Download Aggregate Demand and Aggregate Supply

The models of AD and AS are extremely useful to predict how real GDP, employment and the average price level are affected by external factors and government policy.
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We use real GDP to measure aggregate output and will often use the terms interchangeably. 3
Many assume that the downward slope of the aggregate demand curve is a natural consequence of law of demand.
The demand curve for any individual good shows how the quantity demanded depends on the price of that good, holding the prices of other goods and services constant. This is not the case when we look at the aggregate price level.
The main reason the quantity of a good demanded falls when the price of that good rises
main reason the quantity of a good demanded falls when the price of that good rises—
that is, the quantity of a good demanded falls as we move up the demand curve—is that people switch their consumption to other goods and services that have become relatively less expensive. (Ex. If the price of apples goes up, consumers will switch to a substitute fruit like bananas. Just because consumers choose to buy fewer apples and more bananas doesn’t necessarily change the total quantity of final goods and services they demand.)
Let’s recall the basic equation that represents GDP. Demand in the macroeconomy comes from four general sources and if we measure all of these variables in constant dollars (prices of a base year), then they represent the quantity of domestically produced final goods and services demanded during a given period. G is decided by the government, but the other variables are private‐sector decisions. To understand why the aggregate demand slopes downward we need to understand why a rise in the aggregate price level reduces C, I, and X‐IM.
I, and X
IM. The are three main reasons: the wealth effect, interest rate effect and net The are three main reasons: the wealth effect, interest rate effect and net
export effect.
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Wealth or real balances Effect: When the price level falls, purchasing power of existing financial assets (like money in your savings account rises, this can increase consumer spending and there is a downward movement along the fixed AD curve.
Ex. Sally has $5,000 in a bank account. If the aggregate price level were to rise by 25% that $5,000 would buy only as much as $4,000 would have bought previously. With the loss in purchasing power, Sally will probably scale back her consumption plans. Millions of people would respond the same way leading to a fall in consumption spending resulting in a fall in
would respond the same way, leading to a fall in consumption spending, resulting in a fall in real GDP.
Interest Rate Effect:
A increase in price level means higher interest rates which can decrease levels of certain types of spending. How does this work? A higher price level decreases the purchasing power of money to buy goods and services. This increase in the demand for money holdings puts upward pressure on interest rates. Remember that we learned that nominal interest rate = real interest rate + expected inflation. If inflation expectations gradually rise, nominal interest rates should also gradually rise. Higher interest rates will decrease investment spending, this decreasing real GDP along the AD curve.
Net Export Effect: Foreign goods start to look more appealing when inflation heats up in the US, resulting in a
Foreign goods start to look more appealing when inflation heats up in the US, resulting in a rise in Imports which hurts US real GDP.
Conversely, a lower US price level means prices for goods produced in the US are lower relative to the prices in foreign countries. Thus, people will buy more US‐produced goods and fewer produced goods. This increases net exports, a component of real GDP.
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1. Change in Expectations
When consumers and firms are more optimistic about their future economic prospects, they will increase consumption and investment spending. This shifts AD to the right.
2. Changes in Wealth
We discussed in the last lecture that the consumption function increased if consumer wealth increased. When the value of accumulated household assets goes up, consumers respond by increasing current consumption This is one reason why a weak stock market or
respond by increasing current consumption. This is one reason why a weak stock market or real estate market has a negative ripple effect in the economy by shifting AD to the left. 3. Size of the Existing Stock of physical capital
Firms plan to invest in physical capital when the stock is being depleted or is insufficient to meet demand for their products. If firms have plenty of physical capital already, investment spending will slow down.
Can government spending effect AD? Absolutely. Government can have a powerful influence on aggregate demand and that, in some circumstances, this influence can be used to improve economic performance. The two main ways the government can influence the aggregate demand curve are through fiscal policy and monetary policy.
Fiscal Policy:
Suppose the economy was in a recession. The government can intervene directly or
Suppose the economy was in a recession. The government can intervene directly or indirectly. If the government increases spending (G), it will have a direct impact on AD by shifting AD to the right. If the government decreases taxes, this would increase disposable income, and this would increase consumption spending. The increase in C would shift the AD curve to the right, helping to indirectly reverse the recession. Monetary Policy: When the Fed increases the quantity of money in circulation, households and firms have hi h th
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Economists model economy‐wide consumption of goods and services with something called Aggregate Demand. In the previous slides we saw how the AD curve is downward sloping. This shows that consumption of goods and services (real GDP) declines when the aggregate price level rises. Aggregate Supply shows us the relationship between economy‐wide production and the aggregate price level.
