KRUGMAN_WELLS_MACRO_CHAPTER10

KRUGMAN_WELLS_MACRO_CHAPTER10 - chapter 10 >>...

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: chapter 10 >> Aggregate Supply and Aggregate Demand SHOCKS TO THE SYSTEM O n November 4, 1979, militant Iranian students seized the U.S. embassy in Tehran, taking 52 the hard-hit auto industry, the unemployment rate rose to over 16%. But if the economic slump that followed the Persian Gulf crisis looked in many ways like a small-scale repeat of the Great Depression, it was very different in one important respect. During the Great Depression, from 1929 to 1933, the U.S. economy experienced severe deflation—a falling price level. During the slump from 1979 to 1982, the economy experienced severe inflation—a rising price level—reaching a peak of more than 13%. Many people were as upset by the high inflation as by the job losses because they saw the purchasing power of their incomes shrinking. And the emergence of stagflation, the combination of inflation and rising unemployment, also shook the confidence of economists and Americans hostage. For the next 444 days the news was dominated by the plight of the hostages, the threat of military action, and the resulting political instability. The home front was further shaken by a quadrupling of the price of oil, another repercussion of the hostage crisis in the Persian Gulf. Price controls on gasoline, which limited its price at the pump and had been imposed in response to an earlier jump in the price of oil, led to gasoline shortages and long lines. Next came a severe recession, the worst since the Great Depression. The industrial Midwest, having experienced a catastrophic loss in the number of jobs, became known as the Rust Belt. In Michigan, ground zero of What you will learn in this chapter: ® How the aggregate supply curve illustrates the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy Why the aggregate supply curve is different in the short run compared to the long run How the aggregate demand curve illustrates the relationship between the aggregate price level and the quantity of aggregate output demanded in the economy How the AS–AD model is used to analyze economic fluctuations ® ® ® Sclarandis, P.G./Stockphoto.com ®How monetary policy and fiscal policy can stabilize the economy 236 In the late 1970s and early 1980s, energy price increases arising from events in the Middle East led to recession and inflation here at home. Woodfin Camp policy makers in their ability to manage the economy. Why did the recession of 1979–1982 look different from the slump at the beginning of the Great Depression? Because it had a different cause. Indeed, the lesson of the 1970s was that recessions can have different causes and that the appropriate policy response depends on the cause. The Great Depression was caused by a crisis of confidence that led businesses and consumers to spend less, made worse by a banking crisis. This led to a combination of recession and deflation. At the time, policy makers didn’t know how to respond, but today we think we know what they should have done: pump cash into the economy, fighting the slump and stabilizing prices. But the recession of 1979–1982, like the earlier recession in 1973–1975, was largely caused by events in the Middle East that led to sudden cuts in world oil production and soaring prices for oil and other fuels. These energy price increases led to a combination of recession and inflation—and also to a dilemma: should economic policy fight the slump by pumping cash into the economy, or should it fight inflation by pulling cash out of the economy? In this chapter, we’ll develop a model that shows us how to distinguish between different types of short-run economic fluctuations—demand shocks, like the Great Depression, and supply shocks, like those of the 1970s. This model is our first step toward understanding short-run macroeconomics and macroeconomic policy. To develop this model, we’ll proceed in three steps. First, we’ll develop the concept of aggregate supply. Then we’ll turn to the parallel concept of aggregate demand. Finally, we’ll put them together in the AS–AD model. Aggregate Supply Between 1929 and 1933, the demand curve for almost every good produced in the United States shifted to the left—the quantity demanded at any given price fell. We’ll turn to the reasons for that decline in the next section, but let’s focus first on the effects on producers. One consequence of the decline in demand was a fall in the prices of most goods and services. By 1933 the GDP deflator, one of the price indexes we defined in Chapter 7, was 26% below its 1929 level, and other indexes were down by similar amounts. A second consequence was a decline in the output of most goods and services: by 1933 real GDP was 27% below its 1929 level. A third consequence, closely tied to the fall in real GDP, was a surge in the unemployment rate from 3% to 25%. The association between the plunge in real GDP and the plunge in prices wasn’t an accident. Between 1929 and 1933, the U.S. economy was moving down its aggregate supply curve, which shows the relationship between the economy’s aggregate price level (the overall price level of final goods and services in the economy) and the total quantity of final goods and services, or aggregate output, producers are willing to supply. (As we learned in Chapter 7, we use real GDP to measure aggregate output. So we’ll often use the two terms interchangeably.) More specifically, between 1929 and 1933 the U.S. economy moved down its short-run aggregate supply curve. The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied. The Short-Run Aggregate Supply Curve The period from 1929 to 1933 demonstrated that there is a positive relationship in the short run between the aggregate price level and the quantity of aggregate output supplied. A rise in the aggregate price level leads to a rise in the quantity of aggregate 237 238 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S output supplied, other things equal; a fall in the aggregate price level leads to a fall in the quantity of aggregate output supplied, other things equal. To understand why this positive relationship exists, let’s think about the most basic question facing a producer: is producing a unit of output profitable or not? The answer depends on whether the price the producer receives for a unit of output, such as a bushel of corn, is greater or less than the cost of producing that unit of output. That is, (10-1) Profit per unit output = Price per unit output − production cost per unit output At any given point in time, many of the costs producers face are fixed and can’t be changed for an extended period of time. Typically, the largest source of inflexible production cost is the wages paid to workers. Wages here refers to all forms of worker compensation, such as employer-paid health care and retirement benefits in addition to earnings. Wages are typically an inflexible production cost because the dollar amount of any given wage paid, called the nominal wage, is often determined by contracts that were signed several years earlier. Even when there are no formal contracts, there are often informal agreements between management and workers, reflecting reluctance by companies to change wages in response to economic conditions. For example, companies usually will not reduce wages during poor economic times—unless the downturn has been particularly long and severe—for fear of generating worker resentment. Correspondingly, they typically won’t raise wages during better economic times—until they are at risk of losing workers to competitors—because they don’t want to encourage workers to routinely demand higher wages. So as a result of both formal and informal agreements, nominal wages are “sticky”: slow to fall even in the face of high unemployment, and slow to rise even in the face of labor shortages. We’ll discuss the reasons for this stickiness in greater detail in Chapter 15. It’s important to note, however, that nominal wages cannot be sticky forever: ultimately, formal contracts and informal agreements will be renegotiated to take into account changed economic circumstances. As the Pitfalls on page 000 explains, how long it takes for nominal wages to become flexible is an integral component of what distinguishes the short run from the long run. Let’s return to the question of the positive relationship between the aggregate price level and the quantity of aggregate output supplied in the short run. Imagine that, for some reason, the aggregate price level falls, which means that the price received by the typical producer of a final good or service falls. Because many production costs are fixed in the short run, however, production cost per unit of output doesn’t fall by the same proportion as the fall in the price of the output. So the profit per unit declines, leading producers to reduce the quantity supplied in the short run. In the economy as a whole, aggregate output falls in the short run. Now consider what would happen if, for some reason, the aggregate price level rises. The typical producer would receive a higher price for his or her final good or service. Because many production costs are fixed in the short run, production cost per unit of output doesn’t rise by the same proportion as the rise in the price of a unit. So profit per unit rises, the producer increases output, and aggregate output increases in the short run. The positive relationship between the aggregate price level and the quantity of aggregate output producers are willing to supply during the time period when many production costs, particularly nominal wages, can be taken as fixed is illustrated by the short-run aggregate supply curve. The positive relationship between the aggregate price level and aggregate output gives the short-run aggregate supply curve its upward slope. Figure 10-1 shows a hypothetical short-run aggregate supply curve, SRAS, which matches actual U.S. data for 1929 and 1933. On the horizontal axis is The nominal wage is the dollar amount of the wage paid. The short-run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied that exists in the short run, the time period when many production costs can be taken as fixed. CHAPTER 10 A G G R E G AT E S U P P LY A N D A G G R E G AT E D E M A N D 239 Figure 10-1 Aggregate price level (GDP deflator, 2000 = 100) The Short-Run Aggregate Supply Curve The short-run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the short run, the period in which nominal wages are fixed. It is upward-sloping because a higher aggregate price level leads to higher profits and higher aggregate output given fixed nominal wages. Here we show numbers corresponding to the Great Depression, from 1929 to 1933: when deflation occurred and the aggregate price level fell from 11.9 (in 1929) to 8.9 (in 1933), firms responded by reducing the quantity of aggregate output supplied from $865 billion to $636 billion in 2000 dollars. Short-run aggregate supply curve, SRAS 11.9 8.9 1929 1933 A movement down the SRAS curve leads to deflation and lower aggregate output. 0 $636 865 Real GDP (billions of 2000 dollars) aggregate output (or, equivalently, real GDP)—the total quantity of final goods and services supplied in the economy—measured in 2000 dollars. On the vertical axis is the aggregate price level as measured by the GDP deflator, with 2000 = 100. In 1929, the aggregate price level was 11.9 and real GDP was $865 billion. In 1933, the aggregate price level was 8.9 and real GDP was only $636 billion. The movement down the SRAS curve corresponds to the deflation and fall in aggregate output experienced over those years. FOR INQUIRING MINDS W H AT ’ S T R U LY F L E X I B L E , W H AT ’ S T R U LY S T I C K Y Most macroeconomists agree that the basic picture shown in Figure 10-1 is correct: there is, other things equal, a positive short-run relationship between the aggregate price level and aggregate output. But many would argue that the details are a bit more complicated. So far we’ve stressed a difference in the behavior of the aggregate price level and the behavior of nominal wages. That is, we’ve said that the aggregate price level is flexible but nominal wages are sticky in the short run. Although this assumption is a good way to explain why the short-run aggregate supply curve is upward-sloping, empirical data on wages and prices don’t wholly support a sharp distinction between flexible prices of final goods and services and sticky nominal wages. On one side, some nominal wages are in fact flexible even in the short run because some workers are not covered by a contract or informal agreement with their employers. Since some nominal wages are sticky but others are flexible, we observe that the average nominal wage—the nominal wage averaged over all workers in the economy—falls when there is a steep rise in unemployment. (Nominal wages fell substantially in the early years of the Great Depression.) On the other side, some prices of final goods and services are sticky rather than flexible. Some companies, particularly the makers of luxury or name-brand goods, are reluctant to cut prices even when demand falls, preferring to cut output even if their profit per unit hasn’t declined. These complications, as we’ve said, don’t change the basic picture. When the aggregate price level falls, some producers cut output because the nominal wages they pay are sticky. And some producers don’t cut their prices in the face of a falling aggregate price level, preferring instead to reduce their output. In both cases the positive relationship between the aggregate price level and aggregate output is maintained. So, in the end, the short-run aggregate supply curve is still upward-sloping. 