Interactive CH 33 Aggregate Demand and Aggregate Supply 9e

N.
GREGORY MANKIW NINTH EDITION
PRINCIPLES OF
ECONOMICS
CHAPTER
Aggregate Demand
33 and Aggregate Supply
Interactive PowerPoint Slides by:
V. Andreea Chiritescu
Eastern Illinois University
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IN THIS CHAPTER
• What are economic fluctuations? What are
their characteristics?
• How does the model of aggregate demand
and aggregate supply explain economic
fluctuations?
• Why does the Aggregate-Demand curve
slope downward? What shifts the AD curve?
• What is the slope of the Aggregate-Supply
curve in the short run? In the long run?
What shifts the AS curve(s)?
license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
2
Introduction
• Real GDP over the long run, U.S.
– Grows about 3% per year on average
• GDP in the short run
– Fluctuates around its trend
• Recessions
– Periods of falling real incomes and rising
unemployment
• Depressions
– Severe recessions (very rare)
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a 3
Three facts about economic fluctuations – 1
FACT 1: Economic fluctuations are irregular and unpredictable
Real Gross Domestic Product 1969-2019
4
FACT 2: Most macroeconomic quantities fluctuate together.
Real Gross Private Domestic Investment 1969-2019
5
FACT 3: As output falls, unemployment rises.
Unemployment Rate 1969-2019
6
The Assumptions of Classical Economics
• The Classical Dichotomy
– Separation of variables into two groups:
• Real – quantities, relative prices
• Nominal – measured in terms of money
• The neutrality of money:
– Changes in the money supply affect
nominal but not real variables
The Reality of Short-Run Fluctuations
• Classical theory
– Describes the world in the long run, but
not the short run
• In the short run
– Changes in nominal variables (like the
money supply or P ) can affect real
variables (like Y or the u-rate).
– We use a new model…
Model of aggregate demand and aggregate supply
The price level P
“Short-Run
The model Aggregate Supply”
determines the SRAS
equilibrium price
level P1
AD
“Aggregate
Demand”
and equilibrium Y
Y1
output (real GDP).
Real GDP, the
quantity of output
9
The aggregate-demand (AD) curve
The AD curve shows the quantity of all
P
g&s demanded in the economy
at any given price level.
P2
Why the AD curve slopes downward?
Y = C + I + G + NX
P1
Assume G is fixed by government policy.
AD
To understand the slope of AD, must determine how a
change in P affects C, I, and NX.
Y2 Y1 Y
10
The Wealth Effect (P and C )
• Suppose the price level, P, declines
– Increase in the real value of money
– Consumers are wealthier
– Increase in consumer spending, C
– Increase in quantity demanded of goods
and services
The Interest-Rate Effect (P and I)
• Suppose the price level, P, declines
– Buying goods and services requires fewer
dollars: people buy bonds and other
assets
– Decrease in the interest rate
– Increase spending on investment goods, I
and services
The Exchange-Rate Effect (P and NX )
• Suppose the U.S. price level, P, declines
– Decrease in the U.S. interest rate
– U.S. dollar depreciates (decline in the real
value of the dollar in foreign-exchange
markets)
– Stimulates U.S. net exports, NX
and services
Why the AD curve slopes downward
An increase in P P
reduces the quantity of
goods and services P2
demanded because:
• the wealth effect
(C falls)
• the interest-rate P1
effect (I falls) AD
• the exchange-rate Y
effect (NX falls) Y2 Y1
14
EXAMPLE 1: A shift in the AD curve
What is the effect of a
stock market boom on P
the AD curve?
A stock market boom
makes households feel P1
wealthier, C rises,
the AD curve shifts right.
AD2
Any event that changes AD1
C, I, G, or NX (except Y
a change in P) will shift Y1 Y2
the AD curve.
15
Why the AD Curve Might Shift – 1
• Changes in C
– Stock market boom/crash
– Preferences re: consumption/saving tradeoff
– Tax hikes/cuts
• Changes in I
– Firms buy new computers, equipment, factories
– Expectations, optimism/pessimism
– Interest rates,
– Monetary policy,
– Investment Tax Credit or other tax incentives
Why the AD Curve Might Shift – 2
• Changes in G
– Federal spending, e.g., defense
– State & local spending, e.g., roads, schools
• Changes in NX
– Booms/recessions in countries that buy our
exports
– Appreciation/depreciation resulting from
international speculation in foreign exchange
market
Active Learning 1: The aggregate-demand curve
What happens to the AD curve in each of the

