Principles of Microeconomics Chapter 7 Aggregate Demand and Aggregate Supply

Chapter Aggregate Demand and Aggregate Supply Start Up The Great Warning The first warning came from the Harvard Economic Society , an association of Harvard economics professors , early in 1929 . The society predicted in its weekly newsletter that the expansion was coming to an end . Recession was ahead . Almost no one took the warning seriously . The economy , fueled by soaring investment , had experienced stunning growth . The had seen the emergence of many entirely new , public power , home appliances , synthetic fabrics , radio , and motion pictures . The decade seemed to have acquired a momentum all its own . Prosperity was not about to end , no matter what a few economists might say . Summer came , and no recession was apparent . The Harvard economists withdrew their forecast . As it turned out , they lost their nerve too soon . Indeed , industrial production had already begun to fall . The worst downturn in our history , the Great Depression , had begun . The collapse was swift . The stock market crashed in October 1929 . Real plunged nearly 10 by 1930 . By the time the economy hit bottom in 1933 , real had fallen 30 , unemployment had increased from in 1929 to 25 in 1933 , and prices , measured by the implicit price deflator , had plunged 23 from their 1929 level . The depression held the economy in its cruel grip for more than a decade it was not until World War II that full employment was restored . In this chapter we go beyond explanations of the main variables to introduce a model of activity that we can use to analyze problems such as fluctuations in gross domestic product ( real ) the price level , and employment the model of aggregate demand and aggregate supply . We will use this model throughout our exploration of . In this chapter we will present the broad outlines of the model greater detail , more examples , and more thorough explanations will follow in subsequent chapters . We will examine the concepts of the aggregate demand curve and the and aggregate supply curves . We will identify conditions under which an economy achieves an equilibrium level of real that is consistent with full employment of labor . Potential output is the level of output an economy can achieve when labor is employed at its natural level . Potential output is also called the natural level of real . When an economy fails to produce at its potential , there may be actions that the government or the central bank can take to push the economy toward it , and in this chapter we will begin to consider the pros and cons of doing so . 223

Aggregate Demand Learning Objectives . Define potential output , also called the natural level of . Define aggregate demand , represent it using a hypothetical aggregate demand curve , and identify and explain the three effects that cause this curve to slope downward . Distinguish between a change in the aggregate quantity of goods and services demanded and a change in aggregate demand . Use examples to explain how each component of aggregate demand can be a possible aggregate demand shifter . Explain what a multiplier is and tell how to calculate it . Firms face four sources of demand households ( personal consumption ) other firms ( investment ) government agencies ( government purchases ) and foreign markets ( net exports ) Aggregate demand is the relationship between the total quantity of goods and services demanded ( from all the four sources of demand ) and the price level , all other of spending unchanged . The aggregate demand curve is a graphical representation of aggregate demand . The Slope of the Aggregate Demand Curve We will use the implicit price deflator as our measure of the price level the aggregate quantity of goods and services demanded is measured as real . The table in Figure Aggregate Demand gives values for each component of aggregate demand at each price level for a hypothetical economy . Various points on the aggregate demand curve are found by adding the values of these components at different price levels . The aggregate demand curve for the data given in the table is plotted on the graph in Figure Aggregate Demand . At point A , at a price level of , billion worth of goods and services will he demanded at point , a reduction in the price level to increases the quantity of goods and services demanded to billion and at point , at a price level of , billion will be demanded . Figure Aggregate Demand 224

225 Author removed at request of original publisher Point on aggregate Price Aggregate demand curve level OF demand A A A Aggregate demand ( AD ) ITS 112 . Real ( billions of dollars ) per year An aggregate demand curve ( AD ) shows the relationship between the total quantity of output demanded ( measured as real ) and the price level ( measured as the implicit price ) At each price level , the total quantity of goods and services demanded is the sum of the components of real , as shown in the table . There is a negative relationship between the price level and the total quantity of goods and services demanded , all other things unchanged . The negative slope of the aggregate demand curve suggests that it behaves in the same manner as an ordinary demand curve . But we can not apply the reasoning we use to explain demand curves in individual markets to explain the aggregate demand curve . There are two reasons for a negative relationship between price and quantity demanded in individual markets . First , a lower price induces people to substitute more of the good whose price has fallen for other goods , increasing the quantity demanded . Second , the lower price creates a higher real income . This normally increases quantity demanded further . Neither of these effects is relevant to a change in prices in the aggregate . When we are dealing with the average of all price can no longer say that a fall in prices will induce a change in relative prices that will lead consumers to buy more of the goods and services whose prices have fallen and less of the goods and services whose prices have not fallen . The price of corn may have fallen , but

Principles of 226 the prices of wheat , sugar , tractors , steel , and most other goods or services produced in the economy are likely to have fallen as well . Furthermore , a reduction in the price level means that it is not just the prices consumers pay that are falling . It means the prices people wages , the rents they may charge as landlords , the interest rates they likely to be falling as well . A falling price level means that goods and services are cheaper , but incomes are lower , too . There is no reason to expect that a change in real income will boost the quantity of goods and services , no change in real income would occur . If nominal incomes and prices all fall by 10 , for example , real incomes do not change . Why , then , does the aggregate demand curve slope downward ?

One reason for the downward slope of the aggregate demand curve lies in the relationship between real wealth ( the stocks , bonds , and other assets that people have accumulated ) and consumption ( one of the four components of aggregate demand ) When the price level falls , the real value of wealth packs more purchasing power . For example , if the price level falls by 25 , then of wealth could purchase more goods and services than it would have if the price level had not fallen . An increase in wealth will induce people to increase their consumption . The consumption component of aggregate demand will thus be greater at lower price levels than at higher price levels . The tendency for a change in the price level to affect real wealth and thus alter consumption is called the wealth effect it suggests a negative relationship between the price level and the real value of consumption spending . A second reason the aggregate demand curve slopes downward lies in the relationship between interest rates and investment . A lower price level lowers the demand for money , because less money is required to buy a given quantity of goods . What economists mean by money demand will be explained in more detail in a later chapter . But , as we learned in studying demand and supply , a reduction in the demand for something , all other things unchanged , lowers its price . In this case , the something is money and its price is the interest rate . A lower price level thus reduces interest rates . Lower interest rates make borrowing by firms to build factories or buy equipment and other capital more attractive . A lower interest rate means lower mortgage payments , which tends to increase investment in residential houses . Investment thus rises when the price level falls . The tendency for a change in the price level to affect the interest rate and thus to affect the quantity of investment demanded is called the interest rate effect . John Maynard Keynes , a British economist whose analysis of the Great Depression and what to do about it led to the birth of modern , emphasized this effect . For this reason , the interest rate effect is sometimes called the Keynes effect . A third reason for the rise in the total quantity of goods and services demanded as the price level falls can be found in changes in the net export component of aggregate demand . All other things unchanged , a lower price level in an economy reduces the prices of its goods and services relative to produced goods and services . A lower price level makes that economy goods more attractive to foreign buyers , increasing exports . It will also make goods and services less attractive to the economy buyers , reducing imports . The result is an increase in net exports . The international trade effect is the tendency for a change in the price level to affect net exports . Taken together , then , a fall in the price level means that the quantities of consumption , investment , and net export components of aggregate demand may all rise . Since government purchases are determined through a political process , we assume there is no causal link between the price level and the real volume

227 Author removed at request of original publisher of government purchases . Therefore , this component of does not contribute to the downward slope of the curve . In general , a change in the price level , with all other of aggregate demand unchanged , causes a movement along the aggregate demand curve . A movement along an aggregate demand curve is a change in the aggregate quantity of goods and services demanded . A movement from point A to point on the aggregate demand curve in Figure Aggregate Demand is an example . Such a change is a response to a change in the price level . Notice that the axes of the aggregate demand curve graph are drawn with a break near the origin to remind us that the plotted values reflect a relatively narrow range of changes in real and the price level . We do not know what might happen if the price level or output for an entire economy approached zero . Such a phenomenon has never been observed . Changes in Aggregate Demand Aggregate demand changes in response to a change in any of its components . An increase in the total quantity of consumer goods and services demanded at every price level , for example , would shift the aggregate demand curve to the right . A change in the aggregate quantity of goods and services demanded at every price level is a change in aggregate demand , which shifts the aggregate demand curve . Increases and decreases in aggregate demand are shown in Figure Changes in Aggregate Demand . Figure Changes in Demand Panel ( a ) Panel ) An increase in aggregate A decrease in aggregate demand demand FE AD ADI AD , Real ( billions of dollars ) per year Real ( billions of dollars ) per year An Increase consumption . Investment , government purchases . or nel exports me aggregate demand curve me right as shown Panel ( a ) A reduction one of me components of aggregate demand me curve me , as shown Panel ( What factors might cause the aggregate demand curve to shift ?

