Aggregate Supply and Aggregate Demand

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Aggregate Supply and Aggregate Demand
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GDP 2007 to 2010
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OK One more time..

• Component parts of GDP?
• C I G (X-M) GDP
• Long-Run Aggregate Supply Curve (LRAS)
• A vertical line representing the real output of
  goods and services after full adjustment has
  occurred
• It represents the real GDP of the economy under
  conditions of full employment the economy is on
  its production possibilities curve

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The Production Possibilities and the Economys
Long-Run Aggregate Supply Curve
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Output Growth and the Long-Run Aggregate Supply
Curve (cont'd)

• LRAS is vertical Why?
• Input prices fully adjust to changes in output
  prices
• Suppliers have no incentive to increase output
• Unemployment is at the natural rate
• Determined by technology (or existing resources)
  

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Output Growth and the Long-Run Aggregate Supply
Curve (cont'd)

• Growth is shown by outward shifts of either the
  production possibilities curve or the LRAS curve
  caused by
• Growth of population and the labor-force
  participation rate
• Capital accumulation
• Improvements in technology

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What is Aggregate Demand?

• The total amount of goods and services
  demanded in the economy at a given overall price
  level and in a given time period.Represented by
  Aggregate Demand curve (relationship between
  price level and quantity of output firms are
  willing to provide.)

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Think Why does AD slope downward?
Vertical axis represents Price level for ALL
final goods And services
The aggregate price level Is measured by either
GDP Deflator or CPI
Price level
The horizontal axis represents the real quantity
of all GS purchased as measured by the level of
REAL GDP
AD
Real domestic output, GDP
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Figure 10-4 The Aggregate Demand Curve
As the price level rises, real GDP declines
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• ASSUMPTION for Aggregate demand IS If Price
  level is decreasing, so are incomes.

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• There are 3 Reasons that cause the Aggregate
• Demand Curve to be downward sloping.
• Real Balance Effect (Wealth effect)
• Interest Rate Effect
• International Trade Effect

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Real Balance Effect

• Price level falls- causes purchasing power to
  rise translates into more money to spend or
  monetary wealth improves.
• Real Balance Effect (or wealth effect) Higher
  price level means less consumption spending.

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Real Balance Effect
The change in the purchasing power of
dollar- Relates to assets that result from a
change in the price level
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Interest Rate Effect

• Inverse relationship between price level and
  quantity demanded of GDP because households and
  businesses adjust to interest rates for those
  interest-sensitive purchases.
• Price level falls (bundle of goods costs less)
  rest of money into savings, more money available
  for borrowing interest rate down.
• Think of money as stationary demand drives up
  price of money.

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Interest Rate continued

• Now if bundle of goods increases want to
  purchase interest sensitive good, cost to borrow
  is up.
• An increase in money demand will drive up the
  price paid for its use
• use of money interest rate
• As price level rises, houses and firms require
  more money to handle transactions

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International Trade Effect (Open Economy Effect)

• FYI An open economy is global, a closed economy
  is domestic.
• The Open Economy Effect
• Higher price levels result in foreigners
  desiring to buy fewer American-made goods while
  Americans desire more foreign-made goods (i.e.,
  net exports fall).
• Equivalent to a reduction in the amount of real
  goods and services purchased in the U.S.
• When Demand for exports decreases, this is an
  unfavorable balance of trade (imports exceed
  exports)

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Macro AD vs Micro D

• Aggregate Demand versus Demand for a Single Good
• When the aggregate demand curve is derived, we
  are looking at the entire circular flow of income
  and product.
• When a market demand curve is derived, we are
  looking at a single product in one market only.

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Change in QAD and Change in AD

• What is the difference?

PL
PL
A
B
AD 2
AD1
GDP
GDP
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Difference between Quantity of AD and Change of AD

• QAD movement up or down as result of price
  level changing (ONLY)
• Change in AD
• Change in any of the component parts of AD (C
  I G Net Exports)

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DETERMINANTS OF AGGREGATE DEMAND
Change in Consumer Spending

• Consumer Wealth
• Consumer Expectations (expect higher prices)
• Interest rate (interest sensitive durables)
• Taxes

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Changes in Investment Spending

• Real Interest Rates (rates high- not much I
  taking place)
• Expected Future Sales (health of economy-
  confidence is big)
• Business Taxes (higher taxes less profit less
  investment)

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Government Spending

• This will be discussed further, but anytime
  government spends, it has an affect on GDP.
• Infrastructure Health CareSupplies for
  military
• Education
• Etc.