following scenarios?
A. A ten-year-old investment tax credit
expires.
B. The U.S. exchange rate falls.
C. A fall in prices increases the real value of
consumers’ wealth.
D. State governments replace their sales
taxes with new taxes on interest, dividends,
and capital gains.
18
Active Learning 1: Answers
A. A ten-year-old investment tax credit expires.
– I falls, AD curve shifts left.
B. The U.S. exchange rate falls.
– NX rises, AD curve shifts right.
C. A fall in prices increases the real value of
consumers’ wealth.
– Move down along AD curve (wealth-effect).
D. State governments replace their sales taxes with
new taxes on interest, dividends, and capital
gains.
– C rises, AD shifts right.
19
The aggregate-supply (AS ) curves
The AS curve shows
P LRAS
the total quantity of
goods and services SRAS
firms produce and sell
at any given price
level.
AS is:
 upward-sloping in Y
short run
 vertical in long run
20
The long-run aggregate-supply curve (LRAS)
The natural rate of output

P LRAS
(YN) is the amount of
output the economy
produces when
unemployment is at its
natural rate.
Also called
potential output
or
YN Y
full-employment output.
21
Why LRAS is vertical
YN determined by the
P LRAS
economy’s stocks of
labor, capital, and
natural resources, and
on the level of P2
technology.
P1
An increase in P
does not affect any of
these, so it does not
affect YN. YN Y
(Classical dichotomy)
22
EXAMPLE 2: A shift in the LRAS curve
What is the effect of an

P LRAS1 LRAS2
increase in immigration
on the LRAS curve?
Immigration increases the
economy’s stock of labor,
L, causing YN to rise.
Any event that changes
any of the determinants
of YN will shift LRAS. YN Y’N Y
23
Why the LRAS Curve Might Shift – 1
• Changes in L or natural rate of
unemployment
– Immigration
– Baby-boomers retire
– Government policies reduce natural u-rate
• Changes in K or H
– Investment in factories, equipment
– More people get college degrees
– Factories destroyed by a hurricane
Why the LRAS Curve Might Shift – 2
• Changes in natural resources
– Discovery of new mineral deposits
– Reduction in supply of imported oil
– Changing weather patterns that affect
agricultural production
• Changes in technology
– Productivity improvements from
technological progress
Using AD & AS to depict long-run growth & inflation
Over the long run,

tech. progress shifts LRAS2020
P LRAS2010
LRAS to the right LRAS2000
• and growth in the
money supply P2020
shifts AD to the
right. P2010
AD2020
• Result: P2000
ongoing inflation AD2010

