McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Aggregate Demand, Aggregate Supply, and Modern Macroeconomics Chapter 9.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Aggregate Demand, Aggregate Demand, Aggregate Supply, and Aggregate Supply, and

Modern Modern MacroeconomicsMacroeconomics

Chapter 9 – Part two

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Equilibrium in the Equilibrium in the Aggregate EconomyAggregate Economy Changes in the SAS, AD, and LAS curves

affect short-run and long-run equilibrium.

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Short-Run EquilibriumShort-Run Equilibrium

Short-run equilibrium is where the AS and AD curves intersect.

Increases (decreases) in AD lead to higher (lower) real output and higher (lower) price level.

Upward (downward) shift the SAS curve lead to lower (higher) real output and higher (lower) price level.

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Real output

Pric

e le

vel

Short-Run Equilibrium:Short-Run Equilibrium:Shift in Aggregate Shift in Aggregate DemandDemand

Y0 Y1

P1

P0 EF

AD0

AD1

SAS

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Real output

Pric

e le

vel

Short-Run Equilibrium:Short-Run Equilibrium:Shift in Aggregate Shift in Aggregate SupplySupply

Y1 Y0

P1

P0

E

G

AD

SAS1

SAS0

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Long-Run EquilibriumLong-Run Equilibrium

Long-run equilibrium is where AD and LAS intersect.

In the long run, output is fixed and the price level is variable.

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Long-Run EquilibriumLong-Run Equilibrium

AD determines the price level.

Increases (decreases) in AD lead to higher (lower) prices.

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Long-Run Equilibrium:Long-Run Equilibrium:Shift in Aggregate Shift in Aggregate DemandDemand

LAS

AD0

AD1

Real output

Price level

P0

Y0

E

HP1

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Integrating the Short-Integrating the Short-Run and Long-Run Run and Long-Run FrameworksFrameworks The economy is in both short-run and long-

run equilibrium when all three curves intersect in the same location.

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Integrating the Short-Integrating the Short-Run and Long-Run Run and Long-Run FrameworksFrameworks The ideal situation is for AD to grow at the

same rate as AS and potential output. Unemployment and growth are at their

target rates with no inflation.

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Long-Run EquilibriumLong-Run Equilibrium

AD

SAS

YP Real output

LAS

P0

E

Pric

e le

vel

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The Recessionary GapThe Recessionary Gap

A recessionary gap is the amount by which equilibrium output is below potential output.

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The Recessionary GapThe Recessionary Gap

If the economy remains at this level for a long time, there would be an excess supply of factors of production.

Costs and wages would tend to fall. As factor prices fall, the SAS curve will shift down to

eliminate the recessionary gap.

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Real output

Pric

e le

vel

The Recessionary GapThe Recessionary Gap

YPY1

LAS

AD

SAS0

SAS1

P0

A

P1

B

Recessionary gap

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The Inflationary GapThe Inflationary Gap

An inflationary gap occurs when the economy is above potential at the current price level.

Factor prices rise causing the SAS curve to shift up.

The price level rises, and the inflationary gap is eliminated.

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(c)

The Inflationary GapThe Inflationary Gap

Y2YPReal

output

LAS

SAS0AD

SAS2

P0

CP2

D

Inflationary gap

Pric

e le

vel

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The Economy Beyond The Economy Beyond PotentialPotential When the economy operates below its

potential, firms can hire additional factors of production without increasing production costs.

Once the economy reaches its potential output, that is no longer possible.

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The Economy Beyond The Economy Beyond PotentialPotential As firms compete for resources, costs rise

beyond productivity increases. The short-run AS curve shifts up and the price level rises. The economy will slow down by itself or government

adopt a policy to contract output and eliminate the inflationary gap.

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Aggregate Demand Aggregate Demand PolicyPolicy Fiscal policy – the deliberate change in

either government spending or taxes to stimulate or slow down the economy.

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Aggregate Demand Aggregate Demand PolicyPolicy Expansionary fiscal policy is appropriate if

aggregate income is too low. The deficit should be increased by

decreasing taxes or increasing government spending.

The AD curve shifts to the right.

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Aggregate Demand Aggregate Demand PolicyPolicy Contractionary fiscal policy is appropriate if

aggregate income is too high. The deficit should be decreased by

increasing taxes or decreasing government spending.

The AD curve shifts to the left.

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Real output

Pric

e le

vel

Expansionary Fiscal Expansionary Fiscal PolicyPolicy

YPY0

LAS

P1

P0

AD0

AD1

AS

A

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Contractionary Fiscal Contractionary Fiscal PolicyPolicy

Real output

Pric

e le

vel

YP Y2

LAS

ASP2

AD2

AD0

B

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Additional Policy Additional Policy ExamplesExamples Unemployment is 12 percent and there is

no inflation. What policy would you recommend? Use expansionary fiscal policy to shift the

AD curve out to its potential income.

