rate

Price level P

• Stabilization policies are government policies
used to affect planned aggregate expenditure
and eliminate output gaps
• Fiscal policy

AD

AD'

Output (Y)
20­11


The Aggregate Supply Curve
• The aggregate supply curve (AS) shows the
relationship between the amount of output firms
want to produce and the price level
– Holds all other factors constant
• The aggregate supply curve is upward sloping
– An increase in aggregate demand will increase
the willingness to supply and increase the price
level
• In past chapters firms met demand at present prices
– Holds in the very short run
– Not possible to indefinitely hold price constant
and increase output

20­12


The Aggregate Supply Curve

Price level P

• The expected price level is the price level that is
expected to prevail when the economy is producing at
potential output
• This is point A
• Firms sell the usual amount
Aggregate
Supply (AS)
• An increase in aggregate
B
P2
demand will move the
A
P
e
economy to point B
• The AS curve is upward
P3 C
sloping
Y2

Y*

Y1

Output Y
20­13


Shifts in the AS Curve
• A change in aggregate supply is a shift of the

aggregate supply curve
• An increase in aggregate supply is a rightward
shift of the curve
• A decrease in aggregate
AS
supply is a leftward
AS
shift of the curve
P
• Three main causes
Price level P

2

1

1

Y*

Output Y
20­14


Shifts in the AS Curve
• Increasing available resources and technology will
shift the AS curve to the right
• Supply more output without having to increase
price
• Hire more labor, capital,

AS
or natural resources
AS
• Use existing labor and
P
machines more efficiently
1

Price level P

2

1

Y1

Y2

Output Y
20­15


Shifts in the AS Curve
• An increase in the expected price level shifts
the AS curve upwards
• To maintain profit, increase price
• An increase in the
AS
expected price level
AS

will increase costs
P
in the future
Price level P

2

e

1

2

Pe1

Y1

Output Y
20­16


Shifts in the AS Curve
• A price shock is a change in an input price that is
not caused by a change in output or the price level
• Negative price shock : AS shifts left
• Positive price shock : AS shifts right
• A sudden rise in the price of oil increases prices of
– Gasoline, diesel fuel, jet fuel, heating oil
– Goods made with oil (synthetic rubber, plastics,
etc.)

• OPEC reduced supplies in 1973; price of oil
quadrupled
– Food shortages occurred at the same time
– Sharp increase in inflation in 1974
20­17


Understanding Business Cycles
• The economy is in long run equilibrium at P1
and Y*
• Positive demand shock
• Increase in government
spending
• Decrease in taxes

– Expansionary gap
– The dot-com bubble
from 1995 – 2000

Price level P

– Aggregate demand shifts from AD1 to AD2

AS1

P2
P1

AD2
AD1

Y* Y2

Output (Y)
20­18


Understanding Business Cycles
• The economy is in long run equilibrium at P1
and Y*
– Aggregate demand shifts from AD1 to AD2

• Increase in taxes

– Recessionary gap
– The great recession

AS1

Price level P

• Negative demand shock
• Decrease in government
spending

P1
P2
AD1
AD2

Y2 Y*

Output (Y)
20­19


Understanding Business Cycles
• The economy is in long run equilibrium at P1
and Y*
– AS shifts from AS1 to AS2
–
–
–
–

Oil price shock
1973-4 price of oil tripled
1979 price of oil doubled
2007-2008 price of oil
doubled

• Recessionary gap

Price level (P)

• Negative supply shock
AS2

AS1

P2
P1

A
AD

Y2 Y*

Output Y
20­20


An Expansionary Gap

Price level P

• Initial short-run equilibrium at A
– AD is stable as long as there is no change in
government policy or exogenous spending
• Price level is below the
expected price level
AS2
• Firms are charging less and
AS1
selling more than planned
Pe
– Raise nominal prices
P1
A
– Shifts AS curve to AS2

AD
– Output is at potential, Y*

Y* Y1

Output Y
20­21


A Recessionary Gap

Price level P

• Initial equilibrium is at A
– AD curve remains stable unless government policy
or exogenous spending changes
• Price level is higher than
AS1
the expected price level
AS2
A
– Firms are charging more
P1
and selling less than
Pe
planned
AD
– Aggregate supply shifts
to AS2
Y1 Y*

Output Y
• Long-run equilibrium
20­22


Self-Correcting Economy
• In the long-run the economy tends to be selfcorrecting
– Missing from Keynesian model
– Keynesian model is short-run; no price adjustments
• Given time, output gaps disappear without any
changes in monetary or fiscal policy
• Whether stabilization policies are needed depends on
the speed of the self-correction process
– If the economy returns to potential output quickly,
stabilization policies may be destabilizing
– The greater the gap, the longer the adjustment
period
20­23