Download Aggregate Supply, Aggregate Demand, Classical, Keynesian

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
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
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
Price
level
The aggregate price level
Is measured by either GDP
Deflator or CPI
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
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
1)
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
dollarRelates 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)
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 PL will change
amount of aggregate
spending which changes
amount of real GDP
A
PL
B
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)
PL
GDP
PL is made up of CPI or GDP deflator
GDP
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)
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).
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).
Aggregate Supply
Short 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
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.
Real
Rate
Of
Interest
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
Price level
P
LRASLR
Long-run
Aggregate
Supply
Full-Employment
Qf
Real domestic output, GDP
Q
Unanticipated Increase
in Aggregate Demand
Price
level
LRAS
SRAS1
Short-run effects of an
unanticipated increase in AD
P105
P100
AD1
YF Y2

AD2
Goods & Services
(real GDP)
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
LRAS2
Price
level
LRAS1
SRAS1
SRAS2
P1
P2
AD
YFF1


Goods & Services
(real GDP)
YF2
YF2
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
Price
LRAS
level
SRAS2 (Pr2)
SRAS1 (Pr1)
P110
P100
B
A
AD
YF


Goods & Services
(real GDP)
Y2
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.
INCREASES IN AD:
DEMAND-PULL INFLATION
Price Level
P
AD1
AD2
AS
P2
P1
Qf
Q 1 Q2
Real Domestic Output, GDP
Q
DECREASES IN AS:
COST-PUSH INFLATION
AS2
Price Level
P
P2
P1
AS1
b
a
AD1
Q1 Qf
Real Domestic Output, GDP
Q
Long run growth
Capital
goods
PPC shifts out and
LRAS shifts right.
P
AD2
AD1
P1
P2 AS1
LRAS1 LRAS2
x
AS2
Consumer
goods
Yf1
Yf2 Y
 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