Download the aggregate market

MACROECONOMICS SESSION 4 LECTURE NOTES:
THE AGGREGATE MARKET
AGGREGRATE DEMAND
Aggregate Demand: The Concept
Topic: What It Is
In this lesson we take a look at the demand side of the aggregate market (AD/AS
analysis)--aggregate demand.
A definition:
Aggregate Demand is the aggregate or total expenditure on final goods and services
produced in the domestic economy, at a range of price levels, during a given time
period (usually a year).
Three points:
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Expenditures are made by all members of society.
Expenditures are made during the year.
Expenditures are on the production that people use to satisfy wants and
needs.
Aggregate demand is only one side of the aggregate market--the expenditure side-the other side is aggregate supply--the producing side.
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Expenditures come from the household, business, government, and foreign
sectors.
Production comes from resources--labor, capital, land, and entrepreneurship.
The aggregate market is a model used to analyze the economy's total
production and the price level.
This analysis, also called AD/AS, lets us understand macroeconomic events,
like recessions, inflation, and unemployment.
The aggregate market can be used to evaluate the effects of government
policies.
Aggregate Demand: The Concept
Topic: Circular Flow
Aggregate demand and the aggregate market are all about the flow of production
through the product markets of the circular flow.
The circular flow is the continuous flow of production, income, and resources
between households and businesses.
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Businesses acquire the services of productive factors through the factor
markets
Households acquire the resulting production from businesses through the
product markets
The aggregate market combines all of the individual markets for individual
goods and services into a overall, comprehensive, complete, aggregate
product market.
This is the demand side of the aggregate market.
Aggregate Demand: The Concept
Topic: Summary
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How, first and foremost, aggregate demand represents expenditures made
by all members of all sectors of our economy.
Aggregate demand is one side of the aggregate market (the AD/AS model)
that's used to analyze national economic problems such as recessions,
unemployment, and inflation, that might plague our economy.
How aggregate demand and the aggregate market are related to the circular
flow model of the economy.
Aggregate Demand: Doing More
Topic: Expenditures
Aggregate demand is expenditures made by all members of society, that is,
aggregate expenditures.
A definition:
Aggregate expenditures are the total expenditures on gross domestic product
undertaken in a given time period.

