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Parkin-Bade Chapter 22

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11 CHAPTER Aggregate Supply and Aggregate Demand After studying this chapter you will be able to Distinguish between the macroeconomic long run and short run Explain ... – PowerPoint PPT presentation

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Title: Parkin-Bade Chapter 22


1
11
CHAPTER
Aggregate Supply and Aggregate Demand
2
After studying this chapter you will be able to
  • Distinguish between the macroeconomic long run
    and short run
  • Explain what determines aggregate supply
  • Explain what determines aggregate demand
  • Explain how real GDP and the price level are
    determined and how changes in aggregate supply
    and aggregate demand bring economic growth,
    inflation, and the business cycle
  • Describe the main schools of thought in
    macroeconomics

3
Production and Prices
  • Production grows and prices rise, but the pace is
    uneven.
  • What forces bring persistent and rapid expansion
    of real GDP?
  • What forces bring inflation?
  • Why do we have business cycles?
  • What is the range of view of macroeconomists in
    different schools of thought?

4
Macroeconomic Long Run and Short Run
  • The Macroeconomic Long Run
  • The macroeconomic long run is a time frame that
    is sufficiently long for the real wage rate to
    have adjusted to achieve full employment
  • Real GDP equals potential GDP.
  • Unemployment is at the natural unemployment rate.
  • The price level is proportional to the quantity
    of money.
  • The inflation rate equals the money growth rate
    minus the real GDP growth rate.

5
Macroeconomic Long Run and Short Run
  • The Macroeconomic Short Run
  • The macroeconomic short run a period during
    which some money prices are sticky so that
  • Real GDP might be below, above, or at potential
    GDP.
  • The unemployment rate might be above, below, or
    at the natural unemployment rate.

6
Aggregate Supply
  • The quantity of real GDP supplied is the total
    quantity that firms plan to produce during a
    given period. It depends on
  • The quantity of the labor employed
  • The quantity of physical and human capital
  • State of technology
  • We distinguish two time frames associated with
    different states of the labor market
  • Long-run aggregate supply
  • Short-run aggregate supply

7
Aggregate Supply
  • Long-Run Aggregate Supply
  • Long-run aggregate supply is the relationship
    between the quantity of real GDP supplied and the
    price level when real GDP equals potential GDP.
  • Potential GDP is independent of the price level.
  • So the long-run aggregate supply curve (LAS) is
    vertical at potential GDP.

8
Aggregate Supply
Figure 11.1 shows the LAS curve with potential
GDP of 12 trillion.
Along the LAS curve, all prices and wage rates
vary by the same percentage so relative prices
and the real wage rate remain constant.
9
Aggregate Supply
  • Short-Run Aggregate Supply
  • Short-run aggregate supply is the relationship
    between the quantity of real GDP supplied and the
    price level when the money wage rate, the prices
    of other resources, and potential GDP remain
    constant.
  • A rise in the price level with no change in the
    money wage rate and other factor prices increases
    the quantity of real GDP supplied.
  • The short-run aggregate supply curve (SAS) is
    upward sloping.

10
Aggregate Supply
  • Figure 11.2 shows a short-run aggregate supply
    curve (SAS).

Along the SAS curve, real GDP supplied might be
above potential GDP or below potential GDP.
11
Aggregate Supply
  • The SAS curve is upward sloping because
  • A rise in the price level with no change in costs
    induces firms to bear a higher marginal cost and
    increase production and
  • A fall in the price level with no change in costs
    induces firms to decrease production to lower
    marginal cost.

12
Aggregate Supply
  • Movements Along the LAS and SAS Curves
  • Figure 11.3 shows that a change in the price
    level with
  • an equal percentage change in the money wage
    causes a movement along the LAS curve.
  • no change in the money wage causes a movement
    along the SAS curve.

13
Aggregate Supply
  • Changes in Aggregate Supply
  • When potential GDP increases, both the LAS and
    SAS curves shift rightward.
  • Potential GDP changes, for three reasons
  • The full-employment quantity of labor changes
  • The quantity of capital (physical or human)
    changes
  • Technology advances

14
Aggregate Supply
  • Figure 11.4 shows how an increase in potential
    GDP shifts the LAS curve and the SAS curve shifts
    along with the LAS curve.

15
Aggregate Supply
  • Figure 11.5 shows the effect of a change in the
    money wage rate on aggregate supply.
  • A rise in the money wage rate
  • Decreases short-run aggregate supply and shifts
    the SAS curve leftward.
  • Has no effect on long-run aggregate supply.

16
Aggregate Demand
  • The quantity of real GDP demanded, Y, is the
    total amount of final goods and services produced
    in the United States that people, businesses,
    governments, and foreigners plan to buy.
  • This quantity is the sum of consumption
    expenditures, C, investment, I, government
    expenditure, G, and net exports, X M.
  • That is,
  • Y C I G X M.

