THE AGGREGATE DEMAND AGGREGATE SUPPLY MODEL

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1 THE AGGREGATE DEMAND AGGREGATE SUPPLY MODEL

2 Previously The original Solow model focused on capital investment as the main source of economic growth. Modern growth theory now recognizes that institutions (such as political stability and private property rights) are also essential for growth. Modern growth theory also treats technological advancements in a society as endogenous rather than exogenous.

3 U.S. Potential Real GDP, and Business Cycles Growth trend potential output

4 U.S. Potential Real GDP, and Business Cycles Growth theory focused on this trend

5 U.S. Potential Real GDP, and Business Cycles Business cycle theory focuses on deviations from trend

6 U.S. Real GDP Growth

7 Next Theory of Business Cycles (AD-AS Model) Big question we want to answer 1. What causes business cycles (recessions and booms)? 2. Can government fiscal and monetary policies smooth the business cycles? 3. Who cares? If labor force is 150 million, and during a recession unemployment rate increases from 5% to 10%, this means that at least 7.5 million workers lost their job.

8 U.S. Real GDP and Recessions

9 Aggregate Demand and Aggregate Supply Model Aggregate demand (AD) Total demand for final goods and services in the economy Aggregate supply (AS) Total supply of final goods and services in the economy Price level (P) Average price of all the goods and services (GDP deflator). Real GDP (Y) Economy s output of goods and services, adjusted for inflation

10 AD-AS Model Preview LRAS represents the long run potential output of the economy the growth trend

11 AD-AS Model Preview

12 AD-AS Model Preview SRAS and AD curves can shift and cause short term deviations from potential output business cycles.

13 Aggregate Demand AD = C + I + G + NX Consumption Investment Government Purchases Net Exports Recall: NX = X IM

14 Aggregate Demand

15 Why AD Curve Slopes Down? To explain the downward-sloping AD curve Assume for now that G is determined by policy instead of price level. We can examine how price level affects C, I, and NX. AD curve has a negative slope due to Wealth effect Interest rate effect International trade effect

16 The Wealth Effect Wealth Value of an individual s accumulated assets Currency, stocks, bonds, artwork, real estate, bank accounts Wealth effect The change in purchasing power of money when the price level changes Increasing price levels will decrease your purchasing power, which reduces spending and decreases the quantity of goods demanded.

17 The Interest Rate Effect Recall the market for loanable funds Interest rate on vertical axis Savings and investment on horizontal axis Supply and demand model A reduction in the supply of loanable funds (caused by less savings) will increase the interest rate.

18 The Interest Rate Effect Interest rate effect Change in the price level indirectly leads to a change in the interest rate, which changes the quantity of AD Sequentially: Price level increases, so people need to spend more (save less) to maintain standard of living This causes interest rates to rise (previous figure) Higher interest rates reduce overall spending Thus, a higher price level led to less spending, illustrating the negative AD slope again.

19 International Trade Effect Price level and real GDP We are considering the domestic (USA) market. Changes in the U.S. price level means the prices of U.S. goods change relative to the prices of goods from other nations. International trade effect A change in the domestic price level leads to an inverse change in the quantity demand for domestic goods. Higher U.S. prices will lead people to buy less U.S. goods and more (relatively) cheaper foreign goods instead. This will decrease the quantity of domestic AD since NX falls.

20 Effect on AD Wealth Interest Rate International Trade Why an Increase in Price Level Reduces Quantity of Real GDP Demanded When P rises, consumers are poorer in real terms. This primarily decreases the demand for consumption goods. When P rises, individuals save less, which increases the equilibrium interest rate. Higher interest rates reduce the quantity demanded of investment goods. When P rises in the United States, all else equal, goods and services produced elsewhere are less expensive. Imports rise and exports fall so that net exports fall. Why a Decrease in Price Level Raises Quantity of Real GDP Demanded When P falls, consumers are wealthier in real terms. This primarily increases the demand for consumption goods. When P falls, individuals can afford to save more, which decreases the equilibrium interest rate. Lower interest rates increase the quantity demanded of investment goods. When P falls in the United States, all else equal, goods and services produced elsewhere are more expensive. Imports fall and exports rise so net exports fall.

