# Chapter 3 AGGREGATE DEMAND AND

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1 Chapter 3 AGGREGATE DEMAND AND AGGREGATE G SULY Dr. Mohammed Alwosabi The aggregate demand and aggregate supply (-AS) model determines RGD and GD Deflator and helps us understand the performance of three macroeconomic fundamentals: 1. Growth of potential GD 2. Inflation 3. Business cycle fluctuations (expansion and recession) 1 2 AGGREGATE DEMAND () Aggregate demand () is the total amount of goods and services produced in a country (i.e., the quantity of RGD demanded) that people, businesses, government, and foreigners are willing and able to buy at different price levels within a given period. = RGD = Y = C + I + G + NX The aggregate demand curve () shows the inverse relationship between RGD demanded and the price level (using either the GD Deflator or CI) when all other things remain the same Y 1 Y 0 RGD 4 curve has negative slope (slopes downward) because of two effects: 1. Wealth Effect: Real wealth is measured as the amount of goods and services wealth will buy. (= Wealth / ) When but other things remain the same, real wealth. To restore their wealth people S and C RGD demanded Conversely, if the price level of goods and services but the value of your assets do not, you feel wealthier C RGD demanded 5 6 1

2 2. Substitution Effect: a. Inter-temporal substitution effect (interest rate effect): The substitution effect involves substituting goods in the future for goods in the present or goods in the present for goods in the future. This is called inter-temporal substitution effect (a substitution across time). This effect is mainly a result of changes in the real interest rate, which affect the decisions of households and businesses in terms of their willingness and ability to borrow. As, demand for money and interest rate consumers may decide that it is not worth it to save since they do not receive as much return. 7 8 On the other hand, they may decide that since it is now cheaper to borrow, they will increase their borrowing to finance their consumption and investment, which would increase RGD demanded. The net effect of the of the interest rate is C and S Alternatively, when and other things remain the same, demand for money interest rate C and I RGD demanded. S to increase future C 9 10 b. International substitution effect: When the, and other things remain the same domestically made goods and services become more expensive relative to foreign made goods and services. people p spend less in the domestically made goods and more on foreign made products X and M NX Conversely, when, and other things remain the same domestically made goods and services become less expensive relative to foreign made goods and services people spend more in the domestically made goods and dless on foreign made products X increases and M

3 Changes in RGD demanded (Movement along Curve) The change in the quantity of RGD demanded as a result of changes in price level is represented by movement along curve. When, other things remain the same, RGD demanded an upward movement along curve When price level, other things remain the same, RGD demanded a downward movement along curve 13 Changes in (Shift of Curve) change if one or more of factors, other than price level, change. When change curve shifts rightward or leftward The shifts in means an increase (or a decrease) in the quantity of RGD demanded at every price level 14 The main factors that influence are: 1. Expectations 2. Fiscal and monetary policies 3. The world economy 1. Expectations Expected future income C curve shifts rightward Expected future inflation rate curve shifts rightward. Expected future profit I curve shifts rightward. The opposite is true Fiscal and Monetary olicies a. Fiscal olicy exists when government tries to influence the economy by changing taxes, changing its purchases of goods and services, and making transfer payments If T Y d C curve shifts rightward (Disposable income = Y d =Aggregate income taxes + transfer payments) 17 If transfer payments Y d C curve shifts rightward If G curve shifts rightward b. Monetary olicy, which is conducted by the Central Bank, consists of changes in the interest rates (i) and in the quantity of money (Q d ) in the economy. If i C and I shifts rightward If Q d C and I shifts rightward 18 3

4 3. The World Economy: The world economy affects through foreign exchange rate and foreign income. a. Foreign exchange rate (ER) is the amount of foreign currency that you can buy with the domestic currency. If ER (appreciation of domestic currency) domestic goods become more expensive X (and M ) shifts leftward. 19 b. Foreign income Foreign income foreigners can buy more of domestic products X shifts rightward 20 AGGREGATE SULY (AS) Aggregate Supply (AS) shows the total supply of all goods and services (RGD) produced in the economy at a given time. AS curve depicts the quantity of RGD supplied at different price level. l The RGD supplied at full employment (FE) is called the potential GD (GD). 21 The quantity of RGD produced depends on: 1. The quantity of labor (L), 2. The quantity of capital (K), 3. The state of technology (T) RGD = Y = F (L, K, T) A country can supply more RGD (outward shift of the country s F) if technology improves and/or has more factors of production (L, K). 22 At any given time, the quantity of capital and the state of technology are fixed but the quantity of labor is not fixed (can vary) Over the business cycle, employment fluctuates around FE and RGD fluctuates around GD. Labor market can be: 1. at full employment (FE), 2. above FE, or 3. below FE. To study AS in different states of the labor market we distinguish between short run aggregate supply () and long run aggregate supply () The short run (SR) is a period during which RGD has fallen below or risen above GD. Equivalently, the unemployment rate has fallen below or risen above the natural unemployment rate