240 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S Shifts of the Short-Run Aggregate Supply Curve In Chapter 3, where we introduced the analysis of supply and demand in the market for an individual good, we stressed the importance of the distinction between movements along the supply curve and shifts of the supply curve. The same distinction applies to the aggregate supply curve. Figure 10-1 shows a movement along the short-run aggregate supply curve, as the aggregate price level and aggregate output fell from 1929 to 1933. But there can also be shifts of the short-run aggregate supply curve, as shown in Figure 10-2. Panel (a) shows a decrease in short-run aggregate supply—a leftward shift of the short-run aggregate supply curve. Aggregate supply decreases when producers reduce the quantity of aggregate output they are willing to supply at any given aggregate price level. Panel (b) shows an increase in short-run aggregate supply—a rightward shift of the short-run aggregate supply curve. Aggregate supply increases when producers increase the quantity of aggregate output they are willing to supply at any given aggregate price level. To understand why the short-run aggregate supply curve can shift, it’s important to recall that producers make output decisions based on their profit per unit of output. The short-run aggregate supply curve illustrates the relationship between the aggregate price level and aggregate output: because some production costs are fixed in the short run, a change in the aggregate price level leads to a change in producers’ profit per unit of output and, in turn, leads to a change in output. But there are other factors besides the aggregate price level that can affect profit per unit and, in turn, output. It is changes in these other factors that will shift the short-run aggregate supply curve. To develop some intuition, suppose that something happens that raises production costs—say an increase in the price of oil. At any given price of output, a producer now earns a smaller profit per unit of output. As a result, the producer reduces the quantity supplied at any given aggregate price level, and the short-run aggregate supply curve shifts to the left. If, in contrast, something happens that lowers production costs—say a fall in the nominal wage—a producer now earns a higher profit per unit of output at any given price of output. This leads the producer to increase Figure 10-2 Shifts of the Short-Run Aggregate Supply Curve (a) Leftward Shift (b) Rightward Shift Aggregate price level SRAS2 SRAS1 Aggregate price level SRAS1 SRAS2 Decrease in SRAS Increase in SRAS Real GDP Panel (a) shows a decrease in short-run aggregate supply: the short-run aggregate supply curve shifts leftward from SRAS1 to SRAS2, and the quantity of aggregate output supplied at any given aggregate price level falls. Panel (b) shows Real GDP an increase in short-run aggregate supply: the short-run aggregate supply curve shifts rightward from SRAS1 to SRAS2, and the quantity of aggregate output supplied at any given aggregate price level rises. CHAPTER 10 A G G R E G AT E S U P P LY A N D A G G R E G AT E D E M A N D 241 the quantity of aggregate output supplied at any given aggregate price level, and the short-run aggregate supply curve shifts to the right. Now we’ll discuss some of the other important factors that affect producers’ profit per unit and so can lead to shifts of the short-run aggregate supply curve. Changes in Commodity Prices In this chapter’s opening story, we described how a surge in the price of oil caused problems for the U.S. economy in 1979. An increase in the price of a commodity—oil—raised the cost of production and reduced the quantity of aggregate output supplied at any given aggregate price level, shifting the shortrun aggregate supply curve to the left. Conversely, a decline in commodity prices will reduce production costs, leading to an increase in the quantity supplied at any given aggregate price level and a rightward shift of the short-run aggregate supply curve. Why isn’t the influence of commodity prices already captured by the short-run aggregate supply curve? Because commodities—unlike, say, soft drinks—are not a final good, their prices are not included in the calculation of the aggregate price level. Further, commodities represent a significant cost of production to most suppliers, just like nominal wages do. So changes in commodity prices have large impacts on production costs. And in contrast to non-commodities, the prices of commodities can sometimes change drastically due to industry-specific shocks to supply—such as wars in the Middle East. Changes in Nominal Wages At any given point in time, the dollar wages of many workers are fixed because they are set by contracts or informal agreements made in the past. Nominal wages can change, however, once enough time has passed for contracts and informal agreements to be renegotiated. Suppose, for example, that there is an economy-wide rise in the cost of health care insurance premiums paid by employers as part of employees’ wages. This is equivalent to a rise in nominal wages because it is an increase in employer-paid compensation. So this rise in nominal wages increases production costs and shifts the short-run aggregate supply curve to the left. Conversely, suppose there is an economy-wide fall in the cost of such premiums. This is equivalent to a fall in nominal wages; it reduces production costs and shifts the short-run aggregate supply curve to the right. An important historical fact is that during the 1970s the surge in the price of oil had the indirect effect of also raising nominal wages. This “knock-on” effect occurred because many wage contracts included cost-of-living allowances that automatically raised the nominal wage when consumer prices increased. Through this channel, the surge in the price of oil—which led to an increase in overall consumer prices—ultimately caused a rise in nominal wages. So the economy, in the end, experienced two leftward shifts of the aggregate supply curve: the first generated by the initial surge in the price of oil, the second generated by the induced increase in nominal wages. The negative effect on the economy of rising oil prices was greatly magnified through the cost-of-living allowances in wage contracts. Today, cost-of-living allowances in wage contracts are rare. An increase in productivity means that a worker can produce more units of output with the same quantity of inputs. For example, the introduction of bar-code scanners in retail stores greatly increased the ability of a single worker to stock, inventory, and resupply store shelves. As a result, the cost to a store of “producing” a dollar of sales fell and profits rose. And, correspondingly, the quantity supplied increased. (Think of Wal-Mart and the increase in the number of its stores as an increase in aggregate supply.) So a rise in productivity, whatever the source, increases producers’ profits and shifts the short-run aggregate supply curve to the right. Conversely, a fall in productivity—say, due to new regulations that require workers to spend more time filling out forms—reduces the number of units of output a worker can produce with the same quantity of inputs. Consequently, the cost per unit of output rises, profit falls, and quantity supplied falls. This shifts the short-run aggregate supply curve to the left. Productivity 242 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S The Long-Run Aggregate Supply Curve We’ve just seen that in the short run a fall in the aggregate price level leads to a decline in the quantity of aggregate output supplied because nominal wages are sticky in the short run. But, as we mentioned earlier, contracts and informal agreements are renegotiated in the long run. So in the long run, nominal wages—like the aggregate price level—are flexible, not sticky. This fact greatly alters the long-run relationship between the aggregate price level and aggregate supply. In fact, in the long run the aggregate price level has no effect on the quantity of aggregate output supplied. To see why, let’s conduct a thought experiment. Imagine that you could wave a magic wand—or maybe a magic bar-code scanner—and cut all prices in the economy in half at the same time. By “all prices” we mean the prices of all inputs, including nominal wages, as well as the prices of final goods and services. What would happen to aggregate output, given that the aggregate price level has been halved and all input prices, including nominal wages, have been halved? The answer is: nothing. Consider Equation 10-1 again: each producer would receive a lower price for his or her product, but costs would fall in the same proportion. As a result, every unit of output profitable to produce before the change in prices would still be profitable to produce afterward. So a halving of all prices in the economy has no effect on the economy’s aggregate output. In other words, the aggregate price level now has no effect on the quantity of aggregate output supplied. In reality, of course, no one can change all prices by the same proportion at the same time. But in the long run, when all prices are fully flexible, inflation or deflation has the same effect as someone changing all prices by the same proportion. As a result, changes in the aggregate price level do not change the quantity of aggregate output supplied in the long run. That’s because changes in the aggregate price level will, in the long run, be accompanied by equal proportional changes in all input prices, including nominal wages. The long-run aggregate supply curve, illustrated in Figure 10-3 by the curve LRAS, shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible. The long-run aggregate supply curve is vertical because the aggregate price level has no effect on aggregate output in the long run. At an aggregate price level of 15.0, the quantity of aggregate output supplied is $800 billion in 2000 The long-run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible. Figure 10-3 Aggregate price level (GDP deflator, 2000 = 100) 15.0 A fall in the aggregate price level… …leaves the quantity of aggregate output supplied unchanged in the long run. The Long-Run Aggregate Supply Curve The long-run aggregate supply curve shows the quantity of aggregate output supplied when all prices, including nominal wages, are flexible. It is vertical at potential output, YP , because in the long run an increase in the aggregate price level has no effect on the quantity of aggregate output supplied. Long-run aggregate supply curve, LRAS 7.5 0 Potential output, YP $800 Real GDP (billions of 2000 dollars) CHAPTER 10 A G G R E G AT E S U P P LY A N D A G G R E G AT E D E M A N D 243 dollars. If the aggregate price level falls by 50% to 7.5, the quantity of aggregate output supplied is unchanged at $800 billion in 2000 dollars. It’s important to understand not only that the LRAS curve is vertical but also that its position along the horizontal axis represents a significant measure. The horizontal-axis intercept in Figure 10-3, where LRAS touches the x-axis ($800 billion in 2000 dollars), is the economy’s potential output, YP: the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible. In reality, the actual level of real GDP is almost always either above or below potential output. We’ll see why later in this chapter, when we discuss the AS-AD model. Still, an economy’s potential output is an important number because it defines the trend around which actual aggregate output fluctuates from year to year. In the United States, the Congressional Budget Office (CBO) estimates annual potential output for the purpose of federal budget analysis. Panel (a) of Figure 10-4 shows the CBO’s estimates of U.S. potential output from 1989 to 2004 and the actual values of U.S. real GDP over the same period. As you can see in panel (a), U.S. potential output has risen steadily over time—implying a series of rightward shifts of the LRAS curve. What has caused these rightward shifts? The answer lies in the factors related to long-run growth that we discussed in Chapter 8, such as increases in physical capital and human capital as well as technological progress. Over the long run, as the size of the labor force and the productivity of labor both rise, the level of real GDP that the economy is capable of producing also rises. Indeed, one way to think about long-run economic growth is that it is the Potential output is the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible. Figure Real GDP (billions of 2000 dollars) $11,000 10,000 9,000 8,000 7,000 10-4 Actual and Potential Output (a) Actual vs. Potential Output from 1989 to 2004 Actual real GDP exceeds potential output. Potential output exceeds actual real GDP. Potential output Actual real GDP Actual real GDP roughly equals potential output. 19 90 19 89 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 0 Year (b) Economic Growth Shifts the LRAS Curve Rightward Aggregate price level LRAS (1990) LRAS (1997) LRAS (2004) Yp (1990) Yp (1997) Yp (2004) Real GDP Panel (a) shows the performance of actual and potential output in the United States from 1989 to 2004. The black line shows estimates of U.S. potential output, produced by the Congressional Budget Office, and the blue line shows actual aggregate output. The purple-shaded years are periods in which actual aggregate output fell below potential output, and the green-shaded years are periods in which actual aggregate output exceeded potential output. As shown, significant shortfalls occurred in the recessions of the early 1990s and after 2000. Actual aggregate output was significantly above potential output in the boom of the late 1990s. Panel (b) shows how economic growth has shifted the long-run aggregate supply curve, LRAS, rightward over time. 20 04 20 01 02 20 19 3 244 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S growth in the economy’s potential output. As illustrated in panel (b) of Figure 10-4, we generally think of the long-run aggregate supply curve as shifting to the right over time as an economy experiences long-run growth. From the Short Run to the Long Run As you can see from the CBO estimates shown in panel (a) of Figure 10-4, the economy almost always produces more or less than potential output: in only three periods during the period from 1989 to 2003 did actual aggregate output roughly equal potential output (the three years at which the two lines cross). The economy is almost always on its short-run aggregate supply curve—producing an aggregate output level more than or less than potential output—not on its long-run aggregate supply curve. So why is the long-run curve relevant? Does the economy ever move from the short run to the long run? And if so, how? The first step to answering these questions is to understand that the economy is always in one of only two states with respect to the short-run and long-run aggregate supply curves. It can be on both curves simultaneously by being at a point where the curves cross (as in the three periods in panel (a) of Figure 10-4 in which actual aggregate output and potential output roughly coincide). Or it can be on the short-run