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Ch. 10: Aggregate Supply and Demand  Derive AS/AD model  Understand cause & consequences of change in AS/AD Short run vs Long run Effects on economic.

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Presentation on theme: "Ch. 10: Aggregate Supply and Demand  Derive AS/AD model  Understand cause & consequences of change in AS/AD Short run vs Long run Effects on economic."— Presentation transcript:

1 Ch. 10: Aggregate Supply and Demand  Derive AS/AD model  Understand cause & consequences of change in AS/AD Short run vs Long run Effects on economic growth, prices, unemployment.  Different schools of thought in macroeconomics

2 Macroeconomic Long Run and Short Run The Macroeconomic LR  a time frame that is sufficiently long for the real wage rate to have adjusted to achieve full employment:  Real GDP = potential GDP.  Unemployment=natural unemployment rate.  Price level determined by quantity of money (equation of exchange)  Inflation rate =money growth rate minus the real GDP growth rate. The Macroeconomic SR  a period during which some prices or wages are sticky so  Real GDP might be below, above, or at potential GDP.  The unemployment rate might be above, below, or at the natural unemployment rate

3 Aggregate Supply  The quantity of real GDP supplied is the total quantity that firms plan to produce during a given period. It depends on  The quantity of the labor employed  The quantity of physical and human capital  State of technology  Two time frames associated with different states of the labor market:  Long-run aggregate supply  Short-run aggregate supply

4 Aggregate Supply Long-Run Aggregate Supply (LAS)  the relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP.  Potential GDP is determined by Production function Labor market Independent of price level  LR aggregate supply curve (LAS) is vertical at potential GDP.

5 Determinants of LAS Labor market Production function LAS Real Wage Real GDP Price Level Labor hours Real GDP

6 Determinants of LAS  Change in labor supply immigration taxes on employees transfers (UI, SS) population growth retirement  Change in labor demand worker productivity (also affects PF) taxes on employer payroll  Shifts in Production Function capital/technology (also affects LD) human capital

7 Graphic analysis of changes in LAS (Change in Labor Supply) Effect on Real wage Employment productivity

8 Graphic analysis of changes in LAS (change in Labor Demand) Effect on Real wage Employment Productivity

9 Graphic analysis of changes in LAS (Change in Production Function) Effect on Real wage Employment productivity

10 Aggregate Supply Short-Run Aggregate Supply (SAS)  the relationship between real GDP supplied and the price level when the money wage rate, the prices of other resources, and potential GDP remain constant.  A rise in the price level with no change in the money wage rate and other factor prices increases the quantity of real GDP supplied. as P rises, real wage declines, firms want to hire more employees (movement along labor demand curve)  The short-run aggregate supply curve (SAS) is upward sloping.

11 Short Run Aggregate Supply Labor market Production function SAS As P rises, RW falls, L rises; RGDP rises

12 Aggregate Supply Along the SAS curve, real GDP supplied might be above potential GDP… or below potential GDP.

13 Aggregate Supply A rise in the money wage rate  Decreases short-run aggregate supply and shifts the SAS curve leftward.  Has no effect on long- run aggregate supply.

14 Aggregate Demand  AD is the total amount of final goods and services produced in the United States that people, businesses, governments, and foreigners plan to buy.  AD= C + I + G + (X – M.)  AD depends on  The price level  Expectations about future  Changes in wealth  Fiscal policy and monetary policy  The world economy

15 Aggregate Demand The Aggregate Demand Curve  plots the quantity of real GDP demanded against P.  slopes downward for 2 reasons:  Wealth effect  Substitution effects

16 Aggregate Demand  Wealth Effect P increases  real wealth decr  C decr  AD decr  Substitution Effects Intertemporal P incr  int rate incr  C & I decr  AD decr International P incr  imports incr, exports decr  AD decr

17 Shifts in Aggregate Demand Expectations about future Increases in expected future income  increases C today  increases AD. Increase in expected future inflation  buying goods cheaper today  increases AD. Increase in expected future profits  investment increases  increases AD

18 Shifts in Aggregate Demand Fiscal Policy  setting and changing taxes, transfer payments, and purchasing goods and services.  An income tax cut or increase in transfers  increases disposable income (income-taxes+ transfers)  increases C  increases AD  An increase in government spending  increases G  increases AD

19 Shifts in Aggregate Demand Monetary policy  changes in interest rates and the quantity of money in the economy.  An increase in the money supply reduces interest rates and increases aggregate demand.

20 Shifts in Aggregate Demand Summary: Fiscal policy Monetary policy Value of $ Foreign income

21 Macroeconomic Equilibrium SR Equilibrium: SAS=AD GDP can be above, below, or at potential GDP LR equilibrium LAS=SAS=AD

22 Macroeconomic Equilibrium Graphical illustration of SR equilibria with 1.GDP>potential GDP (inflationary gap) 2. GDP<potential GDP (recessionary gap) 3. GDP=potential GDP (LR equilibrium)

23 Transition from GDP>potential GDP to LR equilibrium (inflationary gap) Initially: empl > equil. Empl unempl < natural rate R-wage < equil. R-wage upward pressure on R-waqes SAS shifts left until GDP=potential GDP As economy moves to LR Equilibrium: Employmentfalls, Unemployment rises, Real wage rises, Real GDP falls

24 Transition from GDP<potential GDP to LR equilibrium (recessionary gap) Initially: empl < equil. Empl unempl > natural rate R-wage > equil. R-wage downward pressure on R-waqes SAS shifts left until GDP=potential GDP As economy moves to LR Equilibrium: Employment risesUnemployment falls Real wage fallsReal GDP rises

25 SR/LR effect of changes in AD Effect of Increase in AD on real wage, prices, real GDP unemployment and employment.

26 Macroeconomic Schools of Thought  Three broad schools of thought:  Classical  believes the economy is self-regulating and always at full employment.  Keynesian  Due to sticky wages/prices, the economy would rarely operate at full employment and that to achieve and maintain full employment, active help from fiscal policy and monetary policy is required  Monetarist  economy is self-regulating and that it will normally operate at full employment, provided that monetary policy is not erratic and that the pace of money growth is kept steady


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