21 Slope of the AD Curve P real Wealth C P Saving r I P X, IM NX

22 Slope of the AD Curve

23 Aggregate Demand Shifts We ve examined the downward-sloping nature of the AD curve (effect of changes in P) We now consider how changes (other than those caused by P) in C, I, G, and NX can increase or decrease (shift) AD. GDP = C + I + G + NX Consumption Investment Government Purchases Net Exports

24 Domestic Factors That Can Shift AD Anything that changes major spending habits of individuals and firms will shift AD. This includes changes in real wealth, expected income, and expected price levels. Stock market rises or falls Widespread change in real estate values General expectations about the future People could expect higher prices People could expect higher or lower income in the future Change in consumer confidence

25 International Factors That Can Shift AD Foreign income and wealth If foreign nations become wealthier, demand for U.S. goods increases (NX increases). If a foreign nation goes into recession, demand for U.S. goods decreases (NX decreases). Exchange rate (value of the dollar) If the value of the U.S. dollar ($) rises, U.S. can buy more imports, but other countries can buy less U.S. goods (decreasing exports), so NX falls, leading to a shift in AD. Similarly, the value of the dollar could fall, leading to an increase in NX.

26 Factors that Increase AD Component of GDP Brief Description Wealth Increase Higher Expected Prices or Inflation Higher Expected Income Increased Consumer Confidence Increased Capital Productivity Increased Investor Sentiment Increased Foreign Income Decreased Value of the Dollar Consumption Consumption Consumption Consumption Investment Investment Net exports Net exports Increased wealth leads to increased consumption. Higher future prices increases spending today. Higher anticipated future income leads to more spending today. Higher consumer confidence increases spending. When capital is more productive, firms increase investment at any interest rate. When firms believe future investments will yield greater returns, they ll invest more today. Wealthier international consumers demand more U.S. goods and services. A weaker dollar makes imports more expensive and our exports less expensive to foreigners.

27 Factors that Shift the Aggregate Demand Curve

28 Fiscal Policies that shift AD GDP = C + I + G + NX Lower Taxes Government can try and stimulate the aggregate demand: Increasing G, Lowering taxes, and increase C. Increasing Government Purchases

29 Aggregate Supply The slope of AS depends on the time horizon. Short-run AS Long-run AS Short-run AS Is positively sloped, depends on price level Long-run AS Vertical (infinite slope) Prices do not affect the long-term output and growth of the economy Causes of growth are resources, technology, and institutions (Ch. 11, 12)

30 The Function of the Firm

31 Long-Run Aggregate Supply Long run A period of time sufficient for all prices to adjust The LRAS curve is vertical. Why? Intuition Suppose we add a 0 to all the dollar bills, and to all prices, including wages. Thus, all prices increase by a factor of 10. Implication Firms will not increase production, and consumers will not buy more goods and services. Different price level, same output.

32 Long-Run Aggregate Supply Natural rate of output The rate of production achieved by the economy in the long run when unemployment is at its natural rate (only structural and frictional unemployment, but no cyclical). Mathematically: Y* = Natural rate of output when u = u*

33 The Long-Run Aggregate Supply Curve

34 Shifts in the Long-Run AS Factors that Shift LRAS Example Brief Description Changes in Resources Changes in Technology Changes in Institutions New Natural Gas Deposits Found The Internet Decrease in Income Taxes New natural gas deposits mean a new energy resource so prices for power should fall around the economy and the long-run aggregate supply shifts out. This should not change the unemployment rate, but now real GDP is at a higher level. The Internet increased access to technological knowledge and made communication easier. This enhanced the productivity of workers and shifted the LRAS to the right. A decrease in income taxes can lead to greater after-tax returns to investments. This changes incentives and leads to greater investment, which shifts long-run aggregate supply to the right.

35 Shifts in the Long-Run AS

36 Short-Run Aggregate Supply Short run Time period in which not all prices have adjusted to some macroeconomic change Some prices adjust immediately, others don t. Three explanations for why the nominal price level affects real GDP in the short run, leading to an upward-sloping SRAS: Sticky input prices Menu costs Money illusion

37 Short-Run AS Curve

38 Sticky Input Prices Resource prices (e.g. wages) Tend to be sticky (not as flexible). Set by contracts. Fixed interest rates, yearly wage contracts Output prices More flexible, easier to change Short-run result if output prices (price level) rise: With sticky resource prices, output is increased to maximize profits. Many firms affected, so aggregate output increases. Short-run result if output prices fall: With sticky resource prices, output will decrease.

