Download Aggregate Supply and Aggregate Demand

124
Aggregate Supply and
Aggregate Demand
125
Aggregate Supply and
Aggregate Demand
 What is the purpose of the aggregate
supply-aggregate demand model?
 What determines aggregate supply
and aggregate demand?
 What is the definition of
macroeconomic equilibrium?
 How do these concepts interact to
cause business cycles?
126
The Aggregate SupplyAggregate Demand Model
 The purpose of this model is:
 to help understand and predict
fluctuations of real GDP around
potential GDP
 to understand and predict fluctuations
in the price level
127
Aggregate Supply
 The aggregate quantity of goods and
services supplied is the sum of the
quantities of final goods and
services produced by all firms in the
economy (real GDP).
 Aggregate supply is the relationship
between the quantity of real GDP
supplied and the price level.
128
Two Time Frames for
Aggregate Supply
 We distinguish two time frames for
aggregate supply:
 Long-run aggregate supply
 Short-run aggregate supply
129
Long-Run Aggregate Supply
 The macroeconomic long run is a
time frame that is long enough so
external shocks have run their
course.
 The long-run aggregate supply curve
(LAS) is the relationship between the
quantity of real GDP supplied and the
price level in the long run when real
GDP equals potential GDP.
130
131
Implications of Long-Run
Aggregate Supply
 In the long run, potential GDP is
independent of the price level.
 A 10 percent increase in the average
price level will be matched by a 10
percent increase in wage rates and
other factor prices.
 Relative prices and the real wage rate
will remain constant.
132
Short-Run
Aggregate Supply
 The macroeconomic short run is a
period during which:
 real GDP has fallen below potential GDP
(and unemployment has risen above the
natural rate) or
 real GDP has risen above potential GDP
(and unemployment has fallen below
the natural rate).
133
Short-Run Aggregate
Supply Curve
 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 all other influences
on production plans (such as the
money wage rate and raw materials
prices) remain constant.
134
135
Implications of Short-Run
Aggregate Supply
 The short run is the normal state of
the economy when it is fluctuating
around potential GDP.
 In the short run, prices of goods and
services change freely, but prices of
factors of production (including the
wage rate) do not change very much.
136
Movements Along
LAS and SAS
 A rise in the price level accompanied
by an equal percentage rise in the
money wage rate (and prices of other
factors of production) brings a
movement along the LAS curve.
 A rise in the price level with no
change in factor prices brings a
movement along the SAS curve.
137
138
Changes in
Aggregate Supply
 A change in the price level, other
things remaining the same, causes a
movement along the aggregate
supply curve.
 Aggregate supply changes when any
influence on production plans (other
than price) changes.
139
Changes in Long-Run
Aggregate Supply
 Long-run aggregate supply changes
when potential GDP changes.
 Potential GDP changes for three
reasons:
 Growth in the full-employment quantity
of labor
 Growth in the quantity of capital
 Advances in technology
140
141
Changes in Short-Run
Aggregate Supply
 All the factors that influence long-run
aggregate supply also influence
short-run aggregate supply.
 If potential GDP increases, both longrun and short-run aggregate supply
increase because the level of fullemployment output has increased.
142
Influences on Short-Run
Aggregate Supply
 The only influences on short-run
aggregate supply that do not affect
long-run aggregate supply are:
 the money wage rate
 prices of other factors of production
 Both these factor prices affect shortrun aggregate supply via their
influence on production costs.
143
Changes in Factor Prices
 An increase in factor prices
decreases short-run aggregate
supply.
 The SAS curve shifts up and to the left.
 A decrease in factor prices increases
short-run aggregate supply.
 The SAS curve shifts down and to the
right.
144
145
Aggregate Demand
 The aggregate quantity of goods and
services demanded is the sum of:
 planned consumption spending by
households
 planned investment spending by firms
 planned government spending
 planned net exports
146
The Aggregate
Demand Curve
 Aggregate demand is the entire
relationship between the quantity of
real GDP demanded and the price
level (the GDP deflator).
 An increase in the average price
level, holding everything else
constant, reduces the quantity of real
GDP demanded.
147
148
Why the Aggregate Demand
Curve Slopes Downward
 Ordinary market demand curves
slope downward because of income
and substitution effects.
 The aggregate demand curve slopes
downward for similar reasons:
 Wealth effect
 Substitution effect
149
The Wealth Effect
 Wealth is the assets of society.