aggregate supply curve but not the long-run aggregate supply curve (as in the years in panel (a) of Figure 10-4 in which actual aggregate output and potential output did not coincide). But that is not the end of the story. If the economy is on the short-run but not the long-run aggregate supply curve, the short-run aggregate supply curve will shift over time until the economy is at a point where both curves cross—a point where actual aggregate output is equal to potential output. Figure 10-5 illustrates how this process works. In both panels LRAS is the long-run aggregate supply curve, SRAS1 is the initial short-run aggregate supply curve, and the aggregate price level is at P1. In panel (a) the economy starts at the initial production Figure 10-5 From the Short Run to the Long Run (b) Rightward Shift of the Short-run Aggregate Supply Curve (a) Leftward Shift of the Short-run Aggregate Supply Curve Aggregate price level LRAS SRAS2 A1 SRAS1 Aggregate price level LRAS SRAS1 SRAS2 P1 A rise in nominal wages shifts SRAS leftward. P1 A1 A fall in nominal wages shifts SRAS rightward. YP Y1 Real GDP Y1 YP Real GDP In panel (a), the initial short-run aggregate supply curve is SRAS1. At the aggregate price level, P1, the quantity of aggregate output supplied, Y1, exceeds potential output, YP. Eventually, low unemployment will cause nominal wages to rise, leading to a leftward shift of the short-run aggregate supply curve from SRAS1 to SRAS2. In panel (b), the reverse happens: at the aggregate price level, P1, the quantity of aggregate output supplied is less than potential output. This reflects the fact that the short-run aggregate supply curve has shifted to the right, due to both the short-run adjustment process in the economy and to a rightward shift of the long-run aggregate supply curve. CHAPTER 10 A G G R E G AT E S U P P LY A N D A G G R E G AT E D E M A N D 245 point, A1, which corresponds to a quantity of aggregate output supplied, Y1, that is higher than potential output, YP. Producing an aggregate output level (such as Y1) that is higher than potential output (YP) is possible only because nominal wages haven’t yet fully adjusted upward. Until this upward adjustment in nominal wages occurs, producers are earning high profits and producing a high level of output. But a level of aggregate output higher than potential output means a low level of unemployment. Because jobs are abundant and workers are scarce, nominal wages will rise over time, gradually shifting the short-run aggregate supply curve leftward. Eventually it will be in a new position, such as SRAS2. (In the next section we’ll show where the short-run aggregate supply curve ends up. As we’ll see, that depends on the aggregate demand curve as well.) In panel (b) of Figure 10-5, the initial production point, A1, corresponds to the aggregate output level, Y1, that is lower than potential output, YP. Producing an aggregate output level (such as Y1) that is smaller than potential output (YP) is possible only because nominal wages haven’t yet fully adjusted downward. Until this downward adjustment occurs, producers are earning low (or negative) profits and producing a low level of output. An aggregate output level lower than potential output means high unemployment. Because workers are abundant and jobs are scarce, nominal wages will fall over time, shifting the short-run aggregate supply curve gradually to the right. Eventually it will be in a new position, such as SRAS2. We’ll see shortly that these shifts of the short-run aggregate supply curve will return the economy to potential output in the long run. To explain why, however, we first need to introduce the concept of the aggregate demand curve. PITFALLS ARE WE THERE YET? WHAT THE LONG RUN REALLY MEANS We’ve used the term long run in two different contexts. In Chapter 8 we focused on long-run economic growth: growth that takes place over decades. In this chapter we introduced the long-run aggregate supply curve, which depicts the economy’s potential output: the level of aggregate output that the economy would produce if all prices were fully flexible. It might seem that we’re using the same term, long run, for two different concepts. But we aren’t: these two concepts are really the same thing. Because the economy always tends to return to potential output, actual aggregate output fluctuates around potential output, rarely getting too far from it. As a result, the economy’s rate of growth over long periods of time—say, decades—is very close to the rate of growth of potential output. And potential output growth is determined by the factors we analyzed in Chapter 8. economics in action Prices and Output During the Great Depression Figure 10-6 shows the actual track of the aggregate price level, as measured by the GDP deflator, and real GDP from 1929 to 1942. As you can see, aggregate output and the aggregate price level fell together during the early part of the period and rose together during the later part of the period. This is what we’d expect to see if the Figure 10-6 Aggregate price level (GDP deflator, 2000 = 100) 12 1930 11 1931 10 1932 9 1933 1937 1939 1938 1936 1940 1935 1934 1941 Prices and Output During the Great Depression Beginning in 1929, falling prices went along with falling aggregate output and rising prices went along with rising aggregate output. That is, the economy behaved as if it were moving down and up the short-run aggregate supply curve. By the late 1930s, however, aggregate output was above 1929 levels even though the aggregate price level had not fully recovered. This shows that the short-run aggregate supply curve had shifted to the right. 1929 1942 00 0 1, 00 0 1, 10 0 1, 20 0 1, 30 0 1, 40 0 1, 50 0 70 80 $6 90 0 0 0 Real GDP (billions of dollars) 246 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S ®® ® QUICK REVIEW ® ® ® The short-run aggregate supply curve is upward-sloping: a higher aggregate price level leads to higher aggregate output given sticky nominal wages. Changes in commodity prices, nominal wages and productivity shift the short-run aggregate supply curve. In the long run, all prices are flexible, and the aggregate price level has no effect on aggregate output. The long-run aggregate supply curve is vertical at potential output. If actual aggregate output exceeds potential output, nominal wages rise and the short-run aggregate supply curve shifts leftward. If potential output exceeds actual aggregate output, nominal wages fall and the short-run aggregate supply curve shifts rightward. economy were moving down the short-run aggregate supply curve from 1929 to 1933 and moving up it (with a brief reversal in 1937–1938) thereafter. But even in 1942 the aggregate price level was still lower than it was in 1929; yet real GDP was much higher. What happened? The answer is that the short-run aggregate supply curve shifted to the right over time. This shift partly reflected rising productivity—a rightward shift of the underlying long-run aggregate supply curve. But since the U.S. economy was producing below potential output during this period, the rightward shift of the short-run aggregate supply curve also reflected the adjustment process shown in panel (b) of Figure 10-5. So the movement of aggregate output from 1929 to 1942 reflected both movements along and shifts of the short-run aggregate supply curve. I <<<<<<<<<<<<<<<<<< >>CHECK YOUR UNDERSTANDING 10-1 1. Explain whether each of the following events represents (i) a shift of the SRAS curve or (ii) a movement along the SRAS curve. a. A rise in the consumer price index (CPI) leads producers to increase output. b. A fall in the price of oil leads producers to increase output. c. A rise in legally mandated retirement benefits paid to workers leads producers to reduce output. 2. Suppose the economy is initially at potential output and the quantity of aggregate output supplied increases. What information would you need to determine whether this was due to a movement along the SRAS or a shift of the LRAS? Solutions appear at back of book. Aggregate Demand The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, and the government. Just as the aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied by producers, the aggregate demand curve shows the relationship between the aggregate price level and the total quantity of aggregate output demanded by households, businesses, and the government. Figure 10-7 shows an aggregate demand curve, AD. One point on the curve Figure 10-7 Aggregate price level (GDP deflator, 2000 = 100) A movement down the AD curve leads to a lower aggregate price level and higher aggregate output. The Aggregate Demand Curve The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded. The curve is downward-sloping due to the wealth effect of a change in the aggregate price level and the interest rate effect of a change in the aggregate price level. Here, the total quantity of goods and services demanded at an aggregate price level of 8.9, the actual number for 1933, is $636 billion in 2000 dollars, the actual quantity of aggregate output demanded in 1933. According to our hypothetical curve, however, if the aggregate price level had been only 5.0, the quantity of aggregate output demanded would have been $950 billion. 8.9 1933 5.0 Aggregate demand curve, AD 0 $636 950 Real GDP (billions of 2000 dollars) CHAPTER 10 A G G R E G AT E S U P P LY A N D A G G R E G AT E D E M A N D 247 corresponds to actual data for 1933, when the aggregate price level was 8.9 and the total quantity of domestic final goods and services purchased was $636 billion in 2000 dollars. AD is downward-sloping, indicating a negative relationship between the aggregate price level and the quantity of aggregate output demanded. A higher aggregate price level, other things equal, reduces the quantity of aggregate output demanded; a lower aggregate price level, other things equal, increases the quantity of aggregate output demanded. According to Figure 10-7, if the price level in 1933 had been 5.0 instead of 8.9, the total quantity of domestic final goods and services demanded would have been $950 billion in 2000 dollars instead of $636 billion. Why Is the Aggregate Demand Curve Downward-Sloping? In Figure 10-7, the curve AD is downward-sloping. Why? Recall the basic equation of national income accounting: (10-2) GDP = C + I + G + X − IM where C is consumer spending, I is investment spending, G is government purchases of goods and services, X is exports to other countries, and IM is imports. If we measure these variables in constant dollars—that is, in prices of a base year—C + I + G + X − IM is the quantity of domestically produced final goods and services demanded during a given period. G is decided by the government, but the other variables are private-sector decisions. To understand why the aggregate demand curve slopes downward, we need to understand why a rise in the aggregate price level reduces C, I, and X − IM. You might think that the downward slope of the aggregate demand curve is a natural consequence of the law of demand we defined back in Chapter 3: since the demand curve for any one good is downward-sloping, isn’t it natural that the demand curve for aggregate output is downward-sloping? This turns out to be a misleading parallel. The demand curve for any individual good shows how the quantity demanded depends on the price of that good, holding the prices of other goods and services constant. The main reason the quantity of a good demanded falls when the price of that good rises is that people switch their consumption to other goods and services. But when we consider movements up or down the aggregate demand curve, we’re considering a simultaneous change in the prices of all final goods and services. Furthermore, changes in the composition of goods and services in consumer spending aren’t relevant to the aggregate demand curve: if consumers decide to buy fewer clothes but more cars, this doesn’t necessarily change the total quantity of final goods and services they demand. Why, then, does a rise in the aggregate price level lead to a fall in the quantity of all domestically produced final goods and services demanded? There are two main reasons: the wealth effect and the interest rate effect of a change in the aggregate price level. The Wealth Effect An increase in the aggregate price level, other things equal, reduces the purchasing power of many assets. Consider, for example, someone who has $5,000 in a bank account. If the aggregate price level were to rise by 25%, that $5,000 would buy only as much as $4,000 would have bought previously. With the loss in purchasing power, the owner of that bank account would probably scale back his or her consumption plans, leading to a fall in spending on final goods and services. The wealth effect of a change in the aggregate price level is the effect of the aggregate price level on consumer spending generated by the effect of a change in the aggregate price level on the purchasing power of consumers’ assets. Because of it, consumer spending, C, falls when the aggregate price level rises, leading to a downward-sloping aggregate demand curve. The wealth effect of a change in the aggregate price level is the effect on consumer spending generated by the effect of the aggregate price level on the purchasing power of consumers’ assets. 