Society is grouped into four sectors, households, business, government, and
foreign.
Expenditures by each sector are:
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Household Consumption
Business Investment
Government Government Purchases
Foreign Net exports
Aggregate Demand: Doing More
Topic: Consumption Expenditures
The household sector is the group responsible for the consumption part of the
aggregate expenditures.
Consumption is the expenditures by the household sector on final goods and services
undertaken in a given time period.
Three specific categories of consumption:
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Nondurable goods Goods lasting less than a year.
Durable goods Goods lasting more than a year.
Services Intangible activities.
Each consumption category plays a different role in the macroeconomy.
Aggregate Demand: Doing More
Topic: Investment Expenditures
The business sector is the group responsible for investment expenditures.
Investment is the expenditures by the business sector on final goods and services,
mainly capital goods like factories and equipment, undertaken in a given time period.
Three specific categories of investment:
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Fixed structures Buildings, factories, housing.
Equipment Machinery and tools.
Inventories Raw materials and unsold goods.
Investment is the most volatile of our four expenditures.
Aggregate Demand: Doing More
Topic: Government Purchases
The government sector, like the household and business sectors, buys a portion of
the final goods and services produced by the economy. These are government
purchases.
Two points:
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We study government purchases made by all three levels: federal, state, and
local. But the federal level will occupy much of our interest.
We study government spending only for newly produced goods. We exclude
government spending on transfer payments.
Aggregate Demand: Doing More
Topic: Net Exports
The foreign sector, everyone who is not a citizen of our domestic economy, also
purchases domestic production. These are termed net exports.
Net exports are exports minus imports.
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Exports are purchases of domestic production by the foreign sector.
Imports are the purchases of foreign production by the domestic sector.
Net exports gives us an overall picture of how our economy interacts with the
foreign sector.
Calculating net exports by subtracting imports gives us aggregate
expenditures on domestic production only.
Aggregate Demand: Doing More
Topic: Summary
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The four expenditures that make up aggregate demand: consumption,
investment, government purchases, and net export expenditures.
How consumption expenditures are made by households on services, durable
goods, and nondurable goods.
How investment expenditures are made by businesses on inventories,
equipment, and fixed structures.
How only government purchases of final goods and services qualify as
expenditures for aggregate demand.
Net exports, which are exports minus imports. Net exports represent the net
expenditures of the foreign sector on our domestically produced final goods
and services.
Aggregate Demand: The Curve
Topic: Highlights
The aggregate demand curve captures the
demand side of the aggregate market.
Highlights:
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First: the price level, our GDP
deflator, is on the vertical axis, and
real production is on the horizontal
axis.
Second: the aggregate demand curve
has a negative slope. At lower prices,
real aggregate expenditures are
higher.
Third: all ceteris paribus aggregate
demand determinants are constant.
Fourth: the aggregate demand curve
gives us information for a given time period.
Aggregate Demand: The Curve
Topic: Slope
The aggregate demand curve has a negative
slope.
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This negative slope means that
households, business, government
and foreign sectors are inclined to
increase their aggregate spending on
real production if the price level
decreases and decrease spending if
the price level rises.
Three reasons:
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The real-balance effect.
The interest-rate effect.
The net-export effect.
Aggregate Demand: The Curve
Topic: Real-Balance Effect
The amount of production we purchase depends on how much money we have and
the price of the production we want to buy.
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A higher price level means money can buy less real production.
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A lower price level means money can buy more real production.
The real-balance effect is when a change in the price level changes aggregate
expenditures on real production because the purchasing power of money changes.
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Real refers to the real purchasing power of money.
Balances refers to the balance of money we have to purchase.
Aggregate Demand: The Curve
Topic: Interest-Rate Effect
Changes in the interest rate can alter consumption and investment spending.
Changes in the investment and consumption spending that occur when changes in
the price level cause changes in the interest rate is the interest-rate effect.
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Investment and consumption expenditures are made with borrowed funds.
The interest rate affects the cost of borrowing these funds.
The price level affects the interest rate:
o A higher price level induces a higher interest rate, which raises the
cost of borrowing and discourages investment and consumption.
o A lower price level induces a lower interest rate, which reduces the
cost of borrowing and encourages investment and consumption.
Aggregate Demand: The Curve
Topic: Net-Export Effect
An increase in the price level decreases exports and increases imports, which gives
us a decrease in net exports.
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If the price level increases in one country, the production of other countries
becomes relatively cheaper.
For example:
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An increase in the U.S. price level discourages foreign buyers from buying
U.S. goods, and encourages U.S. buyers to buy relatively cheaper foreign
goods.
The net-export effect is that a change in the price level, changes the relative prices
of exports and imports, and changes net exports in the opposite way.
Aggregate Demand: The Curve
Topic: Summary
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The basic setup, shape, and position of the aggregate demand curve on a
graph. The AD curve shows the negative relationship between the price level
and real GDP.
What causes the negative slope of the AD curve--namely: 1) the real-balance
effect, 2) the interest-rate effect, and 3) the net-export effect.
Why the real-balance effect means that a higher (or lower) price level reduces
(or increases) the purchasing power of money, resulting in less (or more) real
production purchased.
Why the interest-rate effect means that a higher (or lower) price level leads
to higher (or lower) interest rates and thus a higher (or lower) cost of
borrowing which decreases (or increases) consumption and investment
expenditures on real production.
Why the net-export effect means that a higher (or lower) price level
decreases (or increases) exports and increases (or decreases) imports thus
decreasing (or increasing) net export expenditures on real production.
Aggregate Demand: Determinants
Topic: Instability
Expenditures by the household, business, government and foreign sector change
over time, causing instability in the economy.
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Economic instability found in complex economies, business cycles, can be
traced to shifts of the aggregate demand curve.
The ceteris paribus determinants of the aggregate demand curve are those
things that disrupt equilibrium, and lead to macroeconomic instability.
Aggregate demand determinants are things, other than the price level, that affect
aggregate demand.
Aggregate Demand: Determinants
Topic: Shifts: Increase
The aggregate demand determinants cause
the aggregate demand curve to shift. An
increase in aggregate demand shifts the
aggregate demand curve to the right
Aggregate Demand: Determinants
Topic: Shifts: Decrease
