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Economics principles tools and applications 9th by sullivan sheffrin perez chapter 09

Economics

NINTH EDITION

Chapter 9

Aggregate Demand and
Aggregate Supply

Prepared by Brock Williams

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Learning Objectives

9.1 Explain the role sticky wages and prices play in economic fluctuations.
9.2 List the determinants of aggregate demand.
9.3 Distinguish between the short run and long run aggregate supply curves.
9.4 Explain how the short-run aggregate supply curve shifts over time.


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9.1 STICKY PRICES AND THEIR
MACROECONOMIC CONSEQUENCES
Fluctuations in the economy can be seen as failures in coordination.

Flexible and Sticky Prices



For most firms, the biggest cost of doing business is wages. If wages are sticky, firms’ overall costs will be sticky as well. This means that firms’ product
prices will remain sticky, too.



Sticky wages cause sticky prices and hamper the economy’s ability to bring demand and supply into balance in the short run.

How Demand Determines Output in the Short Run



Short run in macroeconomics
The period of time in which prices do not change or do not change very much.

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APPLICATION 1

MEASURING PRICE STICKINESS IN CONSUMER MARKETS
APPLYING THE CONCEPTS #1: What does the behavior of prices in consumer markets demonstrate about how quickly prices adjust in the U.S.
economy?

To analyze the behavior of retail prices, economist Anil Kashyap of the University of Chicago examined prices in consumer catalogs.
He looked at the prices of 12 selected goods from:






L.L. Bean
Recreational Equipment, Inc. (REI)
The Orvis Company, Inc.

The goods included shoes, blankets, chamois shirts, binoculars, and a fishing rod and fly.
What did he find?





Considerable price stickiness.
When prices did change, he observed a mixture of both large and small changes.
During periods of high inflation, prices tended to change more frequently.

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9.2 UNDERSTANDING AGGREGATE DEMAND (1 of 10)
What Is the Aggregate Demand Curve?



Aggregate demand curve (AD)
A curve that shows the relationship between the level of prices and the quantity of real GDP demanded.

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9.2 UNDERSTANDING AGGREGATE DEMAND (2 of 10)
The Components of Aggregate Demand
The aggregate demand curve plots the total demand for real GDP as a
function of the price level.

The aggregate demand curve slopes downward, indicating that the
quantity of aggregate demand increases as the price level in the
economy falls.

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9.2 UNDERSTANDING AGGREGATE DEMAND (3 of 10)
Why the Aggregate Demand Curve Slopes Downward
REAL-NOMINAL PRINCIPLE
What matters to people is the real value of money or income—its purchasing power—not the face value of money or income.

As the purchasing power of money changes, the aggregate demand curve is affected in three different ways:

THE WEALTH EFFECT



Wealth effect
The increase in spending that occurs because the real value of money increases when the price level falls.

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9.2 UNDERSTANDING AGGREGATE DEMAND (4 of 10)
Why the Aggregate Demand Curve Slopes Downward
THE INTEREST RATE EFFECT
With a given supply of money in the economy, a lower price level will lead to lower interest rates.
With lower interest rates, both consumers and firms will find it cheaper to borrow money to make purchases.
As a consequence, the demand for goods in the economy (consumer durables purchased by households and investment goods purchased by firms) will
increase.

THE INTERNATIONAL TRADE EFFECT

In an open economy, a lower price level will mean that domestic goods (goods produced in the home country) become cheaper relative to foreign goods, so the
demand for domestic goods will increase.

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9.2 UNDERSTANDING AGGREGATE DEMAND (5 of 10)
Shifts in the Aggregate Demand Curve
CHANGES IN THE SUPPLY OF MONEY

An increase in the supply of money in the economy will increase aggregate demand and shift the aggregate demand curve to the right.

CHANGES IN TAXES

A decrease in taxes will increase aggregate demand and shift the aggregate demand curve to the right.

CHANGES IN GOVERNMENT SPENDING

At any given price level, an increase in government spending will increase aggregate demand and shift the aggregate demand curve to the right.

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9.2 UNDERSTANDING AGGREGATE DEMAND (6 of 10)
Shifts in the Aggregate Demand Curve
ALL OTHER CHANGES IN DEMAND
Decreases in taxes, increases in government spending, and an increase in the supply
of money all shift the aggregate demand curve to the right.

Higher taxes, lower government spending, and a lower supply of money shift the curve
to the left.

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9.2 UNDERSTANDING AGGREGATE DEMAND (7 of 10)
How the Multiplier Makes the Shift
Bigger
Initially, an increase in desired spending will shift the
aggregate demand curve horizontally to the right from a
to b.

The total shift from a to c will be larger. The ratio of the
total shift to the initial shift is known as the multiplier.