248 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S The interest rate effect of a change in the aggregate price level is the effect on investment spending generated by the effect of the aggregate price level on the purchasing power of consumers’ money holdings. The Interest Rate Effect Economists use the term money in its narrowest sense to refer to cash and bank deposits on which people can write checks. People and firms hold money because it reduces the cost and inconvenience of making transactions. An increase in the aggregate price level, other things equal, reduces the purchasing power of a given amount of money holdings. To purchase the same basket of goods and services as before, people now need to hold more money. So, in response to an increase in the aggregate price level, people try to increase their money holdings, either by borrowing more or by selling other assets such as bonds, which would reduce the funds available for lending to other borrowers. This has the effect of driving interest rates up. In Chapter 9 we learned that a rise in the interest rate reduces investment spending because it makes the cost of borrowing higher. It also reduces consumer spending as households save more of their disposable income. So a rise in the aggregate price level depresses investment spending, I, and consumer spending, C, through its effect on the purchasing power of money holdings, an effect known as the interest rate effect of a change in the aggregate price level. This also leads to a downward-sloping aggregate demand curve. We’ll have a lot more to say about money and interest rates in Chapter 14. We’ll also see, in Chapter 20, that a higher interest rate indirectly tends to reduce exports (X) and increase imports (IM). For now, the important point is that the aggregate demand curve is downward-sloping due to both the wealth effect and the interest rate effect of a change in the aggregate price level. Shifts of the Aggregate Demand Curve When we talk about an increase in aggregate demand, we mean a shift of the aggregate demand curve to the right, as shown in panel (a) of Figure 10-8 by the shift from AD1 to AD2. A rightward shift occurs when the quantity of aggregate output demanded increases at any given aggregate price level. A decrease in aggregate demand means that AD shifts to the left, as in panel (b). A leftward shift implies that the quantity of aggregate output demanded falls at any given aggregate price level. Figure Aggregate price level 10-8 Shifts of the Aggregate Demand Curve (a) Rightward Shift (b) Leftward Shift Aggregate price level Increase in AD Decrease in AD AD1 AD2 Real GDP AD2 AD1 Real GDP Panel (a) shows the effect of events that increase the quantity of aggregate output demanded at any given aggregate price level, such as improvements in business and consumer expectations or increased government spending. Such changes shift the aggregate demand curve to the right, from AD1 to AD2. Panel (b) shows the effect of events that decrease the quantity of aggregate output demanded at any given price level, such as a fall in wealth caused by a stock market decline. This shifts the aggregate demand curve leftward from AD1 to AD2. CHAPTER 10 A G G R E G AT E S U P P LY A N D A G G R E G AT E D E M A N D 249 A number of factors can shift the aggregate demand curve; among the most important are changes in expectations, changes in wealth, and changes in the stock of physical capital. In addition, macroeconomic policy can shift the aggregate demand curve. Changes in Expectations Both consumer spending and investment spending depend in part on people’s expectations about the future. Consumers base their spending not only on the income they have now but also on the income they expect to have in the future. Firms base their investment spending not only on current conditions but also on the sales they expect to make in the future. As a result, changes in expectations can push both consumer spending and investment spending up or down. If consumers and firms become more optimistic, spending rises; if they become more pessimistic, spending falls. In fact, short-run economic forecasters pay careful attention to surveys of consumer and business optimism. In particular, forecasters watch the Consumer Confidence Index, a monthly measure calculated by the Conference Board, and the Michigan Consumer Sentiment Index, a similar measure calculated by the University of Michigan. Changes in Wealth Consumer spending depends in part on the value of household assets. When the value of these assets rises, the purchasing power they embody also rises, leading to an increase in aggregate demand. For example, in the 1990s there was a significant rise in the stock market that shifted aggregate demand. And when the value of household assets falls—for example, because of a stock market crash—the purchasing power they embody is reduced and aggregate demand also falls. The stock market crash of 1929 was one factor in the Great Depression. Similarly, a sharp decline in stock prices in the United States after 2000 was an important factor in the 2001 recession. Changes in Physical Capital Firms engage in investment spending to add to their stock of physical capital. Their incentive to spend depends in part on how much physical capital they already have: the more they have, the less need they will feel to add more, other things equal. Investment spending fell in 2000–2001 partly because high spending over the previous few years had left companies with more of certain kinds of capital, such as computers and fiber-optic cable, than they needed. PITFALLS CHANGES IN WEALTH: A MOVEMENT ALONG VERSUS A SHIFT OF THE AGGREGATE DEMAND CURVE In the last section we explained that one of the reasons that the AD curve was downward-sloping was due to the wealth effect of a change in the aggregate price level: A higher aggregate price level reduces the purchasing power of households’ assets and leads to a fall in consumer spending, C. But in this section we’ve just explained that changes in wealth lead to a shift of the AD curve. Aren’t those two explanations contradictory? Which one is it— does a change in wealth move the economy along the AD curve or does it shift the AD curve? The answer is both: it depends on the source of the change in wealth. A movement along the AD curve occurs when a change in the aggregate price level changes the purchasing power of consumers’ existing wealth (the value of their assets). This is the wealth effect of a change in the aggregate price level—a change in the aggregate price level is the source of the change in wealth. For example, a fall in the aggregate price level increases the purchasing power of consumers’ assets and leads to a movement down the AD curve. In contrast, a change in wealth independent of a change in the aggregate price level shifts the AD curve. For example, a rise in the stock market or a rise in real estate prices leads to an increase in the value of consumers’ assets at any given aggregate price level. In this case, the source of the change in wealth is a change in the price of assets without any change in the aggregate price level— that is, a change in asset prices holding the price of all final goods and services constant. Government Policies and Aggregate Demand One of the key insights of macroeconomics is that the government can have a powerful influence on aggregate demand and that, in some circumstances, this influence can be used to improve economic performance. The two main ways the government can influence the aggregate demand curve are through fiscal policy and monetary policy. We’ll briefly discuss their influence on aggregate demand, pending our full-length discussion in Chapter 12 and Chapter 14. 250 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S Fiscal Policy As we learned in Chapter 6, fiscal policy is the use of either government spending—government purchases of final goods and services and government transfers—or tax policy to stabilize the economy. In practice, governments often respond to recessions by increasing spending, cutting taxes, or both. They often respond to inflation by reducing spending or increasing taxes. The effect of government purchases of final goods and services, G, on the aggregate demand curve is direct because government purchases are themselves a component of aggregate demand. So an increase in government purchases shifts the aggregate demand curve to the right and a decrease shifts it to the left. History’s most dramatic example of how increased government purchases affect aggregate demand was the effect of wartime government spending during World War II. Because of the war, U.S. federal purchases surged 400%. This increase in purchases is usually given the credit for ending the Great Depression. In the 1990s Japan used large public works projects—such as government-financed construction of roads, bridges, and dams—in an effort to increase aggregate demand in the face of a slumping economy. In contrast, government transfers affect aggregate demand indirectly: by changing disposable income, they change consumer spending. Like transfers, changes in tax rates influence the economy indirectly, through their effect on disposable income. A lower tax rate means that consumers get to keep more of what they earn, increasing their disposable income. This increases consumer spending and shifts the aggregate demand curve to the right. A higher tax rate reduces the amount of disposable income received by consumers. This reduces consumer spending and shifts the aggregate demand curve to the left. Monetary Policy In Chapter 6 we defined monetary policy as changes in the quantity of money or the interest rate. We’ve just discussed how a rise in the aggregate price level, by reducing the purchasing power of money holdings, causes a rise in interest rates. That, in turn, reduces both investment spending and consumer spending. But what happens if the quantity of money in the hands of households and businesses changes? In modern economies, the quantity of money in circulation is largely determined by the decisions of a central bank created by the government. (As we’ll learn in Chapter 13, the Federal Reserve, the U.S. central bank, is a special institution that is neither exactly part of the government nor exactly not part of the government.) When a central bank increases the quantity of money in circulation, people have more money, which they are willing to lend out. The effect is to drive interest rates down at any given aggregate price level and to increase investment spending and consumer spending. That is, increasing the quantity of money shifts the aggregate demand curve to the right. Reducing the quantity of money has the opposite effect: people have less money than before, leading them to borrow more and lend less. This raises the interest rate, reduces investment spending and consumer spending, and shifts the aggregate demand curve to the left. economics in action Moving Along the Aggregate Demand Curve, 1979–1980 When looking at data, it’s often hard to distinguish between changes in spending that represent movements along the aggregate demand curve and shifts of the aggregate demand curve. One telling exception, however, is what happened right after the oil crisis of 1979, which we described in this chapter’s opening story. Faced with a sharp increase in the aggregate price level—the rate of consumer price inflation reached 14.8% in March of 1980—the Federal Reserve stuck to a policy of increasing the quantity of money slowly. The aggregate price level was rising steeply, but the quantity of money going into the economy was growing slowly. The net result was that the purchasing power of the quantity of money in circulation in the economy fell. CHAPTER 10 A G G R E G AT E S U P P LY A N D A G G R E G AT E D E M A N D 251 This led to a surge in interest rates. The prime rate, which is the interest rate banks charge their best customers, went above 20%. High interest rates, in turn, caused both consumer spending and investment spending to fall: in 1980 purchases of durable consumer goods like cars fell by 5.3% and real investment spending fell by 8.9%. In other words, in 1979–1980 the economy responded just as we’d expect if it were moving along the aggregate demand curve: due to the wealth effect and the interest rate effect, the quantity of aggregate output demanded fell as the aggregate price level rose. In the section “The AS-AD Model” we’ll see that although this interpretation of the events in 1979–1980 is correct, the facts are a bit more complicated. There was indeed a movement along the aggregate demand curve. There was also, however, a shift of the aggregate supply curve. And this had unanticipated effects. I ®® ® QUICK REVIEW ® >>>>>>>>>>>>>>>>>>>> >>CHECK YOUR UNDERSTANDING 10-2 1. Determine the effect on aggregate demand of each of the following events. Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward). a. A rise in the interest rate caused by a change in monetary policy b. A fall in the real value of money in the economy due to a higher price level c. Expectations of a poor job market next year d. A fall in tax rates e. A rise in the real value of assets in the economy due to a lower price level f. A rise in the real value of assets in the economy due to a surge in real estate prices Solutions appear at back of book. ® The aggregate demand curve, the relationship between the aggregate price level and the quantity of aggregate output demanded, is downward-sloping because of the wealth effect of a change in the aggregate price level and the interest rate effect of a change in the aggregate price level. The aggregate demand curve shifts in response to changes in consumer and investment spending. Changes in sonsumer spending are caused by changes in wealth and expectations about the future. Investment spending is affected by changes in expectations and in the stock of physical capital. Fiscal policy affects aggregate demand directly through government purchases and indirectly through changes in taxes or government transfers. Monetary policy affects aggregate demand indirectly through changes in the interest rate. The Multiplier Suppose that businesses become more optimistic about future sales and increase investment spending by $50 billion. This shifts the aggregate demand curve rightward— that is, it will increase the quantity of aggregate output demanded at any given aggregate price level. But suppose that we want to know how much the aggregate demand curve will shift to the right. Answering questions like this has led to the concept of the multiplier, which plays an important role in the analysis of economic policy. When we ask how far to the right a $50 billion increase in investment spending shifts the aggregate demand curve, what we’re really asking for is the magnitude of the shift shown in Figure 10-9 on page 252: the increase in the quantity of aggregate output demanded at a given aggregate price level, P*. To answer this question simply, we will hold the aggregate price level constant. (This means, among other things, that there is no difference between changes in nominal GDP and changes in real GDP.) We’ll also make some additional simplifying assumptions: we’ll hold the interest rate constant, and we’ll ignore the roles of taxes and foreign trade, reserving those issues for later chapters. Assuming a constant aggregate price level and a fixed interest rate, you might be tempted to say that a $50 billion increase in investment spending will shift the aggregate demand curve to the right by the quantity of aggregate output that $50 billion would purchase. That, however, is an underestimate. It’s true that an increase in investment spending leads firms that produce investment goods to increase output. If the process stopped there, then the rightward shift of the AD curve would indeed be $50 billion. But the process doesn’t stop there. The increase in output leads to an increase in disposable income that flows to households in the form of profits and wages. The increase in households’ disposable income leads to a rise in consumer spending. The rise in consumer spending, in turn, induces firms to increase output yet again. This generates another rise in disposable income, which leads to another round of consumer spending increases, and so on. So there are multiple rounds of increases in aggregate output. 