Principles of Economics - 3e Chapter 24 The Aggregate Supply-Aggregate Demand Model

The Aggregate Supply Model FIGURE New Home Construction At the peak of the housing bubble , many people across the country were able to secure the loans necessary to build new houses . Credit of our house ! Again ! by Tim Creative Commons , BY ) CHAPTER OBJECTIVES In this chapter , you will learn about Perspectives on Demand and Supply Building a Model of Aggregate Supply and Aggregate Demand Shifts in Aggregate Supply Shifts in Aggregate Demand How the Model Incorporates Growth , Unemployment , and Keynes Law and Say Law in the Model Introduction to the Aggregate Demand Model BRING IT HOME From Housing Bubble to Housing Bust The United States experienced rising home ownership rates for most of the last two decades . Between 1990 and 2006 , the . housing market grew . rates grew from 64 to a high of over 69 between 2004 and 2005 . For many people , this was a period in which they could either buy first homes or buy a larger and more expensive home . During this time mortgage values tripled . Housing became more accessible to Americans and was considered to be a sate investment . Figure shows how new single family home sales peaked in 2005 at units .

582 24 The Aggregate Supply Model 1400 55 800 600 400 200 ( DCI ) FIGURE New Single Family Houses Sold From the early up through 2005 , the number of new single family houses sold rose steadily . In 2006 , the number dropped dramatically and this dramatic decline continued through 2011 . Beginning in 2012 , the number of new houses sold began to climb back up . Source Census Bureau ) The housing bubble began to show signs of bursting in 2005 , as delinquency and late payments began to grow and an oversupply of new homes on the market became apparent . Dropping home values contributed to a decrease in the overall wealth of the household sector and caused homeowners to pull back on spending . Several mortgage lenders were forced to for bankruptcy because homeowners were not making their payments , and by 2008 the problem had spread throughout the markets . Lenders clamped down on credit and the housing bubble burst . Financial markets were now in crisis and unable or unwilling to even extend credit to customers . The housing bubble and the crisis in the markets were major contributors to the Great Recession that led to unemployment rates over 10 and falling . While the United States is still recovering from the impact of the Great Recession , it has made substantial progress in restoring market stability through implementing aggressive and monetary policy . The economic history of the United States is cyclical in nature with and . Some of these fluctuations are severe , such as the economic downturn that occurred Great Depression in the 19305 which lasted several years . Why does the economy grow at different rates in different years ?

What are the causes of the cyclical behavior of the economy ?

This chapter will introduce an important model , the aggregate supply model , to begin our understanding of why economies expand and contract over time . Click to View content ( books pages ) New Houses Sold in the United States . A key part of is the use of models to analyze macro issues and problems . How is the rate of economic growth connected to changes in the unemployment rate ?

Is there a reason why unemployment and seem to move in opposite directions lower unemployment and higher from 1997 to 2000 , higher unemployment and lower in the early , lower unemployment and higher in the , and then higher unemployment and lower in 2009 ?

Why did the current account rise so high , but then decline in 2009 ?

To analyze questions like these , we must move beyond discussing issues one at a time , and begin building economic models that will capture the relationships and between them . The next three chapters take up this task . This chapter introduces the model of aggregate supply and aggregate demand , how the two interact to reach a equilibrium , and how shifts in aggregate demand or aggregate supply will affect that equilibrium . This chapter also relates the model of aggregate supply and aggregate demand to the three goals of economic policy ( growth , unemployment , and Access for free at

Perspectives on Demand and Supply 583 ) and provides a framework for thinking about many of the connections and between these goals . The chapter on The Perspective focuses on the in the short run , where aggregate demand plays a crucial role . The chapter on The Neoclassical Pers explores the in the long run , where aggregate supply plays a crucial role . Perspectives on Demand and Supply LEARNING OBJECTIVES By the end of this section , you will be able to Explain Say Law and understand why it primarily applies in the long run Explain Keynes Law and understand why it primarily applies in the short run over the last two centuries have often divided into two groups those who argue that supply is the most important determinant of the size of the while tags along , and those who argue that demand is the most important factor in the size of the while tags along . Say Law and the of Supply Those economists who emphasize the role of supply in the often refer to the work ofa famous early nineteenth century French economist named Say ( Say law is Supply creates its own As a matter of historical accuracy , it seems clear that Say never actually wrote down this law and that it his beliefs , but the law lives on as useful shorthand for summarizing a point of view . The intuition behind Say law is that each time a good or service is produced and sold , it generates income that is earned for someone a worker , a manager , an owner , or those who are workers , managers , and owners at that supply inputs along the chain of production . We alluded to this earlier in our discussion of the National Income approach to measuring . The forces of supply and demand in individual markets will cause prices to rise and fall . The bottom line remains , however , that every sale represents income to someone , and so , Say law argues , a given value of supply must create an equivalent value of demand somewhere else in the economy . Because Say , Adam Smith , and other economists writing around the turn of the nineteenth century who discussed this view were known as classical economists , modern economists who generally subscribe to the Say law view on the importance of supply for determining the size of the are called neoclassical economists . If supply always creates exactly enough demand at the level , then ( as Say himself recognized ) it is hard to understand why periods of recession and high unemployment should ever occur . To be sure , even if total supply always creates an equal amount of total demand , the economy could still experience a situation of some earning while other suffer losses . Nevertheless , a recession is not a situation where all business failures are exactly by an offsetting number of successes . A recession is a situation in which the economy as a whole is shrinking in size , business failures outnumber the remaining success stories , and many end up suffering losses and laying . Say law that supply creates its own demand does seem a good approximation for the long run . Over periods of some years or decades , as the productive power of an economy to supply goods and services increases , total demand in the economy grows at roughly the same pace . However , over shorter time horizons of a few months or even years , or even depressions occur in which , as a group , seem to face a lack for their products . Keynes Law and the of Demand The alternative to Say law , with its emphasis on supply , is Keynes law Demand creates its own As a matter of historical accuracy , just as Say never wrote down anything as simpleminded as Say law , John Maynard Keynes never wrote down Keynes law , but the law is a useful that conveys a

584 24 The Aggregate Supply Model certain point of view . When Keynes wrote his work The General Theory of Employment , Interest , and the Great Depression , he pointed out that during the Depression , the economy capacity to supply goods and services had not changed much . unemployment rates soared higher than 20 from 1933 to 1935 , but the number of possible workers had not increased or decreased much . Factories closed , but machinery and equipment had not disappeared . Technologies that had been invented in the were not and forgotten in the 19305 . Thus , Keynes argued that the Great many ordinary as not caused by a drop in the ability of the economy to supply goods as measured by labor , physical capital , or technology . He argued the economy often produced less than its full potential , not because it was technically impossible to produce more with the existing workers and machines , but because a lack of demand in the economy as a whole led to inadequate incentives for to produce . In such cases , he argued , the level in the economy was not primarily determined by the potential ofwhat the economy could supply , but rather by the amount of total demand . Keynes law seems to apply fairly well in the short run of a few months to a few years , when many experience either a drop in demand for their output during a recession or so much demand that they have trouble producing enough during an economic boom . However , demand can not tell the whole story , either After all , if demand was all that mattered at the level , then the government could make the economy as large as it wanted just by pumping up total demand through a large increase in the government spending component or by legislating large tax cuts to push up the consumption component . Economies do , however , face genuine limits to how much they can produce , limits determined by the quantity of labor , physical capital , technology , and the institutional and market structures that bring these factors of production together . These constraints on what an economy can supply at the level do not because of an increase in demand . Combining Supply and Demand in Two insights emerge from this overview of Say law with its emphasis on supply and Keynes law with its emphasis on demand . The conclusion , which is not exactly a hot news , is that an economic approach focused only on the supply side or only on the demand side can be only a partial success . We need to take into account both supply and demand . The second conclusion is that since Keynes law applies more accurately in the short run and Say law applies more accurately in the long run , the and connections between the three goals of may be different in the short run and the long run . Building a Model of Aggregate Demand and Aggregate Supply LEARNING OBJECTIVES By the end of this section , you will be able to Explain the aggregate supply curve and how it relates to real and potential Explain the aggregate demand curve and how it is by price levels Interpret the aggregate supply model Identify the point of equilibrium in the aggregate supply model short run aggregate supply and long run aggregate supply To build a useful model , we need a model that shows what determines total supply or total demand for the economy , and how total demand and total supply interact at the level . We call this the aggregate supply model . This module will explain aggregate supply , aggregate demand , and the equilibrium between them . The following modules will discuss the causes of shifts in aggregate supply and aggregate demand . Access for free at