Each of the components of aggregate demand is a possible aggregate demand shifter . We shall look at some of the events that can trigger changes in the components of aggregate demand and thus shift the aggregate demand curve .

Principles of 228 Changes in Consumption Several events could change the quantity of consumption at each price level and thus shift aggregate demand . One determinant of consumption is consumer confidence . If consumers expect good economic conditions and are optimistic about their economic prospects , they are more likely to buy major items such as cars or furniture . The result would be an increase in the real value of consumption at each price level and an increase in aggregate demand . In the second half of the , sustained economic growth and low unemployment fueled high expectations and consumer optimism . Surveys revealed consumer confidence to be very high . That consumer confidence translated into increased consumption and increased aggregate demand . In contrast , a decrease in consumption would accompany diminished consumer expectations and a decrease in consumer confidence , as happened after the stock market crash of 1929 . The same problem has plagued the economies of most Western nations in 2008 as declining consumer confidence has tended to reduce consumption . A survey by the Conference Board in September of 2008 showed that just of consumers surveyed expected economic conditions in the United States to improve in the next six months . Similarly pessimistic views prevailed in the previous two months . That contributed to the decline in consumption that occurred in the third quarter of the year . Another factor that can change consumption and shift aggregate demand is tax policy . A cut in personal income taxes leaves people with more income , which may induce them to increase their consumption . The federal government in the United States cut taxes in 1964 , 1981 , 1986 , 1997 , and 2003 each of those tax cuts tended to increase consumption and aggregate demand at each price level . In the United States , another government policy aimed at increasing consumption and thus aggregate demand has been the use of rebates in which taxpayers are simply sent checks in hopes that those checks will be used for consumption . Rebates have been used in 1975 , 2001 , and 2008 . In each case the rebate was a payment . Careful studies by economists of the 1975 and 2001 rebates showed little impact on consumption . Final evidence on the impact of the 2008 rebates is not yet in , but early results suggest a similar outcome . In a subsequent chapter , we will investigate arguments about whether temporary increases in income produced by rebates are likely to have a significant impact on consumption . Transfer payments such as welfare and Social Security also affect the income people have available to spend . At any given price level , an increase in transfer payments raises consumption and aggregate demand , and a reduction lowers consumption and aggregate demand . Changes in Investment Investment is the production of new capital that will be used for future production of goods and services . Firms make investment choices based on what they think they will be producing in the future . The expectations of firms thus play a critical role in determining investment . If firms expect their sales to go up , they are likely to increase their investment so that they can increase production and meet consumer demand . Such an increase in investment raises the aggregate quantity of goods and services demanded at each price level it increases aggregate demand .

229 Author removed at request of original publisher Changes in interest rates also affect investment and thus affect aggregate demand . We must be careful to distinguish such changes from the interest rate effect , which causes a movement along the aggregate demand curve . A change in interest rates that results from a change in the price level affects investment in a way that is already captured in the downward slope of the aggregate demand curve it causes a movement along the curve . A change in interest rates for some other reason shifts the curve . We examine reasons interest rates might change in another chapter . Investment can also be affected by tax policy . One provision of the Job and Growth Tax Relief Reconciliation Act of 2003 was a reduction in the tax rate on certain capital gains . Capital gains result when the owner of an asset , such as a house or a factory , sells the asset for more than its purchase price ( less any depreciation claimed in earlier years ) The lower capital gains tax could stimulate investment , because the owners of such assets know that they will lose less to taxes when they sell those assets , thus making assets subject to the tax more attractive . Changes in Government Purchases Any change in government purchases , all other things unchanged , will affect aggregate demand . An increase in government purchases increases aggregate demand a decrease in government purchases decreases aggregate demand . Many economists argued that reductions in defense spending in the wake of the collapse of the Soviet Union in 1991 tended to reduce aggregate demand . Similarly , increased defense spending for the wars in Afghanistan and Iraq increased aggregate demand . Dramatic increases in defense spending to fight World War II accounted in large part for the rapid recovery from the Great Depression . Changes in Net Exports A change in the value of net exports at each price level shifts the aggregate demand curve . A major determinant of net exports is foreign demand for a country goods and services that demand will vary with foreign incomes . An increase in foreign incomes increases a country net exports and aggregate demand a slump in foreign incomes reduces net exports and aggregate demand . For example , several major trading partners in Asia suffered in 1997 and 1998 . Lower real incomes in those countries reduced exports and tended to reduce aggregate demand . Exchange rates also influence net exports , all other things unchanged . A country exchange rate is the price of its currency in terms of another currency or currencies . A rise in the exchange rate means that it takes more Japanese yen , for example , to purchase one dollar . That also means that traders get more yen per dollar . Since prices of goods produced in Japan are given in yen and prices of goods produced in the United States are given in dollars , a rise in the exchange rate increases the price to foreigners for goods and services produced in the United States , thus reducing exports it reduces the price of goods and services for consumers , thus increasing imports to the United States . A higher exchange rate tends to reduce net exports , reducing aggregate demand . A lower exchange rate tends to increase net exports , increasing aggregate demand .

Principles of 230 Foreign price levels can affect aggregate demand in the same way as exchange rates . For example , when foreign price levels fall relative to the price level in the United States , goods and services become relatively more expensive , reducing exports and boosting imports in the United States . Such a reduction in net exports reduces aggregate demand . An increase in foreign prices relative to prices has the opposite effect . The trade policies of various countries can also affect net exports . A policy by Japan to increase its imports of goods and services from India , for example , would increase net exports in India . The Multiplier A change in any component of aggregate demand shifts the aggregate demand curve . Generally , the aggregate demand curve shifts by more than the amount by which the component initially causing it to shift changes . Suppose that net exports increase due to an increase in foreign incomes . As foreign demand for domestically made products rises , a country firms will hire additional workers or perhaps increase the average number of hours that their employees work . In either case , incomes will rise , and higher incomes will lead to an increase in consumption . Taking into account these other increases in the components of aggregate demand , the aggregate demand curve will shift by more than the initial shift caused by the initial increase in net exports . The multiplier is the ratio of the change in the quantity of real demanded at each price level to the initial change in one or more components of aggregate demand that produced it Equation A ( real demanded at each price level ) initial A ( component of AD ) Multiplier We use the capital Greek letter delta ( A ) to mean change In the aggregate supply model presented in this chapter , it is the number by which we multiply an initial change in aggregate demand to obtain the amount by which the aggregate demand curve shifts as a result of the initial change . In other words , we can use Equation to solve for the change in real demanded at each price level Equation Delta ( rea , demanded at each price level ) multiplier ( component of AD ) Suppose that the initial increase in net exports is 100 billion and that the initial increase generates additional consumption of 100 billion at each price level . In Panel ( a ) of Figure The Multiplier , the aggregate demand curve shifts to the right by 200 amount of the initial

