Download Lecture 13_14

13_14:Aggregate Supply
and
Aggregate Demand
 What is the purpose of the aggregate
supply-aggregate demand model?
 What determines aggregate supply
and aggregate demand?
 This discussion follows nicely from
the tutorial EIA
 I have included many extra slides to
minimize the notes you will have to
take.
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HOFFMAN
MACRO HAPPENS
The Aggregate SupplyAggregate 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
 next slide is a copy taken from lecture 8
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HOFFMAN
MACRO HAPPENS
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HOFFMAN
MACRO HAPPENS
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
ECON
supplied and the price level.
111
HOFFMAN
MACRO HAPPENS
Aggregate Supply
 The aggregate production function
shows that the quantity of real GDP
supplied is determined by the
quantities of labor and capital and
the state of technology.
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HOFFMAN
MACRO HAPPENS
Aggregate Supply
 Capital and technology are fixed at
any point in time.
 However, labor is not fixed.
 Lower wages result in a greater quantity
of labor demanded
 Higher wages result in a greater
quantity of labor supplied
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HOFFMAN
MACRO HAPPENS
Aggregate Supply
 Full Employment
 Occurs at the wage rate that makes the
quantity of labor demanded equal to the
quantity of labor supplied
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HOFFMAN
MACRO HAPPENS
Aggregate Supply
 Natural Rate of Unemployment
 The unemployment rate that exists at
full employment
 In 1997 it was about 5.5%
 It is probably much lower (e.g. 4%)
today.
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HOFFMAN
MACRO HAPPENS
Aggregate Supply
 Potential GDP is the quantity of real
GDP supplied when unemployment
is at its natural rate and there is full
employment.
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HOFFMAN
MACRO HAPPENS
Aggregate Supply
 Long-Run Aggregate Supply
 The macroeconomic long run is a time
frame that is sufficiently long for forces
that move real GDP toward potential
GDP to have done their work so that full
employment prevails.
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HOFFMAN
MACRO HAPPENS
Aggregate Supply
 Long-Run Aggregate Supply
 The long-run aggregate supply curve 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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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Long-Run Aggregate Supply
140
130
120
110
100
90
6.0 6.5 7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Long-Run Aggregate Supply
LAS
140
130
120
110
100
90
Potential
GDP
6.0 6.5 7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
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HOFFMAN
MACRO HAPPENS
Two Time Frames for
Aggregate Supply
 We distinguish two time frames for
aggregate supply:
 Long-run aggregate supply
 Short-run aggregate supply
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HOFFMAN
MACRO HAPPENS
Aggregate Supply
 Long-Run Aggregate Supply
 Potential GDP is independent of the
price level because the price level, wage
rate, and other resource prices all
change by the same percentage in the
“long-run”.
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HOFFMAN
MACRO HAPPENS
Aggregate Supply
 Short-Run Aggregate Supply
 The macroeconomic short run is a
period during which real GDP has fallen
below or risen above potential GDP.
 The unemployment rate has risen above
or fallen below the natural rate.
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HOFFMAN
MACRO HAPPENS
Aggregate Supply
 Short-Run Aggregate Supply
 The short-run aggregate supply curve is
the relationship between the quantity of
real GDP supplied and the price level in
the short run when the money wage
rate, other resource prices, and
potential GDP remain constant.
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HOFFMAN
MACRO HAPPENS
Short-Run Aggregate
Supply
a
b
c
d
e
Price Level
Real GDP
(GDP deflator)
(trillions of 1992 dollars)
100
105
110
115
120
6.0
6.5
7.0
7.5
8.0
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Short-Run Aggregate
Supply
LAS
140
130
120
110
100
90
6.0 6.5 7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
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111
HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Short-Run Aggregate
Supply
LAS
140
130
SAS
120
e
d
110
100
c
a
b
90
6.0 6.5 7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
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111
HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Short-Run Aggregate
Supply
LAS
140
130
SAS
120
e
d
110
100
90
c
a
b
Real GDP below
potential GDP
Real GDP above
potential GDP
6.0 6.5 7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
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HOFFMAN
MACRO HAPPENS
Aggregate Supply
 Movements Along the LAS and SAS
Curves
 When the price level rises, holding the
money wage rate and other resource
prices constant, the quantity of real
GDP supplied increases and there is a
movement along the SAS curve.