Building a Model of Aggregate Demand and Aggregate Supply 585 The Aggregate Supply Curve and Potential Firms make decisions about what quantity to supply based on the they expect to earn . They determine , in turn , by the price of the outputs they sell and by the prices of the inputs , like labor or raw materials , that they need to buy . Aggregate supply ( AS ) refers to the total quantity of output ( real ) will produce and sell . The aggregate supply ( AS ) curve shows the total quantity of output ( real ) that will produce and sell at each price level . Figure shows an aggregate supply curve . In the following paragraphs , we will walk through the elements of the diagram one at a time the horizontal and vertical axes , the aggregate supply curve itself , and the meaning of the potential vertical line . A 125 Potential AS price level 105 05 ca Price Level ( base year 100 ) oo 75 I Real ( billions of constant dollars ) FIGURE The Aggregate Supply Curve Aggregate supply ( AS ) slopes up , because as the price level for outputs rises , with the price of inputs remaining , have an incentive to produce more to earn higher . The potential line shows the maximum that the economy can produce with full employment of workers and physical capital . The diagrams horizontal axis shows real is , the level of adjusted for . The vertical axis shows the price level , which measures the average price of all goods and services produced in the economy . In other words , the price level in the model is what we called the in The Perspective . Remember that the price level is different from the rate . Visualize the price level as an index number , like the Consumer Price Index , while the rate is the percentage change in the price level over time . As the price level rises , real rises as well . Why ?

The price level on the vertical axis represents prices for goods or outputs bought in the . the the price level for intermediate goods and services that are inputs to production . Thus , the AS curve describes how suppliers will react to a higher price level for outputs of goods and services , while holding the prices of inputs like labor and energy constant . If across the economy face a situation where the price level of what they produce and sell is rising , but their costs of production are not rising , then the lure of higher will induce them to expand production . In other words , an aggregate supply curve shows how producers as a group will respond to an increase in aggregate demand . An AS curve slope changes from nearly at its far left to nearly vertical at its far right . At the far left of the aggregate supply curve , the level in the economy is far below potential , which we as the amount of real an economy can produce by fully employing its existing levels of labor , physical capital , and technology , in the context of its existing market and legal institutions . At these relatively low levels of output , levels of unemployment are high , and many factories are running only , or have closed their

586 24 The Aggregate Supply Model doors . In this situation , a relatively small increase in the prices of the outputs that businesses assuming no rise in input encourage a considerable surge in the quantity of aggregate supply because so many workers and factories are ready to swing into production . As the increases , however , some and industries will start running into limits perhaps nearly all of the expert workers in a certain industry will have jobs or factories in certain geographic areas or industries will be running at full speed . In the AS curve intermediate area , a higher price level for outputs continues to encourage a greater quantity of as the increasingly steep upward slope of the aggregate supply curve shows , the increase in real in response to a given rise in the price level will not be as large . Read the following Clear It Up feature to learn why the AS curve crosses potential . CLEAR IT UP Why does AS cross potential ?

Economists typically draw the aggregate supply curve to cross the potential line . This shape may seem puzzling How can an economy produce at an output level which is higher than its potential or full employment ?

The economic intuition here is that if prices for outputs were high enough , producers would make fanatical efforts to produce all workers would be on , all machines would run 24 hours a day , seven days a week . Such production would go beyond using potential labor and physical capital resources fully , to in a way that is not sustainable in the long term . Thus , it is possible for production to sprint above potential , but only in the short run . At the far right , the aggregate supply curve becomes nearly vertical . At this quantity , higher prices for outputs can not encourage additional output , because even if want to expand output , the inputs of labor and machinery in the economy are fully employed . In this example , the vertical line in the exhibit shows that potential occurs at a total output of . When an economy is operating at its potential , machines and factories are running at capacity , and the unemployment rate is relatively the natural rate of unemployment . For this reason , potential is sometimes also called . The Aggregate Demand Curve Aggregate demand ( AD ) refers to the amount of total spending on domestic goods and services in an economy . Strictly speaking , AD is what economists call total planned expenditure . We will further explain this distinction in the appendix The Model . For now , just think of aggregate demand as total spending . It includes all four components consumption , investment , government spending , and net exports ( exports minus imports ) This demand is determined by a number of factors , but one of them is the price though , that the price level is an index number such as the that measures the average price of the things we buy . The aggregate demand ( AD ) curve shows the total spending on domestic goods and services at each price level . Figure presents an aggregate demand ( AD ) curve . Just like the aggregate supply curve , the horizontal axis shows real and the vertical axis shows the price level . The AD curve slopes down , which means that increases in the price level of outputs lead to a lower quantity of total spending . The reasons behind this shape are related to how changes in the price level affect the different components of aggregate demand . The following components comprise aggregate demand consumption spending ( investment spending ( government spending ( and spending on exports ( minus imports ( I Access for free at

Building a Model of Aggregate Demand and Aggregate Supply 587 125 AD 115 105 95 Price Level 85 75 I I Real FIGURE The Aggregate Demand Curve Aggregate demand ( AD ) slopes down , showing that , as the price level rises , the amount of total spending on domestic goods and services declines . The wealth effect holds that as the price level increases , the buying power of savings that people have stored up in bank accounts and other assets will diminish , eaten away to some extent by . Because a rise in the price level reduces people wealth , consumption spending will fall as the price level rises . The interest rate effect is that as prices for outputs rise , the same purchases will take more money or credit to accomplish . This additional demand for money and credit will push interest rates higher . In turn , higher interest rates will reduce borrowing by businesses for investment purposes and reduce borrowing by households for homes and reducing consumption and investment spending . The foreign price effect points out that if prices rise in the United States while remaining in other countries , then goods in the United States will be relatively more expensive compared to goods in the rest of the world . exports will be relatively more expensive , and the quantity of exports sold will fall . imports from abroad will be relatively cheaper , so the quantity of imports will rise . Thus , a higher domestic price level , relative to price levels in other countries , will reduce net export expenditures . Among economists all three of these effects are controversial , in part because they do not seem to be very large . For this reason , the aggregate demand curve in Figure slopes downward fairly steeply . The steep slope indicates that a higher price level for outputs reduces aggregate demand for all three of these reasons , but that the change in the quantity of aggregate demand as a result of changes in price level is not very large . Read the following Work It Out feature to learn how to interpret the model . In this example , aggregate supply , aggregate demand , and the price level are given for the imaginary country of . Interpreting the Model Table shows information on aggregate supply , aggregate demand , and the price level for the imaginary country of . What information does Table tell you about the state of the economy ?