and growth in AD2000
output. Y
Y Y Y2020 2000 2010
26
Short run aggregate supply (SRAS) curve
The SRAS curve
P
is upward sloping:
SRAS
Over the period
P2
of 1–2 years,
an increase in P
P1
• causes an increase
in the quantity of Y
goods and services Y1 Y2
supplied.
27
Why the Slope of SRAS Matters
If AS is vertical, LRAS
P
fluctuations in AD
do not cause Phi
SRAS
fluctuations in output or
Phi
employment.
ADhi
If AS slopes up, Plo
then shifts in AD AD1
Plo
do affect output and ADlo
employment. Ylo Y1 Yhi Y
28
The Sticky-Wage Theory – 1
• Imperfection:
– Nominal wages are sticky in the short run,
they adjust sluggishly.
• Due to labor contracts, social norms
• Firms and workers set the nominal
wage in advance based on PE, the price
level they expect to prevail.
The Sticky-Wage Theory – 2
• If P > PE,
– Revenue is higher, but labor cost is not.
– Production is more profitable, so firms
increase output and employment.
Hence, higher P causes higher Y, so the SRAS
curve slopes upward.
The Sticky-Price Theory – 1
• Imperfection:
– Many prices are sticky in the short run.
• Due to menu costs, the costs of adjusting
prices.
• Examples: cost of printing new menus,
the time required to change price tags
– Firms set sticky prices in advance based
on PE
The Sticky-Price Theory – 2
• Suppose the Fed increases the money supply
unexpectedly
– In the long run, P will rise
– In the short run:
• Firms without menu costs can raise their
prices immediately
• Firms with menu costs wait to raise prices.
With relatively low prices: increase demand
for their products: increase output and
employment
Hence, higher P is associated with higher Y.
The Misperceptions Theory
• Imperfection:
– Firms may confuse changes in P with changes
in the relative price of the products they sell.
• If P rises above PE
– A firm sees its price rise before realizing all
prices are rising.
• The firm may believe its relative price is
rising, and may increase output and
employment.
So, an increase in P can cause an increase in Y, making
the SRAS curve upward-sloping.
What the 3 theories have in common – 1
• In all 3 theories, Y deviates from YN when
P deviates from PE.
Y = YN + a (P – PE)
Expected
Quantity of
price level
output
supplied a > 0, measures how
much Y responds to Actual
Natural rate unexpected changes price level
of output in P
(long-run)
34
What the 3 theories have in common – 2
Y = YN + a (P – PE)
P
SRAS
When P > PE
the expected
PE
price level
When P < PE
Y
YN
Y < YN Y > YN
35
SRAS and LRAS
• The imperfections in these theories are
temporary. Over time,
– Sticky wages and prices become flexible
– Misperceptions are corrected
• In the LR,
– PE = P
– AS curve is vertical
SRAS and LRAS
Y = YN + a (P – PE)
P LRAS
SRAS
In the long run,
PE = P
PE
and
Y = YN.
Y
YN
37
Why the SRAS curve might shift
Everything that shifts
LRAS shifts SRAS, too.
P LRAS
Also, PE shifts SRAS:
SRAS2
If PE rises, SRAS1
workers & firms set PE
higher wages.
At each P, PE
production is less
profitable, Y falls, SRAS
shifts left. Y
YN
38
The long-run equilibrium
In the long-run
P LRAS
equilibrium:
• PE = P, SRAS
• Y = YN ,
• and PE
unemployment is
at its natural rate. AD
Y
YN
39
Analyzing Economic Fluctuations
• Four steps to analyzing economic
fluctuations:
1. Determine whether the event shifts AD or AS.
2. Determine whether curve shifts left or right.
3. Use AD–AS diagram to see how the shift
changes Y and P in the short run.
4. Use AD–AS diagram to see how economy
moves from new SR equilibrium to new LR
equilibrium .
EXAMPLE 3: The effects of a shift in AD
Use the AD–AS diagram to show the effect of a
stock market crash. P LRAS
1. Affects C, AD curve SRAS1
2. C falls, so AD shifts left
3. SR equilibrium at B. P1 A SRAS
2
P and Y lower,
P2 B
unemployment higher
AD1
4. Over time, PE falls, P3 C
AD2
SRAS shifts right,
until LR equilibrium at C. Y2 YN and
Y Y
unemployment back at initial levels.
41
Two big AD shifts: 1.The Great Depression
From 1929–1933, U.S. Real GDP,
money supply fell 28% billions of 2000 dollars
900
due to problems in 850
banking system 800
750
• stock prices fell 90%,
700
reducing C and I 650
• Y fell 26% 600
550
• P fell 22%
1929
1930
1931
1932
1933
1934
• Unemployment rate
rose from 3% to 25%
42
Two big AD shifts: 2.The World War II boom
From 1939–1944, U.S. Real GDP,
billions of 2000 dollars
• government outlays 2,000
rose from $9.1 billion 1,800
to $91.3 billion 1,600
• Y rose 90% 1,400
• P rose 20% 1,200
• unemployment fell 1,000

800
from 17% to 1%
1939
1940
1941
1942
1943
1944
43
Active Learning 2: Working with the model
Draw the AD–AS diagram for the U.S.
economy starting in a long-run equilibrium
(point A).
• A boom occurs in Canada. Use your
diagram to determine the SR and LR effects
on U.S. GDP, the price level, and
unemployment.
44
Active Learning 2: Answers
Event: Boom in Canada P LRAS
SRAS2
1. Affects NX, AD curve
2. Shifts AD right
P3 C SRAS1
3. SR equilibrium at point
B. P and Y higher, P2 B
unemployment lower A
P1 AD2
4. Over time, PE rises,
SRAS shifts left, until AD1
Y
LR equilibrium at C. YN Y2
Y and unemployment
back at initial levels.
45
The Great Recession of 2008–2009
• Large contractionary shift in AD
– Real GDP fell sharply
• By 4.2% between the forth quarter of 2007
and the second quarter of 2009
– Employment fell sharply
• Unemployment rate rose from 4.4% in May
2007 to 10.0% in October 2009
• The housing market played a central role
in this recession.
46
• Rising house prices during 2002–2006 due to:
– Low interest rates
– Easier credit for subprime borrowers
– Government policies to increase homeownership
– Securitization of mortgages: investment banks
purchased mortgages from lenders,
• Created securities backed by these
mortgages,
• Sold the securities to banks, insurance
companies, and other investors.
– Mortgage-backed securities perceived as safe,
since house prices “never fall”
47
• Consequences of 2006–2009 housing
market crash:
– Millions of homeowners “underwater”—
owed more than house was worth.
– Millions of mortgage defaults and
foreclosures.
– Banks selling foreclosed houses increased
surplus and downward price pressures.
– Housing crash badly damaged construction
industry: 2010 unemployment rate was
20.6% in construction vs. 9.6% overall.
48
• Consequences of 2006–2009 housing
market crash:
– Mortgage-backed securities became “toxic,”
• Heavy losses for institutions that purchased
them,
• Widespread failures of banks and other
financial institutions.
– Sharply rising unemployment and falling
GDP.
49
• The policy response:
– Federal Reserve reduced Fed Funds rate
target to near zero.
– Federal Reserve purchased mortgage-
backed securities and other private loans.
– U.S. Treasury injected capital into the
banking system to increase banks’ liquidity
and solvency in hopes of staving off a “credit
crunch.”
– Fiscal policymakers increased government
spending and reduced taxes by $800 billion.
50
EXAMPLE 4: The effects of a shift in SRAS
Use the AD–AS diagram to show the effect of an
increase in oil prices (assume the LRAS is constant)
1. Increases costs, shifts P SRAS
LRAS
2. SRAS shifts left SRAS2
3. SR equilibrium at point B. P
higher, Y lower, SRAS1
B
unemployment higher P2
From A to B, stagflation, P1 a period
A of
falling output and rising prices.
AD1
Y
Y2 YN
51
EXAMPLE 4: What happens in the long run?
If policymakers do nothing,
4. Low employment P LRAS
causes wages to fall, SRAS2
SRAS shifts right, until
P3 C SRAS1
LR equilibrium at A. B
Or, policymakers could use P2
fiscal or monetary policy to P1 A
increase AD and AD2
accommodate the AS shift: AD1
• Y back to YN, but
Y2 YN Y
P permanently higher.
52
The 1970s Oil Shocks and Their Effects
1973–75 1978–80
Real oil prices + 138% + 99%
CPI + 21% + 26%
Real GDP – 0.7% + 2.9%
# of unemployed + 3.5 + 1.4