252 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S Figure 10-9 Aggregate price level Measuring Shifts of the AD Curve To measure the shift that takes place when the aggregate demand curve shifts rightward from AD1 to AD2, we calculate how much real GDP would rise if we held the aggregate price level fixed at P*. P* AD2 AD1 Y1 Y2 Real GDP Size of rightward shift in AD curve given aggregate price level P* The marginal propensity to consume (MPC ) is the increase in consumer spending when aggregate disposable income rises by $1. How large is the total effect on aggregate output? That is, if we sum the effect on aggregate output from all these rounds of spending increases, how large is it? To answer this question, we need to introduce the concept of the marginal propensity to consume (MPC): the increase in consumer spending when disposable income rises by $1. Alternatively, when consumer spending changes because of a rise or fall in aggregate disposable income, MPC is the change in consumer spending divided by the change in aggregate disposable income: (10-3) MPC = Consumer spending Aggregate disposable income The marginal propensity to save (MPS ) is the fraction of an additional dollar of aggregate disposable income that is saved. For example, if consumer spending goes up by $6 billion when disposable income goes up by $10 billion, MPC is $6 billion/$10 billion = 0.6. Because consumers normally spend part but not all of an additional dollar of disposable income, MPC is a number between 0 and 1. The additional disposable income that consumers don’t spend is saved; the marginal propensity to save (MPS), is the fraction of an additional dollar of aggregate disposable income that is saved, and it is equal to 1 − MPC. Since we’re ignoring taxes for now, we can assume that each $1 increase in real GDP raises real disposable income by $1. The $50 billion increase in investment spending initially raises real GDP by $50 billion. This leads to a second-round increase in consumer spending, which raises real GDP by a further MPC × $50 billion. This leads to a third-round increase in consumer spending of MPC × MPC × $50 billion, and so on. The total effect on GDP is: $50 billion (Increase in investment spending) + MPC × $50 billion (Second-round increase in consumer spending) + MPC × MPC × $50 billion = MPC2 × $50 billion (Third-round increase in consumer spending) + MPC × MPC × MPC × $50 billion = MPC3 × $50 billion (Fourth-round increase in consumer spending) +... = (1 + MPC + MPC2 + MPC3 + . . .) × $50 billion CHAPTER 10 A G G R E G AT E S U P P LY A N D A G G R E G AT E D E M A N D 253 So the initial $50 billion increase in investment spending sets off a chain reaction in the economy. The net result of this chain reaction is that a $50 billion increase in investment spending leads to a change in real GDP that is a multiple of the size of that initial change in spending. How large is this multiple? It’s a mathematical fact that a series of the form 1 + x + x2 + . . ., with x between 0 and 1, is equal to 1/(1 − x). So the total effect of a $50 billion increase in government purchases of goods and services, taking into account all the subsequent increases in consumer spending, is given by (10-4) Total increase in GDP from $50 billion rise in G $50 billion × 1 1 − MPC TABLE 10-1 Suppose that MPC = 0.6: each $1 in additional disposable income causes a $0.60 rise in consumer spending. In that Table Title Tk case, a $50 billion increase in investment spending raises Increase in GDP real GDP by $50 billion. The second-round increase in con(billions of dollars) sumer spending raises GDP by another 0.6 × $50 billion, or First round $50 $30 billion. The third-round increase in consumer spending raises GDP by another 0.6 × $30 billion, or $18 billion. Second round 30 Table 10-1 shows the successive stages of increase, where “. . Third round 18 . ” means the process goes on an infinite number of times. Fourth round 10.8 In the end, GDP rises by $125 billion as a consequence of … … the initial $50 billion rise in investment spending. Notice that even though there are an infinite number of Final round 0 rounds of expansion of GDP, the total rise in GDP is limited. The reason is that at each stage some of the rise in disposable income “leaks out” because it is saved. How much of an additional dollar of disposable income is saved depends on MPS, the marginal propensity to save. Figure 10-10 illustrates the effect of the increase in investment spending on the aggregate demand curve. Panel (a) shows the successive rounds of increasing GDP Total increase in GDP (billions of dollars) $50 80 98 108.8 … 125 Figure Increase in GDP (billions of dollars) $125 100 75 50 10-10 The Multiplier (b) The Corresponding Effect on Aggregate Demand (a) Rounds of Increases in GDP Aggregate price level P* AD1 25 0 1 2 3 4 5 6 7 8 … Final Round AD2 Y2 Real GDP Y1 Initial increase = $50 billion Subsequent increase = $75 billion A change in expectations that leads to a rise in investment spending shifts the aggregate demand curve rightward for two reasons. Holding the aggregate price level constant, there is an initial increase in GDP from the rise in I. Then there are subsequent increases in GDP as rising disposable income leads to higher consumer spending. Panel (a) shows how the rise in GDP at a given aggregate price level takes place. Panel (b) shows how this shifts the aggregate demand curve. 254 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S An autonomous change in aggregate spending is an initial change in the desired level of spending by firms, households, and government at a given level of GDP. The multiplier is the ratio of the eventual change in GDP caused by an autonomous change in aggregate spending to the size of that autonomous change. from Table 10-1. Panel (b) shows the corresponding effect on aggregate demand: the total amount of the rightward shift of the AD curve, from AD1 to AD2, is $125 billion, the sum of the initial increase in investment spending, $50 billion, plus the subsequent rise in consumer spending, $75 billion. We’ve described the effects of a change in investment spending, but the same analysis can be applied to other causes of a shift in the aggregate demand curve. Since there is no foreign trade in the simple economy we’re now considering, we’ll focus on domestic aggregate spending in the economy, the sum of consumer spending, C, investment spending, I, and government purchases of goods and services, G. Shifts in the aggregate demand curve can arise from changes in any of those three components of aggregate spending. The important thing is to distinguish between the initial change in aggregate spending, before real GDP rises, and the additional change in aggregate spending caused by the change in real GDP as the chain reaction unfolds. For example, suppose that total wealth in the economy increases for some reason. This will lead to an initial rise in consumer spending, before real GDP rises. But it will also lead to second and later rounds of higher consumer spending as real GDP rises. An initial rise or fall in aggregate spending at a given level of GDP is called an autonomous change in aggregate spending. It’s autonomous—which literally means “self-governing”—because it’s the cause, not the effect, of the chain reaction we’ve just described. The multiplier is the ratio of the eventual change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change. If we let AAS stand for autonomous change in aggregate spending and Y stand for the change in GDP, then the multiplier is equal to Y/ AAS. And we’ve already seen from equation 10-4 how to find the value of the multiplier: it’s (10-5) Multiplier = 1 1 − MPC Accordingly, the multiplier lets us calculate the change in real GDP that arises from an autonomous change in aggregate spending: (10-6) ®® ® Y= 1 × AAS 1 − MPC QUICK REVIEW ® ® A change in investment spending starts a chain reaction in which the initial rise or fall in real GDP leads to changes in consumer spending, which lead to further changes in real GDP, and so on. The eventual shift in the aggregate demand curve is a multiple of the initial change in investment spending. How large this multiple is depends on the marginal propensity to consume (MPC). The same chain reaction is caused by any autonomous change in aggregate spending. The multiplier is equal to 1/(1−MPC). Notice that the size of the multiplier—and so the size of the shift in the aggregate demand curve resulting from any given initial change in spending—depends on MPC. If the marginal propensity to consume is high, so is the multiplier. This is true because the size of MPC determines how large each round of expansion is compared with the previous round. To put it another way, the higher MPC is, the less disposable income “leaks out” in each round of expansion. In later chapters we’ll use the concept of the multiplier to analyze the effects of fiscal and monetary policies. We’ll also see that the formula for the multiplier changes when we introduce various complications, including taxes and foreign trade. <<<<<<<<<<<<<<<<<< >>CHECK YOUR UNDERSTANDING 10-3 1. Explain why a decline in investment spending, caused by a change in business expectations, would also lead to a fall in consumer spending. Solutions appear at back of book. The AS–AD Model From 1929 to 1933, the U.S. economy moved down the short-run aggregate supply curve as the aggregate price level fell. In contrast, from 1979 to 1980 the U.S. economy moved up the aggregate demand curve as the aggregate price level rose. In each case, the cause of the movement along the curve was a shift of the other curve. In 1929–1933, it was a leftward shift of the aggregate demand curve—a CHAPTER 10 A G G R E G AT E S U P P LY A N D A G G R E G AT E D E M A N D 255 major fall in consumer spending. In 1979–1980, it was a leftward shift of the short-run aggregate supply curve—a dramatic fall in short-run aggregate supply caused by the oil price shock. So to understand the behavior of the economy, we must put the aggregate supply curve and the aggregate demand curve together. The result is the AS–AD model, the basic model we use to understand economic fluctuations. Short-Run Macroeconomic Equilibrium We’ll begin our analysis by focusing on the short run. Figure 10-11 shows the aggregate demand curve and the short-run aggregate supply curve on the same diagram. The point at which the AD and SRAS curves intersect, ESR, is the short-run macroeconomic equilibrium: the point at which the total quantity of aggregate output supplied is equal to the total quantity demanded by domestic households, businesses, the government, and foreigners (through net exports). The aggregate price level at ESR, PE, is the short-run equilibrium aggregate price level. The level of aggregate output at ESR, YE, is the short-run equilibrium aggregate output. In the supply and demand model of Chapter 3 we saw that a shortage of any individual good causes its market price to rise but a surplus of the good causes its market price to fall. These forces ensure that the market reaches equilibrium. The same logic applies to short-run macroeconomic equilibrium. If the aggregate price level is above its equilibrium level, the quantity of aggregate output supplied exceeds the quantity demanded. This leads to a fall in the aggregate price level and pushes it toward its equilibrium level. If the aggregate price level is below its equilibrium level, the quantity of aggregate output supplied is less than the quantity demanded. This leads to a rise in the aggregate price level, again pushing it toward its equilibrium level. In the discussion that follows, we’ll assume that the economy is always in short-run macroeconomic equilibrium. We’ll also make another important simplification based on the observation that there is a long-term upward trend in both aggregate output and the aggregate price level. We’ll assume that a fall in either variable really means a fall compared to the long-run trend. For example, if the aggregate price level normally rises 4% per year, a year in which the aggregate price level rises only 2% would count, for our purposes, as The AS–AD model uses the aggregate supply curve and the aggregate demand curve together to analyze economic fluctuations. The economy is in short-run macroeconomic equilibrium when the quantity of aggregate output supplied is equal to the quantity demanded. The short-run equilibrium aggregate price level is the aggregate price level in the short-run macroeconomic equilibrium. Short-run equilibrium aggregate output is the quantity of aggregate output produced in the short-run macroeconmic equilibrium. Figure 10-11 Aggregate price level The AS-AD Model The AS–AD model combines the short-run aggregate supply curve and the aggregate demand curve. Their point of intersection, ESR , is the point of short-run macroeconomic equilibrium where the quantity of aggregate output demanded is equal to the quantity of aggregate output supplied. PE is the short-run equilibrium aggregate price level, and YE is the short-run equilibrium level of aggregate output. SRAS PE ESR Short-run macroeconomic equilibrium AD YE Real GDP 256 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S a 2% decline. In fact, since the Great Depression there have been very few years in which the aggregate price level of any major nation actually declined—Japan’s deflation after about 1995 is one of the few exceptions. We’ll explain why in Chapter 16. There have, however, been many cases in which the aggregate price level fell relative to the long-run trend. Short-run equilibrium aggregate output and the short-run