231 Author removed at request of original publisher increase in net exports times the multiplier of . We obtained the value for the multiplier in this example by plugging 200 billion ( the initial increase in net exports plus the increase that it generated in consumption ) into the numerator of Equation and 100 billion into the denominator . Similarly , a decrease in net exports of 100 billion leads to a decrease in aggregate demand of 200 billion at each price level , as shown in Panel ( The Panel ( a ) Panel ( 120 Effect of initial ' decrease in net exports without 11 . Effect of initial net exports without multiplier effect ' 110 AD AD Real ( billions of dollars ) per year Real ( billions of dollars ) per year A change In one component of aggregate demand shifts the curve by male than the Initial . in Panel ( a ) an increase of 100 billion of net exports shifts the demand curve to the tight by 200 billion at price level . in Panel ( a uf net exports of 100 billion shifts the curve ( the left by 200 billion . In this , the . is . Key Ta Potential output is the level of output an economy can achieve when labor is employed at its natural level . When an economy fails to produce at its potential , the government or the central bank may try to push the economy toward its potential . The aggregate demand curve represents the total of consumption , investment , government purchases , and net exports at each price level in any period . It slopes downward because of the wealth effect on consumption , the interest rate effect on investment , and the international trade effect on net exports . The aggregate demand curve shifts when the quantity of real demanded at each price level changes . The multiplier is the number by which we multiply an initial change in aggregate demand to obtain the amount by which the aggregate demand curve shifts at each price level as a result of the initial change .

Principles of 232 Try It ! Explain the effect of each of the following on the aggregate demand curve for the United States . A decrease in consumer optimism . An increase in real in the countries that buy US . exports . An increase in the price level . An increase in government spending on highways Case in Point The Multiplied Economic Impact of SARS on China Economy Resurge International , please drop my camera . Severe Acute Respiratory Syndrome ( SARS ) an atypical disease , broke onto the world scene in late 2002 . In March 2003 , the World Health Organization ( WHO ) issued its first worldwide alert and a month later its first travel advisory , which recommended that travelers avoid Hong Kong and the southern province of China , Over the next few months , additional travel advisories were issued for other parts of China , and briefly for , Canada . By the end of June , all WHO travel advisories had been removed . To estimate the overall impact of SARS on the Chinese economy in 2003 , economists Wen Hai , Zhong Zhao , and Jian Want of Peking University China Center for Economic Research conducted a survey of Beijing

233 Author removed at request of original publisher tourism industry in April 2003 . Based on findings from the Beijing area , they projected the tourism sector of China as a whole would lose which billion came from an approximate 50 reduction in foreign tourist revenue and billion from curtailed domestic tourism , as holiday celebrations were cancelled and domestic travel restrictions imposed . To figure out the total impact of SARS on China economy , they argued that the multiplier for tourism revenue in China is between and . Since the SARS outbreak only began to have a major economic impact after March , they assumed a smaller multiplier of for all of 2003 . They thus predicted that the Chinese economy would be billion smaller in 2003 as a result of SARS . Source Wen Hai , Zhong Zhao , and Jian Wan , The Impact of SARS on the Chinese Economy , Asian Economic Papers , no . Winter 2004 ) Answer to Try It ! Problem . A decline in consumer optimism would cause the aggregate demand curve to shift to the left . If consumers are more pessimistic about the future , they are likely to cut purchases , especially of major items . An increase in the real of other countries would increase the demand for exports and cause the aggregate demand curve to shift to the right . Higher incomes in other countries will make consumers in those countries more willing and able to buy goods . An increase in the price level corresponds to a movement up along the unchanged aggregate demand curve . At the higher price level , the consumption , investment , and net export components of aggregate demand will all fall that is , there will be a reduction in the total quantity of goods and services demanded , but not a shift of the aggregate demand curve itself . An increase in government spending on highways means an increase in government purchases . The aggregate demand curve would shift to the right .

Aggregate Demand and Aggregate Supply The Long Run and the Short Run Learning Objectives . Distinguish between the short run and the long run , as these terms are used in . Draw a hypothetical aggregate supply curve and explain what it shows about the natural levels of employment and output at various price levels , given changes in aggregate demand . Draw a hypothetical aggregate supply curve , explain why it slopes upward , and explain why it may shift that is , distinguish between a change in the aggregate quantity of goods and services supplied and a change in aggregate supply . Discuss various explanations for wage and price stickiness . Explain and illustrate what is meant by equilibrium in the short run and relate the equilibrium to potential output . In , we seek to understand two types of equilibria , one corresponding to the short run and the other corresponding to the long run . The short run in analysis is a period in which wages and some other prices do not respond to changes in economic conditions . In certain markets , as economic conditions change , prices ( including wages ) may not adjust quickly enough to maintain equilibrium in these markets . A sticky price is a price that is slow to adjust to its equilibrium level , creating sustained periods of shortage or surplus . Wage and price stickiness prevent the economy from achieving its natural level of employment and its potential output . In contrast , the long run in analysis is a period in which wages and prices are flexible . In the long run , employment will move to its natural level and real to potential . We begin with a discussion of equilibrium , because this type of equilibrium allows us to see the after full market adjustment has been achieved . In contrast , in the short run , price or wage stickiness is an obstacle to full adjustment . Why these deviations from the potential level of output occur and what the implications are for the will be discussed in the section on equilibrium . The Long Run As we saw in a previous chapter , the natural level of employment occurs where the real wage adjusts so that the quantity of labor demanded equals the quantity of labor supplied . When the economy achieves its natural level of employment , it achieves its potential level of output . We will see that real eventually moves to potential , because all wages and prices are assumed to be flexible in the long run . 234

235 Author removed at request of original publisher Aggregate Supply The aggregate supply ( curve relates the level of output produced by firms to the price level in the long run . In Panel ( of Figure Natural Employment and Aggregate Supply , the aggregate supply curve is a vertical line at the economy potential level of output . There is a single real wage at which employment reaches its natural level . In Panel ( a ) of Figure Natural Employment and Aggregate Supply , only a real wage of we generates natural employment . The economy could , however , achieve this real wage with any of an infinitely large set of nominal wage and combinations . Suppose , for example , that the equilibrium real wage ( the ratio of wages to the price level ) is . We could have that with a nominal wage level of and a price level of , a nominal wage level of and a price level of , a nominal wage level of and a price level of , and so on . Figure Natural Employment and Aggregate Supply Panel ( a ) Panel ) Real wage Price level Le Ye Employment per period Real per period When the economy achieves its natural level of . as shown In Panel ( El me of the demand and supply curves for labor , us output , as shown In Panel ( by me aggregate supply curve El Yr . In Panel ( we see price levels ranging from to . Higher price levels would require higher nominal wages to create a real wage of we , and flexible nominal wages would achieve that in the long run . In the long run , then , the economy can achieve its natural level of employment and potential output at any price level . This conclusion gives us our aggregate supply curve . With only one level of output at any price level , the aggregate supply curve is a vertical line at the economy potential level of output of . Equilibrium Levels of Price and Output in the Long Run The intersection of the economy aggregate demand curve and the aggregate supply curve determines its equilibrium real and price level in the long run . Figure Equilibrium

Principles of 236 depicts an economy in equilibrium . With aggregate demand at and the aggregate supply curve as shown , real is billion per year and the price level is . If aggregate demand increases to , equilibrium will be reestablished at real of billion per year , but at a higher price level of . If aggregate demand decreases to , equilibrium will still be at real of billion per year , but with the now lower price level of . Figure Equilibrium Increase in aggregate demand OJ OJ . aggregate CE demand Real ( billions of dollars ) per year equilibrium occurs at the intersection of the aggregate demand curve and the aggregate supply curve . For the three aggregate demand curves shown , equilibrium occurs at three different price levels , but always at an output level of billion per year , which corresponds to potential output . The Short Run Analysis of the in the short period in which stickiness of wages and prices may prevent the economy from operating at potential explain how deviations of real from potential output can and do occur . We will explore the effects of changes in aggregate demand and in aggregate supply in this section .

