Aggregate Demand and Supply Rittenberg Macroeconomics Chapter 7 Aggregate Demand and Supply

Why the Aggregate Demand Curve Slopes Downward (1) Aggregate demand (AD) is the economy-wide demand for goods and services. Like the market demand curve, the aggregate demand curve slopes downward, but for different reasons. The reasons for its downward slope are price-level effects: Wealth Effect (Real Wealth/Real Balances) Interest Rate Effect International Trade Effect (Substitution)

1.1 The Slope of the Aggregate Demand Curve Aggregate demand is the relationship between the total quantity of goods and services demanded (from all the four sources of demand) and the price level, ceteris paribus. The aggregate demand curve is a graphical representation of aggregate demand. The wealth effect is the tendency for a change in the price level to affect real wealth and thus alter consumption.

1.1 The Slope of the Aggregate Demand Curve The interest rate effect is the tendency for a change in the price level to affect the interest rate and thus to affect the quantity of investment demanded. The international trade effect is the tendency for a change in the price level to affect net exports. The change in the aggregate quantity of goods and services demanded refers to a movement along an aggregate demand curve in response to a change in price level, ceteris paribus.

1.2 Changes in Aggregate Demand A Change in aggregate demand is a change in the aggregate quantity of goods and services demanded at every price level. This can be caused by changes in… Consumption, Investment, Government purchases, Net exports. The exchange rate is the price of a currency in terms of another currency or currencies.

Why the Aggregate Demand Curve Slopes Downward (2)

The Interest Rate Effect

Why the Aggregate Demand Curve Slopes Downward (4)

The Aggregate Demand Curve Note that changes in price level result in changes in the aggregate quantity demanded. Copyright © Houghton Mifflin Company. All rights reserved.

Factors that Affect AD AD = C + I + G + XN Consumption Investment Income Wealth Expectations Demographics Taxes Investment Interest Rates Technology Cost of Capital Goods Capacity Utilization Government purchases Net Exports Domestic & Foreign Income Domestic & Foreign Prices Exchange Rates Government Policy

Non-price Determinants: Changes in Aggregate Demand (1) Copyright © Houghton Mifflin Company. All rights reserved.

Nonprice Determinants: Changes in Aggregate Demand (2) Copyright © Houghton Mifflin Company. All rights reserved.

Non-price Determinants: Changes in Aggregate Demand (3) Copyright © Houghton Mifflin Company. All rights reserved.

Shifting the Aggregate Demand Curve Copyright © Houghton Mifflin Company. All rights reserved.

The Multiplier EQUATION 1.1 The multiplier is the ratio of the change in the quantity of real GDP demanded at each price level to the initial change in one or more components of aggregate demand that produced it. EQUATION 1.1 Multiplier = Δ (real GDP demanded at each price level) initial Δ (component of AD) EQUATION 1.2 Δ (real GDP demanded at each price level) = Multiplier × initial Δ (component of AD)

Effect of initial increase in net exports without multiplier effect The Multiplier Effect of initial increase in net exports without multiplier effect AD1 AD2

Effect of initial decrease in net exports without multiplier effect The Multiplier Effect of initial decrease in net exports without multiplier effect AD2 AD1

Effects of a Change in Aggregate Demand Demand-pull inflation: rapid increases in AD outpace the growth of AS, causing price level increases (inflation). Copyright © Houghton Mifflin Company. All rights reserved.

2. AGGREGATE DEMAND AND AGGREGATE SUPPLY: THE LONG RUN AND THE SHORT RUN Learning Objectives Distinguish between the short run and the long run, as these terms are used in macroeconomics. Draw a hypothetical long-run aggregate supply curve and explain what it shows about the natural levels of employment and output at various price levels, given changes in aggregate demand. Draw a hypothetical short-run aggregate supply curve, explain why it slopes upward, and explain why it may shift; that is, distinguish between a change in the aggregate quantity of goods and services supplied and a change in short-run aggregate supply. Discuss various explanations for wage and price stickiness. Explain and illustrate what is meant by equilibrium in the short run and relate the equilibrium to potential output.

