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

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

Aggregate Demand Partner Review! 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]) 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) Name 10 countries in Europe

Aggregate Supply

What is Aggregate Supply? The supply for everything by all firms. 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.

Short-Run Aggregate Supply (SRAS) 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. Profit = $120 With higher profits, the firm has the incentive to increase production.

Long-Run Aggregate Supply (LRAS) 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.

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 LRAS SRAS AS is: upward-sloping in short run The slope of the AS curve depends on the time horizon: In the short run, the aggregate supply curve is upward-sloping. (Hence the upward-sloping curve labeled “SRAS” – “SR” stands for “short run”). In the long run, the aggregate supply curve is vertical. These slopes will be explained in the following slides. vertical in long run

The Long-Run Aggregate-Supply Curve (LRAS) The natural rate of output (YN) is the amount of output the economy produces when unemployment is at its natural rate. YN is also called potential output or full-employment output. P Y LRAS The book does not use the notation YN. I use it here to keep the slides from getting too cluttered, and also to make it easier for students to take notes: it’s easier for them to write “YN” than “the natural rate of output.” YN

Why LRAS Is Vertical YN 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 P2 P1 does not affect any of these, so it does not affect YN. This is review from the chapter “Production and Growth.” YN

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.

Why the LRAS Curve Might Shift P Y LRAS1 LRAS2 YN ’ Any event that changes any of the determinants of YN will shift LRAS. Example: Immigration increases labor, causing YN to rise. YN

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 It might be worth mentioning that the change in weather patterns or reduction in imported resources would have to be reasonably long-lasting for the LRAS curve to shift. Short-lived changes are more likely to affect SRAS than LRAS.

Short-Run Aggregate Supply Price Level AS AS is the production of all the firms in the economy Real domestic output (GDPR) 15

3 Reasons the SRAS slopes upwards

1. The Sticky-Wage Theory 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 PE, the price level they expect to prevail. If P > PE, 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.

2. The Sticky-Price Theory 2. The Sticky-Price Theory 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 PE.

2. The Sticky-Price Theory 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.

3. The Misperceptions Theory 3. The Misperceptions Theory Firms may confuse changes in P with changes in the relative price of the products they sell. If P rises above PE, 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. Of the three theories, this one seems the least plausible. Firms certainly have a strong incentive to not mistake a general price increase for a relative price increase. And information about the price level is costless and available with only a short lag (especially the CPI, which is published monthly and very widely reported the moment it comes out). My remarks here are not officially part of the textbook, so they are not supported in the study guide or test bank. Feel free to ignore them.

Shifters Aggregate Supply R. A. P.

Shifts in Aggregate Supply An increase or decrease in national production can shift the curve right or left AS2 Price Level AS AS1 Real domestic output (GDPR) 22

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 23

3 Shifters of Aggregate Supply (NOT Government Spending) 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…) 24

Aggregate Supply