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9.2 UNDERSTANDING AGGREGATE DEMAND (8 of 10)
How the Multiplier Makes the Shift Bigger



Multiplier
The ratio of the total shift in aggregate demand to the initial shift in aggregate demand.




Consumption function
The relationship between the level of income and consumer spending.

C = Ca + by

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9.2 UNDERSTANDING AGGREGATE DEMAND (9 of 10)
How the Multiplier Makes the Shift Bigger



Autonomous consumption spending
The part of consumption spending that does not depend on income.



Marginal propensity to consume (MPC)
The fraction of additional income that is spent.



Marginal propensity to save (MPS)
The fraction of additional income that is saved.

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9.2 UNDERSTANDING AGGREGATE DEMAND (10 of 10)
How the Multiplier Makes the Shift Bigger

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APPLICATION 2

TWO APPROACHES TO DETERMINING THE CAUSES OF RECESSIONS
APPLYING THE CONCEPTS #2: How can we determine what factors cause recessions?
Economists have used the basic framework of aggregate demand and supply analysis to explain recessions. Recessions can occur either when there is a sharp
decrease in demand or a decrease in aggregate supply.
Economic historian Peter Temin looked at all recessions from 1893 to 1990 to determine their causes. He found, recessions were caused by many different factors.



Sometimes, as in 1929, they were caused by shifts in aggregate demand from the private sector, as consumers cut back their spending.



Other times, as in 1981, the government cut back on aggregate demand to reduce inflation.



Supply shocks were the cause of the recessions in 1973 and 1979.



The most severe shock hit the U.S. economy in 1931 and converted an economic downturn into the Great Depression. He believes that foreign monetary
developments were the ultimate source of this shock to the U.S. economy.

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9.3 UNDERSTANDING AGGREGATE SUPPLY (1 of 7)



Aggregate supply curve (AS)
A curve that shows the relationship between the level of prices and the quantity of output supplied.

The Long-Run Aggregate Supply Curve



Long-run aggregate supply curve
A vertical aggregate supply curve that represents the idea that in the long run, output is determined solely by the factors of production.

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9.3 UNDERSTANDING AGGREGATE SUPPLY (2 of 7)
The Long-Run Aggregate Supply Curve
In the long run, the level of output, yp, is independent of
the price level.

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9.3 UNDERSTANDING AGGREGATE SUPPLY (3 of 7)
The Long-Run Aggregate Supply
Curve
DETERMINING OUTPUT AND THE PRICE LEVEL

Output and prices are determined at the intersection of AD
and AS.

An increase in aggregate demand leads to a higher price
level.

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9.3 UNDERSTANDING AGGREGATE SUPPLY (4 of 7)
The Short-Run Aggregate Supply Curve



Short-run aggregate supply curve
A relatively flat aggregate supply curve that represents the idea that prices do not change very much in the short run and that firms adjust production to
meet demand.

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9.3 UNDERSTANDING AGGREGATE SUPPLY (5 of 7)
The Short-Run Aggregate
Supply Curve
With a short-run aggregate supply curve, shifts
in aggregate demand lead to large changes in
output but small changes in price.

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9.3 UNDERSTANDING AGGREGATE SUPPLY (6 of 7)
The Short-Run Aggregate Supply Curve
What factors determine the costs firms must incur to produce output? The key factors are



Input prices (wages and materials)



The state of technology



Taxes, subsidies, or economic regulations

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9.3 UNDERSTANDING AGGREGATE SUPPLY (7 of 7)
Supply Shocks



Supply shocks
External events that shift the aggregate supply curve.

An adverse supply shock, such as an increase in the
price of oil, will cause the AS curve to shift upward.
The result will be higher prices and a lower level of
output.



Stagflation
A decrease in real output with increasing prices.

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APPLICATION 3

OIL PRICE DECLINES AND THE U.S. ECONOMY


APPLYING THE CONCEPTS #3: Do declines in oil prices always help the U.S. Economy?



Economists have generally believed that falling oil prices will benefit the U.S. economy and lead to higher economic growth.



Falling oil prices should lead to falling gasoline and heating oil prices and put more money in the pockets of consumers that will lead to increases in aggregate demand.



Since fuel is an input into production, lower oil prices may also increase aggregate supply.



But the decrease in oil prices in 2014 and 2015 have had only a modest effect on economic growth.



Consumers appeared to have used the extra money to reduce overall debt instead of other consumption.



Lower oil prices reduce the incentive for firms to produce energy and invest in new capital and equipment.

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9.4 FROM THE SHORT RUN TO THE LONG RUN (1 of 3)
In the short run, the economy produces at
y0, which exceeds potential output yp.

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9.4 FROM THE SHORT RUN TO THE LONG RUN (2 of 3)
With output exceeding potential, the shortrun AS curve shifts upward over time.

The economy adjusts to the long-run
equilibrium at a1.

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