5 The long run (LR) is a time frame that is sufficiently long for all adjustments to be made so that RGD = GD and UR = NRU. That is, when the economy is at full employment. 25 Short Run Aggregate Supply () Curve The curve is the relationship between the RGD supplied and the price level () in the SR when (1) the money wage rate, (2) the prices of other resources, and (3) the GD remain constant. t Only change and as a result the quantity of RGD supplied. The costs of production will be fixed in the short run because the firm previously entered into long-term 26 contracts. A typical curve is positively sloped (upward sloping) because a rise in the price level provides profit incentive for the firms. o 1 0 RGD Y0 Y1 27 Long Run Aggregate Supply () Curve curve shows the relationship between RGD supplied and the price level () in the LR when RGD = GD and the economy is at full employment. otential GD is independent of the price level. The country always produces the GD in the LR (has FE in the LR) regardless of the price level. Thus, the long-run AS () curve is vertical at the level of GD. In LR, RGD is determined by the amount of L, K and T not by price level. 28 Combining and 1 1 * 2 o 0 Yp RGD 0 RGD Y2 Yp Y

6 At *, RGD = GD, UR= NRU (the economy is at FE) If > * (at 1 ) RGD > GD, (At 1 the economy is producing Y 1 > Y p ) and UR < NRU (the economy is above FE) If < * (at 2 ) RGD < GD, (At 2 the economy is producing Y 2 < Y p ) and UR > NRU (the economy is below FE) Thus, RGD may be more or less than GD 31 Change in RGD Supplied (Movements along and curves) Along, the quantity of RGD supplied increases as the price level increases because total revenue increases more than the increase in the cost of production and as a result profit increases; and this is a movement along Y p RGD 33 When price level increases, and at the same time nominal wage rate and other resource prices increase by the same proportion, relative prices remain constant and RGD remains at GD. There is a movement along the curve. Conclusion: a change in the price level brings a movement along the AS curves (both and ) but does not change the aggregate supply (no shift in AS curve). 34 Changes in AS (Shifts in and ) What if stays the same and there is change in AS? We have to determine if the change is permanent or temporary. If the change is permanent, the and the both change. If the change is temporary, only the shifts. AS changes when factors other than price level change. This includes (1) changes in potential GD and (2) changes in money wage rate and other resource prices

7 (1) Change in potential GD: The factors that change are the same factors that shift the F When potential GD changes, both and change and both and curves shift. Why? Since RGD fluctuates around GD, fluctuates around otential GD changes for three reasons 1. Change in full employment (FE) level of labor 2. Change in capital 3. Change in technology When one or some of these factors change, potential GD changes when potential GD change, both and change Y 0 Y 1 RGD (2) Change in money (nominal) wage rate and/or other resource prices: When money wage rate or the money prices of other resources change, changes but does not change. A decrease in money wage rate increases from 0 to 1. The money wage rate (and other resource prices) affect because they influence firms' costs. But they do not change curve MACROECONOMIC EQUILIBRIUM The equilibrium level of and RGD in the economy will be where the desired total level of expenditures in the goods markets exactly matches the desired total level of output to be sold. The equilibrium exists where the quantity of RGD demanded = the quantity of RGD supplied (when curve intersects AS curve). 41 However, there is macroeconomic equilibrium for each time frame (SR and LR). SR equilibrium is the normal state of the economy as it fluctuates around GD; and the UR fluctuates around the NRU LR equilibrium is the state forward, which the economy is heading. -AS model studies the relationship between the price level and unemployment. 42 7

8 SR Macroeconomic Equilibrium SR equilibrium occurs when the quantity of RGD demanded equal the quantity of RGD supplied at the intersection of curve and curve * Y 0 RGD 43 In SR, we assume that money wage and price of other factors are fixed. If >*, RGD supplied > RGD demanded surplus Firms will not be able to sell all their output firms decrease production and lower prices If < *, RGD demanded > RGD supplied shortage Inventories are unexpectedly less than the quantity of RGD Demanded firms increase production and raise prices. 44 These changes bring a movement along the curve toward equilibrium. In short-run equilibrium, real GD can be greater than or less than potential GD because in the SR money wage is fixed. In macroeconomic SR equilibrium, there exists frictional and structural unemployment and the economy might not be at the natural rate of unemployment 45 LR Macroeconomic Equilibrium LR equilibrium occurs when RGD = GD at the intersection of curve and curve (when the economy is at full employment). In the LR, determines price level and has no impact on RGD. The money wage rate adjusts in the LR curve intersects the curve at the equilibrium price level and LR equilibrium point. 46 * Yp RGD Economic Growth and Inflation Economic growth is the persistent increase in GD. It occurs because the quantity of labor at FE grows, capital accumulated and/or technology advances GD increases curve shifts rightward. The growth rate of GD is determined by the pace at which labor, capital, and technology change. (Economic Growth = Y p1 Y p0 )

