NATIONAL INCOME DETERMINATION PART 2: AGGREGATE DEMAND AND SUPPLY TEXT BOOK CHAPTER 10

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1 NATIONAL INCOME DETERMINATION PART 2: AGGREGATE DEMAND AND SUPPLY TEXT BOOK CHAPTER 10 PREPARATION FOR DAY 1: Read pages in your text. A lot of this is review of the determinants of demand so focus primarily on the information that explains the AD curve and the slope of the AD curve. DAY 1: DAY 2: DAY 3: DAY 4: DAY 5: Define aggregate demand Explain why the Aggregate Demand Curve is downward sloping Identify the determinants of Aggregate Demand that cause SHIFTS in the AD curve. Analyze the relationship between price level and GDP as it is illustrated on an AD/AS model. Assign: Complete Activity 23 Macro Book Objective: Review answers to Activity 23 Clear up any questions related to the Aggregate Demand curve. Assign: Read pages Focus on the slope of the AS curve and its meaning as well as the DETERMINANTS of AS and SHIFTS in the AS curve in the SHORT RUN. Define Aggregate Supply Explain why the Aggregate Supply Curve is upward sloping. Identify the determinants of Aggregate Supply that cause SHIFTS in the As curve Define the THREE ranges of the modified Aggregate Supply curve, and analyze the condition in each range Assign: 1. Complete Activity 24 Macro Book 2. Read pages in the text carefully. Review answers to Activity 24 Define equilibrium in macroeconomic terms, and describe the adjustment process that occurs when the economy is not in equilibrium. Analyze changes in Aggregate Demand and Supply to illustrate their effects on the price level and real national output. Practice differentiating between changes in Aggregate Demand and Aggregate Supply Assign: Complete Activity 25 Macro Book Review answers to Activity 25 Illustrate the concepts of Demand Pull and Cost Push inflation using the AD/AS model Assign: Read page 192 of your text making sure to fully comprehend where the LRAS curve lies, and why it has the vertical shape.

2 DAY 6: Differentiate between Short and Long Run Aggregate Supply Recognize the conditions that exist in when Agg. Supply is in the long run. Use graphical analysis to illustrate the conditions of LRAS. Compare and contrast the LRAS curve with the Production Possibilities Frontier Assign: 1. Complete Activity 27 Macro Book 2. Read Closing a Recessionary Gap and Closing an Inflationary Gap in packet. DAY 7: Review answers to Activity 27 and wrap up any AD/AS loose ends. Define and illustrate Recessionary Gaps and Inflationary Gaps using an AD/AS graph. Recognize the theoretical adjustment mechanism that occurs in the long run to reconcile inflationary and recessionary gaps. Assign: Complete Activity 28 in the workbook. DAY 8: Assign: Review the answers to Activity 28 Given specific amounts of recessionary or inflationary gaps, calculate spending changes needed to bring the economy back to long run equilibrium. This requires knowledge of C+I+G+ (X-M), the MPC, and Multiplier. Practice solving inflationary and recessionary gaps. 1. Complete AD/AS practice sheet. 2. Complete practice test and come to class with any questions.

3 VOCABULARY LIST FOR AGGREGATE DEMAND AND SUPPLY MODEL MINI UNIT 1. Aggregate Demand 2. Aggregate Demand Curve 3. Real-Balances Effect 4. Interest-Rate Effect 5. Foreign Purchases Effect 6. Determinants of Aggregate Demand 7. Long Run Aggregate Supply 8. Short Run Aggregate Supply 9. Determinants of Aggregate Supply 10. Short Run Macroeconomic Equilibrium 11. Long Run Macroeconomic Equilibrium 12. Demand Pull Inflation 13. Cost Push Inflation 14. Recessionary Gap 15. Inflationary Gap 16. The Natural Long Run Adjustment Mechanism