Where is the equilibrium price level and output level ( this is the ) Is risking inflationary pressures or facing high unemployment ?

How can you tell ?

588 24 The Aggregate Supply Model Price Level Aggregate Demand Aggregate Supply 110 700 600 120 690 640 130 680 680 140 670 720 150 660 740 160 650 760 170 640 770 TABLE Price Level Aggregate Supply To begin to use the model , it is important to plot the AS and AD curves from the data provided . What is the equilibrium ?

Step . Draw your and . Label the Real and the Price Level . Step . Plot AD on your graph . Step . Plot AS on your graph . Step . Look at Figure which provides a visual to aid in your analysis . 180 170 160 150 140 130 120 110 100 600 850 700 750 800 Real Output ( constant dollars ) AD AS Price Level ( base year 100 ) FIGURE The Curves AD and AS curves created from the data in Table . Step . Determine where AD and AS intersect . This is the equilibrium with price level at 130 and real at 680 . Step . Look at the graph to determine where equilibrium is located . We can see that this equilibrium is fairly far from where the AS curve becomes ( or at least quite steep ) which seems to start at about 750 of real output . This implies that the economy is not close to potential . Thus , unemployment will be high . In the relatively flat part of the AS curve , where the equilibrium occurs , changes in the price level will not be a major concern , since such changes are likely to be small . Access for free at

Building a Model of Aggregate Demand and Aggregate Supply 589 Step . Determine what the steep portion of the AS curve indicates . Where the AS curve is steep , the economy is at or close to potential . Step . Draw conclusions from the given information If equilibrium occurs in the flat range of AS , then economy is not close to potential and will be experiencing unemployment , but stable price level . If equilibrium occurs in the steep range of AS , then the economy is close or at potential and will be experiencing rising price levels or inflationary pressures , but will have a low unemployment rate . Equilibrium in the Aggregate Supply Model The intersection of the aggregate supply and aggregate demand curves shows the equilibrium level of real and the equilibrium price level in the economy . At a relatively low price level for output , have little incentive to produce , although consumers would be willing to purchase a large quantity of output . As the price level rises , aggregate supply rises and aggregate demand falls until the equilibrium point is reached . Figure combines the AS curve from Figure and the AD curve from Figure and places them both on a single diagram . In this example , the equilibrium point occurs at point , at a price level of 90 and an output level of . Potential 125 AD AS 115 ) 105 an price level 90 95 real I 85 I 75 i I Real ( billions of constant dollars ) FIGURE Aggregate Supply and Aggregate Demand The equilibrium , where aggregate supply ( AS ) equals aggregate demand ( AD ) occurs at a price level of 90 and an output level of . Confusion sometimes arises between the aggregate supply and aggregate demand model and the analysis of demand and supply in particular markets for goods , services , labor , and capital . Read the following Clear It Up feature to gain an understanding AS and AD are macro or micro . CLEAR IT UP Are AS and AD macro or micro ?

These aggregate supply and demand models and the analysis of demand and supply in particular markets for goods , services , labor , and capital have a superficial resemblance , but they also have many underlying differences . For example , the vertical and horizontal axes have distinctly different meanings in and

590 24 The Aggregate Supply Model diagrams . The vertical axis of a demand and supply diagram expresses a price ( or wage or rate of return ) for an individual good or service . This price is implicitly relative it is intended to be compared with the prices of other products ( for example , the price of pizza relative to the price of fried chicken ) In contrast , the vertical axis of an aggregate su and aggregate demand diagram expresses the level of a price index like the Consumer Price Index orthe a wide array of prices from across the economy . The price level is absolute it is not intended be compared to any other prices since it is essentially the average price of all products in an economy . The horizontal axis of a supply and demand curve measures the quantity of a particular good or service . In con , the horizontal axis of the aggregate demand and aggregate supply diagram measures , which is the sum of all the final goods and services produced in the economy , not the quantity in a specific market . In addition , the economic reasons or the shapes of the curves in the model are different from the reasons behind the shapes of the curves in models . Demand curves for individual goods or services slope down primarily because of the existence of substitute goods , not the wealth effects , interest rate , and foreign price effects associated with aggregate demand curves . The slopes of individual supply and demand curves can have a variety of different slopes , on the extent to which quantity demanded and quantity supplied react to price in that market , bu the slopes of the AS and AD curves are much the same in every diagram ( although as we shall see in later , and perspectives will emphasize different parts of the AS curve ) In short , just because the diagram has two lines that cross , do not assume that it is the same as every other diagram where two lines cross . The intuitions and meanings of the macro and micro diagrams are only distant cousins from different branches of the economics family tree . Defining and In the Clear It Up feature titled Why does AS cross potential ?

we differentiated between short run changes in aggregate supply which the AS curve shows and long run changes in aggregate supply which the vertical line at potential . In the short run , is too low ( or too high ) it is possible for producers to supply less ( or more ) than potential . In the long run , however , producers are limited to producing at potential . For this reason , we may also refer to what we have been calling the AS curve as the short run aggregate supply ( curve . We may also refer to the vertical line at potential as the long run aggregate supply ( curve . Shifts in Aggregate Supply LEARNING OBJECTIVES By the end of this section , you will be able to Explain how productivity growth changes the aggregate supply curve Explain how changes in input prices change the aggregate supply curve The original equilibrium in the diagram will shift to a new equilibrium if the AS or AD curve shifts . When the aggregate supply curve shifts to the right , then at every price level , producers supply a greater quantity of real . When the AS curve shifts to the left , then at every price level , producers supply a lower quantity of real . This module discusses two of the most important factors that can lead to shifts in the AS curve productivity growth and changes in input prices . How Productivity Growth Shifts the AS Curve In the long run , the most important factor shifting the AS curve is productivity growth . Productivity means how much output can be produced with a given quantity of labor . One measure of this is output per worker or per capita . Over time , productivity grows so that the same quantity of labor can produce more output . Historically , the real growth in per capita in an advanced economy like the United States has averaged Access for free at

Shifts in Aggregate Supply 591 about to per year , but productivity growth has been faster during certain extended periods like the and the late through the early , or slower during periods like the . A higher level of productivity shifts the AS curve to the right , because with improved productivity , can produce a greater quantity of output at every price level . Figure ( a ) shows an outward shift in productivity over two time periods . The AS curve shifts out from to to , and the equilibrium shifts from to to . Note that with increased productivity , workers can produce more . Thus , full employment corresponds to a higher level of potential , which we show as a rightward shift in from to to . A Real Real ( a ) Productivity growth shifts to the right ( Higher prices for key inputs shifts AS to the left FIGURE Shifts in Aggregate Supply ( a ) The rise in productivity causes the curve to shift to the right . The original equilibrium is at the intersection of AD and . When shifts right , then the new equilibrium is at the intersection of AD and , and then yet another equilibrium , is at the intersection of AD and . Shifts in to the right , lead to a greater level of output and to downward pressure on the price level . A higher price for inputs means that at any given price level for outputs , a lower real will be produced so aggregate supply will shift to the left from to . The new equilibrium , has a reduced quantity of output and a higher price level than the original equilibrium ( A shift in the curve to the right will result in a greater real and downward pressure on the price level , if aggregate demand remains unchanged . However , if this shift in results from gains in productivity growth , which we typically measure in terms of a few percentage points per year , the effect will be relatively small over a few months or even a couple ofyears . Recall how in Choice in a World of Scarcity , we said that a nation production possibilities frontier is in the short run , but shifts out in the long run ?