237 Author removed at request of original publisher Aggregate Supply Figure Deriving me Aggregate Supply Curve . I ( of Real ( billions of dollars ) per year The economy shown here equilibrium a ( me or . with me supply curve . demand increases , HI the short run . bath real and me price level rise . demand decreases . In me run . pom real any and me price level fall . A drawn points A , and ( races out me aggregate supply curve Sims . The model of aggregate demand and aggregate supply predicts that the economy will eventually move toward its potential output . To see how nominal wage and price stickiness can cause real to be either above or below potential in the short run , consider the response of the economy to a change in aggregate demand . Figure Deriving the Aggregate Supply Curve shows an economy that has been operating at potential output of billion and a price level of . This occurs at the intersection of with the aggregate supply curve at point . Now suppose that the aggregate demand curve shifts to the right ( to ) This could occur as a result of an increase in exports . The shift from to includes the multiplied effect of the increase in exports . At the price level of , there is now excess demand and pressure on prices to rise . If all prices in the economy adjusted quickly , the economy would quickly settle at potential output of billion , but at a higher price level ( in this case )

Principles of 238 Is it possible to expand output above potential ?

Yes . It may be the case , for example , that some people who were in the labor force but were frictionally or structurally unemployed find work because of the ease of getting jobs at the going nominal wage in such an environment . The result is an economy operating at point A in Figure Deriving the Aggregate Supply Curve at a higher price level and with output temporarily above potential . Consider next the effect of a reduction in aggregate demand ( to ) possibly due to a reduction in investment . As the price level starts to fall , output also falls . The economy finds itself at a price combination at which real is below potential , at point Again , price stickiness is to blame . The prices firms receive are falling with the reduction in demand . Without corresponding reductions in nominal wages , there will be an increase in the real wage . Firms will employ less labor and produce less output . By examining what happens as aggregate demand shifts over a period when price adjustment is incomplete , we can trace out the aggregate supply curve by drawing a line through points A , and The aggregate supply ( curve is a graphical representation of the relationship between production and the price level in the short run . Among the factors held constant in drawing a aggregate supply curve are the capital stock , the stock of natural resources , the level of technology , and the prices of factors of production . A change in the price level produces a change in the aggregate quantity of goods and services supplied and is illustrated by the movement along the aggregate supply curve . This occurs between points A , and in Figure Deriving the Aggregate Supply Curve . A change in the quantity of goods and services supplied at every price level in the short run is a change in aggregate supply . Changes in the factors held constant in drawing the aggregate supply curve shift the curve . These factors may also shift the aggregate supply curve we will discuss them along with other of aggregate supply in the next chapter . One type of event that would shift the aggregate supply curve is an increase in the price of a natural resource such as oil . An increase in the price of natural resources or any other factor of production , all other things unchanged , raises the cost of production and leads to a reduction in aggregate supply . In Panel ( a ) of Figure Changes in Aggregate Supply , shifts leftward to . A decrease in the price of a natural resource would lower the cost of production and , other things unchanged , would allow greater production from the economy stock of resources and would shift the aggregate supply curve to the right such a shift is shown in Panel ( by a shift from to . Figure Changes HI Aggregate Supply

239 Author removed at request of original publisher Panel ( a ) Panel ( 120 , was , Shift caused by increase In ) oi resources I . Shift caused by ' I ' of natural Real ( billions of dollars ) new year Real of dollars ) per year A reduction in aggregate supply sums the curve from in Panel ( a ) An shifts the right , as shown in Panel ( 11 ) Reasons for Wage and Price Stickiness Wage or price stickiness means that the economy may not always be operating at potential . Rather , the economy may operate either above or below potential output in the short run . Correspondingly , the overall unemployment rate will be below or above the natural level . Many prices observed throughout the economy do adjust quickly to changes in market conditions so that equilibrium , once lost , is quickly regained . Prices for fresh food and shares of common stock are two such examples . Other prices , though , adjust more slowly . Nominal wages , the price of labor , adjust very slowly . We will first look at why nominal wages are sticky , due to their association with the unemployment rate , a variable of great interest in , and then at other prices that may be sticky . Wage Stickiness Wage contracts fix nominal wages for the life of the contract . The length of wage contracts varies from one week or one month for temporary employees , to one year ( teachers and professors often have such contracts ) to three years ( for most union workers employed under major collective bargaining agreements ) The existence of such explicit contracts means that both workers and firms accept some wage at the time of negotiating , even though economic conditions could change while the agreement is still in force . Think about your own job or a job you once had . Chances are you go to work each day knowing what your wage will be . Your wage does not fluctuate from one day to the next with changes in demand or supply . You may have a formal contract with your employer that specifies what your wage will be over

Principles of 240 some period . Or you may have an informal understanding that sets your wage . the nature of your agreement , your wage is stuck over the period of the agreement . Your wage is an example of a sticky price . One reason workers and firms may be willing to accept nominal wage contracts is that negotiating a contract is a costly process . Both parties must keep themselves adequately informed about market conditions . Where unions are involved , wage negotiations raise the possibility of a labor strike , an eventuality that firms may prepare for by accumulating additional inventories , also a costly process . Even when unions are not involved , time and energy spent discussing wages takes away from time and energy spent producing goods and services . In addition , workers may simply prefer knowing that their nominal wage will be fixed for some period of time . Some contracts do attempt to take into account changing economic conditions , such as inflation , through adjustments , but even these relatively simple contingencies are not as widespread as one might think . One reason might be that a firm is concerned that while the aggregate price level is rising , the prices for the goods and services it sells might not be moving at the same rate . Also , or other contingencies add complexity to contracts that both sides may want to avoid . Even markets where workers are not employed under explicit contracts seem to behave as if such contracts existed . In these cases , wage stickiness may stem from a desire to avoid the same uncertainty and adjustment costs that explicit contracts avert . Finally , minimum wage laws prevent wages from falling below a legal minimum , even if unemployment is rising . Unskilled workers are particularly vulnerable to shifts in aggregate demand . Price Stickiness Rigidity of other prices becomes easier to explain in light of the arguments about nominal wage stickiness . Since wages are a major component of the overall cost of doing business , wage stickiness may lead to output price stickiness . With nominal wages stable , at least some firms can adopt a wait and see attitude before adjusting their prices . During this time , they can evaluate information about why sales are rising or falling ( Is the change in demand temporary or permanent ?

and try to assess likely reactions by consumers or competing firms in the industry to any price changes they might make ( Will consumers be angered by a price increase , for example ?

Will competing firms match price changes ?

In the meantime , firms may prefer to adjust output and employment in response to changing market conditions , leaving product price alone . Quantity adjustments have costs , but firms may assume that the associated risks are smaller than those associated with price adjustments . Another possible explanation for price stickiness is the notion that there are adjustment costs associated with changing prices . In some cases , firms must print new price lists and catalogs , and notify customers of price changes . Doing this too often could jeopardize customer relations . Yet another explanation of price stickiness is that firms may have explicit contracts to sell their products to other firms at specified prices . For example , electric utilities often buy their inputs of coal or oil under contracts .