equilibrium aggregate price level can change either because of shifts of the SRAS curve or because of shifts of the AD curve. Let’s look at each case in turn. Shifts of the SRAS Curve An event that shifts the short-run aggregate supply curve is a supply shock. An event that shifts the short-run aggregate supply curve is known as a supply shock. A negative supply shock raises production costs and reduces the quantity producers are willing to supply at any given aggregate price level, leading to a leftward shift of the short-run aggregate supply curve. The U.S. economy experienced severe negative supply shocks following disruptions to world oil supplies in 1973 and 1979. In contrast, a positive supply shock reduces production costs and increases the quantity supplied at any given aggregate price level, leading to a rightward shift of the short-run aggregate supply curve. The United States experienced a positive supply shock between 1995 and 2000, when the increasing use of the Internet and other information technologies caused productivity growth to surge. The effects of a negative supply shock are shown in panel (a) of Figure 10-12. The initial equilibrium is at E1, with aggregate price level P1 and aggregate output Y1. The disruption in the oil supply causes the short-run aggregate supply curve to shift to the left, from SRAS1 to SRAS2. As a consequence, aggregate output falls and the aggregate price level rises, a movement up the AD curve. At the new equilibrium, E2, the equi- Figure 10-12 Supply Shocks (b) A Positive Supply Shock (a) A Negative Supply Shock Aggregate price level A negative supply shock... Aggregate price level A positive supply shock... SRAS2 P2 P1 E2 E1 SRAS1 E1 P1 P2 E2 SRAS1 SRAS2 ...leads to higher aggregate output and a lower aggregate price level. ...leads to lower aggregate output and a higher aggregate price level. AD Y2 Y1 Real GDP AD Y1 Y2 Real GDP A supply shock shifts the short-run aggregate supply curve, moving the aggregate price level and aggregate output in opposite directions. Panel (a) shows a negative supply shock, which shifts the short-run aggregate supply curve leftward, causing stagflation—lower aggregate output and a higher aggregate price level. Here the short-run aggregate supply curve shifts from SRAS1 to SRAS2 , and the economy moves from E1 to E2. The aggregate price level rises from P1 to P2 , and aggregate output falls from Y1 to Y2. Panel (b) shows a positive supply shock, which shifts the short-run aggregate supply curve rightward, generating higher aggregate output and a lower aggregate price level. The short-run aggregate supply curve shifts from SRAS1 to SRAS2 , and the economy moves from E1 to E2. The aggregate price level falls from P1 to P2 , and aggregate output rises from Y1 to Y2. CHAPTER 10 A G G R E G AT E S U P P LY A N D A G G R E G AT E D E M A N D 257 librium aggregate price level, P2, is higher, and the equilibrium aggregate output level, Y2, is lower than before. The combination of inflation and falling aggregate output shown in panel (a) has a special name: stagflation (for “stagnation plus inflation”). When an economy experiences stagflation, it’s very unpleasant: falling aggregate output leads to rising unemployment, and people with jobs feel that their purchasing power is squeezed by rising prices. Stagflation in the 1970s led to a mood of national pessimism; it also, as we’ll see shortly, posed a dilemma for policy makers. A positive supply shock, shown in panel (b), has exactly the opposite effects. A rightward shift of the SRAS curve from SRAS1 to SRAS2 results in a rise in aggregate output and a fall in the aggregate price level, a movement down the AD curve. The favorable supply shocks of the late 1990s led to a combination of full employment and declining inflation. That is, the aggregate price level fell compared with the long-run trend. This combination produced, for a time, a great wave of national optimism. The distinctive feature of supply shocks, both negative and positive, is that they cause the aggregate price level and aggregate output to move in opposite directions. Stagflation is the combination of inflation and falling aggregate output. Shifts of Aggregate Demand: Short-Run Effects An event that shifts the aggregate demand curve is known as a demand shock. The Great Depression was caused by a negative demand shock, the collapse of business and consumer demand that followed the stock market crash of 1929 and the banking crisis of 1930–1931. The Depression was ended by a positive demand shock—the huge increase in government purchases during World War II. In 2001 the U.S. economy experienced another significant negative demand shock as the stock market boom of the 1990s turned into a bust and nervous businesses drastically scaled back their investment spending. Figure 10-13 shows the short-run effects of negative and positive demand shocks. A negative demand shock shifts the aggregate demand curve, AD, to the left, from AD1 to AD2, as shown in panel (a). The economy moves from E1 to E2, leading to An event that shifts the aggregate demand curve is a demand shock. Figure 10-13 Demand Shocks (b) A Positive Demand Shock (a) A Negative Demand Shock Aggregate price level A negative demand shock... Aggregate price level A positive demand shock... SRAS P1 P2 E2 AD1 Y2 AD2 Y1 AD1 Real GDP SRAS P2 P1 E1 AD2 Y1 Y2 Real GDP E1 ...leads to lower aggregate price level and lower aggregate output. E2 ...leads to higher aggregate price level and higher aggregate output. A demand shock shifts the aggregate demand curve, moving the aggregate price level and aggregate output in the same direction. In panel (a) a negative demand shock shifts the aggregate demand curve leftward from AD1 to AD2, reducing the aggregate price level from P1 to P2 and aggregate output from Y1 to Y2. In panel (b) a positive demand shock shifts the aggregate demand curve rightward, increasing the aggregate price level from P1 to P2 and aggregate output from Y1 to Y2. 258 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S lower equilibrium aggregate output and a lower equilibrium aggregate price level. A positive demand shock shifts the aggregate demand curve, AD, to the right, as shown in panel (b). Here, the economy moves up the SRAS curve, from E1 to E2. This leads to higher equilibrium aggregate output and a higher equilibrium aggregate price level. In contrast to supply shocks, demand shocks cause aggregate output and the aggregate price level to move in the same direction. There’s another important contrast between supply shocks and demand shocks. As we’ve seen, monetary policy and fiscal policy enable the government to shift the AD curve, meaning that governments are in a position to create the kinds of shocks shown in Figure 10-13. Are there good policy reasons to do this? We’ll turn to that question soon. First, however, let’s look at the difference between short-run macroeconomic equilibrium and long-run macroeconomic equilibrium. Long-Run Macroeconomic Equilibrium Figure 10-14 combines the aggregate demand curve with both the short-run and long-run aggregate supply curves. The aggregate demand curve, AD, crosses the shortrun aggregate supply curve, SRAS, at ELR. Here we assume that enough time has elapsed that the economy is also on the long-run aggregate supply curve, LRAS. As a result, ELR is at the intersection of all three curves, SRAS LRAS, and AD. So equilibrium aggregate output, YE, is equal to potential output. Such a situation, in which the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve, is known as long-run macroeconomic equilibrium. To see the significance of long-run macroeconomic equilibrium, let’s consider what happens if a demand shock moves the economy away from long-run macroeconomic equilibrium. In Figure 10-15, we assume that the initial aggregate demand curve is AD1 and the initial short-run aggregate supply curve is SRAS1. So the initial macroeconomic equilibrium is at E1, which lies on the long-run aggregate supply curve, LRAS. The economy, then, starts from a point of short-run and long-run macroeconomic equilibrium, and actual aggregate output equals potential output at Y1. The economy is in long-run macroeconomic equilibrium when the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve. Figure 10-14 Aggregate price level Long-Run Macroeconomic Equilibrium Here the point of short-run macroeconomic equilibrium also lies on the long-run aggregate supply curve, LRAS. As a result, actual aggregate output is equal to potential output. The economy is in long-run macroeconomic equilibrium at ELR. LRAS SRAS PE ELR Long-run macroeconomic equilibrium AD YE Potential output Real GDP CHAPTER 10 A G G R E G AT E S U P P LY A N D A G G R E G AT E D E M A N D 259 Figure 10-15 Aggregate price level 2.…reducestheagrete pricelevelandagrete outputandleadstohigher unemploymentintheshort run… Short-Run Versus Long-Run Effects of a Negative Demand Shock In the long run the economy is self-correcting: demand shocks have only temporary effects on aggregate output. Starting at E1, a negative demand shock shifts AD1 leftward to AD2. In the short run the economy moves to E2 and a recessionary gap arises: the aggregate price level declines from P1 to P2, aggregate output declines from Y1 to Y2, and unemployment rises. But in the long run nominal wages fall in response to high unemployment, and SRAS1 shifts rightward to SRAS2: aggregate output rises from Y2 to Y1, and the aggregate price level declines again, from P2 to P3. Long-run macroeconomic equilibrium is eventually restored at E3. LRAS SRAS1 SRAS2 P1 P2 P3 1. Anitial negative demandshock… E1 E2 E3 AD2 Y2 Y1 Potential output 3.…untilaneventual fal linominalwages inthelongrunicreas short-runagretesuply andmovestheeconmy AD1 backtopotentialoutput. Real GDP Recessionary gap Now suppose that for some reason—such as a sudden worsening of business and consumer expectations—aggregate demand falls and the aggregate demand curve shifts leftward to AD2. This results in a lower equilibrium aggregate price level at P2 and a lower equilibrium aggregate output level at Y2 as the economy settles in the short run at E2. The short-run effect of such a fall in aggregate demand is what the U.S. economy experienced in 1929–1933: a lower aggregate price level and lower aggregate output than before. Aggregate output in this new short-run equilibrium, E2, is below potential output. When this happens, the economy faces a recessionary gap. In the real world, a recessionary gap inflicts a great deal of pain because it corresponds to high unemployment. The recessionary gap that opened up in the United States by 1933 caused intense social and political turmoil. The recessionary gap that opened up in Germany at the same time played an important role in the rise of Hitler. But this isn’t the end of the story. In the face of high unemployment, nominal wages eventually tend to fall, as do any other sticky prices, ultimately leading producers to increase output. As a result, a recessionary gap causes the short-run aggregate supply curve to shift gradually to the right over time. This process continues until SRAS1 reaches its new position at SRAS2, bringing the economy to equilibrium at E3, where AD2, SRAS2, and LRAS all intersect. At E3, the economy is back in long-run macroeconomic equilibrium; it is back at potential output Y1 but at a lower aggregate price level, P3, reflecting a long-run fall in the aggregate price level. What if, instead, there were an increase in aggregate demand? The results are shown in Figure 10-16 on page 260, where we again assume that the initial aggregate demand curve is AD1, and the initial short-run aggregate supply curve is SRAS1, so that the initial macroeconomic equilibrium, at E1, lies on the long-run aggregate supply curve, LRAS. Initially, then, the economy is in long-run macroeconomic equilibrium. Now suppose that aggregate demand rises, and the AD curve shifts right to AD2. This results in a higher aggregate price level, at P2, and a higher aggregate output There is a recessionary gap when aggregate output is below potential output. 260 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S Figure 10-16 Aggregate price level 1. Anitalpositve demandshock… 3.…untilaneventualriseinominal wagesinthelongrunreducesshort-run agregatesupplyandmovesthe economybacktopentialoutput. Short-Run Versus Long-Run Effects of a Positive Demand Shock Starting at E1 a positive demand shock shifts AD1 rightward to AD2, and the economy moves to E2 in the short run. This results in an inflationary gap as aggregate output rises from Y1 to Y2, the aggregate price level rises from P1 to P2, and unemployment falls to a low level. In the long run, SRAS1 shifts leftward to SRAS2 as nominal wages rise in response to low unemployment. Aggregate output falls back to Y1, the aggregate price level rises again to P3, and the economy returns to long-run macroeconomic equilibrium at E3. LRAS SRAS2 SRAS1 E3 P3 P2 P1 AD1 Potential output E1 E2 AD2 2.