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Movements Along The
Aggregate Supply Curves
LAS
140
130
SAS
120
110
100
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Movements Along The
Aggregate Supply Curves
LAS
140
130
SAS
120
110
100
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Movements Along The
Aggregate Supply Curves
LAS
140
Price level rises and
money wage rate rises
by the same percentage
130
SAS
120
110
Price level rises and
money wage rate is
unchanged
100
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
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HOFFMAN
MACRO HAPPENS
Aggregate Supply
 Changes in Aggregate Supply
 Occurs when influences on production
other than the price level change
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Aggregate Supply
 Potential GDP changes as a result of:
1) Changes in the full-employment
quantity
of labor
2) Changes in the quantity of capital
3) Advances in technology
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
A Change in Potential GDP
LAS
140
130
SAS0
120
110
100
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
A Change in Potential GDP
LAS0
LAS1
140
130
Increase in
potential GDP
SAS0
120
SAS1
110
100
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
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HOFFMAN
MACRO HAPPENS
Aggregate Supply
 Changes in the money wage rate
changes short-run aggregate supply
but does not change long-run
aggregate supply.
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
A Change in the Money Wage
Rate
LAS
140
130
SAS0
120
110
a
100
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
A Change in the Money Wage
Rate
LAS
140
SAS2
130
SAS0
120
b
110
a
100
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
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HOFFMAN
MACRO HAPPENS
Aggregate Demand
 The quantity of real GDP demanded
is the sum of the real consumption
expenditure (C), investment (I),
government purchases (G), and
exports (X) minus imports (M).
Y=C+I+G+X–M
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HOFFMAN
MACRO HAPPENS
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HOFFMAN
Aggregate Demand
MACRO HAPPENS
 Aggregate demand is the
relationship between the quantity of
real GDP demanded and the general
price level.
 Important: The aggregate demand
schedule is not a relationship based
upon the relative prices of goods
such as apples and pears.
Aggregate Demand
a'
b'
c'
d'
e'
Price Level
Real GDP
(GDP deflator)
(trillions of 1992 dollars)
90
100
110
120
130
8.0
7.5
7.0
6.5
6.0
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Aggregate Demand
140
130
120
110
100
90
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Aggregate Demand
140
e'
130
120
110
100
90
d'
c'
b'
e'
AD
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
ECON
111
HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Aggregate Demand
140
e'
130
120
110
100
90
d'
c'
b'
e'
AD
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
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HOFFMAN
MACRO HAPPENS
Aggregate Demand
 The two reasons the demand curve
sloped downward are:
1) Wealth effect
• Changes in the price level, with other things
remaining the same, change real wealth.
• People try to restore wealth by increasing saving and
decreasing consumption.
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HOFFMAN
MACRO HAPPENS
Aggregate Demand
 The two reasons the demand curve
sloped downward are:
2) Substitution effects
• People substitute future consumption for present
consumption as a result of higher interest rates.
• A change in prices cause consumers to spend less on
domestic items and more on imported items.
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HOFFMAN
MACRO HAPPENS
Aggregate Demand
 Changes in the Quantity of Real GDP
Demanded
 When the price level changes, other
things remaining the same, the quantity
of real GDP demanded changes and
there is movement along the aggregate
demand curve.
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HOFFMAN
MACRO HAPPENS
Aggregate Demand
 Changes in Aggregate Demand
 A change in any factor than influences
buying plans other than the price level
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MACRO HAPPENS
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Aggregate Demand
MACRO HAPPENS
 The factors that influence buying
plans other than the price level and
bring a change in aggregate demand
are:
1) Expectations
2) Fiscal policy and monetary policy
3) The world economy
Aggregate Demand
 Expectations
 Expectations about future incomes,
inflation and profits influence buying
plans today.
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HOFFMAN
MACRO HAPPENS
Aggregate Demand
 Fiscal Policy and Monetary Policy
 Fiscal policy is the government’s
attempt to influence the economy by
setting and changing taxes, transfer
payments, and government purchases.
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HOFFMAN
MACRO HAPPENS
Aggregate Demand
 Fiscal Policy and Monetary Policy
 These influence a household’s
disposable income.
• Disposable income equals aggregate income minus
taxes plus transfer payments.
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HOFFMAN
MACRO HAPPENS
Aggregate Demand
 Fiscal Policy and Monetary Policy
 Monetary policy consists of changes in
interest rates and in the quantity of
money in the economy.
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HOFFMAN
MACRO HAPPENS
Aggregate Demand
 The World Economy
 The exchange rate and foreign income
affect aggregate demand.
