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8/14/2019 Lecture 18 (6th Jan, 2009)
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W10 C2 (6th Jan, 2009)
3.Aggregate Demand & Aggregate Supply (AD &
AS)
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Aggregate demand is thetotal demand for goods andservices in the economy.
Deriving the AD curve: toderive the aggregate demandcurve, we examine whathappens to aggregate output(income) (Y) when the pricelevel (P) changes, assuming no
changes in governmentspending (G), net taxes (T), orthe monetary policy variable(Ms).
The aggregate demand
(AD) curve is a curve thatshows the negative
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P M r I A E d Y
The Impact of an Increase in the Price Level on theEconomy Assuming No Changes in G, T, and Ms
Discuss
Later
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A higher price level causesthe demand for money torise, which causes theinterest rate to rise. Then,the higher interest ratecauses aggregate output tofall.
The decrease inconsumption brought aboutby an increase in theinterest rate contributes tothe overall decrease in
output.
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At every point along the aggregate demand curve, theaggregate quantity of output demanded is exactly equal toplanned aggregate expenditure.
Y = C + I + G
equilibrium condition
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An increase in the quantityof money supplied at agiven price level shifts theaggregate demand curve to
the right.
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An increase in governmentpurchases or a decrease innet taxes shifts theaggregate demand curve to
the right.
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Factors That Shift the Aggregate Demand Curve
Expansionary monetary policy
Ms ADcurve shifts to the rightContractionary monetary policy
Ms ADcurve shifts to the leftExpansionary fiscal policy
G ADcurve shifts to the rightContractionary fiscal policy
G ADcurve shifts to the leftT ADcurve shifts to the right T ADcurve shifts to the left
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Aggregate supply is the total supply of all goods andservices in the economy.
The aggregate supply(AS) curve is a graph that shows therelationship between the aggregate quantity of output
supplied by all firms in an economy and the overall pricelevel.
Firms do not simply respond to market-determined prices, butthey actually set prices. Price-setting firms do not have
individual supply curves because these firms are choosingboth output and price at the same time.
When we draw a firms supply curve, we assume that inputprices are constant. In macroeconomics, an increase in theoverall price level means that at least some input prices will
be rising as well. The outputs of some firms are the inputs of
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In the short run, theaggregate supply curve(the price/output responsecurve) has a positive slope.
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At low levels of aggregateoutput, the curve is fairlyflat. As the economyapproaches capacity, the
curve becomes nearlyvertical. At capacity, thecurve is vertical.
Macroeconomists focus on
whether or not theeconomy as a whole isoperating at full capacity.
As the economy
approaches maximumca acit , firms res ond to
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When the economy is operating at low levels of output, anincrease in aggregate demand is likely to result in anincrease in output with little or no increase in the overallprice level.
There must be a lag between changes in input prices andchanges in output prices, otherwise the aggregate supply(price/output response) curve would be vertical.
Wage rates may increase at exactly the same rate as theoverall price level if the price-level increase is fullyanticipated. Most input prices, however, tend to lagincreases in output prices.
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A cost shock, or supply shock, is a changein costs that shifts the aggregate supply (AS)curve.
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Bad weather, natural
disasters, destruction
from wars
Good weather
Public policywaste and inefficiency
over-regulation
Public policy supply-side policies
tax cuts
deregulation
Stagnation
capital deterioration
Economic growth
more capital
more labor
technological change
Higher costs
higher input priceshigher wage rates
Lower costs
lower input priceslower wage rates
Shifts to the LeftDecreases in Aggregate Supply
Shifts to the RightIncreases in Aggregate Supply
Factors That Shift the Aggregate Supply Curve
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The equilibrium pricelevel is the point at whichthe aggregate demand andaggregate supply curves
intersect.
P0 and Y0 correspond to
equilibrium in the goodsmarket and the money
market and a set ofprice/output decisions on thepart of all the firms in theeconomy.
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Costs lag behind price-levelchanges in the short run,resulting in an upward-slopingAS curve.
Costs and the price levelmove in tandem in the longrun, and the AS curve isvertical.
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Output can be pushed abovepotential GDP by higheraggregate demand. Theaggregate price level also
rises.
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When output is pushedabove potential, there isupward pressure on costs,and this causes the short-
runAS curve to the left.
Costs ultimately increase bythe same percentage as theprice level, and the quantity
supplied ends up back at Y0.
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Y0 represents the level of
output that can be sustainedin the long run withoutinflation. It is also calledpotential output orpotential GDP.
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AD can shift to the right for anumber of reasons, includingan increase in the moneysupply, a tax cut, or an
increase in governmentspending.
Expansionary policy works
well when the economy is onthe flat portion of the AScurve, causing little changein P relative to the outputincrease.
Discuss
Later
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On the steep portion of the AScurve, expansionary policydoes not work well. Themultiplier is close to zero.
When the economy isoperating near full capacity,an increase in AD will result in
an increase in the price levelwith little increase in output.
Discuss
Later
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If theAS curve is vertical inthe long run, neithermonetary policy nor fiscalpolicy has any effect on
aggregate output.