Aggregate Demand and Aggregate Supply

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Aggregate Demand and Aggregate Supply
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Aggregate Demand and Aggregate Supply

• Economic fluctuations, also called business
  cycles, are movements of GDP away from potential
  output.
• Insufficient demand for goods and services was a
  key problem of the Great Depression, identified
  by British economist John Maynard Keynes in the
  1930s.

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Sticky Prices and Their Macroeconomic Consequences

• Led by Keynes, many economists since his time
  have focused attention on economic coordination
  problems.
• The price system does not always work
  instantaneously. If prices are slow to adjust,
  then the proper signals are not given quickly
  enough to producers and consumers.
• In modern economies, some prices (auctions
  prices) are very flexible, while others (custom
  prices) are not. Like other input prices, the
  price of labor adjusts very slowly.

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Sticky Prices and Their Macroeconomic
Consequences (Continued)

• If wages are sticky, firms overall costs will be
  sticky as well. Sticky wages cause sticky prices
  and hamper the economys ability to bring demand
  and supply into balance in the short run.
• The short run in macroeconomics is the period in
  which prices dont change or dont change very
  much. In the macroeconomic short run, both
  formal and informal contracts between firms mean
  that changes in demand will be reflected
  primarily in changes in output, not prices.

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Understanding Aggregate Demand

• Aggregate demand is the total demand for goods
  and services in an entire economy.
• The aggregate demand curve plots the total demand
  for GDP as a function of the price level.
• The aggregate demand curve slopes downward.

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The Components of Aggregate Demand

• In our study of GDP accounting, we divided GDP
  into four components
• Consumption spending (C), investment spending
  (I), government purchases (G), and net exports
  (NX).
• These four components are also four parts of
  aggregate demand because the aggregate demand
  curve really just describes the demand for total
  GDP at different price levels.

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Why the Aggregate Demand Curve Slopes Downward

• First, we must consider the effects of a change
  in the overall price level in the economy.
• As the price level or average level of prices in
  the economy changes, so does the purchasing power
  of your money. This is an example of the
  real-nominal principle.
• The change in the purchasing power of money will
  affect aggregate demand.

Real-Nominal PRINCIPLE What matters to people is
the real value of money or incomeits purchasing
powernot the face value of money or income.
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Why the Aggregate Demand Curve Slopes Downward
(Continued)

• The increase in spending that occurs because the
  real value of money increases when the price
  level falls is called the wealth effect.
• The interest rate effect With a given money
  supply in the economy, a lower price level will
  lead to lower interest rates and higher
  consumption and investment spending.
• The impact of foreign trade A lower price level
  makes domestic goods cheaper relative to foreign
  goods.

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Why the Aggregate Demand Curve is
Downward-Sloping?
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Why the Aggregate Demand Curve is
Downward-Sloping?
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Why the Aggregate Demand Curve is
Downward-Sloping?
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Shifts in the Aggregate Demand Curve

• If at a given price level, Consumption,
  Investment, Government Purchases, or Net Exports
  increase, then Aggregate Demand will increase.
• If at a given price level, Consumption,
  Investment , Government Purchases, or Net Exports
  decrease, the Aggregate Demand will decrease.

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Shifts in the Aggregate Demand Curve (Continued)
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Factors That Change Aggregate Demand
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Factors That Change Aggregate Demand(Continued)
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How the Multiplier Makes the Shift Bigger

• The ratio of the final shift in aggregate demand
  to the initial shift in aggregate demand is known
  as the multiplier.
• The logic of the multiplier goes back to Keynes.
  He believed that as government spending increases
  and the aggregate demand curve shifts to the
  right, output will subsequently increase too.
  Increased output also means increased income for
  households and higher consumption. It is this
  additional consumption spending that causes the
  further shift in the aggregate demand curve.

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How the Multiplier Makes the Shift Bigger
(Continued)

• Initially, the shift from a to b equals the
  increase in government spending.
• But after a brief period of time, due to
  multiplier effect, total aggregate demand will
  increase by more than the initial increase in
  government spending.

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How the Multiplier Makes the Shift Bigger
(Continued)

• The relationship between the level of income and
  consumption spending is called the consumption
  function
• Ca autonomous consumption, or the amount of
  consumption spending that does not depend on the
  level of income.
• by the part of consumption that is dependent on
  income, where
• b marginal propensity to consume (MPC), or
  Additional Consumption/Additional Income
• y level of income in the economy.