4 The Aggregate Demand Curve Figure 2.1: Graph of the aggregate demand curve. The most noticeable feature of the aggregate demand curve is that it is downward sloping, as seen in figure 2.1. There are a number of reasons for this relationship. Recall that a downward sloping aggregate demand curve means that as the price level drops, the quantity of output demanded increases. Similarly, as the price level drops, the national income increases. There are three basic reasons for the downward sloping aggregate demand curve. These are Pigou's wealth effect, Keynes's interest-rate effect, and Mundell-Fleming's exchange-rate effect. These three reasons for the downward sloping aggregate demand curve are distinct, yet they work together. The first reason for the downward slope of the aggregate demand curve is Pigou's wealth effect. Recall that the nominal value of money is fixed, but the real value is dependent upon the price level. This is because for a given amount of money, a lower price level provides more purchasing power per unit of currency. When the price level falls, consumers are wealthier, a condition which induces more consumer spending. Thus, a drop in the price level induces consumers to spend more, thereby increasing the aggregate demand. The second reason for the downward slope of the aggregate demand curve is Keynes's interest-rate effect. Recall that the quantity of money demanded is dependent upon the price level. That is, a high price level means that it takes a relatively large amount of currency to make purchases. Thus, consumers demand large quantities of currency when the price level is high. When the price level is low, consumers demand a relatively small amount of currency because it takes a relatively small amount of currency to make purchases. Thus, consumers keep larger amounts of currency in the bank. As the amount of currency in banks increases, the supply of loans increases. As the supply of loans increases, the cost of loans--that is, the interest rate-- decreases. Thus, a low price level induces consumers to save, which in turn drives down the interest rate. A low interest rate increases the demand for investment as the cost of investment falls with the interest rate. Thus, a drop in the price level decreases the interest rate, which increases the demand for investment and thereby increases aggregate demand. The third reason for the downward slope of the aggregate demand curve is Mundell-Fleming's exchange-rate effect. Recall that as the price level falls the interest rate also tends to fall. When the domestic interest rate is low relative to interest rates available in foreign countries, domestic investors tend to invest in foreign countries where return on investments is higher. As domestic currency flows to foreign countries, the real exchange rate decreases because the international supply of dollars increases. A decrease in the real exchange rate has the effect of increasing net exports because domestic goods and services are relatively cheaper. Finally, an increase in net exports increases aggregate demand, as net exports is a component of aggregate demand. Thus, as the price level drops, interest rates fall, domestic investment in foreign countries increases, the real exchange rate depreciates, net exports increases, and aggregate demand increases.

5 A G G R E G A T E S U P P L Y Defining aggregate supply Aggregate Supply (AS) measures the volume of goods and services produced within the economy at a given overall price level. There is a positive relationship between AS and the general price level. Rising prices are a signal for businesses to expand production to meet a higher level of AD. An increase in demand should lead to an expansion of aggregate supply in the economy. Short-run aggregate supply curve Aggregate supply is determined by the supply side performance of the economy. It reflects the productive capacity of the economy and the costs of production in each sector. Shifts in the AS curve can be caused by the following factors: changes in size and or quality of the labor force available for production changes in size and or quality of capital stock through investment technological progress and the impact of innovation changes in productivity of both labor and capital changes in unit wage costs (wage costs per unit of output) changes in producer taxes and subsidies changes in inflation expectations - a rise in inflation expectations is likely to boost wage levels and cause AS to shift inwards

6 In the diagram above - the shift from AS1 to AS2 shows an increase in aggregate supply at each price level might have been caused by improvements in technology and productivity or the effects of an increase in the active labor force. An inward shift in AS (from AS1 to AS3) causes a fall in supply at each price level. This might have been caused by higher unit wage costs, a fall in capital investment spending (capital scrapping) or a decline in the labor force. LONG RUN AGGREGATE SUPPLY Long run aggregate supply is determined by the productive resources available to meet demand and by the productivity of factor inputs (labor, land and capital). In the short run, producers respond to higher demand (and prices) by bringing more inputs into the production process and increasing the utilization of their existing inputs. Supply does respond to change in price in the short run. In the long run we assume that supply is independent of the price level (money is neutral) - the productive potential of an economy (measured by LRAS) is driven by improvements in productivity and by an expansion of the available factor inputs (more firms, a bigger capital stock, an expanding active labor force etc). As a result we draw the long run aggregate supply curve as vertical.

7 Improvements in productivity and efficiency cause the long-run aggregate supply curve to shift out over the years. This is shown in the diagram below

8 L o n g r u n a g g r e g a t e s u p p l y Most supply-side policies are designed to improve the long-term performance of the economy. They clearly have short run effects - but we should really judge supply-side policies by measuring the extent to which the United Kingdom economy is able to sustain economic growth over a number of years and raise total employment and average living standards. Long run aggregate supply is determined by the productive resources available to meet demand and also by the productivity of factor inputs (labour, land and capital). Changes in technology also affect the potential level of national output in the long run. In the short run, producers respond to higher demand (and prices) by bringing more inputs into the production process and increasing the utilization of their existing inputs. Supply does respond to change in price in the short run - we move up or down the short run aggregate supply curve. In the long run we assume that supply is independent of the price level (money is said to be neutral) - the productive potential of an economy (measured by LRAS) is driven by improvements in productivity and by an expansion of the available factor inputs (more firms, a bigger capital stock, an expanding active labour force etc). As a result we draw the long run aggregate supply curve as vertical.

