Page 231 - Economics

CONFIRMING PAGES

PART THREE
202
Macroeconomic Models and Fiscal Policy
of previous vigorous expansions of aggregate demand, in- Throughout 2001 the Federal Reserve lowered inter-
cluding the expansion of the late 1980s. est rates to try to halt the recession and promote recovery.
Between 1990 and 2000, however, larger-than-usual Those Fed actions, along with Federal tax cuts, increased
increases in productivity occurred because of a burst of new military spending, and strong demand for new housing,
technology relating to computers, the Internet, inventory helped spur recovery. The economy haltingly resumed its
management systems, electronic commerce, and so on. We economic growth in 2002 and 2003 and then expanded
represent this higher-than-usual productivity growth as the rapidly in 2004 and 2005.
rightward shift from AS to AS in Figure 10.10 . The rele- We will examine stabilization policies, such as those
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vant aggregate demand and aggregate supply curves thus carried out by the Federal government and the Federal
became AD and AS , not AD and AS . Instead of moving Reserve, in chapters that follow. We will also discuss what
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from a to b , the economy moved from a to c . Real output remains of the New Economy thesis in more detail. (Key
increased from Q to Q , and the price level rose only mod- Questions 5, 6, and 7)
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estly (from P to P ). The shift of the aggregate supply
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curve from AS to AS accommodated the rapid increase in QUICK REVIEW 10.3
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aggregate demand and kept inflation mild. This remark- • The equilibrium price level and amount of real output are
able combination of rapid productivity growth, rapid real determined at the intersection of the aggregate demand
GDP growth, full employment, and relative price-level curve and the aggregate supply curve.
stability led some observers to proclaim that the United • Increases in aggregate demand beyond the full-employment
States was experiencing a “new era” or a New Economy. level of real GDP cause demand-pull inflation.
But in 2001 the New Economy came face-to-face with • Decreases in aggregate demand cause recessions and cyclical
the old economic principles. Aggregate demand declined unemployment, partly because the price level and wages tend
because of a substantial fall in investment spending, and in to be inflexible in a downward direction.
March 2001 the economy experienced a recession. The • Decreases in aggregate supply cause cost-push inflation.
terrorist attacks of September 11, 2001, further dampened • Full employment, high economic growth, and price stability
private spending and prolonged the recession throughout are compatible with one another if productivity-driven
increases in aggregate supply are sufficient to balance
2001. The unemployment rate rose from 4.2 percent in growing aggregate demand.
January 2001 to 6 percent in December 2002.

Summary

1. The aggregate demand–aggregate supply model (AD-AS Figure 10.2 alter the spending by these groups and shift the
model) is a variable-price model that enables analysis of si- aggregate demand curve. The extent of the shift is
multaneous changes of real GDP and the price level. determined by the size of the initial change in spending and
2. The aggregate demand curve shows the level of real output the strength of the economy’s multiplier.
that the economy will purchase at each price level. 5. The aggregate supply curve shows the levels of real output that
3. The aggregate demand curve is downsloping because of the businesses will produce at various possible price levels. The
real-balances effect, the interest-rate effect, and the foreign long-run aggregate supply curve assumes that nominal wages
purchases effect. The real-balances effect indicates that in- and other input prices fully match any change in the price
flation reduces the real value or purchasing power of fixed- level. The curve is vertical at the full-employment output.
value financial assets held by households, causing cutbacks 6. The short-run aggregate supply curve (or simply “aggregate
in consumer spending. The interest-rate effect means that, supply curve”) assumes nominal wages and other input
with a specific supply of money, a higher price level increases prices do not respond to price-level changes. The aggregate
the demand for money, thereby raising the interest rate and supply curve is generally upsloping because per-unit
reducing investment purchases. The foreign purchases ef- production costs, and hence the prices that firms must
fect suggests that an increase in one country’s price level receive, rise as real output expands. The aggregate supply
relative to the price levels in other countries reduces the net curve is relatively steep to the right of the full-employment
export component of that nation’s aggregate demand. output and relatively flat to the left of it.
4. The determinants of aggregate demand consist of spending 7. Figure 10.5 lists the determinants of aggregate supply: input
by domestic consumers, by businesses, by government, and prices, productivity, and the legal-institutional environment.
by foreign buyers. Changes in the factors listed in A change in any one of these factors will change per-unit

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