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141: Topic 3- Ch27 AGGREGATE SUPPLY AND AGGREGATE DEMAND Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 1 Production and Prices Aggregate Supply (AS) and Aggregate Demand (AD) model is used to: determine macroeconomic equilibrium Explain: Economic growth? Inflation? Why do we have business cycles? How do policy actions by the government affect output and prices? Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 2 Aggregate Supply The aggregate (or total) quantity of goods and services supplied depends on three factors: The quantity of labor (L ) The quantity of capital (K ) The state of technology (T ) The aggregate production function shows how quantity of real GDP supplied, Y, depends on labor, capital, and technology. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 3 Aggregate Supply At any given time, capital and the state of technology are fixed but labor can vary. The higher the real wage rate, the smaller is the quantity of labor demanded and the greater is the quantity of labor supplied. The wage rate that makes the quantity of labor demanded equal to the quantity supplied is the equilibrium wage rate and at that wage the level of employment is fullemployment level and the unemployment rate is the natural rate of unemployment, output produced is potential GDP. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 4 Aggregate Supply Prices that may change are two sets of prices: Prices of goods and services (Price level). Prices of productive resources, or inputs. Depending on changes in these price sets and response to them we distinguish between: Short-run aggregate supply (SAS): Price level changes but time is too short for prices of inputs to change. Long-run aggregate supply (LAS): all prices change by same proportion, and time is long enough to respond to all changes. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 5 Aggregate Supply Long-Run Aggregate Supply The long-run aggregate supply curve (LAS) is the relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP. The LAS curve is vertical because prices change by same proportion, thus potential GDP is independent of the price level. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 6 Aggregate Supply Along the LAS curve all prices and money wage rates vary by the same percentage so that relative prices and the real wage rate remain constant. Relative price is the price of one good or service to the price of another. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 7 Aggregate Supply Short-Run Aggregate Supply The short-run aggregate supply curve (SAS) is the relationship between the quantity of real GDP supplied and the price level in the short-run when the money wage rate, the prices of other resources, and potential GDP remain constant. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 8 Aggregate Supply Along the SAS curve, rise in the price level with no change in the money wage rate and other input prices increases the quantity of real GDP supplied—the SAS curve is upward sloping. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 9 Aggregate Supply Along the SAS curve, real GDP might be above, equal to, or below potential GDP. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 10 Aggregate Supply Movement along the LAS and SAS Curves A change in the price level with an equal percentage change in the money wage causes a movement along the LAS curve. A change in the price level with no change in the money wage causes a movement along the SAS curve. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 11 Aggregate Supply Changes in Aggregate Supply Aggregate supply changes when there are changes in potential GDP or changes in prices of inputs. When potential GDP increases, both the LAS and SAS curves shift rightward. Potential GDP changes, for three reasons Change in the full-employment quantity of labor. Change in the quantity of capital (physical or human). Advance in technology. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 12 Aggregate Supply The figure shows how these factors shift the LAS curve and have the same effect on the SAS curve. @ same price level, both PGDP and RGDP increase. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 13 Aggregate Supply A rise in the money wage rate, or price of any other productive resource, decreases short-run aggregate supply and shifts the SAS curve leftward. But it has no effect on long-run aggregate supply, since no change in relative prices. Along the same SAS, money wage rate is constant. Money wage rate is higher on the SAS to the left than on the SAS to the right, given a price level. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 14 Aggregate Demand The quantity of real GDP demanded, Y, is the total amount of final goods and services produced in the country that people, businesses, governments, and foreigners plan to buy. This quantity is the sum of consumption expenditures, C, investment, I, government purchases, G, and net exports, X – M. That is: Y = C + I + G + X – M. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 15 Aggregate Demand The Aggregate Demand Curve Aggregate demand is the relationship between the quantity of real GDP demanded and the price level. The aggregate demand (AD) curve plots the quantity of real GDP demanded against the price level. It slopes downward. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 16 Aggregate Demand The AD curve slopes downward for two reasons A wealth effect Substitution effects Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 17 Aggregate Demand Changes in Aggregate Demand When price level only changes, there is movement along the AD curve. A change in any influence on buying plans other than the price level changes aggregate demand. The main influences on aggregate demand are: Expectations Fiscal and monetary policy The world economy. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 18 Aggregate Demand Changes in Aggregate Demand Expectations about future income, future inflation, and future profits change aggregate demand. Fiscal policy is the government’s attempt to influence economic activity by changing its taxes, spending, deficit, and debt policies. Monetary policy is changes in the interest rate and quantity of money. The world economy influences aggregate demand in two ways: change in the foreign exchange rate, and change in foreign income. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 19 Aggregate Demand The figure illustrates changes in aggregate demand. When aggregate demand increases, the AD curve shifts rightward… … and when aggregate demand decreases, the AD curve shifts leftward. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 20 Macroeconomic Equilibrium: short-run equilibrium Quantity of real GDP demanded equals the quantity of real GDP supplied at the intersection of AD and the SAS curves. If real GDP is below equilibrium GDP, firms increase production and raise prices… … and if real GDP is above equilibrium GDP, firms decrease production and lower prices. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 21 Macroeconomic Equilibrium: short-run equilibrium These changes bring a movement along the SAS curve towards equilibrium. In short-run equilibrium, real GDP can be greater than or less than potential GDP, and the economy could be above, below or at full employment level. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 22 Macroeconomic Equilibrium: Long-run equilibrium long-run equilibrium. Long-run equilibrium occurs where the AD and LAS curves intersect and results when the money wage has adjusted to put the SAS curve through the long-run equilibrium point. It occurs when real GDP equals potential GDP— when the economy is on its LAS curve, producing at full-employment level. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 23 Macroeconomic Equilibrium Economic Growth and Inflation Economic growth occurs because the quantity of labor grows, capital is accumulated, and technology advances, all of which increase potential GDP and bring a rightward shift of the LAS curve. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 24 Macroeconomic Equilibrium Economic Growth and Inflation Inflation occurs because aggregate demand increases by more than long-run aggregate supply. The AD curve shifts rightward faster than the rightward shift of the LAS curve, so there is economic growth with inflation. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 25 Macroeconomic Equilibrium • Economic Growth and Inflation – If the AD curve shifts rightward by less than the rightward shift of the LAS curve, there is would be economic growth with negative inflation. – If the AD curve shifts rightward by same distance as the rightward shift of the LAS curve, there is economic growth with no inflation. Macroeconomic Equilibrium The Business Cycle The business cycle occurs because aggregate demand and the short-run aggregate supply fluctuate but the money wage does not change rapidly enough to keep real GDP at potential GDP. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 27 Macroeconomic Equilibrium A below full-employment equilibrium is an equilibrium in which potential GDP exceeds real GDP. Figures (a) and (d) illustrate below fullemployment equilibrium. The amount by which potential GDP exceeds real GDP is called a recessionary gap. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 28 Macroeconomic Equilibrium A long-run equilibrium is an equilibrium in which potential GDP equals real GDP. Figures b) and (d) illustrate long-run equilibrium. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 29 Macroeconomic Equilibrium An above fullemployment equilibrium is an equilibrium in which real GDP exceeds potential GDP. Figures (c) and (d) illustrate above fullemployment equilibrium. The amount by which real GDP exceeds potential GDP is called an inflationary gap. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 30 Macroeconomic Equilibrium Fluctuations in Aggregate Demand The short- run effects: Starting at long-run equilibrium, an increase in aggregate demand shifts the AD curve rightward Firms increase production and rise prices—a movement along the SAS curve. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 31 Macroeconomic Equilibrium Fluctuations in Aggregate Demand The short- run effects: Real GDP increases, the price level rises, and in the new short-run equilibrium, there is an inflationary gap. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 32 Macroeconomic Equilibrium Fluctuations in Aggregate Demand The long-run effects: money wage rate begins to rise and short-run aggregate supply begins to decrease. The SAS curve shifts left. The price level rises and real GDP decreases until it has returned to potential GDP. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 33 Macroeconomic Equilibrium Fluctuations in Aggregate Supply Figure shows the effects of a decrease in aggregate supply. Starting at long-run equilibrium, a rise in the price of oil decreases short-run aggregate supply and the SAS curve shifts leftward. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 34 Macroeconomic Equilibrium Fluctuations in Aggregate Supply Real GDP decreases and the price level rises. The combination of recession combined with inflation is called stagflation. Parkin: Macroeconomics. Adapted by Dr. Mohamed A abdalla 35