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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. ECON 111 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 ECON 111 HOFFMAN MACRO HAPPENS ECON 111 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. ECON 111 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 ECON 111 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 ECON 111 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. ECON 111 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. ECON 111 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. ECON 111 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. ECON 111 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) ECON 111 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) ECON 111 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 ECON 111 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”. ECON 111 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. ECON 111 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. ECON 111 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 ECON 111 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) ECON 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) ECON 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) ECON 111 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. ECON 111 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) ECON 111 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) ECON 111 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) ECON 111 HOFFMAN MACRO HAPPENS Aggregate Supply Changes in Aggregate Supply Occurs when influences on production other than the price level change ECON 111 HOFFMAN MACRO HAPPENS 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 ECON 111 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) ECON 111 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) ECON 111 HOFFMAN MACRO HAPPENS Aggregate Supply Changes in the money wage rate changes short-run aggregate supply but does not change long-run aggregate supply. ECON 111 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) ECON 111 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) ECON 111 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 ECON 111 HOFFMAN MACRO HAPPENS ECON 111 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 ECON 111 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) 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) 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) ECON 111 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. ECON 111 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. ECON 111 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. ECON 111 HOFFMAN MACRO HAPPENS Aggregate Demand Changes in Aggregate Demand A change in any factor than influences buying plans other than the price level ECON 111 HOFFMAN MACRO HAPPENS ECON 111 HOFFMAN 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. ECON 111 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. ECON 111 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. ECON 111 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. ECON 111 HOFFMAN MACRO HAPPENS Aggregate Demand The World Economy The exchange rate and foreign income affect aggregate demand. ECON 111 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 111 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) ECON 111 HOFFMAN MACRO HAPPENS Changes in Aggregate Demand ECON 111 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 ECON 111 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 111 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) ECON 111 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 111 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 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 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) 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 111 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. ECON 111 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. ECON 111 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. ECON 111 HOFFMAN MACRO HAPPENS Macroeconomic Equilibrium Long-Run Equilibrium Occurs when real GDP equals potential GDP. ECON 111 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. ECON 111 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) ECON 111 HOFFMAN MACRO HAPPENS Real GDP (trillions of 1992 dollars) The Business Cycle Fluctuations in real GDP 7.2 7.0 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 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