Download Chapter 12 Essentials of Economics Paul Gregory 6t Lecture Notes

CHAPTER 12
AGGREGATE SUPPLY AND
AGGREGATE DEMAND
1. Supply and Demand in
Micro and Macro


In micro-economics: the law of demand
provides the foundation for the demand
curve, and the law of diminishing returns
provides the foundation for the supply curve.
In macro-economics: aggregate supply and
demand plays a similar role, but their curve
shapes are based on entirely different
principles.


On the vertical axis – the aggregate price level
On horizontal axis – the total output of the
economy or real GDP
2. Classical and Keynesian
Economics
2.1 Two different views
1.


Classical Economics
Originated in 1900, by classical
economists
Belief: macro-economy has strong selfstabilizing forces that keep it at or near
full employment (no required government
intervention).
2. Classical and Keynesian
Economics
2.1 Two different views – cont.
2.


Keynesian Economics
Originated in the late 1930’s, by John
Maynard Keynes
Belief: macro-economy is inherently
unstable; if left to its own devices, it can
get stuck at high levels of unemployment,
producing a real GDP below potential.
2.2 Classical model




Real GDP was determined by the supply of
resources and their productivity.
David Ricardo, David Hume, and Jean
Baptiste Say believed that economies would
operate at or near full employment.
Say’s law states that whatever aggregate
output is produced will be demanded.
Because the interest rate adjust so that
desired aggregate expenditures equal actual
output.
2.3 Keynesian revolution
Laissez-faire means a hands-off, minimal role
for government in economic affairs.
 The Great Depression of 1930s shook the
belief in the classical model.
 Unemployment rose from 3.2% in 1929 to
24.9% in 1933 and was still 17.2% in 1939.
 Between 1929 and 1933: real investment
dropped by 75% while real consumption fell
by 20%.
2.3 Keynesian revolution
– cont.


The Great Depression caused Keynes to
formulate a new theory of macroeconomics.
He rejected the laissez-faire approach
as too slow and costly, he felt
government intervention is needed to
ensure full employment.
3. Aggregate Supply and
Demand



Aggregate supply and demand are the most
powerful analytical tools of macro-economy.
At the macro level it is the price level and the
economy’s total output that are determined
by the interaction of aggregate supply and
aggregate demand.
Because total output determines the amount
of employment and unemployment,
movements in them (employment) are also
explained by aggregate supply and demand.
3.1 Aggregate Supply and
Demand Defined


The aggregate demand curve shows
the quantities of total output agents are
prepared to buy demand (buy) at
different price levels.
The aggregate supply curve shows
the quantities of total output all firms in
the economy are willing to supply at
different price levels.
3.2 Macro-economic
Equilibrium


Macro-economic equilibrium occurs at that
level at which the aggregate quantity
demanded equals the aggregate quantity
supplied.
If the economy attempted to settle at a
macro-economic equilibrium at a price level
below P, where the aggregate quantity
demanded exceeded aggregate quantity
supplied: the price level would rise, the
quantity demanded would fall, and the
quantity supplied would increase.
3.3 Shifts in Aggregate Supply
and Aggregate Demand



This equilibrium determines the price level and how
much output, and, at the same time, how much
employment and unemployment the economy
produce.
Shifts in aggregate supply and demand curves
determine whether output and employment are
increasing or decreasing; or price level is rising or
falling.
To understand the determinant of inflation and
unemployment, we must understand the
determinants of aggregate supply and aggregate
demand.
4. Aggregate Demand



Aggregate demand schedules reveal how
aggregate demand responds to changes in
the general price level. (Law of demand
applies to individual commodities and not to
aggregate demand)
As the general price level rises, prices and
wages are generally rising.
For a higher price level to elicit a smaller
aggregate quantity demanded, higher prices
must cause economic agents to reduce their
expenditures.
4. Aggregate Demand – cont.
1.
2.
3.
The real balance effect states that at higher
price levels households will purchase less real
consumption because their wealth will purchase
less.
The interest rate effect is higher prices raising
interest rates and thereby discouraging investment.
The foreign trade effect occurs when a rise in
the domestic price level (holding foreign prices and
the exchange rate constant) lowers the aggregate
quantity demanded by pushing down net exports
(X-M)
5. Aggregate Supply



