CHAPTER
11
Aggregate Supply and Demand
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
1
2
3
4
5
Cite the major macro outcomes and their determinants.
Explain how classical and Keynesian macro views differ.
Illustrate the shapes of the aggregate demand and supply curves.
Tell how macro failure occurs.
Outline the major policy options for macro government intervention.
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11-1
CHAPTER 11
The goal of this chapter is to study and
model how the macroeconomy works.
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11-2
MACRO VIEW
Macroeconomics is the study of the
aggregate economy.
The macroeconomy can be described by:
1. Outcomes.
2. Determinants.
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11-3
MACRO VIEW
Determinants influence the macroeconomy
and outcomes measure its performance.
OUTCOMES
DETERMINANTS
Output
Internal
market forces
External
shocks
Jobs
MACRO
ECONOMY
Prices
Growth
Policy levers
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International
balances
11-4
STAPLE OR UNSTAPLE?
The central concern of macroeconomic
theory is whether internal forces of the
marketplace will generate desired
outcomes.
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11-5
STAPLE OR UNSTAPLE?
Classical view based on Say’ Law suggests
an economy self-adjusts.
• Prices and wages are flexible and
adjust until markets clear – all output is
sold and all laborers have jobs.
• Government intervention is
unnecessary.
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11-6
STAPLE OR UNSTAPLE?
ANNUAL RATE OF INFLATION OR
UNEMPLOYMENT (percent)
The Great Depression destroyed credibility
of classic economic theory.
Unemployment
24
20
•
16
12
8
4
•
0
-4
Prices
-8
-12
Prices and
wages adjusted
downward.
Unemployment
soared to 25%.
1900
1910
1920
1930
1940
YEAR
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11-7
STAPLE OR UNSTAPLE?
John Maynard Keynes argued that the
Great Depression was not unique.
• Economies are inherently unstable.
• Recessions would recur if sole
reliance on the market to self-adjust.
• Government intervention required.
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11-8
AD-AS MODEL
The macroeconomy can be modelled
using supply and demand.
• All influences on macro outcomes
must be transmitted through supply
or demand.
• If an influence doesn’t affect supply
or demand, then there is no impact
on macro outcomes .
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11-9
AD-AS MODEL
Aggregate demand (AD) is the total
quantity of output demanded at
alternative price levels.
•
•
•
•
In a given time period, ceteris paribus.
Income is assumed constant.
Price level is average prices.
Quantity of output is Real GDP.
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11-10
AD-AS MODEL
PRICE LEVEL (average price)
AD curve illustrates how the volume of
purchases varies with average price level.
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Education.
Higher
prices
Lower
prices
Lower prices encourage
more spending
Less output More output
demanded demanded
REAL OUTPUT (quantity per year)
Aggregate
demand
11-11
AD-AS MODEL
AD curve slopes downward due to:
1. Real balances effect: As prices fall,
money purchases more output.
2. Foreign trade effect: As domestic prices
fall, consumers purchase more domestic
and fewer imports.
3. Interest-rate effect: As prices fall, so do
interest rates. At lower interest rates,
loan-financed purchases increase.
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11-12
AD-AS MODEL
Aggregate supply (AS) is the total quantity
of output supplied at alternative price
levels.
• In a given time period
• Ceteris paribus.
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11-13
AD-AS MODEL
PRICE LEVEL (average price)
Rate of output increases as price level rises.
Aggregate
supply
Higher
prices
Higher prices
encourage more
production
• Relatively flat
when capacity is
underutilized.
• Steeper as
producers
approach capacity.
More output supplied
REAL OUTPUT (quantity per year)
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11-14
AD-AS MODEL
AS curve slopes upward due to:
1. Profit margins: As product price
rises, output increases.
2. Costs of production: Production
costs tend to increase as producers
try to produce more. This is
reflected in higher prices.
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11-15
AD-AS MODEL
Macro equilibrium is the unique
combination of price level and real output.
PRICE LEVEL (average price)
Aggregate
Supply
Unsold goods
P1
E
PE
Macro
equilibrium
Aggregate
demand
D1
QE
S1
REAL OUTPUT (quantity per year)
At QE, desired
spending equals
production and is
compatible with
buyers’ & sellers’
intentions.
If price is above
PE, then surplus
occurs.
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11-16
AD-AS MODEL
Disequilibrium occurs when intentions of
buyers and sellers are incompatible.
• If market price is not equal to
equilibrium price, then a surplus or
shortage exists.
• Price level adjusts until market price is
equal to equilibrium price.
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11-17
AD-AS MODEL
There are two potential problems with a
macro equilibrium.
1. Undesirability: the price-output
relationship at equilibrium may not satisfy
our macroeconomic goals.
2. Instability: even if the designated macro
equilibrium is optimal, it may be displaced
by macro disturbances.
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11-18
AD-AS MODEL
PRICE LEVEL average price)
An undesirable outcome may occur with
high unemployment and price level.
Aggregate
supply
PE
E
F
Aggregate
demand
P*
QE
QF
REAL OUTPUT (quantity per year)
Point E is equilibrium
outcome.
