124 Aggregate Supply and Aggregate Demand

125  What is the purpose of the aggregate supply-aggregate demand model?  What determines aggregate supply and aggregate demand?  What is the definition of macroeconomic equilibrium?  How do these concepts interact to cause business cycles?

126 The Aggregate Supply- Aggregate Demand Model  The purpose of this model is:  to help understand and predict fluctuations of real GDP around potential GDP  to understand and predict fluctuations in the price level

127 Aggregate Supply  The aggregate quantity of goods and services supplied is the sum of the quantities of final goods and services produced by all firms in the economy (real GDP).  Aggregate supply is the relationship between the quantity of real GDP supplied and the price level.

128 Two Time Frames for Aggregate Supply  We distinguish two time frames for aggregate supply:  Long-run aggregate supply  Short-run aggregate supply

129 Long-Run Aggregate Supply  The macroeconomic long run is a time frame that is long enough so external shocks have run their course.  The long-run aggregate supply curve (LAS) is the relationship between the quantity of real GDP supplied and the price level in the long run when real GDP equals potential GDP.

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131 Implications of Long-Run Aggregate Supply  In the long run, potential GDP is independent of the price level.  A 10 percent increase in the average price level will be matched by a 10 percent increase in wage rates and other factor prices.  Relative prices and the real wage rate will remain constant.

132 Short-Run Aggregate Supply  The macroeconomic short run is a period during which:  real GDP has fallen below potential GDP (and unemployment has risen above the natural rate) or  real GDP has risen above potential GDP (and unemployment has fallen below the natural rate).

133 Short-Run Aggregate Supply Curve  The short-run aggregate supply curve (SAS) is the relationship between the quantity of real GDP supplied and the price level in the short run when all other influences on production plans (such as the money wage rate and raw materials prices) remain constant.

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135 Implications of Short-Run Aggregate Supply  The short run is the normal state of the economy when it is fluctuating around potential GDP.  In the short run, prices of goods and services change freely, but prices of factors of production (including the wage rate) do not change very much.

136 Movements Along LAS and SAS  A rise in the price level accompanied by an equal percentage rise in the money wage rate (and prices of other factors of production) brings a movement along the LAS curve.  A rise in the price level with no change in factor prices brings a movement along the SAS curve.

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138 Changes in Aggregate Supply  A change in the price level, other things remaining the same, causes a movement along the aggregate supply curve.  Aggregate supply changes when any influence on production plans (other than price) changes.

139 Changes in Long-Run Aggregate Supply  Long-run aggregate supply changes when potential GDP changes.  Potential GDP changes for three reasons:  Growth in the full-employment quantity of labor  Growth in the quantity of capital  Advances in technology

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141 Changes in Short-Run Aggregate Supply  All the factors that influence long-run aggregate supply also influence short-run aggregate supply.  If potential GDP increases, both long- run and short-run aggregate supply increase because the level of full- employment output has increased.

142 Influences on Short-Run Aggregate Supply  The only influences on short-run aggregate supply that do not affect long-run aggregate supply are:  the money wage rate  prices of other factors of production  Both these factor prices affect short- run aggregate supply via their influence on production costs.

143 Changes in Factor Prices  An increase in factor prices decreases short-run aggregate supply.  The SAS curve shifts up and to the left.  A decrease in factor prices increases short-run aggregate supply.  The SAS curve shifts down and to the right.

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145 Aggregate Demand  The aggregate quantity of goods and services demanded is the sum of:  planned consumption spending by households  planned investment spending by firms  planned government spending  planned net exports

146 The Aggregate Demand Curve  Aggregate demand is the entire relationship between the quantity of real GDP demanded and the price level (the GDP deflator).  An increase in the average price level, holding everything else constant, reduces the quantity of real GDP demanded.

