Ch. 7 Aggregate Demand and Supply

- Aggregate supply
- Aggregate demand
- Macroeconomic equilibrium.
- Effects of changes in aggregate supply and

aggregate demand on economic growth, inflation,

and business cycles - Explain U.S. economic growth, inflation, and

business cycles by using the AS-AD model.

Aggregate Supply

- Aggregate Supply Fundamentals
- Long-run aggregate supply
- Short-run aggregate supply

Aggregate Supply

- Long-Run Aggregate Supply (LRAS)
- relationship between the quantity of real GDP

supplied and the price level when real GDP equals

potential GDP. - Position of LRAS determined by
- Labor supply
- Labor demand
- Production function

The combination of the labor market equilibrium

and the production function determine the

potential level of GDP and the position of the

LRAS

Aggregate Supply

- The LAS curve is vertical because potential GDP

is independent of the price level. - Along the LAS curve all input and output prices

vary by the same percentage so that relative

prices and the real wage rate remain constant.

Aggregate Supply

- How will each of the following affect the

position of the LAS curve? - increase in labor supply
- Increase in labor demand
- Upward shift of the production function

Aggregate Supply

- Short-Run Aggregate Supply (SRAS)
- The macroeconomic short run
- a period during which some prices have not

adjusted to the long run equilibrium - real GDP may fall below or rise above potential

GDP. - the unemployment rate may rise above or fall

below the natural unemployment rate. - SRAS is the relationship between the quantity of

real GDP supplied and the price level in the

short-run when the money wage rate, the prices of

other resources, and potential GDP remain

constant.

Aggregate Supply

- Along the SAS curve, a rise in the price level

with no change in the money wage rate and other

input prices increases the quantity of real GDP

suppliedthe SAS curve is upward sloping.

Aggregate Supply

- The SAS curve is upward sloping because
- If money wage is fixed, as price level rises,

real wage falls and firms hire more workers. - If P105
- SASLAS
- labor market in equilibrium
- Unemployment ratenatural rate
- No pressure on real wages

Aggregate Supply

- If Pgt105
- SASgtLAS
- real wage lt equilibrium
- Shortage of labor
- Unemplltnatural rate
- Upward pressure on real wages
- If Plt105
- SASltLAS
- real wage gt equilibrium
- surplus of labor
- Unemplgtnatural rate
- Downward pressure on real wages

Aggregate Supply

- Movement along the LAS and SAS Curves
- A change in the price level with no change in the

money wage causes a movement along the SAS curve.

Aggregate Supply

- If real wageltequilibrium
- Real wages rise in long run
- SAS shifts left
- If real wagegtequilibrium
- Real wages fall in long run
- SAS shifts right

Aggregate Supply

- Changes in Aggregate Supply
- When potential GDP increases, both the LRAS and

SRAS curves shift rightward. - Sources of change in Potential GDP
- Change in the full-employment quantity of labor.
- Change in the quantity of capital (physical or

human). - Advance in technology.

Aggregate Demand

- AD C I G X M.
- Same as expenditure side of GDP
- Cconsumption expenditures
- I investment
- G government purchases,
- X M net exports

Aggregate Demand

- The AD curve (drawn against P) slopes downward

because when prices rise - Wealth effect real value of wealth decreases.
- Intertemporal substitution effects interest

rates rise - International substitution effects Exports fall,

imports rise

Aggregate Demand

- Changes in Aggregate Demand
- Expectations
- Future income, future profits, future inflation
- Fiscal policy
- Net Taxes (taxes transfers)
- Government purchases
- Monetary policy
- Interest rates affect investment, consumption.
- The world economy.
- Exports and imports

Macroeconomic Equilibrium

- Short-Run Macroeconomic Equilibrium
- occurs when the quantity of real GDP demanded

equals the quantity of real GDP supplied at the

point of intersection of the AD curve and the

SRAS curve. - Long-run macroeconomic equilibrium
- occurs when real GDP equals potential GDPwhen

the economy is on its LRAS curve.

Macroeconomic Equilibrium

- LR equilibrium occurs
- where the AD and LRAS curves intersect
- results when the money wage has adjusted to put

the SRAS curve through the long-run equilibrium

point.

Macroeconomic Equilibrium

- The Business Cycle
- The business cycle occurs because AD and SRAS

fluctuate but the money wage does not change

rapidly enough to keep real GDP at potential GDP.

Macroeconomic Equilibrium

- A long-run equilibrium is an equilibrium in which

potential GDP equals real GDP. - Unemplnatural rate
- No pressure on real wages

P

LRAS

SRAS

AD

Real GDP

Macroeconomic Equilibrium

- Equilibrium below full employment
- potential GDP exceeds real GDP.
- Recessionary gap
- Unemplgtnatural rate
- Downward pressure on real wages
- SRAS will eventually shift right

P

LRAS

SRAS

AD

Real GDP

Macroeconomic Equilibrium

- Equilibrium above full employment
- real GDP exceeds potential GDP.
- Inflationary gap
- Unempl lt natural rate
- Upward pressure on real wages
- SRAS will eventually shift left

P

LRAS

SRAS

AD

Real GDP

Fluctuations in Aggregate Demand

- An increase in aggregate demand shifts the AD

curve rightward. - SR effect on
- Prices
- Real GDP
- Real wages
- Unemployment

Fluctuations in Aggregate Demand

- In LR,
- upward pressure on real wages causes money wage

to rise and shifts SAS leftward until return to

LR equilibrium. - As move from A to B, effect on
- Prices
- Real wages
- Unemployment
- Real GDP

B

A

Macroeconomic Equilibrium

- Fluctuations in Aggregate Supply
- Starting at LR equilibrium, a rise in the price

of oil decreases short-run aggregate supply and

the SRAS curve shifts leftward.

U.S. Economic Growth, Inflation, and Cycles

- Changes in real GDP and the price level each year

from 1963 to 2003 in terms of shifting AD, SAS,

and LAS curves.

Using the AS/AD model

- Starting from a LR equilibrium, examine the SR

and LR effect of - Tax cut
- Increase in government spending
- Fed cuts interest rates
- Consumer confidence rises
- Temporary supply shock
- Assume NO EFFECT on LRAS (to be considered

later) - Variables to consider
- price, real wage, real GDP, unemployment.