241 Author removed at request of original publisher Taken together , these reasons for wage and price stickiness explain why aggregate price adjustment may be incomplete in the sense that the change in the price level is insufficient to maintain real at its potential level . These reasons do not lead to the conclusion that no price adjustments occur . But the adjustments require some time . During this time , the economy may remain above or below its potential level of output . Equilibrium Levels of Price and Output in the Short Run To illustrate how we will use the model of aggregate demand and aggregate supply , let us examine the impact of two events an increase in the cost of health care and an increase in government purchases . The first reduces aggregate supply the second increases aggregate demand . Both events change equilibrium real and the price level in the short run . A Change in the Cost of Health Care In the United States , most people receive health insurance for themselves and their families through their employers . In fact , it is quite common for employers to pay a large percentage of employees health insurance premiums , and this benefit is often written into labor contracts . As the cost of health care has gone up over time , firms have had to pay higher and higher health insurance premiums . With nominal wages fixed in the short run , an increase in health insurance premiums paid by firms raises the cost of employing each worker . It affects the cost of production in the same way that higher wages would . The result of higher health insurance premiums is that firms will choose to employ fewer workers . Suppose the economy is operating initially at the equilibrium at the intersection of and , with a real of and a price level of , as shown in Figure An Increase in Health Insurance Premiums Paid by Firms . This is the initial equilibrium price and output in the short run . The increase in labor cost shifts the aggregate supply curve to . The price level rises to and real falls to . Figure An Increase in Health Insurance Premiums Paid by Firms

Principles of 242 Shift caused by increase in health insurance premiums paid by Price level Real An increase in health insurance premiums paid by firms increases labor costs , reducing aggregate supply from to . The price level rises from to and output falls from to . A reduction in health insurance premiums would have the opposite effect . There would be a shift to the right in the aggregate supply curve with pressure on the price level to fall and real to rise . A Change in Government Purchases Suppose the federal government increases its spending for highway construction . This circumstance leads to an increase in government purchases and an increase in aggregate demand . Assuming no other changes affect aggregate demand , the increase in government purchases shifts the aggregate demand curve by a multiplied amount of the initial increase in government purchases to in Figure An Increase in Government Purchases . Real rises from to , while the price level rises from to . Notice that the increase in real is less than it would have been if the price level had not risen . Figure An Increase in Government Purchases

243 Author removed at request of original publisher Shift caused by an increase in government purchases Price level Real per year An increase in government purchases boosts aggregate demand from to . equilibrium is at the intersection of and aggregate supply curve . The price level rises to and real rises to . In contrast , a reduction in government purchases would reduce aggregate demand . The aggregate demand curve shifts to the left , putting pressure on both the price level and real to fall . In the short run , real and the price level are determined by the intersection of the aggregate demand and aggregate supply curves . Recall , however , that the short run is a period in which sticky prices may prevent the economy from reaching its natural level of employment and potential output . In the next section , we will see how the model adjusts to move the economy to equilibrium and what , if anything , can be done to steer the economy toward the natural level of employment and potential output . Key Ta The short run in is a period in which wages and some other prices are sticky . The long run is a period in which full wage and price flexibility , and market adjustment , has been

Principles of 244 achieved , so that the economy is at the natural level of employment and potential output . The aggregate supply curve is a vertical line at the potential level of output . The intersection of the economy aggregate demand and aggregate supply curves determines its equilibrium real and price level in the long run . The aggregate supply curve is an curve that shows the quantity of total output that will be produced at each price level in the short run . Wage and price stickiness account for the aggregate supply curve upward slope . Changes in prices of factors of production shift the aggregate supply curve . In addition , changes in the capital stock , the stock of natural resources , and the level of technology can also cause the aggregate supply curve to shift . In the short run , the equilibrium price level and the equilibrium level of total output are determined by the intersection of the aggregate demand and the aggregate supply curves . In the short run , output can be either below or above potential output . The tools we have covered in this section can be used to understand the Great Depression of the 19305 . We know that investment and consumption began falling in late 1929 . The reductions were reinforced by plunges in net exports and government purchases over the next four years . In addition , nominal wages plunged 26 between 1929 and 1933 . We also know that real in 1933 was 30 below real in 1929 . Use the tools of aggregate demand and aggregate supply to graph and explain what happened to the economy between 1929 and 1933 .

245 Author removed at request of original publisher Case in Point The . Recession of 2001 Recession in Tulsa . What were the causes of the recession of 2001 ?

Economist Kevin of the Federal Reserve Bank of Louis points to four factors that , taken together , shifted the aggregate demand curve to the left and kept it there for a long enough period to keep real falling for about nine months . They were the fall in stock market prices , the decrease in business investment both for computers and software and in structures , the decline in the real value of exports , and the aftermath of . Notable exceptions to this list of culprits were the behavior of consumer spending during the period and new residential housing , which falls into the investment category . During the expansion in the late , a surging stock market probably made it easier for firms to raise funding for investment in both structures and information technology . Even though the stock market bubble burst well before the actual recession , the continuation of projects already underway delayed the decline in the investment component of . Also , spending for information technology was probably prolonged as firms dealt with computing issues , that is , computer problems associated with the change in the date from 1999 to 2000 . Most computers used only two digits to indicate the year , and when the year changed from 99 to 00 , computers did not know how to interpret the change , and extensive reprogramming of computers was required . Real exports fell during the recession because ( the dollar was strong during the period and ( real growth in the rest of the world fell almost from 2000 to 2001 .

Principles of 246 Then , the terrorist attacks of , which literally shut down transportation and financial markets for several days , may have prolonged these negative tendencies just long enough to turn what might otherwise have been a mild decline into enough of a downtown to qualify the period as a recession . During this period the measured price level was essentially the implicit price deflator rising by less than . Thus , while the aggregate demand curve shifted left as a result of all the reasons given above , there was also a leftward shift in the aggregate supply curve . Source Kevin , The 2001 Recession How Was It Different and What Developments May Have Caused It ?

The Federal Reserve Bank of Louis Review , 2003 , Answer to Try It ! Problem All components of aggregate demand ( consumption , investment , government purchases , and net exports ) declined between 1929 and 1933 . Thus the aggregate demand curve shifted markedly to the left , moving from to . The reduction in nominal wages corresponds to an increase in aggregate supply from to . Since real in 1933 was less than real in 1929 , we know that the movement in the aggregate demand curve was greater than that of the aggregate supply curve . Price level Real per year

Recessionary and Gaps and Equilibrium Learning Objectives . Explain and illustrate graphically recessionary and gaps and relate these gaps to what is happening in the labor market . Identify the various policy choices available when an economy experiences an inflationary or recessionary gap and discuss some of the pros and cons that make these choices controversial . The intersection of the economy aggregate demand and aggregate supply curves determines equilibrium real and price level in the short run . The intersection of aggregate demand and run aggregate supply determines its equilibrium . In this section we will examine the process through which an economy moves from equilibrium in the short run to equilibrium in the long run . The long run puts a nation house in order only frictional and structural unemployment remain , and the price level is stabilized . In the short run , stickiness of nominal wages and other prices can prevent the economy from achieving its potential output . Actual output may exceed or fall short of potential output . In such a situation the economy operates with a gap . When output is above potential , employment is above the natural level of employment . When output is below potential , employment is below the natural level . Recessionary and Gaps At any time , real and the price level are determined by the intersection of the aggregate demand and aggregate supply curves . If employment is below the natural level of employment , real will be below potential . The aggregate demand and aggregate supply curves will intersect to the left of the aggregate supply curve . Suppose an economy natural level of employment is Le , shown in Panel ( a ) of Figure A Recessionary Gap . This level of employment is achieved at a real wage of me . Suppose , however , that the initial real wage 91 exceeds this equilibrium value . Employment at falls short of the natural level . A lower level of employment produces a lower level of output the aggregate demand and aggregate supply curves , AD and , intersect to the left of the aggregate supply curve in Panel ( The gap between the level of real and potential output , when real is less than potential , is called a recessionary gap . 247

Principles of 248 Figure ) A Gap Panel ( a ) Panel ( a I I I AD . I I ?

