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Long Run Aggregate Demand & Supply Lecture 20 Dr. Jennifer P. Wissink ©2015 Jennifer P. Wissink, all rights reserved. November 3, 2015 The Aggregate Demand Curve: A Warning The AD curve is not a market demand curve like in Econ 1110. It’s a more complex concept. – It’s an equilibrium locus, really. Remember: A higher price level causes the demand for money to rise, which causes the interest rate to rise. – Then, the higher interest rate causes aggregate output to fall. – At all points along the AD curve, both the goods market and the money market are in equilibrium. Shifts in Aggregate Demand via Monetary Policy An increase in Ms at a given price level shifts the aggregate demand curve to the right. A decrease in Ms at a given price level shifts the aggregate demand curve to the left. Shifts in Aggregate Demand via Fiscal Policy An increase in G or a decrease in net T at a given price level shifts the aggregate demand curve to the right. A decrease in G or an increase in net T at a given price level shifts the aggregate demand curve to the left. Tracking an increase in the money supply The Aggregate Supply Curve The Aggregate Supply (AS) Curve is a graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy (Y) and the overall price level (PL). The Aggregate Supply Curve: Warning The aggregate supply curve is not a market supply curve or the sum of all the individual supply curves in the economy like in Econ 1110. Instead… – It refers to all firms in all kinds of markets – even pricesetting firms (which do not even have individual supply curves). – When we draw a firm’s supply curve, we assume that input prices are constant. In macroeconomics, an increase in the overall price level means that at least some input prices will be rising as well. – Rather than an aggregate supply curve, you might want to think of it as a... ... “price/output response” curve — a curve that traces out the price and output decisions of all the markets and firms in the economy under a given set of circumstances. Aggregate Supply in the Short Run: SR-AS In the short run, the aggregate supply curve (the price/output response curve) has a positive slope. At low levels of aggregate output, the curve is fairly flat. Then there is an “intermediate” range. As the economy approaches capacity, the curve becomes nearly vertical. At capacity, the curve is vertical. Shifts in MACRO SR-AS A cost shock, or supply shock, is a change in the economic environment that shifts the SR-AS curve. PL SR-AS0 PL SR-AS0 Bad Shock SR-ASN SR-ASN Good Shock Y Y Factors That Shift the SR-AS Curve GOOD SHOCKS Shift SR-AS Right BAD SHOCKS Shift SR-AS Left Increases in Aggregate Supply Decreases in Aggregate Supply Lower costs lower input prices lower wage rates Higher costs higher input prices higher wage rates Economic growth more capital more labor techno change Stagnation capital deterioration Public policy supply-side policies tax cuts deregulation Public policy waste and inefficiency over-regulation Good weather Bad weather, natural disasters, destruction from wars The Equilibrium Price Level The equilibrium price level is the PL where AD = SR-AS. PL0 and Y0 correspond to equilibrium in the goods market and the money market and a set of price/output decisions on the part of all the firms in the economy. Significant Macro Debate PL What does the SR-AS really look like? Y Where does AD intersect SR-AS? How quickly does SR-AS shift in response to a change in the economic situation? i>clicker question If you were POTUS and you wanted expansionary fiscal policy to work really well (i.e., have the greatest multiplier impact), where would you hope AD currently intersects SR-AS? PL A. B. C. D. SR-AS In the horizontal part. In the intermediate part. In the vertical part. Doesn’t matter. Y Monetary &/or Fiscal Policy When SR-AS is Rather Flat Expansionary Policy – Monetary OR Fiscal – Suppose we are on the “flatter” part of SR-AS. – AD shifts out (to the right). – Policy works well when the economy is on the flatter portion of the SR-AS curve, causing little change in PL relative to the output increase. – Note: assuming no shift in SR-AS for now. Monetary &/or Fiscal Policy When SR-AS is Rather Steep Expansionary Policy – Monetary OR Fiscal – Suppose we start out on the “steeper” part of SR-AS. – AD shifts out. – When the economy is operating near capacity, an increase in AD will result in an increase in the price level, PL, with little increase in output. – Note: still assuming no shift in SR-AS. SR-AS Shifts: The Response of Input Prices to Changes in the Overall Price Level If price-level increases were assumed to be fully anticipated, then wage rates and other input prices would be expected to increase at exactly the same rate as the overall price level a SR-AS that would shift as soon as the AD shifted and the PL changed. But many argue that this is simply not the observed case. So... there must be a lag between changes in input prices and changes in output prices, otherwise the SR-AS (the SR price/output response) curve would be vertical. So... we operate with the idea that enough input prices tend to lag changes in output prices to make it so we talk about SR-AS & LR-AS. SR-AS versus LR-AS We distinguish between the – short run AS curve (SR-AS) – long run AS curve (LR-AS) SR-AS is positively sloped and… – tends to start out rather flat/horizontal at low levels of Y – then has a section that’s positively sloped – then tends to get very steep/vertical as we approach Y-capacity (which is different than Ypotential/YFE ) – will shift with cost/supply shocks (see chart again, the one with the pics) LR-AS is vertical. – – – – This is because eventually all prices adjust, including input prices. Typically we assume the LR-AS is vertical at Ypotential/YFE. Ypotential/YFE is the level of income/output where there is no inflation. If Y>YFE then you’ll get rising price/wage levels and a shift in the SR-AS back to LR-AS, but now at a higher price level. – If Y<YFE then you’ll get falling price/wage levels and a shift in the SR-AS back to LR-AS, but now at a lower price level. AD, LR-AS and SR-AS Curves in a No-Inflation Equilibrium Recall: Some/enough input costs lag behind price-level changes in the short run, resulting in an upward-sloping SR-AS curve. In the long run, costs and the price level move in tandem, so once costs finally “catch up” and adjust, the LR-AS curve is vertical at what we will call YPotential or YFE = Y0