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Aggregate Supply and Aggregate Demand

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Aggregate Supply andAggregate Demand

What is the purpose of the aggregate supply-aggregate demand model?

What determines aggregate supply and aggregate demand?

What is the definition of macroeconomic equilibrium?

How do these concepts interact to cause business cycles?

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The Aggregate Supply-Aggregate Demand Model

The purpose of this model is: to help understand and predict

fluctuations of real GDP around potential GDP

to understand and predict fluctuations in the price level

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Aggregate Supply

The aggregate quantity of goods and services supplied is the sum of the quantities of final goods and services produced by all firms in the economy (real GDP).

Aggregate supply is the relationship between the quantity of real GDP supplied and the price level.

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Two Time Frames for Aggregate Supply

We distinguish two time frames for aggregate supply: Long-run aggregate supply Short-run aggregate supply

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Long-Run Aggregate Supply

The macroeconomic long run is a time frame that is long enough so external shocks have run their course.

The long-run aggregate supply curve (LAS) is the relationship between the quantity of real GDP supplied and the price level in the long run when real GDP equals potential GDP.

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Implications of Long-Run Aggregate Supply

In the long run, potential GDP is independent of the price level.

A 10 percent increase in the average price level will be matched by a 10 percent increase in wage rates and other factor prices.

Relative prices and the real wage rate will remain constant.

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Short-RunAggregate Supply

The macroeconomic short run is a period during which: real GDP has fallen below potential GDP

(and unemployment has risen above the natural rate) or

real GDP has risen above potential GDP (and unemployment has fallen below the natural rate).

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Short-Run Aggregate Supply Curve

The short-run aggregate supply curve (SAS) is the relationship between the quantity of real GDP supplied and the price level in the short run when all other influences on production plans (such as the money wage rate and raw materials prices) remain constant.

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Implications of Short-Run Aggregate Supply

The short run is the normal state of the economy when it is fluctuating around potential GDP.

In the short run, prices of goods and services change freely, but prices of factors of production (including the wage rate) do not change very much.

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Movements AlongLAS and SAS

A rise in the price level accompanied by an equal percentage rise in the money wage rate (and prices of other factors of production) brings a movement along the LAS curve.

A rise in the price level with no change in factor prices brings a movement along the SAS curve.

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Changes inAggregate Supply

A change in the price level, other things remaining the same, causes a movement along the aggregate supply curve.

Aggregate supply changes when any influence on production plans (other than price) changes.

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Changes in Long-Run Aggregate Supply

Long-run aggregate supply changes when potential GDP changes.

Potential GDP changes for three reasons: Growth in the full-employment quantity

of labor Growth in the quantity of capital Advances in technology

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Changes in Short-Run Aggregate Supply

All the factors that influence long-run aggregate supply also influence short-run aggregate supply.

If potential GDP increases, both long-run and short-run aggregate supply increase because the level of full-employment output has increased.

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Influences on Short-Run Aggregate Supply

The only influences on short-run aggregate supply that do not affect long-run aggregate supply are: the money wage rate prices of other factors of production

Both these factor prices affect short-run aggregate supply via their influence on production costs.

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Changes in Factor Prices

An increase in factor prices decreases short-run aggregate supply. The SAS curve shifts up and to the left.

A decrease in factor prices increases short-run aggregate supply. The SAS curve shifts down and to the

right.

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Aggregate Demand

The aggregate quantity of goods and services demanded is the sum of: planned consumption spending by

households planned investment spending by firms planned government spending planned net exports

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The AggregateDemand Curve

Aggregate demand is the entire relationship between the quantity of real GDP demanded and the price level (the GDP deflator).

An increase in the average price level, holding everything else constant, reduces the quantity of real GDP demanded.

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Why the Aggregate Demand Curve Slopes Downward

Ordinary market demand curves slope downward because of income and substitution effects.