Employment per period Real below are natural level . as shown in Panel ( a ) then output must be below potential . Panel ) shows lhe recessionary gap . which occurs when lhe demand curve AD and me aggregate supply curve intersect to lhe left of me aggregate supply curve . Just as employment can fall short of its natural level , it can also exceed it . If employment is greater than its natural level , real will also be greater than its potential level . Figure An Gap shows an economy with a natural level of employment of Le in Panel ( a ) and potential output of in Panel ( If the real wage is less than the equilibrium real wage ( then employment will exceed the natural level . As a result , real , exceeds potential . The gap between the level of real and potential output , when real is greater than potential , is called an gap . In Panel ( the inflationary gap equals . Figure An Gap Panel ( a ) Panel ( a I I I ' gap Employment per period Real Panel ( a ) shows that if employment is above the natural level , then output must be above potential . The inflationary gap , shown in Panel ( equals . The aggregate demand curve AD and the aggregate supply curve intersect to the right of the aggregate supply curve .

249 Author removed at request of original publisher Restoring Equilibrium We have already seen that the aggregate demand curve shifts in response to a change in consumption , investment , government purchases , or net exports . The aggregate supply curve shifts in response to changes in the prices of factors of production , the quantities of factors of production available , or technology . Now we will see how the economy responds to a shift in aggregate demand or aggregate supply using two examples presented earlier a change in government purchases and a change in costs . By returning to these examples , we will be able to distinguish the response from the response . A Shift in Aggregate Demand An Increase in Government Purchases Suppose an economy is initially in equilibrium at potential output as in Figure Adjustment to an Gap . Because the economy is operating at its potential , the labor market must be in equilibrium the quantities of labor demanded and supplied are equal . Figure an Gap

Principles of 250 Shift in long ' run as nominal wages rise Price level Shift caused by increase in government purchases Real per year An increase in aggregate demand to ADz boosts real any and me price level In , creating an gap of . in me long run . as and nominal wages . he supply curve moves . Real returns In potential . Now suppose aggregate demand increases because one or more of its components ( consumption , investment , government purchases , and net exports ) has increased at each price level . For example , suppose government purchases increase . The aggregate demand curve shifts from to in Figure Adjustment to an Inflationary Gap . That will increase real to and force the price level up to in the short run . The higher price level , combined with a fixed nominal wage , results in a lower real wage . Firms employ more workers to supply the increased output . The economy new production level exceeds potential output . Employment exceeds its natural level . The economy with output of and price level of is only in equilibrium there is an inflationary gap equal to the difference between and . Because real is above potential , there will be pressure on prices to rise further . Ultimately , the nominal wage will rise as workers seek to restore their lost purchasing power . As the nominal wage rises , the aggregate supply curve will begin shifting to the left . It will continue to shift as long as the nominal wage rises , and the nominal wage will rise as long as there is an inflationary gap . These shifts in aggregate supply , however , will reduce real and thus begin to close this gap . When the aggregate supply curve reaches , the economy will have returned to

251 Author removed at request of original publisher its potential output , and employment will have returned to its natural level . These adjustments will close the inflationary gap . A Shift in Aggregate Supply An Increase in the Cost of Health Care Again suppose , with an aggregate demand curve at and a aggregate supply at , an economy is initially in equilibrium at its potential output , at a price level of , as shown in Figure Adjustment to a Recessionary Gap . Now suppose that the aggregate supply curve shifts owing to a rise in the cost of health care . As we explained earlier , because health insurance premiums are paid primarily by firms for their workers , an increase in premiums raises the cost of production and causes a reduction in the aggregate supply curve from to . Figure Adjustment a Gap I Shift in long run as nominal wages fall Shift caused by increase in insurance premiums paid by Price level Recessionary . gap Real per year

Principles of 252 A aggregate supply from to real and raises the price level to . Creating a recessionary gap of . In the long run . as prices and nominal wages decrease , the aggregate supply curve moves back and real returns potential . As a result , the price level rises to and real falls to . The economy now has a recessionary gap equal to the difference between and . Notice that this situation is particularly disagreeable , because both unemployment and the price level rose . With real below potential , though , there will eventually be pressure on the price level to fall . Increased unemployment also puts pressure on nominal wages to fall . In the long run , the aggregate supply curve shifts back to . In this case , real returns to potential at , the price level falls back to , and employment returns to its natural level . These adjustments will close the recessionary gap . How sticky prices and nominal wages are will determine the time it takes for the economy to return to potential . People often expect the government or the central bank to respond in some way to try to close gaps . This issue is addressed next . Gaps and Public Policy If the economy faces a gap , how do we get from that situation to potential output ?

Gaps present us with two alternatives . First , we can do nothing . In the long run , real wages will adjust to the equilibrium level , employment will move to its natural level , and real will move to its potential . Second , we can do something . Faced with a recessionary or an inflationary gap , policy makers can undertake policies aimed at shifting the aggregate demand or aggregate supply curves in a way that moves the economy to its potential . A policy choice to take no action to try to close a recessionary or an inflationary gap , but to allow the economy to adjust on its own to its potential output , is a nonintervention policy . A policy in which the government or central bank acts to move the economy to its potential output is called a stabilization policy . Nonintervention or Expansionary Policy ?

Figure Alternatives in Closing a Recessionary Gap illustrates the alternatives for closing a recessionary gap . In both panels , the economy starts with a real of and a price level of . There is a recessionary gap equal to . In Panel ( a ) the economy closes the gap through a process of . Real and nominal wages will fall as long as employment remains below the natural level . Lower nominal wages shift the aggregate supply curve . The process is a gradual one , however , given the stickiness of nominal wages , but after a series of shifts in the aggregate supply curve , the economy moves toward equilibrium at a price level of and its potential output of . Figure in Closing a Gap

253 Author removed at request of original publisher Panel ( a ) Panel ( Shift caused by expansionary ' I policy I Shift caused . I 55 . nominal wages I in the long run I I . AD ' Recessionary ADI gap I gap I , Real per year Real per year Panel ( aj Illustrates a gradual closing of a recessionary gap . Under a nonintervention policy . aggregate supply Shifts from IO . Panel ( shows me effects of expansionary polity acting on aggregate demand to close me gap . Panel ( illustrates the stabilization alternative . Faced with an economy operating below its potential , public officials act to stimulate aggregate demand . For example , the government can increase government purchases of goods and services or cut taxes . Tax cuts leave people with more income to spend , boost their consumption , and increase aggregate demand . As shifts to in Panel ( of Figure Alternatives in Closing a Recessionary Gap , the economy achieves output of , but at a higher price level , A stabilization policy designed to increase real is known as an expansionary policy . Nonintervention or Policy ?