This is the same phenomenon using a different model . How Changes in Input Prices Shift the AS Curve Higher prices for inputs that are widely used across the entire economy can have a impact on aggregate supply . Examples of such widely used inputs include labor and energy products . Increases in the price of such inputs will cause the curve to shift to the left , which means that at each given price level for outputs , a higher price for inputs will discourage production because it will reduce the possibilities for earning . Figure ( shows the aggregate supply curve shifting to the left , from to , causing the equilibrium to move from to . The movement from the original equilibrium of to the new equilibrium of will bring a nasty set of effects reduced or recession , higher unemployment because the economy is

592 24 The Aggregate Supply Model now further away from potential , and an higher price level as well . For example , the economy experienced in , 2001 , and that were each preceded or accompanied by a rise in the key input of oil prices . In the , this pattern ofa shift to the left in leading to a stagnant economy with high unemployment and was nicknamed . Conversely , a decline in the price of a key input like oil will shift the curve to the right , providing an incentive for more to be produced at every given price level for outputs . From 1985 to 1986 , for example , the average price of crude oil fell by almost half , from 24 a barrel to 12 a barrel . Similarly , from 1997 to 1998 , the price of a barrel of crude oil dropped from 17 per barrel to 11 per barrel . In both cases , the plummeting oil price led to a situation like that which we presented earlier in Figure ( a ) where the outward shift of to the right allowed the economy to expand , unemployment to fall , and to decline . Along with energy prices , two other key inputs that may shift the curve are the cost of labor , or wages , and the cost of imported goods that we use as inputs for other products . In these cases as well , the lesson is that lower prices for inputs cause to shift to the right , while higher prices cause it to shift back to the left . Note that , unlike changes in productivity , changes in input prices do not generally cause to shift , only . Other Supply Shocks The aggregate supply curve can also shift due to shocks to input goods or labor . For example , an unexpected early freeze could destroy a large number of agricultural crops , a shock that would shift the AS curve to the left since there would be fewer agricultural products available at any given price . Similarly , shocks to the labor market can affect aggregate supply . An extreme example might be an overseas war that required a large number to cease their ordinary production in order to go for their country . In this case , and would both shift to the left because there would be fewer workers available to produce goods at any given price . Another example in this vein is a pandemic , like the pandemic . A pandemic causes many workers to become sick , temporarily reducing the supply by a large amount . Further , workers might be cautious to go back to work in a pandemic because of health or safety concerns . While the shock to labor supply might not be permanent , it can cause a reduction in the supply of many goods and services , in a leftward shift in the aggregate supply curve . At various points during the pandemic , computer chips for automobiles , meat , and other consumer services were in short supply because of worker shortages around the world . Shifts in Aggregate Demand LEARNING OBJECTIVES By the end of this section , you will be able to Explain how imports aggregate demand Identify ways in which business and consumer can affect aggregate demand Explain how government policy can change aggregate demand Evaluate why economists disagree on the topic of tax cuts As we mentioned previously , the components of aggregate demand are consumption spending ( investment spending ( government spending ( and spending on exports ( minus imports ( Read the following Clear It Up feature for explanation of why imports are subtracted from exports and what this means for aggregate demand . A shift of the AD curve to the right means that at least one of these components increased so that a greater amount of total spending would occur at every price level . A shift of the AD curve to the left means that at least one of these components decreased so that a lesser amount of total spending would occur at every price level . The Perspective will discuss the components of aggregate demand and the factors that affect them . Here , the discussion will sketch two broad categories that could cause AD curves to Access for free at

Shifts in Aggregate Demand 593 shift changes in consumer or behavior and changes in government tax or spending policy . CLEAR IT UP Do imports diminish aggregate demand ?

We have seen that the formula for aggregate demand is AD I , where is the total value of imported goods . Why is there a minus sign in front of imports ?

Does this mean that more imports will result in a lower level of aggregate demand ?

The short answer is yes , because aggregate demand is as total demand for domestically produced goods and services . When an American buys a foreign product , for example , it gets counted along with all the other consumption . Thus , the income generated does not go to American producers , but rather to producers in another country . It would be wrong to count this as part of domestic demand . Therefore , imports added in consumption are subtracted back out in the term of the equation . Because of the way in which we write the demand equation , it is easy to make the mistake of thinking that imports are bad for the economy . Just keep in mind that every negative number in the term has a corresponding positive number in the orI or term , and they always cancel out . How Changes by Consumers and Firms Can Affect AD When consumers feel more about the future of the economy , they tend to consume more . is high , then tend to spend more on investment , believing that the future payoff from that investment will be substantial . Conversely , if consumer or business drops , then consumption and investment spending decline . The University of Michigan publishes a survey of consumer and constructs an index of consumer each month . The survey results are then reported at , which break down the change in consumer among different income levels . According to that index , consumer averaged around 90 prior to the Great Recession , and then it fell to below 60 in late 2008 , which was the lowest it had been since 1980 . During the , has climbed from a 2011 low of back to a level in the upper 903 , before falling to the lower in 2020 due to the pandemic , which economists consider close to a healthy state . The Organization for Economic Development and Cooperation ( publishes one measure of business the business tendency surveys . The collects business opinion survey data for 21 countries on future selling prices and employment , among other business climate elements . After sharply declining during the Great Recession , the measure has risen above zero again and is back to averages ( the indicator dips below zero when business outlook is weaker than usual ) Of course , either of these survey measures is not very precise . They can however , suggest when is rising or falling , as well as when it is relatively high or low compared to the past . Because economists associate a rise in with higher consumption and investment demand , it will lead to an outward shift in the AD curve , and a move of the equilibrium , from to , to a higher quantity of output and a higher price level , as Figure ( a ) shows . Consumer and business often realities for example , is usually high when the economy is growing briskly and low during a recession . However , economic can sometimes rise or fall for reasons that do not have a close connection to the immediate economy , like a risk of war , election results , foreign policy events , or a pessimistic prediction about the future by a prominent public . presidents , for example , must be careful in their public pronouncements about the economy . If they offer economic pessimism , they risk provoking a decline in that reduces consumption and investment and shifts AD to the left , and in a prophecy , contributes to causing the recession that