The aggregate demand curve slopes downward for similar reasons: Wealth effect Substitution effect

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The Wealth Effect

Wealth is the assets of society. If the price level rises, the real value

of wealth decreases. If the price level falls, the real value

of wealth increases.

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Th Wealth Effect and Aggregate Demand

A rise in the price level reduces the real value of wealth, causing a movement up and to the left on an AD curve.

A fall in the price level increases the real value of wealth, causing a movement down and to the right on an AD curve.

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The Substitution Effect

The substitution effect is the change in the quantity of real GDP demanded resulting from a change in the price level (opportunity cost) of goods.

There are two components ot the substitution effect. The intertemporal substitution effect The international substitution effect

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The Interest Rate and Intertemporal Substitution

The higher the interest rate, the greater is the opportunity of spending today versus saving (so you can spend more tomorrow).

The higher the price level, other things remaining the same, the higher is the interest rate.

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The Price Level andthe Interest Rate

An increase in the price level reduces the quantity of real money in circulation.

People will try to maintain their standard of living by saving less and spending more.

This reduces the supply of loanable funds, driving up the interest rate.

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InternationalSubstitution Effect

The international substitution effect is the change in the quantity of real GDP demanded resulting from a change in the opportunity cost of domestic goods in terms of foreign goods.

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International Substitution and the Price Level

The higher the price level in the United States, other things remaining the same, the higher the prices of U.S. made goods relative to foreign made goods.

This means a higher price level will reduce the quantity of real GDP demanded.

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The Aggregate Demand Curve Slopes Downward

Each of the two ways the price level influences the quantity of real GDP demanded causes the aggregate demand to fall as the price level rises.

Therefore the aggregate demand curve slopes downward.

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Changes in the Quantityof Real GDP Demanded

When the price level changes (and causes the interest rate to change), there is a change in the quantity of real GDP demanded.

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Changes inAggregate Demand

There are four main factors that cause the aggregate demand curve to shift: Expectations International factors Fiscal policy Monetary policy

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Expectations

Expectations about future economic conditions play a crucial role in determining household and business spending decisions.

Three important expectations are: future incomes future inflation future profits

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Expected Future Incomes An increase in expected future

income, other things remaining the same, increases the amount households plan to spend, increasing aggregate demand.

When households expect declining future income, they will cut back on current spending, decreasing aggregate demand.

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Expected Inflation

An increase in the expected inflation rate, other things remaining the same, leads to an increase in aggregate demand.

When people expect prices to rise faster in the future, they try to buy more at today’s lower prices.

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Expected Future Profits

If firms expect future profits to be higher, they will spend more on investment today so they will have the plant and equipment ready to produce those profitable goods in the future.

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International Factors

The two main international factors that influence aggregate demand are: the foreign exchange rate foreign income

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The Foreign Exchange Rate

The foreign exchange rate is the amount of foreign currency that you can buy with one U.S. dollar.

The foreign exchange rate affects the prices that foreigners pay for goods and services produced in the U.S., as well as the prices we have to pay for foreign-produced goods.

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Foreign Income

An increase in foreign income increases demand for all goods and services, including goods made in the U.S. (our exports, their imports).

Rapid economic growth in Japan and Western Europe in the 80’s have increased demand for U.S. exports.

The recent depressions in Asia have reduced demand for U.S. exports.

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Fiscal Policy Fiscal policy is the government’s

attempt to influence the economy by setting and changing: government spending taxes the government’s deficit and debt

These decisions are made by Congress in consultation with the President.

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Government Purchases of Goods and Services

The scale of government purchases of goods and services has a direct impact on aggregate demand.

If taxes are held constant, an increase in government purchases causes aggregate demand to increase.

The budget deficit also increases.

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Taxes and Transfer Payments

A decrease in taxes causes aggregate demand to increase.

An increase in transfer payments also increases aggregate demand.

Both these changes in fiscal policy increase households’ disposable income.

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Monetary Policy

Decisions about the money supply and interest rates are made by the Federal Reserve board (the Fed).