17
Aggregate Demand
  • Buying plans depend on many factors and some of
    the main ones are
  • The price level
  • Expectations
  • Fiscal policy and monetary policy
  • The world economy

18
Aggregate Demand
  • The Aggregate Demand Curve
  • Aggregate demand is the relationship between the
    quantity of real GDP demanded and the price
    level.
  • The aggregate demand curve (AD) plots the
    quantity of real GDP demanded against the price
    level.

19
Aggregate Demand
  • Figure 11.6 shows an AD curve.
  • The AD curve slopes downward for two reasons
  • A wealth effect
  • Substitution effects

20
Aggregate Demand
  • Wealth Effect
  • A rise in the price level, other things
    remaining the same, decreases the quantity of
    real wealth (money, stocks, etc.).
  • To restore their real wealth, people increase
    saving and decrease spending, so the quantity of
    real GDP demanded decreases.
  • Similarly, a fall in the price level, other
    things remaining the same, increases the quantity
    of real wealth.
  • With more real wealth, people decrease saving and
    increase spending, so the quantity of real GDP
    demanded increases.

21
Aggregate Demand
  • Substitution Effects
  • 1. Intertemporal substitution effect
  • A rise in the price level, other things
    remaining the same, decreases the real value of
    money and raises the interest rate.
  • When the interest rate rises, people borrow and
    spend less so the quantity of real GDP demanded
    decreases.
  • Similarly, a fall in the price level increases
    the real value of money and lowers the interest
    rate.
  • When the interest rate falls, people borrow and
    spend more so the quantity of real GDP demanded
    increases.

22
Aggregate Demand
  • 2. International substitution effect
  • A rise in the price level, other things remaining
    the same, increases the price of domestic goods
    relative to foreign goods, so imports increase
    and exports decrease, which decreases the
    quantity of real GDP demanded.
  • Similarly, a fall in the price level, other
    things remaining the same, decreases the price of
    domestic goods relative to foreign goods, so
    imports decrease and exports increase, which
    increases the quantity of real GDP demanded.

23
Aggregate Demand
  • Changes in Aggregate Demand
  • A change in any influence on buying plans other
    than the price level changes aggregate demand.
  • The main influences on aggregate demand are
  • Expectations
  • Fiscal policy and monetary policy
  • The world economy

24
Aggregate Demand
  • Expectations
  • Expectations about future income, future
    inflation, and future profits change aggregate
    demand.
  • Increases in expected future income increase
    peoples consumption today and increases
    aggregate demand.
  • A rise in the expected inflation rate makes
    buying goods cheaper today and increases
    aggregate demand.
  • An increase in expected future profits boosts
    firms investment, which increases aggregate
    demand.

25
Aggregate Demand
  • Fiscal Policy and Monetary Policy
  • Fiscal policy is the governments attempt to
    influence the economy by setting and changing
    taxes, making transfer payments, and purchasing
    goods and services.
  • A tax cut or an increase in transfer payments
    increases households disposable incomeaggregate
    income minus taxes plus transfer payments.
  • An increase in disposable income increases
    consumption expenditure and increases aggregate
    demand.

26
Aggregate Demand
  • Fiscal Policy and Monetary Policy
  • Because government expenditure on goods and
    services is one component of aggregate demand, an
    increase in government expenditure increases
    aggregate demand.
  • Monetary policy is changes in interest rates and
    the quantity of money in the economy.
  • An increase in the quantity of money increases
    buying power and increases aggregate demand.
  • A cut in interest rates increases expenditure and
    increases aggregate demand.

27
Aggregate Demand
  • The World Economy
  • The world economy influences aggregate demand in
    two ways
  • A fall in the foreign exchange rate lowers the
    price of domestic goods and services relative to
    foreign goods and services, increases exports,
    decreases imports, and increases aggregate
    demand.
  • An increase in foreign income increases the
    demand for U.S. exports and increases aggregate
    demand.

28
Aggregate Demand
  • Figure 11.7 illustrates changes in aggregate
    demand.
  • When aggregate demand increases, the AD curve
    shifts rightward
  • and when aggregate demand decreases, the AD
    curve shifts leftward.

29
Macroeconomic Equilibrium
  • Short-Run 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 SAS curve.

30
Macroeconomic Equilibrium
  • Figure 11.8 illustrates a short-run equilibrium.
  • If real GDP is below equilibrium GDP, firms
    increase production and raise prices
  • and if real GDP is above equilibrium GDP, firms
    decrease production and lower prices.

31
Macroeconomic Equilibrium
  • These changes bring a movement along the SAS
    curve towards equilibrium.
  • In short-run equilibrium, real GDP can be greater
    than or less than potential GDP.