The aggregate demand determinants cause the aggregate demand curve to
shift. A decrease in aggregate demand shifts the aggregate demand curve to
the left.
Aggregate Demand: Determinants
Topic: Summary
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The nature of economic instability coming from the four basic sectors.
The nature of aggregate demand determinants as ceteris paribus factors
that are initially assumed constant and aren't measured explicitly on our AD
graph.
How an increase (or decrease) in aggregate demand is represented as a shift
to the right (or left) and how this increase (or decrease) represents an
increase (or decrease) in aggregate expenditures over a range of price levels.
Aggregate Demand: Policies Plus
Topic: Business Cycles
The consumption, investment, government purchase, and net export determinants
cause the aggregate demand curve to shift and lead to macroeconomic instability.
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This instability is best viewed in terms of business cycles. The effects of
business-cycle instability are:
o Recession. Means higher unemployment rates and related problems.
o Booming Expansion. Possibility of higher inflation rates and related
problems.
Aggregate demand is the prime source of economic instability.
Aggregate Demand: Policies Plus
Topic: Policies
The federal government can exert a great deal of control over the aggregate
demand curve through government policies. This control of aggregate demand is
called demand-management policies.
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Government use of purchases and taxes to affect aggregate demand is
termed fiscal policy.
o Government can influence aggregate demand directly through
government purchases.
o Government can also indirectly alter aggregate demand through taxes
that affect household consumption and business investment.
Government also changes the interest rate through monetary policy with the
goal of affecting consumption and investment.
Aggregate Demand: Policies Plus
Topic: Summary
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How shifts in the aggregate demand curve are a source of macroeconomic
(business cycle) instability.
The two basic types of macroeconomic problems associated with business
cycles, recessions (with unemployment) and booming expansions (with
inflation).
Controlling aggregate demand instability through demand-management
policies, including fiscal and monetary policies.
Fiscal policy that affects aggregate spending directly through government
purchases and indirectly through taxes.
Monetary policy that affects aggregate spending indirectly interest rates.
AGGREGRATE SUPPLY
Aggregate Supply: The Concept
Topic: What It Is
In this lesson we will look at the other side of the aggregate market, the aggregate
supply, to see how gross domestic product gets produced.
Society's scarce resources, with the opportunity cost of their alternative uses, must
be combined to produce these goods and services.
A Definition:
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Aggregate supply is the total, or aggregate, production of final goods and
services available in the domestic economy at a range of price level, during a
given time period (usually one year).
Similar to aggregate demand.
The goal of aggregate supply is to combine scarce resources to produce our
economy's gross domestic product.
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Four resource categories of aggregate supply:
o Labor The people working.
o Capital Tools and equipment.
o Land Raw materials.
o Entrepreneurship Those who assume the risk of production.
The goods and services produced are supplied to meet the demands of our
households, business, government, and foreign sectors.
Gross production is the supply side of the aggregate market, the supply of
real production, or real GDP.
Aggregate Supply: The Concept
Topic: Price Level
Aggregate supply is the relation between real production, measured as real GDP,
and the price level, measured as the GDP price deflator.
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This is comparable to the relation for aggregate demand and lets us combine
both relations to form the aggregate market.
How does the price level affect the supply of real production? For markets,
the law of supply is that a higher price induces an increase in the quantity
supplied. Does this work for aggregate supply, too?
How the price level affects real production depends on the difference between
the short run and long run.
Aggregate Supply: The Concept
Topic: Summary
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Aggregate supply as one side of the aggregate market (the AD/AS model)
that's used to analyze macroeconomic problems such as recessions,
unemployment, and inflation, that might plague our economy.
How aggregate supply is the combined production of goods and services
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coming from our factors of production.
A few thoughts on the price level and it's role in the supply of aggregate real
production.
Aggregate Supply: Two Options
Topic: Time Periods
Production of goods and services takes time.Two time periods:
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Long run A period in which all prices are flexible. Long run price flexibility
means that all markets are in equilibrium.
Short run A period in which some prices are flexible and some are rigid. Short
run price rigidity leads to disequilibrium in resource markets, even though
product and financial markets are in equilibrium.
In the short run, disequilibrium in resource markets (especially labor) means
that jobs remain unfilled or some workers are unemployed, even though we
have equilibrium in the product markets, with satisfied buyers and sellers.
Aggregate Supply: Two Options
Topic: Long Run
In the long run all prices are flexible, which ensures that all markets are in
equilibrium.
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Prices rise to eliminate market shortages and fall to eliminate market
surpluses, resulting in equilibrium.
Equilibrium in the labor market is particularly important:
o In the long run, the labor market is characterized by both flexible
prices and full employment.
o The economy is operating on the boundary of the production
possibilities curve.
The time it takes prices to adjust to correct market disequilibrium and get to
the long run is critical to the study of macroeconomics and government
policies.
Aggregate Supply: Two Options
Topic: Short Run
In the short run some prices are flexible and some prices are rigid. Rigid prices are
most important to resource and labor markets.
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Rigid prices prevent markets from eliminating surpluses and from reaching
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equilibrium.
In the labor market, surpluses mean unemployment and not reaching full
employment.
Short run aggregate supply involves the interplay of many elements in
addition to price rigidity.
Aggregate Supply: Two Options
Topic: Summary
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The differences between the long run and the short run aggregate supply, in
terms of price flexibility and full employment.
How the long run is achieved when all prices are flexible, giving us full
employment and equilibria in the product, financial, and resource markets.
How aggregate supply reacts in the long run to more or less demand for
aggregate production to maintain full employment at alternative price levels.
Aggregate Supply: The Curves
Topic: Long Run
The long-run aggregate supply (LRAS) curve
captures the relationship between the price
level and the aggregate supply of real
production in the long run.
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GDP deflator, the price level, is
measured on the vertical axis. Real
GDP, the real production, is measured
on the horizontal axis.
Highlights:
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The LRAS is a straight, vertical line.
The price level does not affect the
aggregate supply of real production.
The supply is real production given
that all resources are fully employed.
Flexible prices ensures that full employment production is maintained, in the
long run.
Aggregate Supply: The Curves
Topic: Short Run
The short-run aggregate supply (SRAS)
curve captures the relationship between the
price level and the aggregate supply of real
production in the short run.