Figure Alternatives in Closing an Inflationary Gap illustrates the alternatives for closing an inflationary gap . Employment in an economy with an inflationary gap exceeds its natural quantity of labor demanded exceeds the supply of labor . A nonintervention policy would rely on nominal wages to rise in response to the shortage of labor . As nominal wages rise , the aggregate supply curve begins to shift , as shown in Panel ( a ) bringing the economy to its potential output when it reaches and . Figure Alternatives in Closing an Inflationary Gap

Principles of 254 Shift Caused Panel ( a ) Panel ( by increase in nominal wages in the long run Shift caused by policy . AD gap gap ADI , Real per year Real per year Panel ( a ) illustrates a gradual closing or an inflationary gap . Under a policy . aggregate supply sum from . Panel on shows me effects of policy reduce aggregate demand from AD to AD in order to close me gap . A stabilization policy that reduces the level of is a policy . Such a policy would aim at shifting the aggregate demand curve from to to close the gap , as shown in Panel ( A policy to shift the aggregate demand curve to the left would return real to its potential at a price level of . For both kinds of gaps , a combination of letting market forces in the economy close part of the gap and of using stabilization policy to close the rest of the gap is also an option . Later chapters will explain stabilization policies in more detail , but there are essentially two types of stabilization policy fiscal policy and monetary policy . Fiscal policy is the use of government purchases , transfer payments , and taxes to the level of economic activity . Monetary policy is the use of central bank policies to influence the level of economic activity . To Intervene or Not to Intervene An Introduction to the Controversy How large are inflationary and recessionary gaps ?

Panel ( a ) of Figure Real and Potential Output shows potential output versus the actual level of real in the United States since 1960 . Real appears to follow potential output quite closely , although you see some periods where there have been inflationary or recessionary gaps . Panel ( shows the sizes of these gaps expressed as percentages of potential output . The percentage gap is positive during periods of inflationary gaps and negative during periods of recessionary gaps . Over the last 50 years , the economy has seldom departed by more than from its potential output . So the size and duration of the recessionary gap from 2009 to 2011 certainly stand out . Figure Real and Output

255 Author removed at request of original publisher Panel ( a ) 16000 14000 12000 10000 8000 6000 ' a ea VI 4000 ( lo i mu ti . re 2000 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year Panel ( and recessionary ( gap , percentage of potential output a do 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year Panel ( a ) shows output ( the blue line ) and ( the purple line ) since 1950 . Panel ( 13 ) shows me gap between and actual real expressed as a percentage of . Inflationary gaps are shown in green and gaps shown in . Source . Bureau at Economic Analysis . NIPA Table ( revised February 29 . 2012 ) Real Gloss . Chained Billions of chained ( 2005 ) seasonally adjusted at annual Congressional Budget Office . The Budget and Economic Outlook Ari Update , August 2011 . Panel ( a ) gives a perspective on the economy . It suggests that the economy generally operates at about potential output . In Panel ( a ) the gaps seem minor . Panel ( gives a perspective the view it gives emphasizes the gaps . Both of these perspectives are important . While it is reassuring to see that the economy is often close to potential , the years in which there are substantial gaps have real effects Inflation or unemployment can harm people . Some economists argue that stabilization policy can and should be used when recessionary or inflationary gaps exist . Others urge reliance on the economy own ability to correct itself . They sometimes argue that the tools available to the public sector to influence aggregate demand are not likely

Principles of 256 to shift the curve , or they argue that the tools would shift the curve in a way that could do more harm than good . Economists who advocate stabilization policies argue that prices are sufficiently sticky that the economy own adjustment to its potential will be a slow a painful one . For an economy with a recessionary gap , unacceptably high levels of unemployment will persist for too long a time . For an economy with an gap , the increased prices that occur as the aggregate supply curve shifts upward impose too high an inflation rate in the short run . These economists believe it is far preferable to use stabilization policy to shift the aggregate demand curve in an effort to shorten the time the economy is subject to a gap . Economists who favor a nonintervention approach accept the notion that stabilization policy can shift the aggregate demand curve . They argue , however , that such efforts are not nearly as simple in the real world as they may appear on paper . For example , policies to change real may not affect the economy for months or even years . By the time the impact of the stabilization policy occurs , the state of the economy might have changed . Policy makers might choose an expansionary policy when a one is needed or vice versa . Other economists who favor nonintervention also question how sticky prices really are and if gaps even exist . The debate over how policy makers should respond to recessionary and gaps is an ongoing one . These issues of nonintervention versus stabilization policies lie at the heart of the policy debate . We will return to them as we continue our analysis of the determination of output and the price level . Key Ta When the aggregate demand and aggregate supply curves intersect below potential output , the economy has a recessionary gap . When they intersect above potential output , the economy has an inflationary gap . Inflationary and recessionary gaps are closed as the real wage returns to equilibrium , where the quantity of labor demanded equals the quantity supplied . Because of nominal wage and price stickiness , however , such an adjustment takes time . When the economy has a gap , policy makers can choose to do nothing and let the economy return to potential output and the natural level of employment on its own . A policy to take no action to try to close a gap is a nonintervention policy . Alternatively , policy makers can choose to try to close a gap by using stabilization policy . Stabilization policy designed to increase real is called expansionary policy . Stabilization policy designed to decrease real is called policy .

257 Author removed at request of original publisher Try It ! Using the scenario of the Great Depression of the , as analyzed in the previous Try It ! tell what kind of gap the economy faced in 1933 , assuming the economy had been at potential output in 1929 . Do you think the unemployment rate was above or below the natural rate of unemployment ?

How could the economy have been brought back to its potential output ?

Case in Point This Time is Different , Or is it ?

Ahmed Stock Market . In an analysis that spans 66 countries over nearly eight centuries , economists Carmen and Kenneth investigate hundreds of financial crises and the economic busts each leaves in its wake . With a database that includes crisis episodes that go back as far as China and medieval Europe and continue until the financial crisis of , the authors look at the patterns of economic behavior that characterize the periods leading up to financial crises and the patterns that characterize the recoveries . They argue that looking over a long period of history is necessary because financial crises are rare events . Financial crises occur at varying intervals , and researchers studying a period of 25 years or so may not encounter the equivalent of a , category hurricane that hits a major , city with a faulty levee system . In general , such crises follow periods of relative economic calm . For example , the period in the United States from the until 2007 was often referred to as the Great Moderation . During such periods , inflationary and recessionary gaps may occur , but they are relatively small and . Societies begin to feel that they have tamed the business cycle , that policy makers have gotten smarter , and that moderation will continue .

Principles of 258 But then it happens . The accumulation of too much debt by governments , businesses , or consumers leads to a financial meltdown . As housing prices are run up , for example , people tend to find ways to justify their heavy borrowing and to rationalize the ascent in prices Demographics have changed mortgage terms have improved the regulation we have put in place is better this time it better to buy now , before prices go up even more housing prices won fall . Memories of the last crisis fade . This time is different , they argue . But and provide convincing evidence that this time is usually not different . debt lead to crises of confidence , and a financial crisis ensues . The aftermath is typically a severe and prolonged recessionary gap . On average , they find the following to be true . The collapse in asset market prices is large and . Housing prices decline an average of 35 over years , and stock prices decline an average of 56 over years . falls on average , and the recession averages years in length . The unemployment rate rises percentage points over a period . Government debt swells due to bailout costs and , more importantly , because tax revenues fall off due to lower . recoveries in stock prices are more common than recoveries in housing prices or employment . To what extent is the financial crisis of the late likely to follow this typical pattern ?