Economists have different views about the
shape of the aggregate supply curve.
The aggregate supply curve shows the
quantities of real output all firms in the
economy are prepared to supply at different
price levels.
The aggregate supply curve considers why
economic agents in the economy might
supply more goods and services at a higher
price level.
5.1 The Classical Aggregate
Supply Curve



The classical aggregate supply curve is vertical
because it assumes no money illusion.
Money illusion could cause economic agents to
think that a change in the price level is actually a
change in real wages or relative prices and so change
their production and employment decisions.
Economic agents may respond to changes in real
wages and relative prices, but for the economy as a
whole, they will recognize that inflation does not
cause real wages and relative prices to rise; therefore
the supply of G&S are not affected by inflation.
5.2 The Keynesian Aggregate
Supply Curve



The aggregate supply curve has a
backward L-shape.
The flat part characterizes an economy
with substantial unemployment that
cannot be removed by lower wages
because wages are not falling.
When full employment is reached , the
supply curve becomes vertical.
5.3 Short-Run Aggregate
Supply



Modern economics use a blend of classical
and Keynesian economics to describe the
behavior of aggregate supply.
In the short run, an increase in the price level
could cause firms to supply more real output.
Multi-year wage contracts reduce the
flexibility of the economy to adjust wages and
prices to changes in business conditions.
5.3 Short-Run Aggregate
Supply – cont.



Short-run aggregate supply (SRAS) is the
schedule of the real GDP’s that firms are
prepared to supply at different price levels,
holding the expected price level constant.
Short-run aggregate supply shows what
happens to output when the price level
changes unexpectedly.
The short-run aggregate supply is positively
sloped because unanticipated increases in the
price level lower real wages and raise selling
prices relative to cost.
6. Shifts in Aggregate Supply and
Demand Curves
6.1 Demand shock



Any factor that causes C, I, G, or X-M:
to increase independently of the price
level will shift the aggregate demand
curve to the right (an increase in AD).
to decrease independently of the price
level will shift the aggregate demand
curve to the left (a decrease in AD).
6.1.1 The Classical Model


In this model with a vertical supply
curve, increases in aggregate demand
do not raise output, only prices.
In an economy with flexible wages and
prices, the economy operates at full
employment (yn), therefore , increases
in aggregate demand translate to
higher prices, not more output.
6.1.2 The Keynesian Model




The Keynesian supply curve is horizontal below fullemployment output (yn).
If the initial equilibrium is below full-employment,
increases in aggregate demand curve cause more
output and employment without driving up prices.
In the Keynesian high-unemployment model, demand
increases do only good! They increases output and
do not raise prices.
When full employment is reached (the vertical section
of the aggregate supply curve), further increases in
aggregate demand only cause higher prices.
6.1.3 The Short-Run
Aggregate Supply Model


When inflation is unanticipated, an
increase in aggregate demand raises
both process and output in the short
run. SRAS is upward sloping.
The new equilibrium is established at a
higher price level and a higher real
GDP.
6.2 Supply Shocks



OPEC’s acquisitions of control over crude-oil
exports, poor harvest, etc. reduce aggregate
supply.
A supply shock is a shift in aggregate
supply caused by some external factor that
causes costs of production to change.
Supply shocks can be either adverse or
beneficial:
6.2 Supply Shocks – cont.



An adverse supply shock raises costs, so
the short-run aggregate supply curve shifts
to the left.
A beneficial supply shock occurs when
costs fall so that the short-run aggregate
supply curve shifts to the right.
Adverse supply shocks create inflation
and unemployment.
6.3 The Long-Run, SelfCorrecting Mechanism


Can the economy automatically return
to full employment if, for some reason,
it is operating above or below full
employment?
In the long run, the economy produces
at the natural level of GDP because of
the self-correcting mechanism.
6.4 Policy implications of the
Self-Correcting Mechanism
The tendency of the economy to return to
(yn) means that the economy’s long-run
output and employment cannot be controlled.
 How long must the economy wait for selfcorrecting actions to restore the economy to
the natural rate?
Evidence of a Self-Correcting Mechanism
Example