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148 Why the Aggregate Demand Curve Slopes Downward  Ordinary market demand curves slope downward because of income and substitution effects.  The aggregate demand curve slopes downward for similar reasons:  Wealth effect  Substitution effect

149 The Wealth Effect  Wealth is the assets of society.  If the price level rises, the real value of wealth decreases.  If the price level falls, the real value of wealth increases.

150 Th Wealth Effect and Aggregate Demand  A rise in the price level reduces the real value of wealth, causing a movement up and to the left on an AD curve.  A fall in the price level increases the real value of wealth, causing a movement down and to the right on an AD curve.

151 The Substitution Effect  The substitution effect is the change in the quantity of real GDP demanded resulting from a change in the price level (opportunity cost) of goods.  There are two components ot the substitution effect.  The intertemporal substitution effect  The international substitution effect

152 The Interest Rate and Intertemporal Substitution  The higher the interest rate, the greater is the opportunity of spending today versus saving (so you can spend more tomorrow).  The higher the price level, other things remaining the same, the higher is the interest rate.

153 The Price Level and the Interest Rate  An increase in the price level reduces the quantity of real money in circulation.  People will try to maintain their standard of living by saving less and spending more.  This reduces the supply of loanable funds, driving up the interest rate.

154 International Substitution Effect  The international substitution effect is the change in the quantity of real GDP demanded resulting from a change in the opportunity cost of domestic goods in terms of foreign goods.

155 International Substitution and the Price Level  The higher the price level in the United States, other things remaining the same, the higher the prices of U.S. made goods relative to foreign made goods.  This means a higher price level will reduce the quantity of real GDP demanded.

156 The Aggregate Demand Curve Slopes Downward  Each of the two ways the price level influences the quantity of real GDP demanded causes the aggregate demand to fall as the price level rises.  Therefore the aggregate demand curve slopes downward.

157 Changes in the Quantity of Real GDP Demanded  When the price level changes (and causes the interest rate to change), there is a change in the quantity of real GDP demanded.

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159 Changes in Aggregate Demand  There are four main factors that cause the aggregate demand curve to shift:  Expectations  International factors  Fiscal policy  Monetary policy

160 Expectations  Expectations about future economic conditions play a crucial role in determining household and business spending decisions.  Three important expectations are:  future incomes  future inflation  future profits

161 Expected Future Incomes  An increase in expected future income, other things remaining the same, increases the amount households plan to spend, increasing aggregate demand.  When households expect declining future income, they will cut back on current spending, decreasing aggregate demand.

162 Expected Inflation  An increase in the expected inflation rate, other things remaining the same, leads to an increase in aggregate demand.  When people expect prices to rise faster in the future, they try to buy more at today’s lower prices.

163 Expected Future Profits  If firms expect future profits to be higher, they will spend more on investment today so they will have the plant and equipment ready to produce those profitable goods in the future.

164 International Factors  The two main international factors that influence aggregate demand are:  the foreign exchange rate  foreign income

165 The Foreign Exchange Rate  The foreign exchange rate is the amount of foreign currency that you can buy with one U.S. dollar.  The foreign exchange rate affects the prices that foreigners pay for goods and services produced in the U.S., as well as the prices we have to pay for foreign-produced goods.

166 Foreign Income  An increase in foreign income increases demand for all goods and services, including goods made in the U.S. (our exports, their imports).  Rapid economic growth in Japan and Western Europe in the 80’s have increased demand for U.S. exports.  The recent depressions in Asia have reduced demand for U.S. exports.

167 Fiscal Policy  Fiscal policy is the government’s attempt to influence the economy by setting and changing:  government spending  taxes  the government’s deficit and debt  These decisions are made by Congress in consultation with the President.

168 Government Purchases of Goods and Services  The scale of government purchases of goods and services has a direct impact on aggregate demand.  If taxes are held constant, an increase in government purchases causes aggregate demand to increase.  The budget deficit also increases.

169 Taxes and Transfer Payments  A decrease in taxes causes aggregate demand to increase.  An increase in transfer payments also increases aggregate demand.  Both these changes in fiscal policy increase households’ disposable income.