594 24 The Aggregate Supply Model the president warned against in the place . Figure ( shows a shift of AD to the left , and the corresponding movement of the equilibrium , from to , to a lower quantity of output and a lower price level . LINK IT UP Visit this website ( for data on consumer . LINK IT UP Visit this website ( for data on business . Price Level Price Level ( a ) Aggregate demand shifts right ( Aggregate demand shifts left FIGURE Shifts in Aggregate Demand ( a ) An increase in consumer or business can shift AD to the right , from ADO to . When AD shifts to the right , the new equilibrium ( will have a higher quantity of output and also a higher price level compared with the original equilibrium ( In this example , the new equilibrium ( is also closer to potential . An increase in government spending or a cut in taxes that leads to a rise in consumer spending can also shift AD to the right . A decrease in consumer or business can shift AD to the left , from ADO to . When AD shifts to the left , the new equilibrium ( will have a lower quantity of output and also a lower price level compared with the original equilibrium ( In this example , the new equilibrium ( is also farther below potential . A decrease in government spending or higher taxes that leads to a fall in consumer spending can also shift AD to the left . How Government Policy Choices Can Shift AD Government spending is one component of AD . Thus , higher government spending will cause AD to shift to the right , as in Figure ( a ) while lower government spending will cause AD to shift to the left , as in Figure ( For example , in the United States , government spending declined by of during the , from 21 of in 1991 , and to in 1998 . However , from 2005 to 2009 , the peak of the Great Recession , government spending increased from 19 to of . If changes of a few percentage points of seem small to you , remember that since was about trillion in 2009 , a seemingly small change of of is equal to close to 300 billion . Since 2009 , government expenditures have gone back down to around of , although in 2020 they rose to . Access for free at

Shifts in Aggregate Demand 595 Tax policy can affect consumption and investment spending , too . Tax cuts for individuals will tend to increase consumption demand , while tax increases will tend to diminish it . Tax policy can also pump up investment demand by offering lower tax rates for corporations or tax reductions that kinds of investment . Shifting or I will shift the AD curve as a whole . During a recession , when unemployment is high and many businesses are suffering low or even losses , the Congress often passes tax cuts . During the 2001 recession , for example , the Congress enacted a tax cut into law . At such times , the political rhetoric often focuses on how people experiencing hard times need relief from taxes . The aggregate supply and aggregate demand framework , however , offers a complementary rationale , as Figure 249 illustrates . The original equilibrium during a recession is at point , relatively far from the full employment level of output . The tax cut , by increasing consumption , shifts the AD curve to the right . At the new equilibrium ( real rises and unemployment falls and , because in this diagram the economy has not yet reached its potential or full employment level of , any rise in the price level remains muted . Read the following Clear It Up feature to consider the question whether economists favor tax cuts or oppose them . Price Level AD Real FIGURE Recession and Full Employment in the Model Whether the economy is in a recession is illustrated in the model by how close the equilibrium is to the potential line as indicated by the vertical line . In this example , the level of output at the equilibrium is relatively far from the potential line , so it can represent an economy in recession , well below the full employment level of . In contrast , the level of output at the equilibrium is relatively close to potential , and so it would represent an economy with a lower unemployment rate . CLEAR IT UP Do economists favor tax cuts or oppose them ?

One of the most fundamental divisions in American politics over the last few decades has been between those who believe that the government should cut taxes substantially and those who disagree . Ronald Reagan rode into the presidency in 1980 partly because of his promise , soon carried out , to enact a substantial tax cut . George Bush lost his bid for reelection against Bill Clinton in 1992 partly because he had broken his 1988 promise Read my lips ! No new taxes ! In the 2000 presidential election , both George Bush and Al Gore advocated substantial tax cuts and Bush succeeded in pushing a tax cut package through Congress early in 2001 . More recently in 2017 and 2018 , Donald Trump initiated a new round of tax cuts throughout the economy , and President promised his own set

596 24 The Aggregate Supply Model of tax cuts in his 2021 spending bills . What side do economists take ?

Do they support broad tax cuts or oppose them ?

The answer , unsatisfying to zealots on both sides , is that it depends . One issue is whether equally large government spending cuts accompany the tax cuts . Economists differ , as does any broad of the public , on how large government spending should be and what programs the government might cut back . A second issue , more relevant to the discussion in this chapter , concerns how close the economy is to the full employment output level . In a recession , when the AD and AS curves intersect far below the full employment level , tax cuts can make sense as a way of shifting AD to the right . However , when the economy is already performing extremely well , tax cuts may shift AD so far to the right as to generate inflationary pressures , with little gain to . With the framework in mind , many economists might readily believe that the 1981 Reagan tax cuts , which took effect just after two serious , were economic policy . Similarly , Congress enacted the 2001 Bush tax cuts and the 2009 Obama tax cuts during . However , some of the same economists who favor tax cuts during recession would be much more dubious about identical tax cuts at a time the economy is performing well and cyclical unemployment is low . Government spending and tax rate changes can be useful tools to affect aggregate demand . We will discuss these in greater detail in the Government Budgets and Fiscal Policy chapter and The Impacts of Government Borrowing . Other policy tools can shift the aggregate demand curve as well . For example , as we will discuss in the Monetary Policy and Bank Regulation chapter , the Federal Reserve can affect interest rates and credit availability . Higher interest rates tend to discourage borrowing and thus reduce both household spending on items like houses and cars and investment spending by business . Conversely , lower interest rates will stimulate consumption and investment demand . Interest rates can also affect exchange rates , which in turn will have effects on the export and import components of aggregate demand . Clarifying the details of these alternative policies and how they affect the components of aggregate demand can wait for The Pers chapter . Here , the key lesson is that a shift of the aggregate demand curve to the right leads to a greater real and to upward pressure on the price level . Conversely , a shift of aggregate demand to the left leads to a lower real and a lower price level . Whether these changes in output and price level are relatively large or relatively small , and how the change in equilibrium relates to potential , depends on whether the shift in the AD curve is happening in the AS curve relatively or relatively steep portion . How the Model Incorporates Growth , Unemployment , and Inflation LEARNING OBJECTIVES By the end of this section , you will be able to Use the aggregate supply model to show periods of economic growth and recession Explain how unemployment and impact the aggregate supply model Evaluate the importance of the aggregate supply model The model can convey a number of interlocking relationships between the three goals of growth , unemployment , and low . Moreover , the framework is enough to accommodate both the Keynes law approach that focuses on aggregate demand and the short run , while also including the Say law approach that focuses on aggregate supply and the long run . These advantages are considerable . Every model is a version of the deeper reality and , in the context of the model , the three goals arise in ways that are sometimes indirect or incomplete . In this module , we consider how the model illustrates the three goals of economic growth , low unemployment , and low . Access for free at