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How the Multiplier Makes the Shift Bigger
(Continued)
Multiplier 1/(1 MPC)
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Understanding Aggregate Supply

• The aggregate supply curve depicts the
  relationship between the level of prices and the
  total quantity of final goods and services that
  firms are willing and able to supply.

• To determine both the price level and real GDP,
  we need to combine both aggregate demand and
  aggregate supply.

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The Short Run Aggregate Supply Curve

• In the short run, firms are assumed to supply all
  the output demanded, with small changes in
  prices.
• The short run aggregate supply curve has a small
  upward slope.
• Higher aggregate demand will cause a higher level
  of output, and only a slight increase in the
  price level.

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The Short Run Aggregate Supply Curve (Continued)

• Why is it upward-sloping?
• Sticky Wages
• Sticky Prices
• Menu Costs
• Producer Misperceptions
• Worker Misperceptions

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Changes in Short-Run Aggregate Supply
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How Short-Run Equilibrium In The Economy Is
Achieved

• AD and SRAS determine the price level, real GDP,
  and the unemployment rate in the short run.
• In instances of both surplus and shortage,
  economic forces are moving the economy toward the
  short-run equilibrium point.
• Ceteris paribus, we expect a higher real GDP
  level to be associated with a lower unemployment
  rate and a lower real GDP level to be associated
  with a higher unemployment rate.

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Short-Run Equilibrium
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Changes in Short-Run Equilibrium in the Economy
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How a Factor Affects the Price Level, Real GDP,
and the Unemployment Rate in the Short Run
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A Summary Exhibit of AD and SRAS
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Q A Identify what will happen to the price
level and Real GDP when each of the following
occurs

• Aggregate Demand rises by more than the Short-Run
  Aggregate Supply rises
• Aggregate Demand falls by less than the Short-Run
  Aggregate Supply falls

• Short-Run Aggregate Supply rises
• Short-Run Aggregate Supply falls
• Aggregate Demand rises
• Aggregate Demand falls

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Supply Shocks

• Supply shocks are external events that shift the
  aggregate supply curve.
• Adverse supply shocks can cause a recession (a
  fall in output) with increasing prices. This
  phenomenon is known as stagflation.

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Long Run Aggregate Supply

• Short-Run equilibrium identifies the Real GDP the
  economy produces when any of these conditions
  hold sticky wages, sticky prices, producers
  misperceptions, workers misperceptions.
• Wages and prices eventually become unstuck and
  misperceptions will turn to accurate perceptions
  when this happens the economy is said to be in
  The Long Run.

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The Long Run Aggregate Supply Curve

• In the long run, the level of output, y, is
  independent of the price level. Output depends
  solely on the supply factorscapital, laborand
  the state of technology.
• In the long run, the economy operates at full
  employment and changes in the price level do not
  affect this.

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Equilibrium States of the Economy
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Questions Economists Ask

• What can cause the economy to move from one
  short-run equilibrium position to another
  short-run equilibrium position?
• What happens to certain economic variables such
  as the price level and Real GDP, as the economy
  moves from one short-run equilibrium to another
  short-run equilibrium?
• If the economy is in the short-run equilibrium,
  what path does it travel to long-run equilibrium?
• How long does it take the economy to move from
  short-run equilibrium to long-run equilibrium?

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Questions Economists Ask (Continued)

• If the economy is in long-run equilibrium, what
  must happen to move it to another long-run
  equilibrium?
• How long does it take to move from one long-run
  equilibrium position to another long-run
  equilibrium position?
• Are some of the states of an economy better than
  other states?
• If some states of the economy are better than
  others, is there anything that government can do
  to move the economy from one state to another?

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Determining Output and the Price Level

• The intersection of aggregate demand and
  aggregate supply determines the price level and
  the equilibrium level of output.
• In the long run, an increase in aggregate demand
  will raise prices but leave the level of output
  unchanged.
• In the long run, output is determined solely by
  the supply of capital and the supply of labor,
  not the price level.

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From the Short Run to the Long Run

• Aggregate demand intersects the short run
  aggregate supply curve at an output level (e)
  that exceeds the potential level of output (E).
  In other words, this is a boom economy.
• As firms compete for labor and raw materials,
  there will be a tendency for both wages and
  prices to increase over time.

E
e
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From the Short Run to the Long Run (Continued)

• Increasing wages and prices will shift the short
  run aggregate supply curve upward.
• Adjustments in wages and prices will continue as
  long as the level of output (e) exceeds potential
  level of output (E). These adjustments take the
  economy from short-run equilibrium (point e) to
  long run equilibrium (point E.)

E
e
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Coming Up (Ch. 8) The Self-Regulating Economy