…increasesthe agregatepricelevel andagregateoutput andreducesunemployment intheshortun… Y1 Y2 Real GDP Inflationary gap There is an inflationary gap when aggregate output is above potential output. In the long run the economy is selfcorrecting: shocks to aggregate demand do not affect aggregate output in the long run. level, at Y2, as the economy settles in the short run at E2. Aggregate output in this new short-run equilibrium is above potential output, and unemployment is low in order to produce this higher level of aggregate output. When this happens, the economy experiences an inflationary gap. As in the case of a recessionary gap, this isn’t the end of the story. In the face of low unemployment, nominal wages tend to rise, as do other sticky prices. An inflationary gap causes the short-run aggregate supply curve to shift gradually to the left as producers reduce output in the face of rising nominal wages. This process continues until SRAS1 reaches its new position at SRAS2, bringing the economy to equilibrium at E3, where AD2, SRAS2, and LRAS all intersect. At E3, the economy is back in long-run macroeconomic equilibrium; it is back at potential output, but at a higher price level, P3, reflecting a long-run rise in the aggregate price level. There is an important lesson about the macroeconomy to be learned from this analysis. When there is a recessionary gap, nominal wages eventually fall, moving the economy back to potential output. And when there is an inflationary gap, nominal wages eventually rise, also moving the economy back to potential output. So in the long run the economy is self-correcting: shocks to aggregate demand affect aggregate output in the short run but not in the long run. economics in action Supply Shocks versus Demand Shocks in Practice How often do supply shocks and demand shocks, respectively, cause recessions? The verdict of most, though not all, macroeconomists is that most recessions are caused by demand shocks. But when a negative supply shock happens, the resulting recession tends to be particularly nasty. CHAPTER 10 A G G R E G AT E S U P P LY A N D A G G R E G AT E D E M A N D 261 Let’s get specific. Officially there have been ten recessions in the United States since World War II. However, two of these, in 1979–1980 and 1981–1982, are often treated as a single “doubledip” recession (bringing the total number down to nine). Of these nine recessions, only two—the recession of 1973–1975 and the double-dip recession of 1979–1982—showed the distinctive combination of falling aggregate output and a surge in the price level that we call stagflation. In each case, the cause of the supply shock was political turmoil in the Middle East—the Arab–Israeli war of 1973 and the Iranian revolution of 1979—that disrupted world oil supplies and sent oil prices skyrocketing. In fact, economists sometimes refer to the two slumps as “OPEC I” and “OPEC II,” after the Organization of Petroleum Exporting Countries, the world oil cartel. So seven of nine postwar recessions were the result of demand shocks, not supply shocks. The two supply-shock recessions, however, were the two worst as measured by the unemployment rate. Figure 10-17 shows the U.S. unemployment rate since 1948, with the dates of the 1973 Arab–Israeli war and the 1979 Iranian revolution marked on the graph. The two highest unemployment rates since World War II came after the two big negative supply shocks. There’s a reason the aftermath of a supply shock is particularly nasty: macroeconomic policy has a much harder time dealing with supply shocks than with demand shocks. We’ll see why in a minute. Figure 10-17 Negative Supply Shocks are Relatively Rare But Nasty 1979 Iranian revolution 1973 Arab–Israeli war Unemployment rate 12% 10 8 6 4 >>>>>>>>>>>>>>>>>>>> >>CHECK YOUR UNDERSTANDING 10-4 1. Describe the short-run effects of each of the following shocks on the aggregate price level and aggregate output, as measured by real GDP: a. The government sharply increases the minimum wage, raising the wages of many workers. b. Telecommunications companies launch a major program of investment spending. c. Congress raises taxes and cuts spending. d. Severe weather destroys crops around the world. 2. A rise in productivity increases potential output, but some worry that demand for the additional output will be insufficient even in the long run. How would you respond? Solutions appear at back of book. Macroeconomic Policy We’ve just seen that the economy is self-correcting, that in the long run it always trends back toward potential output. Most macroeconomists believe, however, that the process of self-correction takes several years—typically a decade or more. In particular, if aggregate output is below potential output, the economy can suffer an extended period of depressed aggregate output and high unemployment before it returns to normal. This belief is the background to one of the most famous quotations in economics: John Maynard Keynes’s declaration, “In the long run we are all dead.” We explain the context in which he made this remark in For Inquiring Minds. 19 1948 5 19 0 55 19 60 19 65 19 70 19 75 19 80 19 85 19 90 19 9 20 5 0 20 0 04 Year Only two of nine postwar recessions seem to fit the profile of a recession caused by a negative supply shock: the recession that followed the increase in oil prices after the 1973 Arab–Israeli war and the recession that followed another surge in oil prices after the Iranian revolution. These two recessions were, however, the worst in terms of unemployment. ®® ® QUICK REVIEW ® ® Short-run macroeconomic equilibrium occurs at the intersection of the short-run aggregate supply and aggregate demand curves. A supply shock, a shift of the SRAS curve, causes the aggregate price level and aggregate output to move in opposite directions; a demand shock, a shift of the AD curve, causes them to move in the same direction. Stagflation is the consequence of a negative supply shock. The economy is self-correcting. A fall in nominal wages is a recessionary gap, and a rise in nominal wages is an inflationary gap. Both move the economy to long-run macroeconomic equilibrium, where the AD, SRAS, and LRAS curves intersect. 262 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S FOR INQUIRING MINDS KEYNES AND THE LONG RUN The British economist John Maynard Keynes (1883–1946), probably more than any single economist, created the modern field of macroeconomics. We’ll look at his role, and the controversies that still swirl around some aspects of his thought, in Chapter 17. But for now let’s just look at his most famous quote. In 1923 Keynes published A Tract on Monetary Reform, a small book on the economic problems of Europe after World War I. In it he decried the tendency of many of his colleagues to focus on how things work out in the long run—as in the long-run macroeconomic equilibrium we have just analyzed—while ignoring the often very painful and possibly disastrous things that can happen along the way. Here’s a fuller version of the quote: This long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the sea is flat again. Economists usually interpret Keynes as saying that governments should not wait around for the economy to correct itself. Instead, Keynes and many other—but not all—economists have argued that the government should use monetary and fiscal policy to get the economy back to potential output in the aftermath of a shift of the aggregate demand curve. This is the rationale for an active stabilization policy, which we defined in Chapter 6 as the use of government policy to reduce the severity of recessions and rein in excessively strong expansions. Can stabilization policy improve the economy’s performance? If we reexamine Figure 10-4, the answer certainly appears to be yes. Under active stabilization policy, the U.S. economy returned to potential output in 1996 after an approximately six-year recessionary gap. Likewise, in 2001 it also returned to potential output after an approximately four-year inflationary gap. These periods are much shorter than the decade or more that economists believe it would take for the economy to self-correct in the absence of active stabilization policy. However, as we’ll see shortly, the ability to improve the economy’s performance is not always guaranteed. It depends on the kinds of shocks the economy faces. Policy in the Face of Demand Shocks Imagine that the economy experiences a negative demand shock, like the one shown in Figure 10-15. As we’ve discussed in this chapter, monetary and fiscal policy shift the aggregate demand curve. If policy makers react quickly to the fall in aggregate demand, they can use monetary or fiscal policy to shift it back to the right. And if policy were able to perfectly anticipate shifts of the aggregate demand curve, it could short-circuit the whole process shown in Figure 10-15. Instead of going through a period of low aggregate output and falling prices, the government could manage the economy so that it would stay at E1. Why might a policy that short-circuits the adjustment shown in Figure 10-15, and maintains the economy at its original equilibrium, be desirable? For two reasons. First, the temporary fall in aggregate output that would happen without policy intervention is a bad thing, particularly because such a decline is associated with high unemployment. Second, as we explained briefly in Chapter 6 and will explain at greater length in Chapter 16, price stability is generally regarded as a desirable goal. So preventing deflation—a fall in the aggregate price level—is a good thing. Does this mean that policy makers should always act to offset declines in aggregate demand? Not necessarily. Some policy measures to increase aggregate demand, especially those that increase budget deficits, may have long-term costs, such as the CHAPTER 10 A G G R E G AT E S U P P LY A N D A G G R E G AT E D E M A N D 263 crowding out of private investment spending. Furthermore, in the real world policy makers aren’t perfectly informed, and the effects of policies aren’t perfectly predictable. This creates the danger that stabilization policy will do more harm than good, that attempts to stabilize the economy may end up creating more instability. We’ll describe the long-running debate over macroeconomic policy in Chapter 17. Despite these qualifications, most economists believe that a good case can be made for offsetting major negative shocks to the AD curve. Should policy makers also try to offset positive shocks to aggregate demand? It may not seem obvious that they should; after all, even though inflation may be a bad thing, aren’t more output and lower unemployment a good thing? Not necessarily. As we’ll see in Chapter 16, most economists now believe that any short-run gains from an inflationary gap must be paid back later. So policy makers today usually try to offset positive as well as negative demand shocks. We can see evidence of this in panel (a) of Figure 10-4. For reasons we’ll explain in Chapter 17, both the recessionary gap of the early 1990s and the inflationary gap of the late 1990s were managed with monetary rather than fiscal policy. During the recessionary gap of the early 1990s the Federal Reserve cut interest rates to stimulate consumer and investment spending. And it raised interest rates during the inflationary gap of the late 1990s to generate the opposite effect. But how should policy respond to supply shocks? Responding to Supply Shocks We’ve now come full circle to the story that began this chapter. We can now explain why the inflationary recessions of the 1970s posed such a policy puzzle. Back in panel (a) of Figure 10-12 we showed the effects of a negative supply shock: in the short run such a shock leads to lower aggregate output but a higher aggregate price level. As we’ve noted, policy makers can respond to a negative demand shock by using monetary and fiscal policy to return aggregate demand to its original level. But what can or should they do about a negative supply shock? In contrast to the aggregate demand curve, there are no easy policies that shift the short-run aggregate supply curve. That is, there is no government policy that can easily affect producers’ profitability and so compensate for shifts of the short-run aggregate supply curve. So the policy response to a supply shock cannot be simply to try to push the curve that shifted back to its original position. And if you consider using monetary or fiscal policy to shift the aggregate demand curve in response to a supply shock, the right response isn’t obvious. Two bad things are happening simultaneously: a fall in aggregate output and a rise in the aggregate price level. Any policy that shifts the aggregate demand curve helps one problem only by making the other worse. If the government acts to increase aggregate demand, it reduces the decline in output but causes more inflation. If it acts to reduce aggregate demand, it curbs inflation but causes a further decline in output. It’s a nasty trade-off. In the end, as we’ll see in Chapter 17, the United States and other economically advanced nations suffering from the supply shocks of the 1970s chose to stabilize prices. But being an economic policy maker in the 1970s meant facing even harder choices than usual. economics in action The End of the Great Depression In 1939, a full decade after the 1929 stock market crash, the U.S. economy remained deeply depressed, with 17% of the labor force unemployed. But then the economy began a rapid recovery, growing an amazing 12% per year until 1944. By 1943 the unemployment rate had fallen below 2%. 264 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S What caused this turnaround? The answer, without question, was a huge increase in aggregate demand caused by World War II. Although World War II began in September 1939, the United States didn’t become a combatant until the attack on Pearl Harbor in December 1941. But the war boosted aggregate demand before the United States became involved in the fighting. A U.S. military buildup began as soon as the risk of war was apparent. In addition, Britain began buying large amounts of U.S. military equipment and other goods during 1940, boosting U.S. exports. Once the United States was directly involved, government spending on arms increased at a spectacular rate. Did the behavior of prices match the predicA spectacular rise in government spending on arms during World War II spurred women to enter the workforce in droves tions of the AS-AD model? Yes. At the height of and was the catalyst that ended the Great Depression. the war, many goods were subject to price controls and rationing. Still, the aggregate price level as measured by the GDP deflator rose 30% during the war years and shot up further ®® Q U I C K R E V I E W after the war as controls were removed. I ® ® ® Stabilization policy is the use of fiscal or monetary policy to offset demand shocks. There can be drawbacks, however. The cost of such policies may lead to a longterm rise in the budget deficit; and, due to incorrect predictions, a misguided policy can increase economic instability. Negative supply shocks pose a policy dilemma because fighting the slump worsens inflation and fighting inflation worsens the slump. The role of World War II in ending the Great Depression is the classic example of how fiscal policy can increase aggregate demand and so increase aggregate output. <<<<<<<<<<<<<<<<<< >>CHECK YOUR UNDERSTANDING 10-5 1. Suppose someone says, “Expansionary monetary or fiscal policy does nothing but temporarily overstimulate the economy—you get a brief high, but then you have the pain of inflation.” a. Explain what this means in terms of the AS–AD model. b. Is this a valid argument against stabilization policy? Why or why not? Solutions appear at back of book. • A LOOK AHEAD • The AS-AD model is a powerful tool for understanding both economic fluctuations and the ways economic policy can sometimes fight adverse shocks. But in order to present the basic idea, we’ve been somewhat sketchy about the details. In the next three chapters we’ll put some flesh on these economic bones. We’ll begin with a more detailed analysis of the factors that determine aggregate demand, then move on to how fiscal and monetary policy actually work. CHAPTER 10 A G G R E G AT E S U P P LY A N D A G G R E G AT E D E M A N D 265 SUMMARY 1. The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied. 2. The short-run aggregate supply curve is upward-sloping because nominal wages are sticky in the short run: a higher aggregate price level leads to higher profits and increased aggregate output in the short run. Changes in commodity prices, nominal wages, and productivity lead to changes in producers’ profits and shift the short-run aggregate supply curve. 