How the Model Incorporates Growth , Unemployment , and Inflation 597 Growth and Recession in the Diagram In the diagram , economic growth due to productivity increases over time will be represented by a gradual shift to the right of aggregate supply . The vertical line representing potential ( or the full employment level of ) will gradually shift to the right over time as well . Earlier Figure ( a ) showed a pattern of economic growth over three years , with the AS curve shifting slightly out to the right each year . However , the factors that determine the speed of this economic growth investment in physical and human capital , technology , and whether an economy can take advantage of not appear directly in the diagram . In the short run , falls and rises in every economy , as the economy dips into recession or expands out of recession . The diagram illustrates when the equilibrium level of real is substantially below potential , as we see at the equilibrium point in Figure . From another standpoint , in years of resurgent economic growth the equilibrium will typically be close to potential , as equilibrium point in that earlier shows . Unemployment in the Diagram We described two types in the Unemployment chapter . Short run variations in unemployment ( cyclical unemployment ) are caused by the business cycle as the economy expands and contracts . Over the long run , in the United States , the unemployment rate typically hovers around ( give or take one percentage point or so ) when the economy is healthy . In many of the national economies across Europe , the unemployment rate in recent decades has only dropped to about 10 or a bit lower , even in good economic years . We call this baseline level that occurs and the natural rate of unemployment and we determine it by how well the structures of market and government institutions in the economy lead to a matching of workers and employers in the labor market . Potential can imply different unemployment rates in different economies , depending on the natural rate of unemployment for that economy . The diagram shows cyclical unemployment by how close the economy is to the potential or full employment level . Returning to Figure , relatively low cyclical unemployment for an economy occurs when the level of output is close to potential , as in the equilibrium point . Conversely , high cyclical unemployment arises when the output is substantially to the left of potential on the diagram , as at the equilibrium point . Although we do not show the factors that determine the natural rate of unemployment separately in the model , they are implicitly part ofwhat determines potential or full employment in a given economy . Inflationary Pressures in the Diagram in the short run . Higher rates have typically occurred either during orjust after economic booms for example , the biggest spurts of in the economy during the twentieth century followed the wartime booms of World War I and World War 11 . Conversely , rates of generally decline during . As an extreme example , actually became situation called the Great Depression . Even during the relatively short recession , the rate declined from in 1990 to in 1992 . During the relatively short 2001 recession , the rate of declined from in 2000 to in 2002 . During the deep recession of , the rate declined from in 2008 to in 2009 . Some countries have experienced bouts of high that lasted for years . In the economy since the , does not seem to have had any term trend to be substantially higher . Instead , it has stayed in the range annually . The framework implies two ways that pressures may arise . One possible trigger is if aggregate demand continues to shift to the right when the economy is already at or near potential and full employment , thus pushing the equilibrium into the AS curve steep portion . In Figure 2410 ( a ) there is a shift of aggregate demand to the right . The new equilibrium is clearly at a higher price level

598 24 The Aggregate Supply Model than the original equilibrium . In this situation , the aggregate demand in the economy has soared so high that in the economy are not capable additional goods , because labor and physical capital are fully employed , and so additional increases in aggregate demand can only result in a rise in the price level . OJ , a ) Inflationary pressure from a shift in AD ( Inflationary pressure from a shift in AS FIGURE Sources of Inflationary Pressure in the Model ( a ) A shift in aggregate demand , from ADO to , when it happens in the area of the curve that is near potential , will lead to a higher price level and to pressure for a higher price level and inflation . The new equilibrium ( is at a higher price level ( than the original equilibrium . A shift in aggregate supply , from to , will lead to a lower real and to pressure for a higher price level and inflation . The new equilibrium ( is at a higher price evel ( while the original equilibrium ( is at the lower price level ( Po ) An alternative source of pressures can occur due to a rise in input prices tlat affects many or most across the an important input to production like oil or causes the aggregate supply curve to shift back to the left . In Figure ( the curve shift to the left also increases the price level from at the original equilibrium ( to a higher price level of at the new equilibrium ( In effect , the rise in input prices ends up , after the final output is and sold , passing along in the form ofa higher price level for outputs . The diagram shows only a shift in the price level . It does not address the question ofwhat would cause either to vanish after a year , or to sustain itself for several years . here are two explanations for why may persist over time . One way that continual price increases can occur is if the government continually attempts to stimulate aggregate demand in a way that keeps pushing the AD curve when it is already in the curve steep portion . A second possibility is that , if has been occurring for several years , people might begin to expect a certain level of . do , then these expectations will cause prices , wages and interest rates to increase annually by the amount of the expected . These two reasons are interrelated , because if a government fosters a environment with pressures , then people will grow to expect . However , the diagram does not show these patterns of ongoing or expected in a direct way . Importance ofthe Aggregate Supply Model takes an overall view of the economy , which means that it needs to juggle many different concepts . For example , start with the three goals of growth , low , and low Access for free at

Keynes Law and Say Law in the Model 599 unemployment . Aggregate demand has four elements consumption , investment , government spending , and exports less imports . Aggregate supply reveals how businesses throughout the economy will react to a higher price level for outputs . Finally , a wide array of economic events and policy decisions can affect aggregate demand and aggregate supply , including government tax and spending decisions consumer and business changes in prices of key inputs like oil and technology that brings higher levels of productivity . The aggregate supply model is one of the fundamental diagrams in this course ( like the budget constraint diagram that we introduced in the Choice in a World of Scarcity chapter and the supply and demand diagram in the Demand and Supply chapter ) because it provides an overall framework for bringing these factors together in one diagram . Some version of the model will appear in every chapter in the rest of this book . Keynes Law and Say Law in the Model LEARNING OBJECTIVES By the end of this section , you will be able to Identify the neoclassical zone , the intermediate zone , and the zone in the aggregate aggregate supply model Use an aggregate supply model as a diagnostic test to understand the current state of the economy We can use the model to illustrate both Say law that supply creates its own demand and Keynes law that demand creates its own su . Consider the curve three zones which Figure the zone , the neoclassical zone , and the intermediate zone . Neoclassical zone ) PI zone EK ZONE I i i ( Yn Real FIGURE Keynes , Neoclassical , and Intermediate Zones in the Aggregate Supply Curve Near the equilibrium Ek , in the zone at the far left of the curve , small shifts in AD , either to the right or the left , will affect the output level , but will not much affect the price level . In the zone , AD largely determines the quantity of output . Near the equilibrium En , in the neoclassical zone at the curve far right , small shifts in AD , either to the right or the left , will have relatively little effect on the output level Yn , but instead will have a greater effect on the price level . In the neoclassical zone , the curve close to the level of potential largely determines the quantity of output . In the intermediate zone around equilibrium Ei , movement in AD to the right will increase both the output level and the price level , while a movement in AD to the left would decrease both the output level and the price level .

600 24 The Aggregate Supply Model Focus first on the zone , that portion of the curve on the far left which is relatively . Ifthe AD curve crosses this portion of the curve at an equilibrium point like Ek , then certain statements about the economic situation will follow . In the zone , the equilibrium level of real is far below potential , the economy is in recession , and cyclical unemployment is high . demand shifted to the right or left in the zone , it will determine the resulting level of output ( and thus unemployment ) However , price pressure is not much of a worry in the zone , since the price level does not vary much in this zone . Now , focus your attention on the neoclassical zone of the curve , which is the portion on the righthand side . Ifthe AD curve crosses this portion of the curve at an equilibrium point like En where output is at or near potential , then the size pretty much determines the level of output in the economy . Since the equilibrium is near potential , cyclical unemployment is low in this economy , although structural unemployment may remain an issue . In the neoclassical zone , shifts of aggregate demand to the right or the left have little effect on the level of output or employment . The only way to increase the size of the real in the neoclassical zone is for AS to shift to the right . However , shifts in AD in the neoclassical zone will create pressures to change the price level . Finally , consider the curve intermediate zone in Figure . If the AD curve crosses this portion of the curve at an equilibrium point like Ei , then we might expect unemployment and to move in opposing directions . For instance , a shift of AD to the right will move output closer to potential and thus reduce unemployment , but will also lead to a higher price level and upward pressure on . Conversely , a shift to the left will move output further from potential and raise unemployment , but will also lead to a lower price level and downward pressure on . This approach of dividing the curve into different zones works as a diagnostic test that we can apply to an economy , like a doctor checking a patient for symptoms . First , out in what zone the economy is . This will clarify the economic issues , and policy choices . Some economists believe that the economy is strongly predisposed to be in one zone or another . Thus , economists believe that the economies are in the zone most of the time , and so they view the neoclassical zone as a theoretical abstraction . Conversely , neoclassical economists argue that economies are in the neoclassical zone most of the time and that the zone is a distraction . The Perspective and The Neoclassical Perspective should help to clarify the underpinnings and consequences of these contrasting views of the . BRING IT HOME The Recession Supply or Demand ?