170 Monetary Policy  Decisions about the money supply and interest rates are made by the Federal Reserve board (the Fed).  The Fed’s attempt to influence the economy by varying the money supply and interest rates is called monetary policy.

171 The Money Supply  The greater the quantity of money in circulation, the greater is the level of aggregate demand.  As people and businesses hold more money, they also will spend more even if their income has not changed.  Increases in the money supply also lower interest rates.

172 Interest Rates  If the Fed increases interest rates, households and firms reduce their borrowing, lending, and spending plans, particularly on durable goods.  Remember, interest rates are the opportunity cost of consumption and investment spending.

173 Shifts of the Aggregate Demand Curve  Changes in expectations, international factors, fiscal policy, or monetary policy cause the aggregate demand curve to shift.  An increase in aggregate demand causes the AD curve to shift right.  A decrease in aggregate demand causes the AD curve to shift left.

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175 Macroeconomic Equilibrium  Macroeconomic equilibrium is determined by the intersection of the aggregate supply and aggregate demand curves.  There is an equilibrium for each of the time frames: long run and short run.  Let’s look at the short run first.

176 Determination of Real GDP and the Price Level  Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the short-run quantity of real GDP supplied.  This is where the AD and SAS curves intersect.

177 Short-Run Macroeconomic Excess Supply of Goods  If the price level is above equilibrium, short-run aggregate supply (production) will exceed aggregate demand (spending).  This will cause unwanted inventories to pile up.  Firms will reduce production and cut prices.

178 Short-Run Macroeconomic Excess Demand for Goods  If the price level is below equilibrium, aggregate demand (spending) will exceed short-run aggregate supply (production).  This will cause unwanted inventory decreases.  Firms will increase production and raise prices.

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180 Short-Run and Long-Run Macroeconomic Equilibrium  Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP and there is full employment.  This implies the economy is on its long-run aggregate supply curve.  Short-run equilibrium can occur at a real GDP other than potential GDP.

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182 Equilibrium Below Full Employment  A below full-employment equilibrium is a short-run equilibrium in which potential GDP exceeds real GDP.  This difference between potential and actual GDP is called a recessionary gap.

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184 Equilibrium Above Full Employment  An above full-employment equilibrium is a short-run equilibrium in which real GDP exceeds potential GDP.  This difference between real and potential GDP is called an inflationary gap.

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186 Long-Term Growth and Inflation  Long-term economic growth occurs when the long-run aggregate supply curve shifts to the right.  Inflation occurs when aggregate demand increases at a faster rate than long-run aggregate supply.

187 Fluctuations in Aggregate Demand  Suppose the economy is at a full- employment equilibrium.  Foreign demand for U.S. goods (exports) increases, causing U.S. aggregate demand to increase.  Real GDP and the price level will increase in the short run.

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189 The Return to Long-Run Equilibrium  The short-run equilibrium is above full employment.  Prices and output have increased, but wage rates have not.  In the long run, wage rates will increase because demand for labor exceeds labor supply.  The SAS curve shifts.

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191 The New Long-Run Equilibrium  In the long run, the economy will produce its potential output (full- employment real GDP).  However, the price level will be higher, reflecting the higher level of aggregate demand and shift of the SAS curve.

192 Fluctuations in Aggregate Supply  Fluctuations in short-run aggregate supply can also cause fluctuations in real GDP.  Beginning at full employment equilibrium, suppose there is a large increase in the world price of oil.  This causes a decrease in short-run aggregate supply.

193 A Decrease in Short-Run Aggregate Supply  When short-run aggregate supply decreases, the SAS curve shifts up and to the left.  This causes unemployment and inflation, a condition known as stagflation.

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195 Anti-Stagflation Policies  If AD does not change, the price level will eventually fall back to its original level.  If AD is increased via monetary or fiscal policy, unemployment will fall but inflation will rise.  If AD is decreased to fight inflation, unemployment will rise.  There are no perfect policy choices.

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