39 Menu Costs Menu costs Costs associated with changing prices Can cause output prices to be sticky Coffee shop or gas station (low menu costs) Easy to rewrite prices on chalkboard or change plastic letters outside Restaurant (high menu costs) Expensive to reprint menus for all establishments Relationship to aggregate supply If the general price level falls, firms do not adjust their output price (due to menu costs), the quantity demanded of their product falls. This happens systematically throughout the economy, and aggregate output falls.

40 Money Illusion Money illusion (debatable) Occurs when people irrationally interpret nominal values as real values How it relates to aggregate supply Workers are very reluctant to accept pay decreases, even if the pay decrease is nominal This reinforces input price stickiness Firms will reduce output in response to decreases in the price level, rather than cut wages

41 Sticky Input Prices P W P ( real wage decreases) Y (output increases)

42 Effect on AS Sticky Resource Prices Why an Increase in the Price Level Raises Real GDP Workers and other resource suppliers who are locked into longterm contracts end up earning salaries that are too low in real terms. This makes production more profitable and encourages firms to raise their output. Why a Decrease in the Price Level Lowers Real GDP Workers and other resource suppliers who are locked into longterm contracts end up earning salaries that are too high in real terms. This makes production less profitable and encourages firms to lower their output. Menu Costs Money Illusion Due to menu costs, some prices do not adjust upward quickly. This causes the quantity demanded by consumers to rise and increases the amount sold. Workers irrationally focus on the nominal level of their wage and don t require firms to increase their wage when prices rise. This also makes output more profitable and encourages firms to increase output. Due to menu costs, some prices do not adjust downward quickly. This causes the quantity demanded by consumers to fall and lowers the amount sold. Workers irrationally focus on the nominal level of their wage and are reluctant to let firms decrease their wage when prices fall. This also makes output less profitable and encourages firms to decrease output.

43 Shifts in Short-Run Aggregate Supply Long-run shifts Whenever the long-run AS curve shifts, it takes the short-run AS curve with it. Factors that shift only the short-run AS curve: Temporary supply shocks Changes in expected future prices Adjustments to errors in past price expectations

44 Shifts in Short-Run Aggregate Supply Supply shock An event that affects aggregate supply Drought, hurricane, oil shock

45 Price of Crude Oil and Oil Supply Shocks Figure here

46 Shifts in Short-Run Aggregate Supply Expected future price levels If workers and firms expect higher prices tomorrow, they negotiate those expectations into today s contracts. Costs are higher, and the short-run AS shifts left. However, it does not affect long-run production possibilities, so the long-run AS doesn t change.

47 Shifts in Short-Run Aggregate Supply Adjustments to past errors in price level expectations We re not always correct in our assumptions about future prices. If we greatly underestimate inflation, we ll want to renegotiate our wage contracts as soon as we can. Many workers will do this, affecting SRAS as costs for many firms change

48 Shifts in Short-Run Aggregate Supply The three factors that shift the SRAS are all different stories for one factor cost of production: 1. Temporary supply shocks 2. Changes in expected future prices 3. Adjustments to errors in past price expectations If cost of production temporarily increase (bad weather, high oil prices, increases in wages), the SRAS will decrease (shift to the left). A temporary decrease in cost of production, increase the SRAS (shift to the right).

49 Factors that Shift SRAS Example Brief Description Temporary Supply Shocks Winter Freezes in Florida A winter freeze in Florida affects crops like oranges, strawberries and tomatoes. While this is only temporary, short-run aggregate supply decreases. Expected Future Price Levels Workers Expect Lower Prices If workers and resource suppliers expect prices to fall in the future, they negotiate wages and prices at lower nominal levels. Short-run aggregate supply increases. Adjustments to Past Errors in Price Level Expectations Workers Underpredict Current Inflation If workers expected less inflation than actually occurred, they negotiate higher wages now to compensate for the earlier deficiency. This decreases short-run aggregate supply.

50 Factors that Shift the SRAS

51 Long-Run Equilibrium in the Economy Long-run equilibrium Occurs after all prices have fully adjusted The economy will move toward this point at any point in time. Short-run expectations are consistent with the actual price level. Economy operating at full employment Graphically, mathematically LRAS = SRAS = AD u = u* at Y* and P*

52 Long-Run Equilibrium in the Economy

53 Using the AD and AS Model Dynamic changes in our world affect the macroeconomy. Here is the method to determine how the economy is affected. 1. Begin with the model in long-run equilibrium. 2. Determine which curve(s) are affected by the change(s), and the direction(s) of the change(s). 3. Shift the curve(s) in the appropriate direction(s). 4. Determine the new short-run and/or long-run equilibrium points. 5. Compare the new equilibrium(s) with the starting point.