We mentioned earlier that a pandemic could cause a shock in the or aggregate supply curve by temporarily reducing labor supply and slowing or stopping production of goods and services . Pandemics can also affect aggregate demand . When people are hesitant to spend or travel , or if they are not allowed to spend or travel because of social restrictions , this will affect spending in the economy . Consumers spend less at restaurants , hotels , and travel , among other areas , while firms stop investing because of the lack of demand and an uncertain future . Both actions lead to a leftward shift in the aggregate demand curve . While there is some debate over whether the recession that the economy experienced in 2020 was primarily a or one , most likely , it is a combination of both . In March and April 2020 , workers left the labor market en masse , and later in the year , they were hesitant to return due to health and safety concerns . Many people were also forced to cancel travel plans or voluntarily did so out of concern for their safety , further reducing aggregate demand . These changes caused deep cuts in the global economy that continued to be felt two years after the initial shocks . Access for free at

24 Key Terms 601 Key Terms aggregate demand ( AD ) the amount of total spending on domestic goods and services in an economy aggregate demand ( AD ) curve the total spending on domestic goods and services at each price level aggregate supply model a model that shows what determines total supply or total demand for the economy , and how total demand and total supply interact at the level aggregate supply ( AS ) the total quantity of output ( real ) will produce and sell aggregate supply ( AS ) curve the total quantity of output ( real ) that will produce and sell at each price level another name for potential , when the economy is producing at its potential and unemployment is at the natural rate of unemployment intermediate zone portion of the curve where is below potential but not so far below as in the zone the curve is , but not vertical in the intermediate zone Keynes law demand creates its own supply zone portion of the curve where is far below potential and the curve is long run aggregate supply ( curve vertical line at potential showing no relationship between the price level for output and real in the long run neoclassical economists economists who generally emphasize the importance of aggregate supply in determining the size of the over the long run neoclassical zone portion of the curve where is at or near potential output where the curve is steep potential the maximum quantity that an economy can produce given full employment of its existing levels of labor , physical capital , technology , and institutions Say law supply creates its own demand short run aggregate supply ( curve positive short run relationship between the price level for output and real , holding the prices of inputs an economy experiences stagnant growth and high at the same time Key Concepts and Summary Perspectives on Demand and Neoclassical economists emphasize Say law , which holds that supply creates its own demand . economists emphasize Keynes law , which holds that demand creates its own supply . Many mainstream economists take a perspective , emphasizing the importance of aggregate demand , for the short run , and a neoclassical perspective , emphasizing the importance of aggregate supply , for the long run . Building a Model of Aggregate Demand and Aggregate Supply The short run aggregate supply ( curve shows the positive relationship between the price level and the level of real in the short run . Aggregate supply slopes up because when the price level for outputs increases , while the price level of inputs remains , the opportunity for additional encourages more production . The aggregate supply curve is on the left and on the right . In the long run , we show the aggregate supply by a vertical line at the level output , which is the maximum level of output the economy can produce with its existing levels , physical capital , technology , and economic institutions . The aggregate demand ( AD ) curve shows the relationship between the price level for outputs and the quantity of total spending in the economy . It slopes down because of ( a ) the wealth effect , which means that a higher price level leads to lower real wealth , which reduces the level of consumption ( the interest rate effect , which holds that a higher price level will mean a greater demand for money , which will tend to drive up interest rates and reduce investment spending and ( the foreign price effect , which holds that a rise in the price level will make domestic goods relatively more expensive , discouraging exports and

602 24 Key Concepts and Summary encouraging imports . Shifts in Aggregate Supply The aggregate supply ( diagram shows how AD and AS interact . The intersection of the AD and AS curves shows the equilibrium output and price level in the economy . Movements AS or AD will result in a different equilibrium output and price level . The aggregate supply curve will shift out to the right as productivity increases . It will shift back to the left as the price of key inputs rises , and will shift out to the right if the price of key inputs falls . Ifthe AS curve shifts back to the left , the combination of lower output , higher unemployment , and higher , called , occurs . shifts out to the right , a combination of lower , higher output , and lower unemployment is possible . Shifts in Aggregate Demand The AD curve will shift out as the components of aggregate , I , and . It will shift back to the left as these components fall . These factors can change because of different personal choices , like those resulting from consumer or business , or from policy choices like changes in government spending and taxes . If the AD curve shifts to the right , then the equilibrium quantity of output and the price level will rise . If the AD curve shifts to the left , then the equilibrium quantity of output and the price level will fall . Whether equilibrium output changes relatively more than the price level or whether the price level changes relatively more than output is determined by where the AD curve intersects with the AS curve . The diagram resembles the supply and demand diagram on the surface , but in reality , what is on the horizontal and vertical axes and the underlying economic reasons for the shapes of the curves are very different . We can illustrate economic growth in the framework by a gradual shift of the aggregate supply curve to the right . We illustrate a recession when the intersection of AD and AS is substantially below potential , while we illustrate an expanding economy when the intersection of AS and AD is near potential . How the Model Incorporates Growth , Unemployment , and Inflation Cyclical unemployment is relatively large in the framework when the equilibrium is substantially below potential . Cyclical unemployment is small in the framework when the equilibrium is near potential . The natural rate , as determined by the labor market institutions of the economy , is built into what economists mean by potential , but does not otherwise appear in an diagram . The framework shows pressures for to rise or fall when the movement from one equilibrium to another causes the price level to rise or to fall . The balance of trade does not appear directly in the diagram , but it appears indirectly in several ways . Increases in exports or declines in imports can cause shifts in AD . Changes in the price of key imported inputs to production , like oil , can cause shifts in AS . The model is the key model we use in this book to understand issues . Keynes Law and Say Law in the Model We can divide the curve into three zones . Keynes law says demand creates its own supply , so that changes in aggregate demand cause changes in real and employment . We can show Keynes law on the horizontal zone of the aggregate supply curve . The zone occurs at the left of the curve where it is fairly , so movements in AD will affect output , but have little effect on the price level . Say law says supply creates its own demand . Changes in aggregate demand have no effect on real and employment , only on the price level . We can show Say law on the vertical neoclassical zone of the aggregate supply curve . The neoclassical zone occurs at the right of the curve where it is fairly vertical , and so movements in AD will affect the price level , but have little impact on output . The intermediate zone in the middle of the curve is , so a rise in AD will cause higher output and price level , while a fall in AD will lead to a lower output and price level . Access for free at

24 Questions 603 Questions . 10 . 11 . 12 . 13 . 14 . 15 . Describe the mechanism by which supply creates its own demand . Describe the mechanism by which demand creates its own supply . The short run aggregate supply curve was constructed assuming that as the price of outputs increases , the price of inputs stays the same . How would an increase in the prices of important inputs , like energy , affect aggregate supply ?

In the model , what prevents the economy from achieving equilibrium at potential output ?

Suppose the Congress passes immigration reform that makes it more for foreigners to come to the United States to work . Use the model to explain how this would affect the equilibrium level of and the price level . Suppose concerns about the size of the federal budget lead the Congress to cut all funding for research and development for ten years . Assuming this has an impact on technology growth , what does the model predict would be the likely effect on equilibrium and the price level ?

