Unit 3: Aggregate Demand and Aggregate Supply and Fiscal Policy Aggregate Demand 1

1.List and define the 3 reasons aggregate demand is downward sloping: 2.List the 4 shifters of aggregate demand and give an example of each: 3.Name 10 countries in Europe Aggregate Demand Partner Review!

1.List the 3 reasons aggregate demand is downward sloping: The Wealth Effect (nominal value of $1 fixed, real value not) The Interest-Rate Effect (low PL means we hold fewer $$. ↓PL →↓interest rates→↑C and I →↑quantity of goods demanded) The Foreign Trade/Exchange-Rate Effect (↓ interest rates cause investors to go to foreign markets→↑supply of dollars → depreciation of the dollar = foreign goods more expensive relative to the dollar→↑ exports and domestic purchases [fewer imports]) 2.List the 4 shifters of aggregate demand: Change in consumer spending (i.e., saving for retirement becomes a priority) Change in investment spending (i.e., businesses become pessimistic about future business conditions) Change in government spending (i.e., war breaks out) Change in net exports (Europe in a recession buys fewer US goods) 3.Name 10 countries in Europe Aggregate Demand Partner Review!

A C T I V E L E A R N I N G 1 : Exercise What happens to the AD curve in each of the following scenarios? A. A ten-year-old investment tax credit expires. B. The U.S. exchange rate falls. C. A fall in prices increases the real value of consumers’ wealth. D. State governments replace their sales taxes with new taxes on interest, dividends, and capital gains. 4

A C T I V E L E A R N I N G 1 : Answers A. A ten-year-old investment tax credit expires. I falls, AD curve shifts left. B. The U.S. exchange rate falls. NX rises, AD curve shifts right. C. A fall in prices increases the real value of consumers’ wealth. Move down along AD curve (wealth-effect). D. State governments replace sales taxes with new taxes on interest, dividends, and capital gains. C rises, AD shifts right. 5

Aggregate Supply 6

What is Aggregate Supply? Aggregate Supply is the amount of goods and services (real GDP) that firms will produce in an economy at different price levels. The supply for everything by all firms. Aggregate Supply differentiates between short run and long-run and has two different curves. Short-run Aggregate Supply Wages and Resource Prices will not increase as price levels increase. Long-run Aggregate Supply Wages and Resource Prices will increase as price levels increase. 7

Short-Run Aggregate Supply In the Short Run, wages and resource prices will NOT increase as price levels increase. Example: If a firm currently makes 100 units that are sold for $1 each. The only cost is $80 of labor. How much is profit? Profit = $100 - $80 = $20 What happens in the SHORT-RUN if price level doubles? Now 100 units sell for $2, TR=$200. How much is profit? Profit = $120 With higher profits, the firm has the incentive to increase production. 8

Long-Run Aggregate Supply In the Long Run, wages and resource prices WILL increase as price levels increase. Same Example: The firm has TR of $100 an uses $80 of labor. Profit = $20. What happens in the LONG-RUN if price level doubles? Now TR=$200 In the LONG RUN workers demand higher wages to match prices. So labor costs double to $160 Profit = $40, but REAL profit is unchanged. If REAL profit doesn’t change the firm has no incentive to increase output. 9

The Aggregate-Supply (AS) Curves The AS curve shows the total quantity of g&s firms produce and sell at any given price level. P Y SRAS LRAS AS is:  upward-sloping in short run  vertical in long run

The Long-Run Aggregate-Supply Curve (LRAS) The natural rate of output (Y N ) is the amount of output the economy produces when unemployment is at its natural rate. Y N is also called potential output or full-employment output. P Y LRAS YNYN

Why LRAS Is Vertical Y N determined by the economy’s amount of labor, capital, and natural resources, and on the level of technology. An increase in Price level P Y LRAS P1P1 does not affect any of these, so it does not affect Y N. P2P2 YNYN

Long-Run Aggregate Supply In the Long Run, an economy’s production of goods and services (its real GDP) depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services. 13

Why the LRAS Curve Might Shift Any event that changes any of the determinants of Y N will shift LRAS. Example: Immigration increases labor, causing Y N to rise. P Y LRAS 1 YNYN LRAS 2 YNYN ’

Why the LRAS Curve Might Shift Changes in labor or natural rate of unemployment –Immigration –Baby-boomers retire –Govt policies reduce natural u-rate Changes in physical or human capital –Investment in factories, equipment –More people get college degrees –Factories destroyed by a hurricane

Why the LRAS Curve Might Shift Changes in land (natural resources) –discovery of new mineral deposits –reduction in supply of imported oil –changing weather patterns that affect agricultural production Changes in technology –productivity improvements from technological progress

Short-Run Aggregate Supply Price Level Real domestic output (GDP R ) AS 17 AS is the production of all the firms in the economy

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CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 1. The Sticky-Wage Theory Imperfection: Nominal wages are sticky in the short run, they adjust sluggishly. –Due to labor contracts, social norms. Firms and workers set the nominal wage in advance based on P E, the price level they expect to prevail.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 1. The Sticky-Wage Theory If P > P E, revenue is higher, but labor cost is not. Production is more profitable, so firms increase output and employment. Hence, higher P causes higher Y, so the SRAS curve slopes upward.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 2. The Sticky-Price Theory Imperfection: Many prices are sticky in the short run. –Due to menu costs, the costs of adjusting prices. –Examples: cost of printing new menus, the time required to change price tags. Firms set sticky prices in advance based on P E.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 2. The Sticky-Price Theory Suppose the Fed increases the money supply unexpectedly. In the long run, P will rise. In the short run, firms without menu costs can raise their prices immediately. Firms with menu costs wait to raise prices. Meantime, their prices are relatively low, which increases demand for their products, so they increase output and employment. Hence, higher P is associated with higher Y, so the SRAS curve slopes upward.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 3. The Misperceptions Theory Imperfection: Firms may confuse changes in P with changes in the relative price of the products they sell. If P rises above P E, a firm sees its price rise before realizing all prices are rising. The firm may believe its relative price is rising, and may increase output and employment. So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping.

24 Shifters Aggregate Supply R. A. P.

Shifts in Aggregate Supply Price Level Real domestic output (GDP R ) AS 25 An increase or decrease in national production can shift the curve right or left AS 1 AS 2

3 Shifters of Aggregate Supply 1. Change in Resource Prices Prices of Domestic and Imported Resources (Increase in price of Canadian lumber…) (Decrease in price of Chinese steel…) Supply Shocks (Negative Supply shock…) (Positive Supply shock…) Inflationary Expectations (If people expect higher prices in the future…) If producers expect higher prices in the future, workers will demand higher wages and costs will increase. This will decrease AS 26

3 Shifters of Aggregate Supply 2. Change in Actions of the Government (NOT Government Spending) Taxes on Producers (Lower corporate taxes…) Subsidies for Domestic Producers (Lower subsidies for domestic farmers…) Government Regulations (EPA inspections required to operate a farm…) 3. Change in Productivity Technology (Computer virus that destroy half the computers…) (The advent of a teleportation machine…) 27

Aggregate Supply 28