9 Inflation is the persistent rise in the price level. Inflation occurs because the quantity of money grows faster than potential GD, which increases by more than. curve shifts rightward by more than the rightward shift in the curve. (Inflation = 1 0) Deflation occurs if curve shifts is less than the shift in the curve If the increase in is the same as the increase of, GD will grow with no inflation (price level is constant) Yp 0 Yp 1 RGD 50 In LR, the main influence on is the growth rate of the quantity of money (Q m ). Quantity of money increases increases inflation rate increases. When the growth rate of quantity of money slows, the inflation rate decreases The Equilibrium and Business Cycle The business cycle occurs because and fluctuate but the money wage rate does not adjust quickly enough to keep RGD at GD. To simplify our analysis of the business cycle, we ignore economic growth 0 Yp0 Yp RGD (1) recessionary gap Below FE equilibrium is a macroeconomic SR equilibrium where curve intersects curve at RGD of Y 1 (less than Y p ) and price level 1. The amount by which h RGD < GD is called a recessionary gap. In the LR, money wage rate decreases shifts rightward unemployment decreases and price level decreases. 1 recessionary gap Y 1 Y p

10 (2) Inflationary gap At above FE equilibrium RGD > GD. It occurs when intersects at RGD = Y 2 (more than Y p ) and = 2. The amount by which RGD exceeds GD is called an inflationary gap In the LR money wage rate increases shift leftward price level increases and above full employment goes back to full employment. 2 Inflationary gap Yp Y (3) Full Employment Equilibrium A long-run equilibrium is an equilibrium in which GD = RGD, where curve intersects curve on a point at. The economy is at FE and RGD=GDGD * Y p Business Cycle The economy moves from one type of SR equilibrium to another as a result of fluctuations in and. These fluctuations produce fluctuations of RGD around GD and unemployment rate around the natural rate of unemployment. So, business cycle occurs because and change at different rates. RGD=GD recessionary gap Inflationary gap

11 FLUCTUATIONS IN ( shifts rightward) 1 0 C B A 1 0 RGD Yp Y1 61 One reason that RGD fluctuates around GD is the fluctuations in. fluctuates for any changes in C, I, G, NX, or Q m Initially, the economy is at LR equilibrium (FE equilibrium at point A), where the intersection of, 0 and 0. At this point, RGD = GD and = Suppose some of C, I, G, NX, or Qm increase increases curve shifts rightward to 1 (firms expect higher future profits) Short- run effect: Faced with the increase in, firms increase production and raise the price. RGD increases from Y p to Y 1 and price increases from 0 to 1 (at B) The economy is now in an aboveemployment equilibrium (negative cyclical unemployment) where RGD > GD and 1 > 0 inflationary gap. 63 At this stage, price level increases but wage rates have not change (as we move along, money wage rate is constant) Long-run effect: The economy cannot produce in excess of GD forever. At point B, firms have higher profits but workers now have lower real wage because price level increased from 0 to 1 but money wage remains the same as in point A. 64 Thus, inflationary gap exists and the purchasing power of workers wages falls. Workers (and owners of other factors of production) demand higher wages and prices for their services and firms meet their demand in order to keep the higher level of production and profits (if firms do not raise the money wage rate they will either lose workers or have to hire less productive ones). As money wage and other resource prices increase (higher cost of production) begins to shift leftward until it reaches 1 where it intersects with 1 and at point C. RGD comes back to FE equilibrium (GD =Y p ) and price level increases to 2 causing higher inflation

12 In the LR, the increase in nominal (money) wage rate will decrease inflationary gap and reach FE with higher price level In LR, money wage rate increases by the same percentage as the increase in price level Firms' owners use this illustration to argue with labor unions that any increase in wages would result in higher price level, which, at the end, increases the cost of living for workers and for the entire population. 67 Firms expect a loss in the future ( shifts leftward) 68 FLUCTUATIONS IN When nominal wage and prices of other factors of production increase (cost of production increases) Initially at point A, LR FE equilibrium, where RGD = GD If nominal wages or prices of other factors of production increase production cost increases firms reduce production curve shifts leftward to 1 (1) price level increases to 1 the economy experiences inflation (2) RGD decreases to Y1 (RGD < GD) the economy experiences recession A combination of recession (stagnation) and inflation is called stagflation Government should intervene to correct the situation In the LR, money wage decreases shifts rightward until FE equilibrium where RGD = GD at lower price level B 0 A Y1 Yp RGD

13 When nominal wage and prices of other factors of production decrease (cost of production decreases) The economy was initially at point A where RGD = GD When prices of factors of production fall, cost of production falls increases curve shifts rightward to 2 New short run equilibrium is at point C. RGD increases to Y 2 (employment increases to more than FE equilibrium) and price level to 2 deflation Low prices discourage firms from increasing their production RGD until it goes back to LR equilibrium at some higher price A C 0 2 FLUCTUATIONS IN BOTH AND AS rofit is expected to increase and cost of production is expected to decrease Initially the economy was at point A If resource cost expected to decrease, AS curve shifts rightward and firms profit expected to increase curve shifts rightward Yp Y2 RGD If the shift in C > the shift in C RGD and 2. If the shift in C < the shift in C RGD but 3. If the shift in both curves is with the same pace, RGD but remains the same Conclusion: When both curves shift rightward, RGD but,, or remains the same ( is undetermined). 1 0 Yp A 0 Y1 E RGD

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