How would a dramatic increase in the value of the stock market shift the AD curve ?

What effect would the shift have on the equilibrium level of and the price level ?

Suppose Mexico , one of our largest trading partners and purchaser of a large quantity of our exports , goes into a recession . Use the model to determine the likely impact on our equilibrium and price level . A claims that tax cuts led the economy out of a recession . Can we use the diagram to show this ?

Many analysts and economists eagerly await the press releases for the reports on the home price index and consumer index . What would be the effects ofa negative report on both of these ?

What about a positive report ?

What impact would a decrease in the size of the labor force have on and the price level according to the model ?

Suppose , after years of sluggish growth , the European Union economy picks up speed . What would be the likely impact on the trade balance , and employment ?

Suppose the Federal Reserve begins to increase the supply of money at an increasing rate . What impact would that have on , unemployment , and ?

If the economy is operating in the neoclassical zone of the curve and aggregate demand falls , what is likely to happen to real ?

If the economy is operating in the zone of the curve and aggregate demand falls , what is likely to happen to real ?

Review Questions 16 . 17 . 18 . 19 . 20 . What is Say law ?

What is Keynes law ?

Do neoclassical economists believe in Keynes law or Say law ?

Does Say law apply more accurately in the long run or the short run ?

What about Keynes law ?

What is on the horizontal axis of the diagram ?

What is on the vertical axis ?

604 24 Critical Thinking Questions 21 . 22 . 23 . 24 . 25 . 26 . 27 . 28 . 29 . 30 . 31 . 32 . 33 . 34 . 35 . 36 . 37 . 38 . 39 . 40 . What is the economic reason why the curve slopes up ?

What are the components of the aggregate demand ( AD ) curve ?

What are the economic reasons why the AD curve slopes down ?

explain the reason for the shape of the curve on its far left . explain the reason for the shape of the curve on its far right . What is potential ?

Name some factors that could cause the curve to shift , and say whether they would shift to the right or to the left . Will the shift of to the right tend to make the equilibrium quantity and price level higher or lower ?

What about a shift of to the left ?

What is ?

Name some factors that could cause AD to shift , and say whether they would shift AD to the right or to the left . Would a shift to the right tend to make the equilibrium quantity and price level higher or lower ?

What about a shift of AD to the left ?

How is growth illustrated in an model ?

How is recession illustrated in an model ?

How is cyclical unemployment illustrated in an model ?

How is the natural rate illustrated in an model ?

How is pressure for price increases shown in an model ?

What are some of the ways in which exports and imports can affect the model ?

What is the zone of the curve ?

How much is the price level likely to change in the zone ?

What is the neoclassical zone of the curve ?

How much is the output level likely to change in the neoclassical zone ?

What is the intermediate zone of the curve ?

Will a rise in output be accompanied by a rise or a fall in the price level in this zone ?

Critical Thinking Questions 41 . 42 . 43 . Why would an economist choose either the neoclassical perspective or the perspective , but not both ?

On a demand curve , a decrease in price causes an increase in quantity demanded because the product in question is now relatively less expensive than substitute products . Explain why aggregate demand does not increase for the same reason in response to a decrease in the aggregate price level . In other words , what causes total spending to increase if it is not because goods are now cheaper ?

Economists expect that as the labor market continues to tighten going into the latter part of 2015 that workers should begin to expect wage increases in 2015 and 2016 . Assuming this occurs and it was the only development in the labor market that year , how would this affect the AS curve ?

What if it was also accompanied by an increase in worker productivity ?

Access for free at 44 . 45 . 46 . 47 . 48 . 49 . 50 . 51 . 52 . 53 . 54 . 55 . 56 . 57 . 58 . 24 Critical Thinking Questions 605 If new government regulations require to use a cleaner technology that is also less than what they previously used , what would the effect he on output , the price level , and employment using the diagram ?

During spring 2016 the Midwestern United States , which has a large agricultural base , experiences average rainfall . Using the diagram , what is the effect on output , the price level , and employment ?

Hydraulic fracturing ( fracking ) has the potential to increase the amount of natural gas produced in the United States . large percentage of factories and utility companies use natural gas , what will happen to output , the price level , and employment as fracking becomes more widely used ?

Some politicians have suggested tying the minimum wage to the consumer price index ( Using the diagram , what effects would this policy most likely have on output , the price level , and employment ?

If households decide to save a larger portion of their income , what effect would this have on the output , employment , and price level in the short run ?

What about the long run ?

If become more optimistic about the future of the economy and , at the same time , innovation in printing makes most workers more productive , what is the combined effect on output , employment , and the ?

If Congress cuts taxes at the same time that businesses become more pessimistic about the economy , what is the combined effect on output , the price level , and employment using the diagram ?

Suppose the level of structural unemployment increases . How would you illustrate the increase in structural unemployment in the model ?

Hint How does structural unemployment affect potential ?

If foreign decide that the United States is the safest place to invest their savings , what would the effect be on the economy here ?

Show graphically using the model . The model is static . It shows a snapshot of the economy at a given point in time . Both economic growth and are dynamic phenomena . Suppose economic growth is per year and aggregate demand is growing at the same rate . What does the model say the rate should be ?

Explain why the aggregate supply curve might be fairly in the zone of the curve . How might we tell ifwe are in the zone of the AS ?

Explain why the aggregate supply curve might be vertical in the neoclassical zone of the curve . How might we tell ifwe are in the neoclassical zone of the AS ?

Why might it be important for to know which in zone of the curve the economy is ?

In your view , is the economy currently operating in the , intermediate or neoclassical portion of the economy aggregate supply curve ?

Are Say law and Keynes law necessarily mutually exclusive ?

606 24 Problems Problems Review the problem in the Work It Out titled Interpreting the Model . Like the information provided in that feature , Table shows information on aggregate supply , aggregate demand , and the price level for the imaginary country of . Price Level AD AS 110 700 600 120 690 640 130 680 680 140 670 720 150 660 740 160 650 760 170 640 770 TABLE Price Level a . Plot the diagram from the data . Identify the equilibrium . Imagine that , as a result of a government tax cut , aggregate demand becomes higher by 50 at every price level . Identify the new equilibrium . How will the new equilibrium alter output ?

How will it alter the price level ?

What do you think will happen to employment ?

Access for free at 24 Problems 607 60 . The imaginary country of Harris Island has the aggregate supply and aggregate demand curves as Table shows . Price Level AD AS 100 700 200 120 600 325 140 500 500 160 400 570 180 300 620 TABLE Price Level Plot the diagram . Identify the equilibrium . Would you expect unemployment in this economy to be relatively high or low ?

Would you expect concern about in this economy to be relatively high or low ?

Imagine that consumers begin to lose about the state of the economy , and so AD becomes lower by 275 at every price level . Identify the new aggregate equilibrium . How will the shift in AD affect the original output , price level , and employment ?

61 . Table describes economy . Price Level AD AS 50 250 60 950 580 70 900 750 80 850 850 90 800 900 TABLE Price Level Plot the curves and identify the equilibrium . Would you expect unemployment in this economy to be relatively high or low ?

Would you expect prices to be a relatively large or small concern for this economy ?

Imagine that input prices fall and so AS shifts to the right by 150 units . Identify the new equilibrium . How will the shift in AS affect the original output , price level , and employment ?