9 Improvements in labour productivity and efficiency cause the long-run aggregate supply curve to shift out over the years

10 Closing a Recessionary Gap Recessionary Gap To see how self-correction closes a recessionary gap, consider the recessionary gap presented in the exhibit to the right. This graph reveals a short-run equilibrium that lies to the left of the LRAS curve and which is less than full employment real production. This particular recessionary gap is, in all likelihood, the result of a decrease in aggregate demand and a leftward shift of the AD curve. A recessionary gap persists in the short run because inflexible wages and resource prices do not decline enough to eliminate unemployment and achieve equilibrium in the labor and resource markets. However, in the long run, wages and resource prices ARE flexible and they DO decline enough to eliminate imbalances in the resource markets. The result of declining wages (and other resource prices) is a reduction in production cost. A decrease in production cost causes an increase in short-run aggregate supply, or a rightward shift of the SRAS curve. Note that the SRAS curve shifts rightward until it intersects BOTH the LRAS and AD curves at fullemployment real production, which is long-run equilibrium. In particular, the new long-run equilibrium is at the full-employment level of real production. The SRAS curve absolutely MUST shift until this long-run equilibrium is reached. If the aggregate market does NOT reach long-run equilibrium, resource market imbalances persist, resource prices and production cost decline further, and the SRAS curve shifts more. However, once long-run equilibrium is reached, resource market imbalances are eliminated, resource prices and production cost do not change, and the SRAS curve does not shift any further.

11 Closing an Inflationary Gap Inflationary Gap To see how self-correction closes an inflationary gap, consider the inflationary gap presented in the exhibit to the right. This graph reveals a short-run equilibrium that lies to the right of the LRAS curve and which is greater than full employment real production. This particular inflationary gap is, in all likelihood, the result of an increase in aggregate demand and a rightward shift of the AD curve. An inflationary gap persists in the short run due to a reduction in frictional and structural unemployment and imbalances in real resource prices that allow over-employment and prevent equilibrium in the labor and resource markets. However, in the long run, rising wages and resource prices allow employment to return to its natural, full-employment level and eliminate imbalances in real resource prices. The result of rising wages and resource prices is rising production cost. An increase in production cost causes a decrease in short-run aggregate supply, or a leftward shift of the SRAS curve. Note that the SRAS curve shifts leftward until it intersects BOTH the LRAS and AD curves at fullemployment real production, which is long-run equilibrium. In particular, the new long-run equilibrium is at the full-employment level of real production. The SRAS curve absolutely MUST shift until this long-run equilibrium is reached. If the aggregate market does NOT reach long-run equilibrium, resource market imbalances persist, resource prices and production cost rise further, and the SRAS curve shifts more. However, once long-run equilibrium is reached, resource market imbalances are eliminated, resource prices and production cost do not change, and the SRAS curve does not shift any further.

12 PRACTICE QUESTION FOR SOLVING INFLATIONARY AND RECESSIONARY GAPS WITH THE AD/AS MODEL Assume the following conditions exist: An injection of $200 Billion dollars will create $1000 Billion dollars in total GDP Current equilibrium is at AD1/AS1, and is in the amount of $5,000 Billion Current LRAS is labeled as LRAS 1 and is in the amount of $4,500 Billion Current price level is 108 Price Level LRAS AS 1 AD Real 1. Based on the current short run equilibrium, what problem would the economy be experiencing? How would this show up in the local supermarket or retail store? 2. Based on the information given, what is the MPC in this economy? How do you know this? Explain briefly. 3. If you had to correct the problem in this economy what would your objective be for Aggregate Demand, and why would this solve the problem? 4. By precisely how much would you change things in the economy based on the MPC? Why is this the correct amount? 5. What problem might you create by taking the actions that you are recommending? (Think labor) 6. Illustrate the effect of your policy decision on the graph above by making necessary changes.

13 PRACTICE QUESTION FOR SOLVING INFLATIONARY AND RECESSIONARY GAPS WITH THE AD/AS MODEL Price Level LRAS AS 1 AD Real 1. Based on the current short run equilibrium, what problem would the economy be experiencing? How would this show up in the local supermarket or retail store? 2. If you had to correct the problem in this economy what would your objective be for Aggregate Demand, and why would this solve the problem? Give TWO (2) specific examples of policies that you would propose to solve the problem. 3. What problem might you create by taking the actions that you are recommending? (Think labor) 4. Illustrate the effect of your policy decision on the graph above by making necessary changes.