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• Net Export Spending
• National Income Abroad-(when foreign nations do
  well, their incomes are higher- can buy more U.S.
  goods and services. U.S. exports rise) China
  an example today.
• Exchange Rates- Price of one nations currency in
  terms of another. Dollar vs Euro
• Our currency appreciates if it takes more foreign
  to buy it.. (depreciates if it takes more of
  ours to buy theirs.) 1.00 to 1.25 Euro.
• Depreciation of nations currency makes foreign
  goods more expensive (but attracts foreigners to
  buy our goods.) Our exports rise. this is why
  the Fed has not worried about our low dollar
  valuation.

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Long-Run Equilibrium and the Price Level

• For the economy as a whole, long-run equilibrium
  occurs at the price level where the aggregate
  demand curve (AD) crosses the long-run aggregate
  supply curve (LRAS).

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Figure 10-5 Long-Run Economywide Equilibrium
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SRAS?

• Period where adjustment occurs.
• Short-Run Aggregate Supply shows the different
  quantities of real output that will be supplied
  at different prices.

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Things that affect SRAS

• Aggregate price (increase in QS.)
• Input prices (increase shift to left)
• Technology improves (shift to right)
• Government policy on taxes (lower rates shift
  to right)
• Investments increase (SAS shifts to right)

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Common Factor

• is that any increase in input prices will
  decrease SAS and any decreases in input prices
  will increase production in the SAS.
• Stated another way
• anything that is able to change the factor costs
  will be a shift factor of Short-Run Aggregate
  Supply.

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• LRAS long-run aggregate supply
• (a period when nominal wages and other resource
  prices respond to price-level changes)
• LRAS is a vertical line reflecting that LR
  Aggregate Supply is not affected by changes in
  PL.
• The LRAS is labeled as the natural level of real
  GDP
• The natural level of real GDP is defined as the
  level of real GDP that arises when the economy is
  fully employing all of its available input
  resources ( We are in agreement that it hovers
  around 5)

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Equilibrium States of the Economy
During the time an economy moves from one
equilibrium to another, it is said to be in
disequilibrium.
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Factors That Change Aggregate Demand
Consumption/Interest Rates
Interest Rate ? ? C? ? AD?
Interest Rate ? ? C ? ? AD?
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Factors That Change Aggregate Demand
Investment/ Interest Rates
Interest rates ? ? I? ? AD?
Interest rates ? ? I ? ? AD?
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Factors That Change Aggregate Demand
Investment/ Business Taxes
Business taxes? ? I? ? AD?
Business taxes? ? I? ? AD?
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Real Rate Of Interest
D2
D1
Money Supply
Can a Change in Money Supply Change AD? Probably
but it is a chain of events.MS changes, then
Interest Rates, then chance in consumption and
investment. Then Change in AD
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Long Run Aggregate Supply
P
LRASLR
Price level
Long-run Aggregate Supply
Full-Employment
Q
Qf
Real domestic output, GDP
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Unanticipated Increase in Aggregate Demand

• In response to an unanticipated increase in AD
  for goods services (shift from AD1 to AD2),
  prices will rise to P105 and output will
  temporarily exceed full-employment capacity
  (increases to Y2).

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Growth in Aggregate Supply

• Here we illustrate the impact of economic growth
  due to capital formation or a technological
  advancement, for example.

• Both LRAS and SRAS increase (to LRAS2 and SRAS2)
  the full employment output of the economy expands
  from YF1 to YF2.

• A sustainable, higher level of real output and
  real income is the result. If the money
  supply is held constant, a new long-run
  equilibrium will emerge at a larger output rate
  (YF2) and lower price level (P2).

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Effects of Adverse Supply Shock

• The higher resource prices shift the SRAS curve
  to the left in the short-run, the price level
  rises to P110 and output falls to Y2.

• What happens in the long-run depends on whether
  the reduction in the supply of resources is
  temporary or permanent.

• If temporary, resource prices fall in the future,
  permitting the economy to return to its original
  equilibrium (A).

• If permanent, the productive potential of the
  economy will shrink (LRAS shifts to the left) and
  (B) will become the long-run equilibrium.

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INCREASES IN AD DEMAND-PULL INFLATION
P
AS
AD1
AD2
P2
Price Level
P1
Q
Q1
Q2
Qf
Real Domestic Output, GDP
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DECREASES IN AS COST-PUSH INFLATION
AS2
P
AS1
b
P2
Price Level
a
P1
AD1
Q
Q1
Qf
Real Domestic Output, GDP
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• Non-governmental actions that
• Shift AS left
• Raw materials cost rise
• Wages rise faster than productivity
• Worker productivity decreases
• Obsolescence
• Wars
• Natural disasters

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Fiscal Policy

• Governmental actions that shift AD
• Shift AD right
• Govt spending increases
• Taxes decreases
• Money Supply increases
• Shift AD left
• G decreases
• T increases
• MS decreases

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KILEY SAYS THAT'S ALL!