54 Shifts in Long-Run Aggregate Supply Suppose the long-run aggregate supply shifts to the right. Could be caused by changes in Resources Institutions Technology Suppose we have a technology improvement. Result: Higher output (in short and long run) Lower price level Employment at the same level but workers are more productive due to more technology

55 Increase in Long-Run AS

56 Shifts in Short-Run Aggregate Supply Suppose there is a short-run supply shock caused by an oil pipeline break Leftward shift in SRAS Break is only temporary, and SRAS will eventually shift back to the right to original curve End result: Short-run disruptions in AS do not alter the long-run equilibrium in the economy. Price level, output, and unemployment rate will eventually return to their long-run levels. Assumptions Constant AD curve Adjustment back to original SRAS doesn t take too long.

57 An Unexpected Decline in SRAS

58 Unexpected Shifts in Aggregate Demand Can an increase in AD have real effects on the economy? Consumer confidence rises, and people start spending more. Result? AD shifts right Short-run result of higher price level, higher output, and lower unemployment As prices adjust toward LR equilibrium, SRAS shifts left Brings us back to original output and unemployment, but prices are higher Demand change: No real effects in long run, only affect price level, which is nominal

59 Unexpected Increase in Aggregate Demand

60 Summary of Results from Aggregate Demand Shifts Unexpected Increase in Aggregate Demand Unexpected Decrease in Aggregate Demand Short Run Long Run Short Run Long Run Real GDP Y rises Y returns to original level Y falls Y returns to original level Unemployment u falls u returns to original level u rises u returns to original level Price Level P rises P rises even further P falls P falls even further

61 Conclusion The AD-AS model helps us understand the macroeconomic impacts of real world changes and gives an important tool to use in government policy analysis. Most economist believe the macroeconomy needs at least a little help from government. Help could come in two forms: Monetary policy (changing the money supply) Fiscal policy (changing government taxes and spending)

62 Summary The aggregate demand and aggregate supply model is a simplified view of the economy that helps us evaluate short-term fluctuations in real GDP and unemployment (business cycles). While short-term fluctuations (recessions and expansions) can be painful, the United States spends much less time in recession than in times past.

63 Summary The aggregate demand curve is downward sloping for three reasons: 1. the wealth effect, 2. the interest rate effect, and 3. the international trade effect. Aggregate demand shifts for a myriad of reasons, but these include actual and expected changes in real wealth, expected changes in price levels, consumer confidence, foreign income, the world value of the dollar, and fiscal and monetary policies (not discussed in this chapter).

64 Summary Long-run aggregate supply Not affected by the price level Shifts with changes in resources, technology, and institutions. Short-run aggregate supply depends on the price level because of sticky prices. In the short run, the intersection of aggregate demand and short-run aggregate supply can deviate from the economy s long-run potential. This means that output, at any given moment, may be more or less than the natural rate.

65 Practice What You Know With the AD-AS graph, what variable is on the vertical axis? a. national income b. the price of the good we are studying c. the price of labor d. the price level

66 Practice What You Know The wealth effect can help explain a. the positive slope of the AS curve. b. the negative slope of the AD curve. c. the difference between real and nominal GDP. d. the rate of economic growth.

67 Practice What You Know Consider just the AD curve. Suppose consumption [C] broadly increases across the entire economy. This will cause a. a movement along the AD curve. b. the AD curve to shift outward. c. the slope of the AD curve to get steeper. d. a decrease in the price level of the economy.

68 Practice What You Know Why is the LRAS curve vertical? a. The short run sets a given output that will remain in the long run. b. Long-term output can only increase at a specific equilibrium price level. c. Prices have nothing to do with long-term output. d. Unemployment is zero in the long run.

69 Practice What You Know Suppose there is an increase in AD, causing a price level increase, what will happen in the long run as prices adjust? a. The price level will go back to its previous level. b. The price level will rise even further. c. The price level will fall to a level below its previous level. d. The price level will fall slightly to a level somewhere between its current level and the original level.

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