Download CHAPTER 10- Real GDP and PL in Long Run

CHAPTER 9
Aggregate Supply and
Aggregate Demand
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)
Output Growth and the Long-Run
Aggregate Supply Curve (cont'd)

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
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
Vertical and Horizontal Axis
Horizontal axis = GDP
Veritcal axis = GDP deflator (includes C+I+G)
or CPI…. Government uses the deflator so it
get a lower number.
A broader measure of price level… includes airplanes, dentist
Visits, pizzas, new shopping centers, etc.
Figure 10-4 The Aggregate
Demand Curve
As the price
level rises, real
GDP declines
ASSUMPTION for Aggregate demand IS:
If Price level is decreasing, so are
incomes.
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)
Price level falls- causes purchasing
power to rise… translates into more
money to spend or monetary wealth
improves.
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 –
because households and businesses
adjust to interest rates for those
interest-sensitive purchases.
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.
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).

Equivalent to a reduction in the amount of real goods
and services purchased in the U.S.
When Demand for exports decreases, this is an
unfavorable balance of trade (imports
exceed exports)
Macro AD vs Micro D
Aggregate Demand versus Demand for a
Single Good
When the aggregate demand curve is
derived, we are looking at the entire
circular flow of income and product.
When a market demand curve is derived,
we are looking at a single product in one
market only.
Change in QAD and Change in AD
What is the difference?
PL
PL
A
B
AD 2
AD1
GDP
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)
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).
Figure 10-5 Long-Run
Economywide Equilibrium
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.
Factors That Change Aggregate Demand &
Consumption/Interest Rates
Interest Rate ↑ → C↓ → AD↓
Interest Rate ↓ → C ↑ → AD↑
Factors That Change Aggregate Demand &
Investment/ Interest Rates
Interest rates ↑ → I↓ → AD↓
Interest rates ↓ → I ↑ → AD↑
Factors That Change Aggregate Demand &
Investment/ Business Taxes
Business taxes↓ → I↑ → AD↑
Business taxes↑ → I↓ → AD↓
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 fullemployment capacity (increases to Y2).
Growth in Aggregate
Supply
LRAS2
Price
level
LRAS1
SRAS1
SRAS2
P1
P2
YFF1


AD
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
Y
2.
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