McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

12 Aggregate Demand and Aggregate Supply McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Aggregate Demand Real GDP desired at each price level Inverse relationship Real balances effect Interest effect Foreign purchases effect LO1 12-2

Aggregate Demand Price level AD 0 Real domestic output, GDP LO1 12-3

Changes in Aggregate Demand Determinants of aggregate demand Shift factors affecting C, I, G, X n 2 components involved Change in one of the determinants Multiplier effect LO1 12-4

Changes in Aggregate Demand Price level AD 2 LO1 0 AD 3 Real domestic output, GDP AD 1 12-5

Consumer Spending Consumer wealth Household borrowing Consumer expectations Personal taxes LO1 12-6

Investment Spending Real interest rates Expected returns Expectations about future business conditions Technology Degree of excess capacity Business taxes LO1 12-7

Government Spending Government spending increases Aggregate demand increases (as long as interest rates and tax rates do not change) More transportation projects Government spending decreases Aggregate demand decreases Less military spending LO1 12-8

Net Export Spending National income abroad Exchange rates Dollar depreciation Dollar appreciation LO1 12-9

Aggregate Supply Total real output produced at each price level Relationship depends on time horizon Immediate short run Short run Long run LO2 12-10

AS: Immediate Short Run Immediate-short-run aggregate supply Price level P 1 AS ISR 0 Q f Real domestic output, GDP LO2 12-11

Aggregate Supply: Short Run AS Price level Aggregate supply (short run) 0 Q f Real domestic output, GDP LO2 12-12

Aggregate Supply: Long Run AS LR Price level Long-run aggregate supply 0 Q f Real domestic output, GDP LO2 12-13

Changes in Aggregate Supply Determinants of aggregate supply Shift factors Collectively position the AS curve Changes raise or lower per-unit production costs LO2 12-14

Changes in Aggregate Supply AS 3 AS 1 AS 2 Price level 0 Real domestic output, GDP LO2 12-15

Input Prices Domestic resource prices Labor Capital Land Prices of imported resources Imported oil Exchange rates LO2 12-16

Productivity Real output per unit of input Increases in productivity reduce costs Decreases in productivity increase costs Productivity = total output total inputs Per-unit production cost = total input cost total output LO2 12-17

Legal-Institutional Environment Legal changes alter per-unit costs of output Taxes and subsidies Extent of government regulation LO2 12-18

Equilibrium Price level (index numbers) 100 92 a b AS AD Real Output Demanded (Billions) Price Level (Index Number) Real Output Supplied (Billions) $506 108 $513 508 104 512 510 100 510 512 96 507 514 92 502 0 502 510 514 Real domestic output, GDP (billions of dollars) LO3 12-19

AD Increases: Demand-Pull Inflation AS Price level P 2 P 1 AD 2 AD 1 0 Q f Q 1 Q 2 Real domestic output, GDP LO4 12-20

Decreases in AD: Recession AS Price level P 1 P 2 b c a AD 1 AD 2 0 Q 1 Q 2 Q f Real domestic output, GDP LO4 12-21

Decreases in AD: Recession Prices are downwardly inflexible Fear of price wars Menu costs Wage contracts Efficiency wages Minimum wage law LO4 12-22

Decreases in AS: Cost-Push Inflation AS 2 AS 1 Price level P 2 P 1 b a AD 0 Q 1 Q f Real domestic output, GDP LO4 12-23

Increases in AS: Full-Employment AS 1 AS 2 Price level P 3 P 2 P 1 a b c AD 2 AD 1 0 Q 1 Q 2 Q 3 Real domestic output, GDP LO4 12-24

Impact of Oil Prices Diminished? 1970 s Reduced AS and negative GDP gap Cost-push inflation Rising unemployment 2000 s Core inflation steady Use 50% less oil and gas today Federal Reserve more vigilant 12-25

Stagflation is a combination of recession (falling real GDP) and inflation. Now we will show how stagflation could be produced by a supply shock

16 14 Inflation-Unemployment pairs for the U.S., 1960-89 www.bls.gov 80 Inflation Rate 12 10 8 6 4 69 68 66 67 73 70 74 79 78 89 88 71 87 72 77 85 81 84 76 75 82 83 2 0 3 4 65 5 64 62 6063 6 61 86 7 8 9 10 Unemployment Rate

Price per barrel of 32 0 crude oil Date Price ($) Jan. 1972 1.79 Dec. 1973 4.68 Jan. 1974 10.84 April 1979 14.55 June 1979 18.00 Nov 1979 24.00 Aug. 1980 30.00 Oct. 1981 34.00 Anchovies Grain failures Source: Petroleum Economist

Stagflation due to oil price shock Price Level Story of Joseph Buffer Stock program AS 0 AS 1 115 110 AD 0 9.75 10.0 Real GDP