Aggregate Supply and Aggregate Demand

1
Aggregate Supply andAggregate Demand

• What determines aggregate supply and aggregate
  demand?
• What is the definition of macroeconomic
  equilibrium?

2
Important Concepts

• Potential GDP (Long Run AS)
• Aggregate Supply, AS
• Aggregate Demand, AD
• Short-run and Long-run equilibrium

3
Aggregate Demand

• The aggregate quantity of goods and services
  demanded is the sum of planned
• Consumption by households, C,
• Investment spending by firms, I,
• Government spending, G,
• Net exports to the R.O.W., (X - M).
• AD C I G X - M

4
The Aggregate Demand Curve
140
130
120
Price level (GDP deflator, 1992 100)
110
100
90
AD
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
5
Why the Aggregate Demand Curve Slopes Downward

• The aggregate demand curve slopes downward
  because of
• The Buying Power of Money
• The Real Interest Rate
• The Real prices of Exports and Imports

6
Changes inAggregate Demand

• There are three main factors that cause the
  aggregate demand curve to shift
• 1. Expectations
• 2. Fiscal policy and Monetary policy
• 3. International factors

7
Expectations

• Expectations about
• future incomes
• future inflation
• future profits

8
Fiscal Policy

• Fiscal policy is the governments attempt to
  influence the economy by setting and changing
• Government spending and
• Taxes
• These decisions are made by Congress in
  consultation with the President.

9
Monetary Policy

• Decisions about the money supply and interest
  rates are made by the central bank.
• The Feds attempt to influence the economy by
  varying the money supply and interest rates is
  called monetary policy.

10
International Factors

• The two main international factors are
• the foreign exchange rate, and
• income in the Rest of the World (R.O.W.)

11
Potential GDP

• Potential GDP is the value of production when all
  the economy's resources are fully employed.
• Unemployment is at its natural rate and the
  economy is at full employment.

12
Potential GDP (Yp )Yp f(hLn, K, NR, T)

• where
• Ln the number of workers at full employment.
• h the average number of hours worked.
• K the capital stock.
• NR the natural resources used.
• T the state of technology.

13
The Long-Run Aggregate Supply
Yp
140
130
120
Price level (GDP deflator, 1992 100)
110
100
Potential GDP
90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
14
What is a Supply Curve?

• The supply curve is the profit maximizing output
  at each price. It is where MC MR.
• A supply curve shifts when input costs change.

15
Aggregate Supply

• Aggregate supply is the relationship between the
  desired quantity of real GDP supplied and the
  price level.

16
Aggregate Supply

• Prices of goods and services change freely.
• Prices of factors of production (including the
  wage rate) do not change - - in the short-run.

17
Aggregate Supply
140
130
AS
120
Price level (GDP deflator, 1992 100)
110
c
b
a
100
90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
18
What shifts the AS?

• The AS shifts when the cost per unit of input
  changes.

19
What happens when the economy is not at Potential
GDP?

• What happens when there is too much or too little
  unemployment?

20
What happens when Y gt Yp?

• UN lt UNn and there is a shortage of labor and
  wages rise.
• What does this do to the cost of production? It
  increases.
• This shifts supply curves up. The AS shifts left.

21
AS Curve shifts up.
140
AS
130
AS
120
Price level (GDP deflator, 1992 100)
110
100
AD
90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
22
What happens when Y lt Yp?

• UN gt UNn and there is an excess of labor and
  wages might fall.
• What would this do to the cost of production? It
  would decrease.
• This shifts supply curves down. The AS shifts
  right.

23
AS Curve shifts down.
AS
140
AS
130
120
Price level (GDP deflator, 1992 100)
110
100
AD
90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
24
What happens when Y Yp?

• UN UNn and there is just the right amount of
  labor and wages are stable.
• What does this do to the cost of production?
  Nothing.
• This shifts supply curves do not shift. The AS
  is stable.

25
AS Curve is stable.
140
130
AS
120
Price level (GDP deflator, 1992 100)
110
100
AD
90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
26
At Equilibrium
Yp
140
130
AS
120
Price level (GDP deflator, 1992 100)
110
100
90
AD
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
27
Returning to equilibrium.
Yp
140
AS
130
AS
120
Price level (GDP deflator, 1992 100)
110
100
AD
90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
28
Returning to equilibrium.
Yp
AS
140
AS
130
120
Price level (GDP deflator, 1992 100)
110
100
AD
90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
29
The Long-Run Aggregate Supply

• In the long run, Aggregate Supply is equal to
  Potential GDP
• Yp is independent of the price level.
• The reason is because prices of output and the
  prices of inputs, relative to each other, will
  remain constant.