The Fed’s attempt to influence the economy by varying the money supply and interest rates is called monetary policy.

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The Money Supply The greater the quantity of money in

circulation, the greater is the level of aggregate demand.

As people and businesses hold more money, they also will spend more even if their income has not changed.

Increases in the money supply also lower interest rates.

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Interest Rates

If the Fed increases interest rates, households and firms reduce their borrowing, lending, and spending plans, particularly on durable goods.

Remember, interest rates are the opportunity cost of consumption and investment spending.

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Shifts of the Aggregate Demand Curve

Changes in expectations, international factors, fiscal policy, or monetary policy cause the aggregate demand curve to shift.

An increase in aggregate demand causes the AD curve to shift right.

A decrease in aggregate demand causes the AD curve to shift left.

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Macroeconomic Equilibrium

Macroeconomic equilibrium is determined by the intersection of the aggregate supply and aggregate demand curves.

There is an equilibrium for each of the time frames: long run and short run.

Let’s look at the short run first.

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Determination of Real GDP and the Price Level

Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the short-run quantity of real GDP supplied.

This is where the AD and SAS curves intersect.

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Short-Run Macroeconomic Excess Supply of Goods

If the price level is above equilibrium, short-run aggregate supply (production) will exceed aggregate demand (spending).

This will cause unwanted inventories to pile up.

Firms will reduce production and cut prices.

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Short-Run Macroeconomic Excess Demand for Goods

If the price level is below equilibrium, aggregate demand (spending) will exceed short-run aggregate supply (production).

This will cause unwanted inventory decreases.

Firms will increase production and raise prices.

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Short-Run and Long-Run Macroeconomic Equilibrium Long-run macroeconomic

equilibrium occurs when real GDP equals potential GDP and there is full employment.

This implies the economy is on its long-run aggregate supply curve.

Short-run equilibrium can occur at a real GDP other than potential GDP.

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Equilibrium BelowFull Employment

A below full-employment equilibrium is a short-run equilibrium in which potential GDP exceeds real GDP.

This difference between potential and actual GDP is called a recessionary gap.

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Equilibrium AboveFull Employment

An above full-employment equilibrium is a short-run equilibrium in which real GDP exceeds potential GDP.

This difference between real and potential GDP is called an inflationary gap.

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Long-Term Growthand Inflation

Long-term economic growth occurs when the long-run aggregate supply curve shifts to the right.

Inflation occurs when aggregate demand increases at a faster rate than long-run aggregate supply.

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Fluctuations inAggregate Demand

Suppose the economy is at a full-employment equilibrium.

Foreign demand for U.S. goods (exports) increases, causing U.S. aggregate demand to increase.

Real GDP and the price level will increase in the short run.

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The Return toLong-Run Equilibrium

The short-run equilibrium is above full employment.

Prices and output have increased, but wage rates have not.

In the long run, wage rates will increase because demand for labor exceeds labor supply.

The SAS curve shifts.

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The New Long-Run Equilibrium

In the long run, the economy will produce its potential output (full-employment real GDP).

However, the price level will be higher, reflecting the higher level of aggregate demand and shift of the SAS curve.

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Fluctuations inAggregate Supply

Fluctuations in short-run aggregate supply can also cause fluctuations in real GDP.

Beginning at full employment equilibrium, suppose there is a large increase in the world price of oil.

This causes a decrease in short-run aggregate supply.

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A Decrease in Short-Run Aggregate Supply

When short-run aggregate supply decreases, the SAS curve shifts up and to the left.

This causes unemployment and inflation, a condition known as stagflation.

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Anti-Stagflation Policies If AD does not change, the price level

will eventually fall back to its original level.

If AD is increased via monetary or fiscal policy, unemployment will fall but inflation will rise.

If AD is decreased to fight inflation, unemployment will rise.

There are no perfect policy choices.

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Expenditure Multipliers

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