In the short run, there is a positive slope to the SRAS curve.
In the long run, the LRAS curve is vertical at the level of potential GDP.
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Economists believe that in the short run, there is a positive relationship between the aggregate price level and quantity of aggregate output supplied. In other words, the SRAS curve is upward sloping like supply curves studied in earlier. Why? What is the goal of producers? TO EARN A PROFIT! So each producer must ask the same basic question: is producing a unit of output profitable or not?
Suppose that the price of a unit of output increased, but production cost of that unit stayed the same Profit on that unit will rise and so it will be a produced What if the price of
the same. Profit on that unit will rise, and so it will be a produced. What if the price of output increased 5%, while the production cost increased 1%? Profit on that unit will also rise, so it will be produced.
Summary: If the price of a unit of output is rising faster than the cost of producing that unit of output, that unit of output will be produced. This is exactly what economists believe happens in the short run. And this gives us an upward sloping SRAS curve.
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But why does it take a long time to raise input prices? Wages are typically an inflexible production cost because the dollar amount of any given wage paid, called nominal wage, is often determined by contracts that were signed some time ago. Some input prices are “sticky.” This just means that they don’t rise or fall very quickly in response to a change in demand for them. It’s important to note that nominal wages cannot be sticky forever: ultimately, formal contracts and informal agreements will be renegotiated to take into account changed economic circumstances. Let me give you a detailed example about the labor market.
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The SRAS curve is upward sloping, but it can also shift to the right or left.
An increase, or outward shift, in SRAS means that producers are willing to produce more aggregate output at any price level.
A decrease, or leftward shift, in SRAS implies that the quantity of aggregate output supplied falls at any aggregate price level.
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1. Changes in Commodity Prices:
These commodities are production inputs for many final products so higher commodity prices make it more costly for firms economy‐wide to produce. This would shift SRAS to the left. An economy‐wide decrease in commodity prices would shift the SRAS curve to the right.
2. Change in Nominal Wages
A very important input to production is labor and the current price of labor is the nominal
A very important input to production is labor and the current price of labor is the nominal wage. Gradually these nominal wages change due to changes in the labor markets. If the nominal wage were to increase, the SRAS will shift to the left.
3. Suppose workers at a factory are provided with better tools so that they can increase output with the same amount of effort. If this is happening across the economy, the same amount of labor can produce more goods and services and SRAS shifts to the right.
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The reason the SRAS is upward sloping is because nominal wages are sticky. But what if they were not? Or better yet, what if there was enough time for all wages to adjust?
Another example: If the price of output increased by 5% and nominal wages had enough time to increase by 5%, there would be no profit incentive to increase output. All we would experience would be an increase in the level of aggregate price level.
The LRAS curve is vertical But where is it located on the x‐axis?
The LRAS curve is vertical. But where is it located on the x
axis?
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One way to think about long‐run economic growth is that it is the growth in the eocnomy’s
potential output. We generally think of the long run aggregate supply curve as shifting to the right over time as an economy experiences long‐run growth.
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As you can see, the economy normally produces more or less than potential output. Actual aggregate output was below potential output in the early 1990s, above potential output in the late 1990s, and below potential output for most of the 2000s. So the economy is normally on its short‐run aggregate supply curve—but not on its long‐run aggregate supply curve.
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Scenario 1: The economy is booming. Current real GDP Y1 > Yp. So what is expected to happen?
A strong labor market has rising demand for labor. There are very few workers that are unemployed. Employers are scrambling to find scarce employees while jobs are abundant. Eventually nominal wages rise and SRAS shifts to the left until current output is equal to Yp.
Scenario 2: The economy is weak and in a recession. Current real GDP Y1 < Yp. So what is expected to happen?
expected to happen?
A weak labor market has falling demand for labor. Producers are earning low (or negative profits) and producing a low level of output. There are many unemployed workers. Employers find that they can get workers to accept lower wages. Eventually nominal wages fall and SRAS shifts to the right until current output is equal to Yp.
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