32
Macroeconomic Equilibrium
  • Long-Run Macroeconomic Equilibrium
  • Long-run macroeconomic equilibrium occurs when
    real GDP equals potential GDPwhen the economy is
    on its LAS curve.
  • Long-run equilibrium occurs at the intersection
    of the AD and LAS curves.

33
Macroeconomic Equilibrium
Figure 11.9 illustrates long-run
equilibrium. Long-run equilibrium occurs when the
money wage has adjusted to put the SAS curve
through the long-run equilibrium point.
34
Macroeconomic Equilibrium
  • Economic Growth and Inflation
  • Figure 11.10 illustrates economic growth.
  • Because the quantity of labor grows, capital is
    accumulated, and technology advances, potential
    GDP increases.
  • The LAS curve shifts rightward.

35
Macroeconomic Equilibrium
  • Figure 11.10 illustrates inflation.
  • Because the quantity of money grows faster than
    potential GDP, aggregate demand increases by more
    than long-run aggregate supply.
  • The AD curve shifts rightward faster than the
    rightward shift of the LAS curve.

36
Macroeconomic Equilibrium
  • The Business Cycle
  • The business cycle occurs because aggregate
    demand and the short-run aggregate supply
    fluctuate, but the money wage does not change
    rapidly enough to keep real GDP at potential GDP.
  • A below full-employment equilibrium is an
    equilibrium in which potential GDP exceeds real
    GDP.
  • An above full-employment equilibrium is an
    equilibrium in which real GDP exceeds potential
    GDP.
  • A full-employment equilibrium is an equilibrium
    in which real GDP equals potential GDP.

37
Macroeconomic Equilibrium
  • Figures 11.11(a) and (d) illustrate below
    full-employment equilibrium.
  • The amount by which potential GDP exceeds real
    GDP is called a recessionary gap.
  • Figures 11.11(b) and (d) illustrate
    full-employment equilibrium.

38
Macroeconomic Equilibrium
  • Figures 11.11(c) and (d) illustrate above
    full-employment equilibrium.
  • The amount by which real GDP exceeds potential
    GDP is called an inflationary gap.
  • Figure 11.11(d) shows how, as the economy moves
    from one type of short-run equilibrium to
    another, real GDP fluctuates around potential GDP
    in a business cycle.

39
Macroeconomic Equilibrium
  • Fluctuations in Aggregate Demand
  • Figure 11.12 shows the effects of an increase in
    aggregate demand.
  • An increase in aggregate demand shifts the AD
    curve rightward.
  • Firms increase production and the price level
    rises in the short run.

40
Macroeconomic Equilibrium
  • At the short-run equilibrium, there is an
    inflationary gap.
  • The money wage rate begins to rise and the SAS
    curve starts to shift leftward.
  • The price level continues to rise and real GDP
    continues to decrease until the economy has
    returned to full-employment.

41
Macroeconomic Equilibrium
  • Fluctuations in Aggregate Supply
  • Figure 11.13 shows the effects of a rise in the
    price of oil.
  • Short-run aggregate supply decreases and the SAS
    curve shifts leftward.
  • Real GDP decreases and the price level rises.
  • The economy experiences stagflation.

42
Macroeconomic Schools of Thought
  • Macroeconomists can be divided into three broad
    schools of thought
  • Classical
  • Keynesian
  • Monetarist

43
Macroeconomic Schools of Thought
  • The Classical View
  • A classical macroeconomist believes that the
    economy is self-regulating and always at full
    employment.
  • The term classical derives from the name of the
    founding school of economics that includes Adam
    Smith, David Ricardo, and John Stuart Mill.
  • A new classical view is that business cycle
    fluctuations are the efficient responses of a
    well-functioning market economy that is bombarded
    by shocks that arise from the uneven pace of
    technological change.

44
Macroeconomic Schools of Thought
  • The Keynesian View
  • A Keynesian macroeconomist believes that left
    alone, the economy would rarely operate at full
    employment and that to achieve and maintain full
    employment, active help from fiscal policy and
    monetary policy is required.
  • The term Keynesian derives from the name of one
    of the twentieth centurys most famous
    economists, John Maynard Keynes.
  • A new Keynesian view holds that not only is the
    money wage rate sticky but also are the prices of
    goods sticky.

45
Macroeconomic Schools of Thought
  • The Monetarist View
  • A monetarist is a macroeconomist who believes
    that the economy is self-regulating and that it
    will normally operate at full employment,
    provided that monetary policy is not erratic and
    that the pace of money growth is kept steady.
  • The term monetarist was coined by an
    outstanding twentieth-century economist, Karl
    Brunner, to describe his own views and those of
    Milton Friedman.

46
THE END
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