Aggregate Supply, Aggregate Demand, Classical, Keynesian Condensed version of 4 chapters.

GDP 2007 to 2010

OK… One more time….. Component parts of GDP? C + I + G + (X-M) = GDP Long-Run Aggregate Supply Curve (LRAS) A vertical line representing the real output of goods and services after full adjustment has occurred It represents the real GDP of the economy under conditions of full employment; the economy is on its production possibilities curve

The Production Possibilities and the Economy’s Long-Run Aggregate Supply Curve 5

Output Growth and the Long-Run Aggregate Supply Curve (cont'd) LRAS is vertical Input prices fully adjust to changes in output prices Suppliers have no incentive to increase output Unemployment is at the natural rate Determined by endowments and technology (or existing resources) Growth is shown by outward shifts of either the production possibilities curve or the LRAS curve caused by Growth of population and the labor-force participation rate Capital accumulation Improvements in technology 10 6

What is AD and why slope downward? AD = C + I + G + (X-M)

Think: Why does AD slope downward? Vertical axis represents Price level for ALL final goods And services The aggregate price level Is measured by either GDP Deflator or CPI Price level The horizontal axis represents the real quantity of all G&S purchased as measured by the level of REAL GDP AD Real domestic output, GDP

Figure 10-4 The Aggregate Demand Curve As the price level rises, real GDP declines 9

There are 3 Reasons that cause the Aggregate Demand Curve to be downward sloping. Real Balance Effect (Wealth effect) Interest Rate Effect International Trade Effect

Real Balance Effect Wealth effect= as price level falls, the real wealth people hold increases and they can consumer more. 2) Real Balance Effect (or wealth effect) – Higher price level means less consumption spending.

Real Balance Effect The change in the purchasing power of dollar- Relates to assets that result from a change in the price level

Interest Rate Effect Inverse relationship between price level and quantity demanded of GDP – . Price level falls (bundle of goods costs less) rest of money into savings, more money available for borrowing interest rate down. Think of money as stationary… demand drives up price of money.

Factors That Change Aggregate Demand & Consumption/Interest Rates Interest Rate ↑ → C↓ → AD↓ Interest Rate ↓ → C ↑ → AD↑

Interest Rate continued Now if bundle of goods increases… want to purchase interest sensitive good, cost to borrow is up. An increase in money demand will drive up the price paid for its use … use of money = interest rate As price level rises, houses and firms require more money to handle transactions…

International Trade Effect (Open Economy Effect) FYI: An open economy is global, a closed economy is domestic. The Open Economy Effect Higher price levels result in foreigners’ desiring to buy fewer American- made goods while Americans desire more foreign-made goods (i.e., net exports fall). Decrease in price level leads domestic goods to be cheaper- Means foreigners want to purchase more and exports increase. When Demand for exports decreases, this is an unfavorable balance of trade (imports exceed exports) 25 16

Reminder about PL Definition below: Price level is the weighted average of the prices of al final goods and services produced in an economy. PL is measured by CPI (most common) GDP deflator (govt prefers because it yields a lower figure) Price Level Stability = steadiness of the PL from one period to the next. (low annual rate of inflation = price stability Can take your $20 dollars and know what you can buy.

Changes in AD Change in one of determinants of AD (C+I+G+X-M) which directly affects real GDP. (consumption GDP Change in any of the component parts of AD (C + I + G + Net Exports) GDP Change in PL will change amount of aggregate spending which changes amount of real GDP PL A B PL GDP PL is made up of CPI or GDP deflator

Difference between Quantity of AD and Change of AD QAD = movement up or down as result of price level changing (ONLY) Change in AD = Change in any of the component parts of AD (C + I + G + Net Exports)

Change in Consumer Spending DETERMINANTS OF AGGREGATE DEMAND Change in Consumer Spending Consumer Wealth Consumer Expectations (expect higher prices) Interest rate (interest sensitive durables) Taxes

Changes in Investment Spending Real Interest Rates (rates high- not much I taking place) Expected Future Sales (health of economy- confidence is big) Business Taxes (higher taxes less profit)

Factors That Change Aggregate Demand & Investment/ Business Taxes Business taxes↓ → I↑ → AD↑ Business taxes↑ → I↓ → AD↓

Government Spending This will be discussed further, but anytime government spends, it has an affect on GDP. Infrastructure – Health Care Supplies for military Education Etc.