Point F is what could be
produced at full
employment.
Point F has lower price
level.
Unemployment arises
when QE < QF
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11-19
AD-AS MODEL
An equilibrium does not persist due to
shifts in AD and/or AS curve.
• Business cycles result from shifts of the
AS and AD curves.
• Unstable outcomes result from shifts in
AS and AD curves in different directions.
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11-20
AD-AS MODEL
(b)Supply shifts
AS0
F
P*
P2
H
AD0
AD1
PRICE LEVEL (average price)
PRICE LEVEL (average price)
(a) Demand shifts
Q2QF
REAL OUTPUT (quantity per year)
A demand side recession
occurs when AD curve
shifts inward.
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Education.
AS1
AS0
AD0
G
P1
F
P*
Q1 QF
REAL OUTPUT (quantity per year)
A supply side recession
occurs when AS curve
shifts inward.
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AD-AS MODEL
AD curve may shift in undesirable ways
due to changes in:
1.
2.
3.
4.
5.
Consumer sentiment.
Income and wealth.
Consumer spending.
Taxes and government spending.
Interest rates.
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11-22
AD-AS MODEL
AS curve may shift in undesirable ways
due to changes in:
1.
2.
3.
4.
Resource costs.
Business taxes.
Government regulation.
Production shocks.
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11-23
COMPETING THEORIES OF INSTABILITY
E0
E1
AS0
AD0
AD1
Q1 QF
REAL OUTPUT
(quantity per year)
Higher unemployment.
Lower price level.
(b)Supply shifts
E2
AS1
AS0
E0
AD0
Q2 QF
REAL OUTPUT
(quantity per year)
Higher unemployment.
Higher price level.
PRICE LEVEL (avg. price)
(a)Demand shifts
PRICE LEVEL (avg. price)
PRICE LEVEL (avg. price)
Business cycles can results from several
kinds of market phenomena.
(c) AS/AD shifts
AS1
AS0
E3
E0
AD0
AD1
Q3
QF
REAL OUTPUT
(quantity per year)
Higher unemployment.
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11-24
COMPETING THEORIES OF INSTABILITY
There are several demand and supply side
theories on why macro instability occurs.
Macro controversies focus on the shape of
AS and AD curves and the potential to shift
them.
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11-25
COMPETING THEORIES OF INSTABILITY
There are two leading demand side
theories.
Keynesian Theory argues demand creates
supply.
• If consumers aren’t spending, idle
production capacity occurs.
• Urges increased government spending
or tax cuts to increase AD.
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11-26
COMPETING THEORIES OF INSTABILITY
Monetary Theory argues that tight money
supply and high interest rates contract AD.
• Money and credit affect the ability and
willingness of people to buy goods and
services.
• Adjust amount of money and interest
rates.
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11-27
COMPETING THEORIES OF INSTABILITY
Supply side theories suggest that
producers are unwilling to provide more
goods at existing prices.
• These theories focus on shifting AS
curve outward.
• This requires lower input costs, lower
business taxes, and removing costly
regulation.
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11-28
COMPETING THEORIES OF INSTABILITY
Eclectic explanations suggest that shifts in
AS and AD cause undesirable macro
outcomes.
• Shifts in AS and AD can achieve any
specific output or price level.
• Implementing policy for political reasons
may cause AS to shift left and AD to shift
left.
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11-29
POLICY OPTIONS
Government intervention through policy
attempts to:
1. Shift the AD curve.
2. Shift the AS curve.
Some suggest that government shouldn’t
interfere if it cannot identify or control the
determinants of AD or AS.
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11-47
POLICY OPTIONS
Three prominent policy categories exist:
1. Fiscal policy: use of taxes and spending
to shift AD curve. Set by President and
Congress.
2. Monetary policy: use of money and
credit controls to shift AD curve. Set by
Central Bank.
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11-31
POLICY OPTIONS
3. Supply-side policy: use of business
taxes, (de)regulation, and other
mechanisms to shift AS curve. Set by
Congress and the president.
Also includes policies aimed at improving
the labor force, such as subsidies for higher
education.
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11-32
POLICY PERPECTIVES
The US has a used various policy levers
over the last century.
Pre-Great Depression: Little government
intervention.
Great Depression: spurred desire for active
government.
Post WWII: Fiscal policy dominated. Late
1960s and 1970s: High inflation and
unemployment. Fiscal policy suspect.
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11-52
WHICH POLICY LEVER TO USE?
1970s: Monetary policy dominated.
1980s: Supply-side policies dominated,
coined Reaganomics.
1990s: Fiscal restraint.
2000s: Fiscal and monetary policy.
Obamanomics: Extensive use of fiscal,
monetary, and supply-side policies.
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11-34
SUMMARY
• We cited major macro outcomes and
their determinants.
• We explained how classical and
Keynesian macro views differ.
• We illustrated the shapes of the
aggregate demand and supply curves.
• We explained how macro failure occurs.
• We outlined the major policy options for
macro government intervention.
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
11-35