GDP deflator, the price level, is
measured on the vertical axis. Real
GDP, the real production, is measured
on the horizontal axis.
Highlights:
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The SRAS is a positively-sloped line.
The positive slope means that higher
price levels correspond to greater
levels of real production.
With rigid prices, the price level does affect the aggregate supply of real
production in the short run.
Aggregate Supply: The Curves
Topic: Market Supply
While the market supply curve and the short-run aggregate supply curve look
similar, there are important differences.
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The price and quantity for the short-run aggregate supply curve are the price
level and real production, not the price and quantity of a specific good.
The positive slope of the short-run aggregate supply curve is based on rigid
wages, tapping into frictional, and structural unemployment, and
misperceptions about real wages. The slope of the market supply curve is
based on increasing opportunity cost.
The short-run aggregate supply curve is not just the aggregation of all market
supply curves in the economy.
Aggregate Supply: The Curves
Topic: Summary
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The vertical long-run aggregate supply curve which graphically illustrates
that the price level has no affect on the full employment level of aggregate
supply in the long run.
The positively-sloped short-run aggregate supply curve which graphically
illustrates that the price level does affect aggregate supply in the long run,
and that it's possible to change short-run production, above or below full
employment, if the price level changes.
Similarities and differences between aggregate supply and market supply.
Aggregate Supply: Determinants
Topic: Stability
The shifts in the aggregate supply curves are usually small, steady, and readily
expected.
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The supply-side of the aggregate market is usually the perfect picture of
stability.
Most of economy's instability result from instability on the demand side of the
aggregate market.
Shifts of the aggregate supply curve are due to ceteris paribus determinants.
The supply determinants are things, other than the price level, that affect
aggregate supply.
Both, short-run aggregate supply and long-run aggregate supply curves, can
increase or decrease.
In both, long run and shot run:
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An increase shifts the aggregate supply curve to right.
It means that producers are willing and able to offer more real production for
sale at any and all price levels.
A decrease shifts the aggregate supply curve to left.
It means that producers are willing and able to offer less real production for
sale at any and all price levels.
Aggregate Supply: Determinants
Topic: Long Run Supply
The key characteristic of the long-run aggregate supply (LRAS) curve is that it is
vertical at the full employment level of production.
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Whatever affects the full-employment level of real production will cause the
long-run aggregate supply curve to shift.
The determinants of the long-run aggregate supply curve are the same things
that cause the production possibilities curve to shift:
The Q and Q determinants:
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Quantity of Resources.
Quality of Resources.
Aggregate Supply: Determinants
Topic: Quantity of Resources
A change in the quantity of labor, capital, land, or entrepreneurship will alter full
employment real production and shift the long-run aggregate supply curve.
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Changes in resource quantities tend to be steady and predictable.
Labor can change for three reasons:
o Natural growth of population.
o Migration.
o The labor force participation rate.
Capital changes from depreciation of capital and investment in capital.
Land changes from exploration and discovery of natural resources.
Entrepreneurship, while difficult to measure, increases when more people
assume the risk of production.
Aggregate Supply: Determinants
Topic: Quality of Resources
Resource quality tends to change slowly and gradually. We seldom see big jumps in
these long run aggregate supply determinants.
Two ways to improve resource quality:
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Technology: The information about production techniques. It generally moves
forward, so that aggregate supply increases. Technology primarily affects
capital and land.
Education: Transferring information, knowledge, and training to people. It
also generally moves forward, increasing aggregate supply. Education is most
important for labor.
Resource quality generally increases, but it can decrease in unusual circumstances.
Aggregate Supply: Determinants
Topic: Short Run Supply
The short-run aggregate supply (SRAS) curve is related to the price level, and this
relation depends on production cost.
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An increase in production cost decreases aggregate supply and shifts the
SRAS leftward.
A decrease in production cost increases aggregate supply and shifts the SRAS
rightward.
Key production cost changes:
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Wages: Wages shift the SRAS from adjustments in workers perceptions of the
current price level and expectations about future prices.
Material Cost: Key economy-wide resources, like oil, can cause the SRAS to
shift through big changes in price.
Aggregate Supply: Determinants
Topic: Summary
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The rather stable, passive nature of the supply side of the aggregate
market--at least when compared to the demand side.
How aggregate supply determinants shift the LRAS and SRAS curves, with an
increase in aggregate supply moving rightward and a decrease moving
leftward.
How the LRAS curve shifts from changes in full employment production
resulting from changes in the quantity or quality of scarce resources.
Some of the ways that quantities of labor, capital, land, and entrepreneurship
can change.
How resource quality is primarily changed through technology and education.
Production cost--especially things like wages and oil prices--as the primary
determinant of the SRAS curve.
Aggregate Supply: Connections
Topic: Self-Correction
The aggregate market has a self-correcting mechanism that ensures the long-run
full-employment equilibrium will be reached by itself, without government policies.
The predicament:
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Long run means full employment and flexible prices.
Short run means price rigidity without full employment.
The automatic, self-correcting solution:
1. Disequilibrium in the labor market exerts pressure on wages to correct the
imbalance, even with wage rigidity.
2. This automatically moves us from the short run to the long run and fullemployment equilibrium.
The critical question: How long does the self-correcting mechanism take? Days?
Months? Years?
Aggregate Supply: Connections
Topic: Policies
Government can use supply-management policies to shift the aggregate supply
curves.
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Supply-management policies have been less popular among politicians
because they tend to be slower than demand-management policies.
Politicians tend to prefer faster demand-management policies when seeking
to replace the slow-moving automatic mechanism.
Supply-management policies:
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Business deregulation to reduce production cost.
Tax policies that stimulate capital investment.
Technology and education that increase capital and labor quality.
Aggregate Supply: Connections
Topic: Summary
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Questions over undertaking government policies or letting the selfcorrection mechanism of the aggregate market achieve full employment.
An introduction into supply-management policies that can be used to reduce
macroeconomic instability.
How aggregate supply comes together with aggregate demand for a model
that we can use to analyze our macroeconomy.
AGGREGRATE MARKET
Aggregate Market: The Concept
Topic: What It Is
In this lesson we will learn about the aggregate market and how it is used to
understand and explain the macroeconomy.
A definition:



The aggregate market is the combined product markets for all final goods and
services produced in the economy in a given time period, usually one year.
It combines aggregate demand and aggregate supply to analyze the price
level and real production.
Everyone is part of the aggregate market: the household, business,
government, and foreign sectors.

The aggregate market (also called AD/AS analysis) is a tool for explaining the
macroeconomy
Aggregate Market: The Concept
Topic: Two Sides: SRAS
The aggregate market combines two sides,
those who buy, aggregate demand, and
those who sell, aggregate supply.
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Aggregate demand is the spending by
the four basic sectors of the
economy: household, business,
government, and foreign sector.
Aggregate supply is the economy's
producers -- the factors of
production: labor, capital, land, and
entrepreneurship.
The aggregate market is the
mechanism through which buyers and
sellers come together to exchange
the economy's production.
The SRAS curves represents part of the supply side of the aggregate market.
Aggregate Market: The Concept
Topic: Two Sides: LRAS
The aggregate market combines two sides,
those who buy, aggregate demand, and
those who sell, aggregate supply.

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Aggregate demand is the spending by
the four basic sectors of the
economy: household, business,
government, and foreign sector.
Aggregate supply is the economy's
producers -- the factors of
production: labor, capital, land, and
entrepreneurship.
The aggregate market is the
mechanism through which buyers and
sellers come together to exchange
the economy's production.
The LRAS curves represents part of the supply side of the aggregate market.
Aggregate Market: The Concept
Topic: Two Sides: AD
The aggregate market combines two sides,
those who buy, aggregate demand, and
those who sell, aggregate supply.

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Aggregate demand is the spending by
the four basic sectors of the
economy: household, business,
government, and foreign sector.
Aggregate supply is the economy's
producers -- the factors of
production: labor, capital, land, and
entrepreneurship.
The aggregate market is the
mechanism through which buyers and
sellers come together to exchange
the economy's production.
The AD curves represents the demand side of the aggregate market.
Aggregate Market: The Concept
Topic: Two Traits
The aggregate market is designed to explain the macroeconomy's price level and
real production.
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Aggregate demand is the relation between expenditures on real production
and the price level.
Aggregate supply is the relation between the supply of real production and
the price level--short run and long run.
The aggregate market identifies suitable values for the price level and real
production that keep the aggregate economy--buyers and sellers--satisfied.
The aggregate market helps us to analyze and understand the
macroeconomy.
We are primarily concerned with the problems of inflation and unemployment.
Aggregate Market: The Concept
Topic: Summary
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The notion of the aggregate market as an analytical tool used for
understanding the macroeconomy.
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Combining the two sides of the aggregate market, aggregate demand and
aggregate supply.
The two aspects of the macroeconomy analyzed with the aggregate market-the price level and real production.
The two basic problems that can be examined with the aggregate market-unemployment and inflation.
Aggregate Market: Equilibrium
Topic: Concept
Equilibrium in the aggregate market occurs when the forces of aggregate demand
and aggregate supply are balanced.
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Equilibrium is a balance of forces that will remain unchanged until some
other, outside force intervenes.
For the market, the forces are supply and demand. For the aggregate market,
the forces are aggregate demand and aggregate supply.
The aggregate demand force is our four sectors who want GDP at the lowest
price level possible.
The aggregate supply force is our scarce resources who want to sell GDP at
the highest prices possible.
Aggregate Market | Unit 2: Equilibrium
Topic: Three Markets
The macroeconomy contains three interrelated aggregate markets--product
markets, resource markets, and financial markets.
In general, a market is in equilibrium when buyers and sellers come upon a price
that generates the same quantity demanded and quantity supplied.
Two macroeconomic notions of equilibrium:
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Long-run equilibrium: All three aggregate markets achieve equilibrium
simultaneously.
Short-run equilibrium: Price and wage rigidity prevent equilibrium in the
resource markets, even though the aggregate product and financial markets
are in equilibrium.
Aggregate Market: Equilibrium
Topic: Moving Target
The dynamic nature of the aggregate market makes the long-run equilibrium a
moving target.
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The difference between long-run and short-run equilibria is critical to the
study of the macroeconomy.
Aggregate demand, especially investment, is volatile.
Aggregate supply, although somewhat predictable, involves continuous
adjustments.
Long-run equilibrium is a perpetually pursued goal, but seldom actually
reached.
As we approach the long-run equilibrium target, it has likely changed due to different
economic conditions, due to changes in aggregate demand, aggregate supply, or
more than likely, both.
Aggregate Market: Equilibrium
Topic: Summary





How the equilibrium concept is applied to the aggregate market.
The three macroeconomic markets that are relevant to macroeconomic
equilibrium--product, financial, and resource markets.
How long-run equilibrium exists when all three aggregated markets--product,
financial, resource--are in equilibrium.
How short-run equilibrium results when the product and financial markets are
in equilibrium, but the resource market is not.
The long-run equilibrium as a moving target that is always pursued, but
seldom reached.
Aggregate Market: Doing Curves
Topic: Long-Run Equilibrium
Long-run equilibrium in the aggregate
market can be seen by combining the
aggregate demand and supply sides (curves)
of the market into a graph.