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Changes in Aggregate
Demand
140
130
120
110
100
90
AD0
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
ECON
111
HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Changes in Aggregate
Demand
140
130
120
Increase in
aggregate
demand
110
100
AD1
90
AD0
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
ECON
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Changes in Aggregate
Demand
140
Increase in
aggregate
demand
130
120
110
100
90
Decrease in
aggregate
demand
AD1
AD2
AD0
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
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HOFFMAN
MACRO HAPPENS
Changes in Aggregate
Demand
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Aggregate demand
Decreases if:
Increases if:
 Expected future
incomes, inflation, or
profits decrease
 Expected future
incomes, inflation, or
profits increase
 Fiscal policy decreases
government purchases,
increases taxes, or
decreases transfer
payments
 Fiscal policy increases
government
purchases, decreases
taxes, or increases
transfer payments
HOFFMAN
MACRO HAPPENS
Changes in Aggregate
Demand
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Aggregate demand
Decreases if:
Increases if:
 Monetary policy
decreases the
quantity of money
and increases
interest rates
 Monetary policy
increases the
quantity of money
and decreases
interest rates
 The exchange rate
increases or foreign
income decreases
 The exchange rate
decreases or
foreign income
increases
HOFFMAN
MACRO HAPPENS
Macroeconomic Equilibrium
 Short-Run Macroeconomic
Equilibrium
 Occurs when the quantity of real GDP
demanded equals the quantity of real
GDP supplied
ECON
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Short-Run Equilibrium
140
130
120
110
100
90
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
ECON
111
HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Short-Run Equilibrium
140
130
SAS
120
e
d
110
100
c
a
b
90
AD
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
ECON
111
HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Short-Run Equilibrium
140
e'
130
120
c'
110
100
90
SAS
d'
c
a
b
e
d
b'
e'
AD
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
ECON
111
HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Short-Run Equilibrium
140
Firms cut
production
and prices
e'
130
120
c'
110
100
90
SAS
d'
c
a
b
e
d
b'
e'
AD
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
ECON
111
HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Short-Run Equilibrium
140
Firms cut
production
and prices
e'
130
120
c'
110
100
90
SAS
d'
c
a
b
Firms increase
production
and prices
e
d
b'
e'
AD
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
ECON
111
HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Short-Run Equilibrium
140
e'
130
120
c'
110
100
90
SAS
d'
c
a
b
e
d
b'
Short-run
macroeconomic
equilibrium
e'
AD
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
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HOFFMAN
MACRO HAPPENS
Macroeconomic Equilibrium
 Long-Run Macroeconomic
Equilibrium
 Occurs when real GDP equals potential
GDP, (i.e. the economy is on its long-run
aggregate supply curve)
ECON
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Long-Run Equilibrium
140
130
120
110
100
90
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
ECON
111
HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Long-Run Equilibrium
140
130
SAS
120
110
In the long run,
money wage
adjusts
100
90
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
ECON
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Long-Run Equilibrium
140
130
SAS
120
110
In the long run,
money wage
adjusts
100
90
AD
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
ECON
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
Long-Run Equilibrium
LAS
140
130
SAS
120
110
In the long run,
money wage
adjusts
100
90
AD
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
ECON
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HOFFMAN
MACRO HAPPENS
Macroeconomic Equilibrium
 In the long run, the main influence on
aggregate demand is the growth rate
of the quantity of money.
 Real GDP fluctuates around potential
GDP in a business cycle.
 Inflation fluctuates at the same time.
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HOFFMAN
MACRO HAPPENS
Macroeconomic Equilibrium
 Business Cycles
 Occur because aggregate demand and
short-run aggregate supply fluctuate
but the money wage rate does not
adjust quickly enough to keep real GDP
at potential GDP.
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HOFFMAN
MACRO HAPPENS
Macroeconomic Equilibrium
 Below Full-employment Equilibrium
 A macroeconomic equilibrium in which
potential GDP exceeds real GDP
• The difference is called a recessionary gap.
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HOFFMAN
MACRO HAPPENS
Macroeconomic Equilibrium
 Long-Run Equilibrium
 Occurs when real GDP equals potential
GDP.
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HOFFMAN
MACRO HAPPENS
Macroeconomic Equilibrium
 Above Full-employment Equilibrium
 A macroeconomic equilibrium in which
real GDP exceeds potential GDP
• The difference is called a inflationary gap.