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Real output

Price level

Expansionary Fiscal Expansionary Fiscal PolicyPolicy

P1P0

SAS

AD0

Y0 YP

AD1

B

LAS

A

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Additional Policy Additional Policy ExamplesExamples Unemployment is at its target rate and it is

likely that consumer expenditures will rise. What policy would you recommend? Use contractionary fiscal policy to shift the

AD curve inward to counteract the expected increase in AD.

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Real output

Price level

Contractionary Fiscal Contractionary Fiscal PolicyPolicy

YP

LAS

AD0

SASP1

Y1

AD2

B

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Additional Policy Additional Policy ExamplesExamples What would have happened if the

government didn’t institute a contractionary fiscal policy?

There would be an inflationary gap which would increase factor prices.

The SAS curve would shift up until it intersects the AD curve at YP.

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Real output

Price level

Economy Above PotentialEconomy Above Potential

YP

LAS

AD1

SAS0

P0

Y1

AD0

D

SAS1

C

EP1

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Fiscal Policy in World Fiscal Policy in World War IIWar II The deficit increased greatly during World

War II. Real GDP grew by even more than the

increase in the deficit. Wartime wage and price controls

prevented the SAS curve from shifting up.

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Fiscal Policy in World Fiscal Policy in World War IIWar II Although World War II expanded the

economy, that doesn’t mean wars are good for the economy. The production of military goods

increased, but the production of consumer goods decreased.

Many people were killed or permanently disabled.

War Finance: War Finance: Expansionary Fiscal Expansionary Fiscal PolicyPolicy

Year

1937193819391940194119421943194419451946

GDP(billions of

1958 dollars)

$ 90849099

124157191210211208

Deficit(billions ofDollars)

$ -2.8-1.0-2.9-2.7-4.8

-19.4-53.8-46.1-45.0-18.2

Unemploymentrate

14.3%19.017.214.6

9.94.71.91.21.9

3.9

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Real output (in billions of dollars)

LAS

$90 $208

AD1

AD0

SAS

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U.S. Economic ExpansionU.S. Economic Expansion

The economy boomed during the late 1990s and early 2000s.

The budget went from a large deficit to a large surplus.

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U.S. Economic ExpansionU.S. Economic Expansion

Significant increases in consumer and investment spending offset the contractionary effect of the surplus.

The surplus was more due to a booming economy than due to contractionary policy.

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U.S. Economic ExpansionU.S. Economic Expansion

During 2000-2001, political pressures increased government spending and cut taxes which led to a shrinking surplus.

The tax cut came just at the right time because the economy moved into a recession in mid-2001.

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Macro Policy Is More Macro Policy Is More Complicated Than It Complicated Than It LooksLooks Using the AS/AD model to analyze the

economy is more complicated than it looks. Implementing fiscal policy. Estimating potential output. Effectiveness of fiscal policy.

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1. The Problem of 1. The Problem of Implementing Fiscal Implementing Fiscal PolicyPolicy There is no guarantee that government will

do what the economy needs to be done. Implementing government spending and

tax changes is a slow legislative process. Government spending and tax decisions

are made for political rather than for economic reasons.

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2. The Problem of 2. The Problem of Estimating Potential Estimating Potential OutputOutput Increasing AD when the economy is

operating at its potential will accelerate inflation by shifting up the SAS curve.

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2. The Problem of 2. The Problem of Estimating Potential Estimating Potential OutputOutput One way of estimating potential output is to

estimate the target rate of unemployment. Target rate of unemployment – the rate

below which inflation began to accelerate in the past.

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2. The Problem of 2. The Problem of Estimating Potential Estimating Potential OutputOutput Unfortunately, the target rate of

unemployment fluctuates and is difficult to predict.

For example, there is structural but no cyclical unemployment at potential output – it is difficult to differentiate between the two.

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2. The Problem of 2. The Problem of Estimating Potential Estimating Potential OutputOutput Another way to determine potential output

is to add the normal growth factor (3%) the economy’s previous level.

Estimating the economy’s potential from past growth rates is complicated by potentially dramatic changes in regulations, technology, and expectations.

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3. The Questionable 3. The Questionable Effectiveness of Fiscal Effectiveness of Fiscal PolicyPolicy The effectiveness of fiscal policy depends

on the government’s ability to perceive a problem and react appropriately to it.

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3. The Questionable 3. The Questionable Effectiveness of Fiscal Effectiveness of Fiscal PolicyPolicy Countercyclical fiscal policy – fiscal

policy in which the government offsets any change in aggregate expenditures that would create a business cycle.

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3. The Questionable 3. The Questionable Effectiveness of Fiscal Effectiveness of Fiscal PolicyPolicy Most economists agree that the

government is unable to fine tune the economy.

Fine tuning – fiscal policy designed to keep the economy always at its target or potential level of income.

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End of Chapter 9

Aggregate Demand, Aggregate Demand, Aggregate Supply, and Aggregate Supply, and

Modern Modern MacroeconomicsMacroeconomics