Net Export Spending National Income Abroad-(when foreign nations do well, their incomes are higher- can buy more U.S. goods and services. – U.S. exports rise) Exchange Rates- Price of one nation’s currency in terms of another. Dollar vs Euro Our currency appreciates if it takes more foreign $ to buy it.. (depreciates if it takes more of ours to buy theirs.) $1.00 to $1.25 Euro. Depreciation of nation’s currency makes foreign goods more expensive (but attracts foreigners to buy our goods.) Our exports rise. *this is why the Fed has not worried about our low dollar valuation.

Long-Run Equilibrium and the Price Level For the economy as a whole, long-run equilibrium occurs at the price level where the aggregate demand curve (AD) crosses the long-run aggregate supply curve (LRAS). 37 25

Long-Run Equilibrium and the Price Level For the economy as a whole, long-run equilibrium occurs at the price level where the aggregate demand curve (AD) crosses the long-run aggregate supply curve (LRAS). 37 26

Aggregate Supply Short Run Long Run In short run input prices and output prices are fixed (referred to as immediate SR) Regular SR = SRAS – input prices fixed but output can vary. * Example: wages/contracts fixed and little adjustment can occur until either laid off or contract renewal. Long run supply curve is vertical. Full employment and capacity has been reached *wages and prices are flexible and the profit level will adjust to give firms the right profit level and firm has no incentive to produce beyond Qf.

SRAS Period where adjustment occurs.

AD and SRAS

LRAS = long-run aggregate supply (a period when nominal wages and other resource prices respond to price-level changes) LRAS is a vertical line reflecting that LR Aggregate Supply is not affected by changes in PL. The LRAS is labeled as the natural level of real GDP The natural level of real GDP is defined as the level of real GDP that arises when the economy is fully employing all of its available input resources ( We are in agreement that it hovers around 5%)

Equilibrium States of the Economy During the time an economy moves from one equilibrium to another, it is said to be in disequilibrium.

Can a Change in Money Supply Change AD? Real Rate Of Interest D2 D1 Money Supply Can a Change in Money Supply Change AD? Probably… but it is a chain of events. MS changes, then Interest Rates, then chance in consumption and investment. Then Change in AD

Long Run Aggregate Supply LRASLR Price level Long-run Aggregate Supply Full-Employment Qf Q Real domestic output, GDP

Unanticipated Increase in Aggregate Demand LRAS Goods & Services (real GDP) Price level P 100 Y F SRAS1 AD1 AD2 Short-run effects of an unanticipated increase in AD P 105 Y 2 In response to an unanticipated increase in AD for goods & services (shift from AD1 to AD2), prices will rise to P105 and output will temporarily exceed full-employment capacity (increases to Y2).

Growth in Aggregate Supply F2 LRAS2 LRAS1 Goods & Services (real GDP) Price level Y F AD P 1 SRAS1 F1 SRAS2 P 2 Y F2 Here we illustrate the impact of economic growth due to capital formation or a technological advancement, for example. Both LRAS and SRAS increase (to LRAS2 and SRAS2); the full employment output of the economy expands from YF1 to YF2. A sustainable, higher level of real output and real income is the result. ***If the money supply is held constant, a new long-run equilibrium will emerge at a larger output rate (YF2) and lower price level (P2).

Effects of Adverse Supply Shock LRAS Goods & Services (real GDP) Price level AD Y F P 100 SRAS1 (Pr1) A SRAS2 (Pr2) B P 110 Y 2 The higher resource prices shift the SRAS curve to the left; in the short-run, the price level rises to P110 and output falls to Y2. What happens in the long-run depends on whether the reduction in the supply of resources is temporary or permanent. If temporary, resource prices fall in the future, permitting the economy to return to its original equilibrium (A). If permanent, the productive potential of the economy will shrink (LRAS shifts to the left) and (B) will become the long-run equilibrium.

DEMAND-PULL INFLATION INCREASES IN AD: DEMAND-PULL INFLATION P AD1 AD2 AS P2 Price Level P1 Q Qf Q1 Q2 Real Domestic Output, GDP

DECREASES IN AS: COST-PUSH INFLATION b Price Level a P1 AD1 Q Q1 Qf Real Domestic Output, GDP

Non-governmental actions that shift AS Shift AS left: Raw materials cost rise Wages rise faster than productivity Worker productivity decreases Obsolescence Wars Natural disasters

Fiscal Policy Governmental actions that shift AD Shift AD right: Govt spending increases Taxes decreases Money Supply increases Shift AD left: G decreases T increases MS decreases

KILEY SAYS THAT'S ALL!