2. AGGREGATE DEMAND AND AGGREGATE SUPPLY: THE LONG RUN AND THE SHORT RUN The short run in macroeconomic analysis, is a period in which wages and some other prices are sticky and do not respond to changes in economic conditions. A sticky price is a price that is slow to adjust to its equilibrium level, creating sustained periods of shortage or surplus. The long run in macroeconomic analysis, is a period in which wages and prices are flexible.

Short-run Aggregate Supply Aggregate Supply (AS) is the total of all the firm (market) supply curves. It shows the quantity of real GDP produced at different price levels. Like Supply at the microeconomic level, it is a positive, upward-sloping curve

Short-run Aggregate Supply Short-run AS slopes upward because an increase in the price level (while production costs (wages) and capital are held constant on the short-run), means higher profit margins—firms will want to produce more. The reverse is true when price level falls…. Sticky Prices: esp. Sticky Wages: Changes in Nominal Wages tend to lag behind changes in price level. This leads to a short term effective change in REAL WAGE.

Copyright © Houghton Mifflin Company. All rights reserved. Aggregate Supply Copyright © Houghton Mifflin Company. All rights reserved.

Shape of Short-run AS (SRAS) In the short-run, the capital stock (the number of factories and machines, etc.) are held constant. Increasing the number of workers increases output, but at a diminishing rate. Diminishing returns manifest as an ever-steeper SRAS curve. In the short-run, some prices do not adjust quickly; they are “sticky”: Labor Costs (wages) Contracted supplies “Sticky” prices effect the short-run equillibrium

The Shape of the Short-Run Aggregate Supply Curve Copyright © Houghton Mifflin Company. All rights reserved.

The Shape of Long-run AS (LRAS) Resource costs are NOT fixed. As prices rise, workers will want higher wages and will eventually get them. The amount of capital is not fixed—firms can build new plants and buy new equipment over the long-run. In the long-run, AS is set by the production possibilities curve—the capacity of the economy, and is not affected by prices, hence is vertical.

2.1 The Long Run The long run aggregate supply (LRAS) curve is a graphical representation that relates the level of output produced by firms to the price level in the long run.

The Shape of the Long-Run Aggregate Supply Curve Copyright © Houghton Mifflin Company. All rights reserved.

Long-Run Equilibrium

Determinants of Aggregate Supply (1) Copyright © Houghton Mifflin Company. All rights reserved.

Determinants of Aggregate Supply (2) Copyright © Houghton Mifflin Company. All rights reserved.

Determinants of Aggregate Supply (3) Copyright © Houghton Mifflin Company. All rights reserved.

2.2 The Short Run The short run aggregate supply (SRAS) curve is a graphical representation of the relationship between production and the price level in the short run. A change in the aggregate quantity of goods and services supplied is characterized by movement along the short-run aggregate supply curve. A change in short-run aggregate supply is characterized by a change in the aggregate quantity of goods and services supplied at every price level in the short-run.

Shifting the Long-Run Aggregate Supply Curve Growth occurs as the labor force and the capital stock grow, as technological innovation improves production efficiency. Copyright © Houghton Mifflin Company. All rights reserved.

Changes in Short-Run Aggregate Supply Copyright © Houghton Mifflin Company. All rights reserved.

Changes in Short-Run Aggregate Supply Shift caused by increase in price of natural resources. SRAS3 SRAS1 SRAS2 Shift caused by decrease in price of natural resources.

Short-Run Equilibrium SRAS2 SRAS1 P2 Shift caused by increase in health insurance premium paid by firms P1 AD1 Y2 Y1

Short-Run Equilibrium SRAS1 Shift caused by increase in government purchases. P2 P1 AD1 AD2 Y1 Y2

Effects of a Change in Aggregate Supply Cost-push inflation: cost increases push AS to the left (relative to AD), causing price level increases (inflation). Copyright © Houghton Mifflin Company. All rights reserved.

Aggregate Demand and Aggregate Supply Equilibrium

Aggregate Demand and Supply Equilibrium

Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved.

Economic Insight: OPEC and Aggregate Supply