 If the price level rises, the real value
of wealth decreases.
 If the price level falls, the real value
of wealth increases.
150
Th Wealth Effect and
Aggregate Demand
 A rise in the price level reduces the
real value of wealth, causing a
movement up and to the left on an
AD curve.
 A fall in the price level increases the
real value of wealth, causing a
movement down and to the right on
an AD curve.
151
The Substitution Effect
 The substitution effect is the change
in the quantity of real GDP demanded
resulting from a change in the price
level (opportunity cost) of goods.
 There are two components ot the
substitution effect.
 The intertemporal substitution effect
 The international substitution effect
152
The Interest Rate and
Intertemporal Substitution
 The higher the interest rate, the
greater is the opportunity of
spending today versus saving (so
you can spend more tomorrow).
 The higher the price level, other
things remaining the same, the
higher is the interest rate.
153
The Price Level and
the Interest Rate
 An increase in the price level
reduces the quantity of real money in
circulation.
 People will try to maintain their
standard of living by saving less and
spending more.
 This reduces the supply of loanable
funds, driving up the interest rate.
154
International
Substitution Effect
 The international substitution effect
is the change in the quantity of real
GDP demanded resulting from a
change in the opportunity cost of
domestic goods in terms of foreign
goods.
155
International Substitution
and the Price Level
 The higher the price level in the
United States, other things remaining
the same, the higher the prices of
U.S. made goods relative to foreign
made goods.
 This means a higher price level will
reduce the quantity of real GDP
demanded.
156
The Aggregate Demand
Curve Slopes Downward
 Each of the two ways the price level
influences the quantity of real GDP
demanded causes the aggregate
demand to fall as the price level
rises.
 Therefore the aggregate demand
curve slopes downward.
157
Changes in the Quantity
of Real GDP Demanded
 When the price level changes (and
causes the interest rate to change),
there is a change in the quantity of
real GDP demanded.
158
159
Changes in
Aggregate Demand
 There are four main factors that
cause the aggregate demand curve
to shift:




Expectations
International factors
Fiscal policy
Monetary policy
160
Expectations
 Expectations about future economic
conditions play a crucial role in
determining household and business
spending decisions.
 Three important expectations are:
 future incomes
 future inflation
 future profits
161
Expected Future Incomes
 An increase in expected future
income, other things remaining the
same, increases the amount
households plan to spend,
increasing aggregate demand.
 When households expect declining
future income, they will cut back on
current spending, decreasing
aggregate demand.
162
Expected Inflation
 An increase in the expected inflation
rate, other things remaining the
same, leads to an increase in
aggregate demand.
 When people expect prices to rise
faster in the future, they try to buy
more at today’s lower prices.
163
Expected Future Profits
 If firms expect future profits to be
higher, they will spend more on
investment today so they will have
the plant and equipment ready to
produce those profitable goods in
the future.
164
International Factors
 The two main international factors
that influence aggregate demand are:
 the foreign exchange rate
 foreign income
165
The Foreign Exchange Rate
 The foreign exchange rate is the
amount of foreign currency that you
can buy with one U.S. dollar.
 The foreign exchange rate affects the
prices that foreigners pay for goods
and services produced in the U.S., as
well as the prices we have to pay for
foreign-produced goods.
166
Foreign Income
 An increase in foreign income
increases demand for all goods and
services, including goods made in
the U.S. (our exports, their imports).
 Rapid economic growth in Japan and
Western Europe in the 80’s have
increased demand for U.S. exports.
 The recent depressions in Asia have
reduced demand for U.S. exports.
167
Fiscal Policy
 Fiscal policy is the government’s
attempt to influence the economy by
setting and changing:
 government spending
 taxes
 the government’s deficit and debt
 These decisions are made by
Congress in consultation with the
President.
168
Government Purchases of
Goods and Services
 The scale of government purchases
of goods and services has a direct
impact on aggregate demand.
 If taxes are held constant, an
increase in government purchases
causes aggregate demand to
increase.
 The budget deficit also increases.
169
Taxes and Transfer
Payments
 A decrease in taxes causes
aggregate demand to increase.
 An increase in transfer payments
also increases aggregate demand.
 Both these changes in fiscal policy
increase households’ disposable
income.
170
Monetary Policy
 Decisions about the money supply
and interest rates are made by the
Federal Reserve board (the Fed).