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HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
The Business Cycle
LAS
140
130
Recessionary
gap
SAS0
120
110
a
Below full-employment
equilibrium
100
90
AD0
6.8
7.0
7.2
Real GDP (trillions of 1992 dollars)
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HOFFMAN
MACRO HAPPENS
Real GDP (trillions of 1992 dollars)
The Business Cycle
Fluctuations in
real GDP
7.2
7.0
6.8
ECON
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0
1
2
3
4
HOFFMAN
Year MACRO HAPPENS
Real GDP (trillions of 1992 dollars)
The Business Cycle
Fluctuations in
real GDP
7.2
7.0
Potential
GDP
6.8
ECON
111
0
1
2
3
4
HOFFMAN
Year MACRO HAPPENS
Real GDP (trillions of 1992 dollars)
The Business Cycle
Fluctuations in
real GDP
7.2
7.0
Recesssionary
gap
Potential
GDP
Actual
GDP
6.8
a
ECON
111
0
1
2
3
4
HOFFMAN
Year MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
The Business Cycle
LAS
140
Full
employment
130
SAS1
120
110
b
Long-run
equilibrium
100
90
AD1
ECON
111
6.8
7.0
7.2
Real GDP (trillions of 1992 dollars)
HOFFMAN
MACRO HAPPENS
Real GDP (trillions of 1992 dollars)
The Business Cycle
Fluctuations in
real GDP
7.2
7.0
Recesssionary
gap
Potential
GDP
Actual
GDP
6.8
a
ECON
111
0
1
2
3
4
HOFFMAN
Year MACRO HAPPENS
Real GDP (trillions of 1992 dollars)
The Business Cycle
Fluctuations in
real GDP
7.2
7.0
Recesssionary
gap
Full
employment
Potential
GDP
b
Actual
GDP
6.8
a
ECON
111
0
1
2
3
4
HOFFMAN
Year MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
The Business Cycle
LAS
140
130
120
SAS2
Inflationary
gap
c
110
100
Above full-employment
equilibrium
AD2
90
ECON
111
7.0
7.2
Real GDP (trillions of 1992 dollars)
HOFFMAN
MACRO HAPPENS
Real GDP (trillions of 1992 dollars)
The Business Cycle
Fluctuations in
real GDP
7.2
7.0
Recesssionary
gap
Full
employment
Potential
GDP
b
Actual
GDP
6.8
a
ECON
111
0
1
2
3
4
HOFFMAN
Year MACRO HAPPENS
Real GDP (trillions of 1992 dollars)
The Business Cycle
Fluctuations in
real GDP
7.2
7.0
Recesssionary
gap
Full
employment
c
Potential
GDP
b
Inflationary
gap
Actual
GDP
6.8
a
ECON
111
0
1
2
3
4
HOFFMAN
Year MACRO HAPPENS
Macroeconomic Equilibrium
 Fluctuations is Aggregate Demand
 Real GDP sometimes fluctuates as a
result of changes in aggregate demand.
ECON
111
HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
An Increase in Aggregate
Demand
LAS
Short-run
effect
140
130
SAS0
115
110
100
90
AD0
6.0
7.0 7.5
Real GDP (trillions of 1992 dollars)
ECON
111
HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
An Increase in Aggregate
Demand
LAS
Short-run
effect
140
130
SAS0
115
110
100
AD1
90
AD0
6.0
7.0 7.5
Real GDP (trillions of 1992 dollars)
ECON
111
HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
An Increase in Aggregate
Demand
LAS
Long-run
effect
140
130
SAS0
115
100
AD1
90
ECON
111
6.0
7.0 7.5
Real GDP (trillions of 1992 dollars)
HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
An Increase in Aggregate
Demand
LAS
140
SAS1
130
125
Long-run
effect
SAS0
115
100
AD1
90
ECON
111
6.0
7.0 7.5
Real GDP (trillions of 1992 dollars)
HOFFMAN
MACRO HAPPENS
Macroeconomic Equilibrium
 An economy cannot produce in
excess of potential forever.
 Workers begin to demand higher wages
 Eventually, wage rates rise by the
same percentage as the price level.
ECON
111
HOFFMAN
MACRO HAPPENS
Macroeconomic Equilibrium
 Fluctuations in Aggregate Supply
 Fluctuations in short-run aggregate
supply can bring fluctuations in real
GDP around potential GDP.
 A decrease in aggregate supply can
lead to a recession and inflation —
stagflation.
ECON
111
HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
A Decrease in Aggregate Supply
LAS
140
130
120
SAS0
110
100
90
AD0
6.0 6.5 7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
ECON
111
HOFFMAN
MACRO HAPPENS
Price level (GDP deflator, 1992 = 100)
A Decrease in Aggregate Supply
LAS
140
SAS1
130
120
An oil price rise
decreases short-run
aggregate supply
SAS0
110
100
90
AD0
6.0 6.5 7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
ECON
111
HOFFMAN
MACRO HAPPENS
Aggregate Supply and
Aggregate Demand: 1960–
1996
ECON
111
HOFFMAN
MACRO HAPPENS