The authors argue that experience with expansionary fiscal policy in such circumstances is actually quite limited . Most often , governments are shut out of borrowing markets when crises hit . government explicitly tried to implement fiscal stimulus , but the authors warn against drawing conclusions from one such example . The authors caution that governments should weigh any potential benefit of fiscal stimulus against the problem of higher public debt . They also note that central banks in acted quickly and aggressively with expansionary monetary policies . But , they caution against push ing too far the conceit that we are smarter than our predecessors ( 238 ) The global nature of the current situation only adds to the difficulty of recovering fully . There was a company failure around 15 years ago that looked like a big deal at the time , but now seems like little more than a blip . The authors quote a trader who , during this event , presciently remarked , More money has been lost because of four words than at the point of a gun . Those words are This time is Source Carmen and Kenneth , This Time Is Different Eight Centuries Folly ( Princeton Princeton University Press , 2009 ) Answer to Try It ! Problem To the graph in the previous Try It ! problem we add the aggregate supply curve to show that , with output below potential , the economy in 1933 was in a recessionary gap . The unemployment rate was above the natural rate of unemployment . Indeed , real in 1933 was about 30 below what it had been in 1929 , and the unemployment rate had increased from to 25 . Note that during the period of the Great Depression , wages did fall . The notion of nominal wage and other price stickiness discussed in this section should not be construed to mean complete wage and price inflexibility . Rather , during this period , nominal wages and other prices were not flexible enough to restore the economy to the potential level of output . There are two basic choices on how to close recessionary gaps . Nonintervention would mean waiting for wages to

259 Author removed at request of original publisher fall further . As wages fall , the aggregate supply curve would Continue to shift to the right . The alternative would be to use some type of expansionary policy . This would shift the aggregate demand Curve to the right . These two options were illustrated in Figure Alternatives in Closing an Gap . Price level 933 929 Real per year

Review and Practice Summary In this chapter , we outlined the model of aggregate demand and aggregate supply . We saw that the aggregate demand curve slopes downward , the tendency for the aggregate quantity of goods and services demanded to rise as the price level falls and to fall as the price level rises . The negative relationship between the price level and the quantity of goods and services demanded results from the wealth effect for consumption , the interest rate effect for investment , and the international trade effect for net exports . We examined the factors that can shift the aggregate demand curve as well . Generally , the aggregate demand curve shifts by a multiple of the initial amount by which the component causing it to shift changes . We distinguished between two types of equilibria in corresponding to the short run , a period of analysis in which nominal wages and some prices are sticky , and the other corresponding to the long run , a period in which full wage and price , and hence market adjustment , have been achieved . equilibrium occurs at the intersection of the aggregate demand curve with the aggregate supply curve . The aggregate supply curve is a vertical line at the economy potential level of output . equilibrium occurs at the intersection of the aggregate demand curve with the aggregate supply curve . The aggregate supply curve relates the quantity of total output produced to the price level in the short run . It is upward sloping because of wage and price stickiness . In equilibrium , output can be below or above potential . If an economy is initially operating at its potential output , then a change in aggregate demand or aggregate supply will induce a recessionary or inflationary gap . Such a gap will be closed in the long run by changes in the nominal wage , which will shift the aggregate supply curve to the left ( to close an inflationary gap ) or to the right ( to close a recessionary gap ) Policy makers might respond to a recessionary or gap with a nonintervention policy , or they could use stabilization policy . Concept Problems . Explain how the following changes in aggregate demand or aggregate supply , other things held unchanged , are likely to affect the level of total output and the price level in the short run . An increase in aggregate demand . A decrease in aggregate demand . An increase in aggregate supply . A reduction in aggregate supply . Explain why a change in one component of aggregate demand will cause the aggregate demand 260

261 Author removed at request of original publisher curve to shift by a multiple of the initial change . Use the model of aggregate demand and aggregate supply to explain how each of the following would affect real and the price level in the short run . An increase in government purchases . A reduction in nominal wages . A major improvement in technology . A reduction in net exports . How would an increase in the supply of labor affect the natural level of employment and potential output ?

How would it affect the real wage , the level of real , and the price level in the short run ?

How would it affect aggregate supply ?

What kind of gaps would be created ?

Give three reasons for the downward slope of the aggregate demand curve . When the price level falls , people wealth increases . When wealth increases , the real Volume of consumption increases . Therefore , a decrease in the price level will cause the aggregate demand curve to shift to the Do you agree ?

Explain . Suppose the economy has a recessionary gap . We know that if we do nothing , the economy will close the gap on its own . Alternatively , we could arrange for an increase in aggregate demand ( say , by increasing government spending ) to close the gap . How would your views about the degree of price stickiness in the economy your views on whether such a policy would be desirable ?

The cost of hiring workers includes not only payments made directly to workers , that is , wages , but payments made on behalf of workers as well , such as contributions by employers to pension plans and to insurance for employees . How would a decrease in the cost of provided health insurance affect the economy ?

Using Figure An Increase in Health Insurance Premiums Paid by Firms as a guide , draw a graph to illustrate your answer . Suppose nominal wages never changed . What would be the significance of such a characteristic ?

10 . Suppose the minimum wage were increased sharply . How would this affect the equilibrium price level and output level in the model of aggregate demand and aggregate supply in the short run ?

In the long run ?

11 . Explain the impact of each of the following . A discovery that makes cold fusion a reality , greatly reducing the cost of producing energy . An increase in the payroll tax Numerical Problems . Suppose the aggregate demand and aggregate supply schedules for an economy whose potential output equals are given by the table .

Principles of 262 Aggregate Quantity of Goods and Services Price Level Demanded . An economy is characterized by the values in the table for aggregate demand and aggregate supply . Its potential output is . Draw the aggregate demand , aggregate supply , and aggregate supply curves . State the equilibrium level of real and the price level . Characterize the current economic situation . 15 there an or a recessionary gap ?

If so , how large is it ?

Now suppose aggregate demand increases by 700 at each price level for example , the aggregate quantity of goods and services demanded at a price level of now equals . Show the new aggregate demand curve , state the new equilibrium price level and real , and state whether there is an inflationary or a recessionary gap and give its size . Aggregate Quantity of Goods and Services Price Level Demanded 500 Draw the aggregate demand , aggregate supply , and aggregate supply curves . State the equilibrium level of real and the price level . Characterize the current economic situation . 15 there an or a recessionary gap ?

If so , how large is it ?

Now suppose that nominal wages rise and that the price level required to induce a particular level of total output rises by . For example , a price level of is now required to induce producers to produce a real of . Show the new Supplied Supplied 263 Author removed at request of original publisher run aggregate supply curve , state the new equilibrium price level and real , and state whether there is an or a recessionary gap and give its size . Why might such a change occur ?

Suppose the price level in a particular economy equals and that the quantity of real demanded at that price level is . An increase of point in the price level reduces the quantity of real demanded by 220 , and a reduction of point would produce an increase in the quantity of real demanded of 220 . Draw the aggregate demand curve and show the price level and quantity of real demanded at three points . Suppose an economy is described by the following aggregate demand and aggregate supply curves . The potential level of output is 10 trillion . Price Level . Aggregate Quantity of Goods and Services Demanded Supplied trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion Draw the aggregate demand and aggregate supply curves . What is the initial real ?

What is the initial price level ?

What kind of gap , if any , exists ?

After the increase in costs , each level of real requires an increase in the price level of . For example , producing trillion worth of goods and services now requires a price level of . What is the equilibrium level of real ?

After the cost increase , what is the new equilibrium price level in the short run ?

What sort of gap , if any , now exists ?

According to Alaskan state economist Mark Edwards , the multiplier effect of Alaska trade with Principles of 264 Japan is such that for every billion exported from Alaska to Japan another 600 million is added to the state economy ( 2004 ) Calculate the size of the export multiplier . The Research Observatory in England calculated that students who attend Technical University spend about each in the local economy for a total of million . In total , the impact of their spending on the local economy is Calculate the size of the student spending multiplier . In Goa , India , the multiplier effect of iron ore exports is calculated to be ( Ta , 2003 ) Calculate the impact of an additional rupees of iron ore exports on the economy of Goa . References Ta , Iron Ore Mining Gives Impetus to Goa Economy , Times of India , April 30 , 2003 . Trade Officials Hopeful for Japanese Recovery , Associated Press and Local Wire , June 22 , 2004 , cycle . University Brings in to Economy , Evening Post , November , 2004 , 37 .