Equilibrium in the long run aggregate
market equilibrium is at the
intersection of the two curves and at
full-employment production.
At the long-run equilibrium:
o The quantity of real production
supplied is equal to the
quantity of real production
demanded.
o Both sides of the market are
satisfied and not inclined to
change the price level.
Aggregate Market: Doing Curves
Topic: Long Run Disequilibrium: Too High
We can see what happens if the price level is
not at the long-run equilibrium price level of
Pe. If price level is the too high the supply of
real production is greater than demand. We
have surpluses in product markets
throughout the economy. Market prices
decrease and so too does the price level.
Aggregate expenditures then increase to
reach full employment.
Aggregate Market: Doing Curves
Topic: Long Run Disequilibrium: Too Low
We can see what happens if the price level is
not at the long-run equilibrium price level of
Pe. If price level is the too low the supply of
real production is less than demand. We
have shortages in product markets
throughout the economy. Market prices
increase and so too does the price level.
Aggregate expenditures then decrease to
reach full employment.
Aggregate Market: Doing Curves
Topic: Short-Run Equilibrium
Let's identify short-run equilibrium.



The negatively-sloped aggregate
demand curve, is labeled AD. This
curve is the same as in the long run.
The SRAS curve is the positivelysloped short-run aggregate supply
curve.
The short-run aggregate market
equilibrium at the intersection of the
two curves.
At this short-run equilibrium:


The quantities of real production
demanded and supplied are equal,
buyers and sellers are satisfied, and the price level doesn't change.
But, we don't know where full employment is located. This equilibrium might
involve a surplus or a shortage in the labor market.
Aggregate Market: Doing Curves
Topic: Summary



The long-run equilibrium of the aggregate market achieved at the
intersection of the aggregate demand and long-run aggregate supply
curves.
What happens when the price level is above or below the long-run equilibrium
price level.
The short-run equilibrium of the aggregate market achieved at the
intersection of the aggregate demand and short-run aggregate supply curves.
Aggregate Market: Self Correction
Topic: Short Run
The aggregate market, which is typically at or near short-run equilibrium, is
persistently motivated to seek out the long-run equilibrium.



This motivation comes from an imbalance in the labor market created by rigid
wages, temporarily tapping into frictional and structural unemployment, and
misperceptions about the real wage.
The imbalance is temporary. The macroeconomy will automatically move
toward long-run equilibrium and full employment.
Wages are flexible in the long run, but rigid in the short run. This is the key to
the self-correction mechanism of the aggregate market.
Aggregate Market: Self Correction
Topic: Recessionary Gap
The aggregate market can automatically
reach long-run equilibrium by closing a
recessionary gap.
Key points:






Short-run equilibrium is at the
intersection of the AD and the SRAS
(SRo) curves.
The initial short-run price level is Po,
and real production is Qo.
Short-run equilibrium is to the left of
the full employment production, Qf.
We have a recessionary gap.
As wages fall, production cost
decreases which increases short-run
aggregate supply.
The SRAS curves shift to reach the full employment level at the intersection of
the LRAS and AD curves.
Aggregate Market: Self Correction
Topic: Inflationary Gap
The aggregate market can automatically
reach long-run equilibrium by closing an
inflationary gap.
Key points:






Short-run equilibrium is at the
intersection of the AD and the SRAS
(SRo) curves.
The initial short-run price level is Po,
and real production is Qo.
Short-run equilibrium is to the right of
the full employment production, Qf.
We have an inflationary gap.
As wages rise, production cost
increases which decreases short-run
aggregate supply.
The SRAS curves shift to reach the full employment level at the intersection of
the LRAS and AD curves.
Aggregate Market: Self Correction
Topic: Summary



How the short-run equilibrium creates an imbalance in the labor market that
leads to self-correction of the aggregate market to the long-run equilibrium.
How the aggregate market adjusts to full employment automatically, with
shifts of the short-run aggregate supply curve to eliminate a recessionary
gap.
How the aggregate market adjusts to full employment automatically, with
shifts of the short-run aggregate supply curve to eliminate a inflationary gap.
Aggregate Market: Policy Preview
Topic: Time
It takes time to move the economy from short run equilibrium to long run
equilibrium.
Two options:


Wait for self-correcting mechanism --> A short-run imbalance in the labor
market eventually triggers the steps that move the economy to fullemployment production and long-run equilibrium.
Take immediate steps --> Induced shifts in the AD, SRAS, LRAS curves that
would, presumably reach full employment faster than the self-correcting
mechanism.
The critical questions remains:

How much time is needed to adjust from the short run to the long run?
Aggregate Market: Policy Preview
Topic: Time of Adjustment
There is no specific, absolute time period that separates short run from long run.
Time factors:


First: The size of the gap between short-run real production and long-run real
production. Bigger gaps take longer to close.
Second: Because prices are less rigid going up than down, inflationary gaps
tend to close more quickly than recessionary gaps.

Third: Adjustment speed depends on the underlying structure of the
economy, including things like size, government laws, resource endowments,
and culture.
These change over time and differ among countries. But adjustment is usually
months not days.
Aggregate Market: Policy Preview
Topic: Summary



A preview of how the aggregate market is used to analyze government
policies.
The two alternatives for closing recessionary and inflationary gaps--(1) self
correction based on shifts of the automatic SRAS and (2) government policies
that induce shifts in the AD, SRAS, and LRAS curves.
Questions about the time it takes for the economy to adjust from the short
run to the long run.
AGGREGRATE SHOCKS
Aggregate Shocks: Instability
Topic: What It Is
The aggregate market is a useful analysis for the study of the macroeconomy and
its adjustments.