persons million million
53
John Maynard Keynes, 1883–1946
The General Theory of Employment, Interest, and
Money, 1936
• Argued recessions and depressions
can result from inadequate demand;
policymakers should shift AD.
• Famous critique of classical theory:
The 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 when the
storm is long past, the ocean will be flat.
54
THINK-PAIR-SHARE
You are watching the evening news on
television. The news anchor reports that union
wage demands are much higher this year
because the workers anticipate an increase in
the rate of inflation. Your roommate says,
“Inflation is a self-fulfilling prophecy. If workers
think there are going to be higher prices, they
demand higher wages. This increases the cost of
production and firms raise their prices. Expecting
higher prices simply causes higher prices.”
55
THINK-PAIR-SHARE
A. Is this true in the short run? Explain.

B. If policymakers do nothing and allow the
economy to adjust to the natural level of
output on its own, does expecting higher
prices cause higher prices in the long run?
Explain.
C. If policymakers accommodate the adverse
supply shock, does the expectation of higher
prices cause higher prices in the long run?
Explain.
56
CHAPTER IN A NUTSHELL
• Short-run economic fluctuations around long-run
trends are irregular and largely unpredictable.
• When recessions occur, real GDP and other
measures of income, spending, and production
fall, while unemployment rises.
• Classical economic theory assumption: nominal
variables such as the money supply and the
price level do not influence real variables such as
output and employment.
• Accurate in the long run but not in the short run
57
• Model of aggregate demand and aggregate
supply” the output of goods and services and the
overall level of prices adjust to balance
aggregate demand and aggregate supply.
• The aggregate-demand curve slopes downward
due to: the wealth effect, the interest-rate effect,
and the exchange-rate effect.
• Any event or policy that raises consumption,
investment, government purchases, or net
exports at a given price level increases
aggregate demand.
58
• Any event or policy that reduces consumption,
investment, government purchases, or net exports
at a given price level decreases aggregate
demand.
• The long-run aggregate-supply curve is vertical.
The quantity of goods and services supplied
depends on the economy’s labor, capital, natural
resources, and technology but not on the overall
level of prices.
• Three theories explain the upward slope of the
short-run aggregate-supply curve: Sticky-wage
theory, Sticky-price theory, Misperceptions theory
59
• All three theories imply that output deviates from
its natural level when the actual price level
deviates from the price level that people
expected.
• Shifts of short-run aggregate supply curve:
events that alter the economy’s ability to produce
output
• Causes of economic fluctuations: shifts in
aggregate demand and aggregate supply.
60

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N.

GREGORY MANKIW NINTH EDITION

What happens to the AD curve in each of the

The natural rate of output

What is the effect of an

Over the long run,

ongoing inflation AD2010

• P rose 20% 1,200

• unemployment fell 1,000

Real oil prices + 138% + 99%

CPI + 21% + 26%

Real GDP – 0.7% + 2.9%

# of unemployed + 3.5 + 1.4

A. Is this true in the short run? Explain.

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