30
Changes in Long-Run Aggregate Supply

• Yp, or Potential GDP, shifts right if there is an
  increase in the factors of production or an
  improvement in technology.
• The AS curve will shift with the Yp curve.

31
Shift in both Yp and AS
Yp0
Yp1
140
AS0
AS1
130
120
Price level (GDP deflator, 1992 100)
110
100
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
32
Influences on Short-Run Aggregate Supply

• The AS curve shifts with the Yp.
• The AS will also shift with a change in
• the money wage rate,
• prices of other factors of production.

33
Yp and AS
Yp
140
130
AS
120
Price level (GDP deflator, 1992 100)
110
100
Real GDP above potential GDP
Real GDP below potential GDP
90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
34
Macroeconomic Equilibrium

• Macroeconomic equilibrium is where aggregate
  demand aggregate supply.
• There is an equilibrium for both
• the long run and short run.

35
Short-Run and Long-Run Macroeconomic Equilibrium

• Long-run macroeconomic equilibrium occurs when
  real GDP equals potential GDP.
• This implies that AD AS Yp.
• Short-run equilibrium can occur at a real GDP
  other than potential GDP.
• This implies that AD AS ? Yp.

36
Equilibrium Below Full Employment
Yp
140
Recessionary gap
130
AS0
120
Price level (GDP deflator, 1992 100)
a
Below full-employment equilibrium
110
100
90
AD0
6.8
7.0
7.2
Real GDP (trillions of 1992 dollars)
37
Equilibrium Above Full Employment
Yp
140
130
AS2
Inflationary gap
120
Price level (GDP deflator, 1992 100)
Above full-employment equilibrium
c
110
100
AD2
90
7.0
7.2
Real GDP (trillions of 1992 dollars)
38
The Business Cycle
Fluctuations in real GDP
c
7.2
Recesssionary gap
Full employment
Potential GDP
Real GDP (trillions of 1992 dollars)
7.0
b
Inflationary gap
Actual GDP
6.8
a
1
2
3
0
4
Year
39
Long-Term Growthand Inflation

• Long-term economic growth occurs when the
  long-run aggregate supply curve shifts to the
  right.
• Inflation occurs when aggregate demand increases
  faster than long-run aggregate supply.

40
Inflation and Money Growth

• The pace at which the aggregate demand curve
  shifts is determined mainly by the growth rate of
  the money supply.
• Rapid increases in the quantity of money relative
  to economic growth cause rapid inflation.

41
AD shifts faster than AS
140
AS2
AS0
AS1
130
120
AD2
Price level (GDP deflator, 1992 100)
110
AD1
100
AD0
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
42
Shock to Aggregate Demand

• Suppose the economy is at a full-employment
  equilibrium.
• Something causes AD to increase.
• Real GDP and the price level will increase in the
  short run.

43
Increase in AD
Yp
Short-run effect
140
130
AS0
Price level (GDP deflator, 1992 100)
115
110
100
AD1
90
AD0
6.0
7.0
7.5
Real GDP (trillions of 1992 dollars)
44
The Return toLong-Run Equilibrium

• The short-run equilibrium is above full
  employment.
• Prices and output have increased, but wage rates
  have not.
• In the long run, wage rates will increase.

45
Return to Equilibrium
Yp
Long-run effect
140
AS1
130
AS0
125
115
Price level (GDP deflator, 1992 100)
100
AD1
90
6.0
7.0
7.5
Real GDP (trillions of 1992 dollars)
46
The New Long-Run Equilibrium

• In the long-run, what has happened to output and
  prices?

47
A shock to AS
Yp
An oil price rise decreases short-run aggregate
supply
140
AS1
130
AS0
120
Price level (GDP deflator, 1992 100)
110
100
90
AD0
6.0
7.0
7.5
6.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
48
Anti-Stagflation Policies

• What will happen if there is no policy response?
• What will happen if there is a policy response?

49
Long-Term Growth, Inflation, and Cycles inthe
U.S. Economy

• The economy is continuously changing.
• The AD-AS model helps us understand what is going
  on at a point in time.
• Lets consider 1960 to the present.

50
The Economy, 1960-1996

• The three important features of the economys
  path are
• Long-term growth
• Inflation
• Business Cycles

51
The Economy 1960-1998