The aggregate market tends toward equilibrium.
Short-Run Equilibrium:



Intersection of AD and SRAS curves.
Expenditures on real output match production.
Labor market is prone to be out of equilibrium.
Long-Run Equilibrium:



Intersection of AD and LRAS curves.
Expenditures on real output match production.
Labor market in equilibrium.
Real world changes can be analyzed by examining how the aggregate market adjusts
toward equilibrium.
To examine aggregate market adjustments we need to make use of the ceteris
paribus concept.

The aggregate market curves, AD, LRAS, and SRAS, are constructed


assuming other things remain unchanged.
The determinants of each curve, initially assumed constant, don't really stay
unchanged, and they cause changes in the aggregate market.
The purpose of this aggregate market analysis is to help us to understand
why the macroeconomy tends to be unstable, volatile and prone toward
business cycles.
Aggregate Shocks: Instability
Topic: Fluctuations
Our goal is to explain business cycle
fluctuations.







The real GDP path the economy
would take with long-run equilibrium-at full employment--is the straight,
green upward-sloping line.
The actual real GDP path, the jagged
red line, tends to be less smooth.
The business cycle is the movement
above and below the long-run trend.
When the actual is below the long-run
equilibrium line, we get
unemployment.
When the actual is above the long-run
equilibrium line, we get inflation.
Ceteris paribus factors are what create fluctuations away from the long-run
trend.
Aggregate demand determinants are the main cause.
Aggregate Shocks: Instability
Topic: Summary




The aggregate market as a tool to analyze the macroeconomy and its
adjustments toward equilibrium.
How aggregate market adjustments are important to the difference between
short-run equilibrium and long-run equilibrium.
That the aggregate market curves--AD, LRAS, and SRAS--are constructed
assuming other (ceteris paribus) things remain unchanged.
Ceteris paribus determinants as the source of business cycle fluctuations
away from the long-run, full employment growth trend of the economy.
Aggregate Shocks: Extension
Topic: Instability
Before getting to the graphs, here are four specific real-world-type issues to
illustrate the direction that we're headed with our analysis of instability:




Increases in physical wealth, especially consumer durable goods and capital
investment, which affect aggregate demand.
Changes in monetary policy that affect interest rates, which affect aggregate
demand expenditures on durable goods and capital.
Technological advances that improve long-run and short-run aggregate
supply.
Changes in wages and production costs that affect short-run aggregate
supply.
Aggregate Shocks: Extension
Topic: Self-Correction
The aggregate market has a perpetual inclination to adjust from short-run
equilibrium to long-run equilibrium.


The aggregate market self-correction mechanism relies on wages, the key
production cost determinant.
Short-run labor market imbalances induce wage changes that move the
aggregate market to long-run equilibrium.
A recessionary gap Unemployment causes lower wages and production costs, and an
increase in short-run aggregate supply.
An inflationary gap Labor market imbalances increase wages and production cost,
and decrease in short-run aggregate supply.
Long run equilibrium is restored in both cases.
Aggregate Shocks: Extension
Topic: Summary




The different determinant induced shifts of the AD, LRAS, and SRAS curves.
A few of the more important determinants that shift the AD, LRAS, and
SRAS curves.
How specific real-world issues, such as increases in physical wealth, changes
in monetary policy, technological advances, and wage changes, create
instability in the macroeconomy.
How the self-correction mechanism works through wage-changes and the
labor market to restore the long-run equilibrium.
Aggregate Shocks: Basic Shifts
Topic: AD Shifts
There are two directions that the aggregate demand curve can shift:


An increase in aggregate demand is a rightward shift of the AD curve.
A decrease in aggregate demand is a leftward shift of the AD curve.
And we have the AD curve shifting in two versions of the aggregate market, long run
and short run.
This gives us four basic curve-shifting alternatives:




An increase, with the long-run aggregate market.
A decrease, with the long-run aggregate market.
An increase, with the short-run aggregate market.
A decrease, with the short-run aggregate market.
Aggregate Shocks: Basic Shifts
Topic: AD Increase: Long Run
The long-run equilibrium is given by the
intersection of the negatively-sloped AD
curve and the vertical LRAS.



An increase in AD results in a new
long-run equilibrium.
At the new equilibrium, real
production does not change, it stays
at Qf. The price level increases from
Po to P1.
We're missing a lot of short-run
action that occurs as we go from one
long-run equilibrium to another.
Aggregate Shocks: Basic Shifts
Topic: AD Decrease: Long Run
The long-run equilibrium is given by the
intersection of the negatively-sloped AD
curve and the vertical LRAS.



A decrease in AD results in a new
long-run equilibrium.
At the new equilibrium, real
production does not change, it stays
at Qf. The price level decreases from
Po to P2.
We're still missing a lot of short-run
action that occurs as we go from one
long-run equilibrium to another.
Aggregate Shocks: Basic Shifts
Topic: AD Increase: Short Run
The short-run equilibrium is given by the
intersection of the negatively sloped AD
curve and the positively-sloped SRAS.




An increase in AD and results in a
new short-run equilibrium.
At the new equilibrium, both real
production and the price level
increase.
Real production can increase above
full employment -- in the short run.
This shift gives us an intermediate
point from one long-run equilibrium
to another.
Aggregate Shocks: Basic Shifts
Topic: AD Decrease: Short Run
The short-run equilibrium is given by the
intersection of the negatively sloped AD
curve and the positively-sloped SRAS.