3. In the long run, all prices, including nominal wages, are flexible and the economy produces at its potential output. If actual aggregate output exceeds potential output, nominal wages will eventually rise in response to low unemployment and aggregate output will fall. If potential output exceeds actual aggregate output, nominal wages will eventually fall in response to high unemployment and aggregate output will rise. So the long-run aggregate supply curve is vertical at potential output. 4. The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded. It is downward-sloping for two reasons. The first is the wealth effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households’ wealth and reduces consumer spending. The second is the interest rate effect of a change in aggregate the price level—a higher aggregate price level reduces the purchasing power of households’ money holdings, leading to a rise in interest rates and a fall in investment spending and consumer spending. The aggregate demand curve shifts because of changes in expectations, wealth, and the stock of physical capital. Policy makers can use fiscal policy and monetary policy to shift the aggregate demand curve. 5. An autonomous change in aggregate spending leads to a chain reaction in which the change in real GDP is equal to the multiplier times the initial change in aggregate spending. The size of the multiplier, 1/1 − MPC, depends on the marginal propensity to consume, MPC: the larger the MPC, the larger the change in real GDP for any given autonomous increase in aggregate spending. The marginal propensity to save, MPS, is equal to 1 − MPC . 6. In the AS–AD model, the intersection of the short-run aggregate supply curve and the aggregate demand curve is the point of short-run macroeconomic equilibrium. It determines the short-run equilibrium aggregate price level and the level of short-run equilibrium aggregate output. 7. Economic fluctuations occur because of a shift of the short-run aggregate supply curve (a supply shock) or the aggregate demand curve (a demand shock). A supply shock causes the aggregate price level and aggregate output to move in opposite directions as the economy moves along the aggregate demand curve. A demand shock causes them to move in the same direction as the economy moves along the short-run aggregate supply curve. A particularly nasty occurrence is stagflation—rising prices and falling aggregate output—which is caused by a negative supply shock. 8. Demand shocks have only temporary effects on aggregate output because the economy is self-correcting in the long run. In a recessionary gap, an eventual fall in nominal wages moves the economy to long-run macroeconomic equilibrium, where aggregate output is equal to potential output. In an inflationary gap, an eventual rise in nominal wages moves the economy to long-run equilibrium. 9. The high cost—in terms of unemployment—of a recessionary gap and the future adverse consequences of an inflationary gap lead many economists to advocate active stabilization policy: using fiscal or monetary policy to offset demand shocks. Fiscal policy affects aggregate demand directly through government purchases and indirectly through changes in taxes or government transfers that affect consumer spending. Monetary policy affects aggregate demand indirectly through changes in the interest rate that affect consumer and investment spending. There can be drawbacks, however, because such policies may contribute to a long-term rise in the budget deficit and erroneous predictions can increase economic instability. 10. Negative supply shocks pose a policy dilemma: a policy that stabilizes aggregate output by increasing aggregate demand will lead to inflation, but a policy that stabilizes prices by reducing aggregate demand will deepen the output slump. 266 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S KEY TERMS Aggregate supply curve, p. 000 Nominal wage, p. 000 Short-run aggregate supply curve, p. 000 Long-run aggregate supply curve, p. 000 Potential output, p. 000 Aggregate demand curve, p. 000 Wealth effect of a change in the aggregate price level, p. 000 Interest rate effect of a change in the aggregate price level, p. 000 Marginal propensity to consume (MPC), p. 000 Marginal propensity to save (MPS), p. 000 Autonomous change in aggregate spending, p. 000 Multiplier, p. 000 AS–AD model, p. 000 Short-run macroeconomic equilibrium, p. 000 Short-run equilibrium aggregate price level, p. 000 Short-run equilibrium aggregate output, p. 000 Supply shock, p. 000 Stagflation, p. 000 Demand shock, p. 000 Long-run macroeconomic equilibrium, p. 000 Recessionary gap, p. 000 Inflationary gap, p. 000 Self-correcting, p. 000 PROBLEMS 1. Your study partner is confused by the upward-sloping shortrun aggregate supply curve and the vertical long-run aggregate supply curve. How would you explain this? 2. Suppose that in Wageland all workers sign annual wage contracts each year on January 1. No matter what happens to prices of final goods and services during the year, all workers earn the wage specified in their annual contract. This year, prices of final goods and services fall unexpectedly after the contracts are signed. ing more in response to a lower price. You, however, insist that this represents a rightward shift of the aggregate demand curve. Who is right? Explain. 5. Suppose that local, state and federal governments were obliged to cut government purchases whenever consumer spending falls. Then suppose, that consumer spending falls due to a fall in the stock market. Draw a diagram and explain the full effect of the fall in the stock market on the aggregate demand curve and on the economy. How is this similar to the experience of stagflation in the 1970s? 6. Due to autonomous change in consumer spending in the economies of Westlandia and Eastlandia has risen by $40 billion because of an increase in consumer wealth. Assuming that the aggregate price level is constant, the interest rate is fixed in both countries, and there are no taxes and no foreign trade, the accompanying tables show the various rounds of increased spending that will occur in both economies if the marginal propensity to consume is 0.5 in Westlandia and 0.75 in Eastlandia. What do the results indicate about the relationship between the size of the marginal propensity to consume and the multiplier? Westlandia Incremental change in GDP Total increase in GDP a. How will the quantity of aggregate output supplied respond to the fall in prices? Illustrate with a diagram. b. What will happen when firms and workers renegotiate their wages? Illustrate with a diagram. 3. In each of the following cases, in the short run, determine whether the events cause the shift of a curve or a movement along a curve. Determine which curve is involved and the direction of the change. a. As a result of an increase in the value of the dollar in relation to other currencies, American producers now pay less in dollar terms for foreign steel, a major component of production. b. An increase in the quantity of money by the Federal Reserve increases the amount of money that people wish to lend, lowering interest rates. c. Greater union activity leads to higher nominal wages. d. A fall in the aggregate price level increases the purchasing power of households’ money holdings. As a result, they borrow less and lend more. 4. A fall in the value of the dollar against other currencies makes U.S. final goods and services cheaper to foreigners even though the U.S. aggregate price level stays the same. As a result, foreigners demand more American aggregate output. Your study partner says that this represents a movement down the aggregate demand curve because foreigners are demand- Rounds 1 2 3 4 ... Final change in GDP C = $40 billion MPC × C = MPC × MPC × C = MPC × MPC × MPC × C = ... ... (1/(1 − MPC)) × C = CHAPTER 10 A G G R E G AT E S U P P LY A N D A G G R E G AT E D E M A N D 267 Eastlandia Incremental change in GDP Total increase in GDP Rounds 1 2 3 4 ... Final change in GDP C = $40 billion MPC × C = MPC × MPC × C = MPC × MPC × MPC × C = ... ... 10. Suppose that the economy is currently at potential output. Also suppose that you are an economic policy maker and that a college economics student asks you to rank, if possible, your most preferred to least preferred type of shock: positive demand shock, negative demand shock, positive supply shock, negative supply shock. How would you rank them and why? 11. Explain whether the following government policies affect the aggregate demand curve or the short-run aggregate supply curve and how. a. The government reduces the minimum wage in nominal terms. (1/(1 − MPC)) × C = b. The government increases Temporary Assistance to Needy Families (TANF) payments, government transfers to families with dependent children. 7. Assuming that the aggregate price level is constant, the interest rate is fixed, and there are no taxes and no foreign trade, how much will the aggregate demand curve shift and in what direction if the following events occur? c. To reduce the budget deficit, the government announces that households will pay much higher taxes beginning next year. d. The government reduces military spending. 12. In Wageland, all workers sign an annual wage contract each year on January 1. In late January, a new computer operating system is introduced that increases labor productivity dramatically. Explain how Wageland will move from one short-run macroeconomic equilibrium to another. Illustrate with a diagram. 13. Using aggregate demand, short-run aggregate supply, and long-run aggregate supply curves, explain the process by which each of the following economic events will move the economy from one long-run macroeconomic equilibrium to another. Illustrate with diagrams. In each case, what are the short-run and long-run effects on the aggregate price level and aggregate output? a. An autonomous consumer increase in spending of $25 billion; the marginal propensity to consume is 2/3. b. Businesspeople reduce investment spending by $40 billion; the marginal propensity to consume is 0.8. c. The government increases its purchases of military equipment by $60 billion; the marginal propensity to consume is 0.6. 8. The economy is at point A1 in the accompanying diagram. Suppose that the aggregate price level rises permanently from P1 to P2. How will aggregate supply adjust in the short run and in the long run to the increase in the aggregate price level? Aggregate price level LRAS SRAS1 a. There is a decrease in households’ wealth due to a decline in the stock market. b. There is a decrease in households’ desire to save. 14. Using aggregate demand, short-run aggregate supply, and long-run aggregate supply curves, explain the process by which each of the following government policies will move the economy from one long-run macroeconomic equilibrium to another. Illustrate with diagrams. In each case, what are the short-run and long-run effects on the aggregate price level and aggregate output? P2 P1 A Y1 Real GDP a. There is an increase in taxes on households. 9. Suppose that all households hold all their wealth in assets that automatically rise in value when the aggregate price level rises (an example of this is what is called an “inflationindexed bond”—a bond whose interest rate, among other things, changes one-for-one with the inflation rate). What KrugmanMacro PR10.08 happens to the wealth effect of a change in the aggregate price level as a result of this allocation of assets? What happens to the slope of the aggregate demand curve? Will it still slope downward? Explain. b. There is an increase in the quantity of money. c. There is an increase in government spending. 15. The economy is in short-run macroeconomic equilibrium at point E1 in the accompanying diagram. a. Is the economy facing an inflationary or a recessionary gap? 268 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S b. What policies can the government implement that might bring the economy back to long-run macroeconomic equilibrium? Illustrate with a diagram. a. How do the aggregate price level and aggregate output change in the short run as a result of the oil shock? What is this phenomenon known as? c. If the government did not intervene to close this gap, would the economy return to long-run macroeconomic equilibrium? Explain and illustrate with a diagram. b. What fiscal or monetary policies can the government use to address the effects of the supply shock? Use a diagram that shows the effect of policies chosen to address the change in real GDP. Use another diagram to show the effect of policies chosen to address the change in the aggregate price level. d. What are the advantages and disadvantages of the government’s implementing policies to close the gap? 16. In the accompanying diagram, the economy is in long-run macroeconomic equilibrium at point E1 when an oil shock shifts the short-run aggregate supply curve to SRAS2. c. Why do supply shocks present a dilemma for government policy makers? 17. The late 1990s in the United States were characterized by substantial economic growth with low inflation; that is, real GDP increased with little, if any, increase in the aggregate price level. Explain this experience using aggregate demand and aggregate supply curves. Illustrate with a diagram. Aggregate price level LRAS SRAS2 SRAS1 E2 E1 P2 P1 AD1 Y2 Y1 Real GDP KrugmanMacro PR10.16 ...
View Full Document

This note was uploaded on 03/17/2009 for the course ECON 102 taught by Professor Erus during the Spring '09 term at Boğaziçi University.

Ask a homework question - tutors are online