 The Fed’s attempt to influence the
economy by varying the money
supply and interest rates is called
monetary policy.
171
The Money Supply
 The greater the quantity of money in
circulation, the greater is the level of
aggregate demand.
 As people and businesses hold more
money, they also will spend more
even if their income has not
changed.
 Increases in the money supply also
lower interest rates.
172
Interest Rates
 If the Fed increases interest rates,
households and firms reduce their
borrowing, lending, and spending
plans, particularly on durable goods.
 Remember, interest rates are the
opportunity cost of consumption and
investment spending.
173
Shifts of the Aggregate
Demand Curve
 Changes in expectations,
international factors, fiscal policy, or
monetary policy cause the aggregate
demand curve to shift.
 An increase in aggregate demand
causes the AD curve to shift right.
 A decrease in aggregate demand
causes the AD curve to shift left.
174
175
Macroeconomic Equilibrium
 Macroeconomic equilibrium is
determined by the intersection of the
aggregate supply and aggregate
demand curves.
 There is an equilibrium for each of
the time frames: long run and short
run.
 Let’s look at the short run first.
176
Determination of Real GDP
and the Price Level
 Short-run macroeconomic
equilibrium occurs when the quantity
of real GDP demanded equals the
short-run quantity of real GDP
supplied.
 This is where the AD and SAS curves
intersect.
177
Short-Run Macroeconomic
Excess Supply of Goods
 If the price level is above equilibrium,
short-run aggregate supply
(production) will exceed aggregate
demand (spending).
 This will cause unwanted inventories
to pile up.
 Firms will reduce production and cut
prices.
178
Short-Run Macroeconomic
Excess Demand for Goods
 If the price level is below equilibrium,
aggregate demand (spending) will
exceed short-run aggregate supply
(production).
 This will cause unwanted inventory
decreases.
 Firms will increase production and
raise prices.
179
180
Short-Run and Long-Run
Macroeconomic Equilibrium
 Long-run macroeconomic
equilibrium occurs when real GDP
equals potential GDP and there is full
employment.
 This implies the economy is on its
long-run aggregate supply curve.
 Short-run equilibrium can occur at a
real GDP other than potential GDP.
181
182
Equilibrium Below
Full Employment
 A below full-employment equilibrium
is a short-run equilibrium in which
potential GDP exceeds real GDP.
 This difference between potential
and actual GDP is called a
recessionary gap.
183
184
Equilibrium Above
Full Employment
 An above full-employment
equilibrium is a short-run equilibrium
in which real GDP exceeds potential
GDP.
 This difference between real and
potential GDP is called an
inflationary gap.
185
186
Long-Term Growth
and Inflation
 Long-term economic growth occurs
when the long-run aggregate supply
curve shifts to the right.
 Inflation occurs when aggregate
demand increases at a faster rate
than long-run aggregate supply.
187
Fluctuations in
Aggregate Demand
 Suppose the economy is at a fullemployment equilibrium.
 Foreign demand for U.S. goods
(exports) increases, causing U.S.
aggregate demand to increase.
 Real GDP and the price level will
increase in the short run.
188
189
The Return to
Long-Run Equilibrium
 The short-run equilibrium is above
full employment.
 Prices and output have increased,
but wage rates have not.
 In the long run, wage rates will
increase because demand for labor
exceeds labor supply.
 The SAS curve shifts.
190
191
The New Long-Run
Equilibrium
 In the long run, the economy will
produce its potential output (fullemployment real GDP).
 However, the price level will be
higher, reflecting the higher level of
aggregate demand and shift of the
SAS curve.
192
Fluctuations in
Aggregate Supply
 Fluctuations in short-run aggregate
supply can also cause fluctuations in
real GDP.
 Beginning at full employment
equilibrium, suppose there is a large
increase in the world price of oil.
 This causes a decrease in short-run
aggregate supply.
193
A Decrease in Short-Run
Aggregate Supply
 When short-run aggregate supply
decreases, the SAS curve shifts up
and to the left.
 This causes unemployment and
inflation, a condition known as
stagflation.
194
195
Anti-Stagflation Policies
 If AD does not change, the price level
will eventually fall back to its original
level.
 If AD is increased via monetary or
fiscal policy, unemployment will fall
but inflation will rise.
 If AD is decreased to fight inflation,
unemployment will rise.
 There are no perfect policy choices.
196
NEXT:
Expenditure
Multipliers