A decrease in AD and results in a new
short-run equilibrium.
At the new equilibrium, both real
production and the price level
decrease.
Real production can decrease below
full employment -- in the short run.
This shift gives us an intermediate
point from one long-run equilibrium
to another.
Aggregate Shocks: Basic Shifts
Topic: Summary


How increases in aggregate demand in the long run affect only the price
level, not real production which remains at full employment.
How increases in aggregate demand in the short run affect both the price
level and the level of real production which may be below or above the full
employment level.
Aggregate Shocks: Complex Shifts
Topic: AD
Our analysis of AD-curve-induced aggregate market adjustment from one
equilibrium to another is more complex when we include the self-correction
mechanism from the short run to the long run.
Two cases:


Aggregate demand increases.
Aggregate demand decreases.
The complex adjustment is a two step process:


First: The AD curve shifts, which leads to a short-run equilibrium and moves
the aggregate market away from the long-run equilibrium.
Second: Wages adjust to achieve equilibrium in the labor market--eventually-which changes production costs, shifts the SRAS, and restores long-run
equilibrium.
Aggregate Shocks: Complex Shifts
Topic: AD Increase
The case of an increase in the AD curve.
Let's start at long-run equilibrium. All three
curves, AD, LRAS, and SRAS, intersect at the
same long-run equilibrium values, Po and Qf.


With a rightward shift of the AD
curve, the aggregate market achieves
short-run equilibrium at a higher price
level and more real production.
The labor market imbalance causes
wages and production cost to rise.
The SRAS shifts leftward. It stops
shifting when it intersects the new AD
and the original LRAS curves for a
new long-run equilibrium. The price
level is even higher and real
production returns to full employment.
Aggregate Shocks: Complex Shifts
Topic: AD Decrease
The case of an decrease in the AD curve.
Let's start at long-run equilibrium. All three
curves, AD, LRAS, and SRAS, intersect at the
same long-run equilibrium values, Po and Qf.


With a leftward shift of the AD curve,
the aggregate market achieves shortrun equilibrium at a lower price level
and less real production.
The labor market imbalance causes
wages and production cost to fall. The
SRAS shifts rightward. It stops
shifting when it intersects the new AD
and the original LRAS curves for a
new long-run equilibrium. The price
level is even lower and real
production returns to full employment.
Aggregate Shocks: Complex Shifts
Topic: SRAS
Shifts of the SRAS curve that move the aggregate market away of the long-run
equilibrium also trigger the self-correcting mechanism that moves it back.


The initial shift of the SRAS curve is caused by any of the ceteris paribus
determinants.
The self-correcting shift of the SRAS curve is caused by wage changes
triggered by an imbalance in the labor market.
Once again, we have two alternatives:


Short run aggregate supply increases.
Short run aggregate supply decreases.
Aggregate Shocks: Complex Shifts
Topic: SRAS Increase
The case of an increase in the SRAS curve.
Let's start at long-run equilibrium, Po and
Qf.


With a rightward shift of the SRAS
curve, the aggregate market achieves
short-run equilibrium at a lower price
level and more real production.
The labor market imbalance causes
wages and production cost to rise.
The SRAS shifts leftward, returning to
its original position. The price level
and real production return to full
employment levels.
From long run to long run, nothing changed.
But before the long-run adjustment, we have more production at lower prices.
Aggregate Shocks: Complex Shifts
Topic: SRAS Decrease
The case of an decrease in the SRAS curve.
Again we start at long-run equilibrium, Po
and Qf.


With a leftward shift of the SRAS
curve, the aggregate market achieves
short-run equilibrium at a higher price
level and less real production.
The labor market imbalance causes
wages and production cost to fall. The
SRAS shifts rightward, returning to its
original position. The price level and
real production return to full
employment levels.
From long run to long run, nothing changed.
But before the long-run adjustment, we have less production at higher prices.
Aggregate Shocks: Complex Shifts
Topic: Summary




How the self-correction mechanism moves the aggregate market from
short-run equilibrium to long-run equilibrium.
That the analysis of the shifts of the AD and SRAS curves are only the start of
a process that becomes more complex when we include self-correcting shifts
of the SRAS.
The two adjustment stages triggered by shifts of the AD curve. First, the shift
of the AD curve. Second, the self-correcting shift of the SRAS curve.
The two adjustment stages triggered by shifts of the SRAS curve. First, the
shift of the SRAS curve. Second, the self-correcting shift of the SRAS curve
that returns the aggregate market back to it's original position.
Aggregate Shocks: Synthesis
Topic: Business Cycles
To illustrate a business cycle, let's begin with long-run, full-employment
equilibrium.





With an expansion, consumers have accumulated durable goods.
This decreases consumption spending and aggregate demand. The AD curve
shifts leftward. We have a recession.
Before the SRAS curve automatically shifts to restore full employment, people
start buying durable goods again and the AD curve shifts rightward. We have
a recovery.
The AD curve doesn't stop at full employment. With our expansion we have
(possibly) inflation.
But accumulation of durable goods causes a decrease in aggregate demand
again and another recession.

The process continues.
Aggregate Shocks: Synthesis
Topic: Summary

How the aggregate market can be used to demonstrate a simple business
cycle that's caused by consumption expenditures on durable goods.