Macroeconomic Equilibrium: Aggregate Demand and Supply

1
Macroeconomic EquilibriumAggregate Demand and
Supply

• ECN111 Macroeconomic Principles
• Lecture 15 Spring 2000
• Instructor Igor Lukashin

2
Fundamental Questions

• What factors affect aggregate demand?
• What causes the aggregate demand curve to shift?
• What factors affect aggregate supply?
• Why does the short-run aggregate supply curve
  become steeper as real GDP increases?
• Why is the long-run aggregate supply curve
  vertical?
• What causes the aggregate supply curve to shift?
• What determines the equilibrium price GDP?

3
Aggregate Demand, Supply Business Cycles

• Simple equilibrium model to study the causes and
  expected effects of business cycles
• Equilibrium is at the intersection of aggregate
  demand (AD) and aggregate supply (AS) curves
• Need to understand
• How to construct AD AS
• Factors that influence AD AS
• AD increase causes demand-pull inflation
• AS increase can cause cost-push inflation

4
Determinants of AD

• Aggregate Demand
• the relation between aggregate expenditures, or
  total spending, and the price level
• Aggregate Expenditures
• is the sum of expenditures of all sectors
• Households (consumption)
• Firms (investment)
• Government
• Rest of the world (net exports)

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Determinants of AD Consumption

• Household consumption depends on
• Income
• Larger income -gt more consumption
• Wealth
• different from income, includes all assets owned
  by household, e.g. cars, stocks, bonds, homes
• Increase in wealth means higher consumption
• Expectations
• Less optimistic about future income or wealth
  means lower consumption
• Demographics
• Population growth means higher consumption
• Younger older HH consume more save less
• Taxes

6
Determinants of AD Investment

• Business spending on capital goods depends on
• Interest Rate
• the greater the cost of borrowing, the less
  investment will happen
• Technology
• new technology stimulates investment as firms
  struggle to adopt the new technology to stay
  competitive
• Cost of capital goods
• rising cost of capital goods would lower
  profitability and investment would fall
• Capacity utilization
• the lower capacity utilization is, the more the
  firms are able to expand production without new
  capital goods, and the lower investment is

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Determinants of AD Government Spending

• Government spending may be set by government
  authorities independent of current income or
  other determinants of aggregate expenditures

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Determinants of AD Net Exports

• Net Exports Exports - Imports
• Exports determined by conditions in the rest of
  the world
• Imports are determined by similar domestic
  factors
• Income
• Rise in domestic income causes net exports to
  fall
• Prices
• Rise in foreign prices increases net exports
  (relative prices)
• Exchange Rates
• Depreciation of domestic currency increases net
  exports
• Government Policy
• Restrictive trade policy by foreign governments
  causes net exports to fall

9
Change in Aggregate QD Price-Level Effects

• The Wealth Effect
• P ? gt reduction of purchasing power gt C?, Y?
• The Interest Rate Effect
• P ? gt need more money gt sell bonds gt price of
  bonds ? gt interest rate ?gt investment ?gt Y ?
• The International Trade Effect
• P ? exports more expensive for foreigners gt
  Exports ?gt Net Exports?gt Y?
• All 3 Effects work in the same direction !

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Change in Aggregate Demand Nonprice Determinants

• Expectations
• Expected Higher Income gt C ? gt AD shifts right
• Foreign Income and Price Level
• FI ? gt D for US goods ? , X ? gt AD shifts right
• FPL? gt US goods relatively cheaper, X ? and
• Government Policy
• Gvt Spending ? gt Y ? gt AD shifts right
• Taxes ? gt C decreases gtAD shifts left

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Aggregate Supply

• Aggregate Supply Curve
• a curve that shows the amount of real GDP
  produced at different price levels
• Short-Run Aggregate Supply (SRAS)
• costs of production are held constant (1 year or
  so) why?
• Slope of SRAS
• positive costs fixed, P ?, profits ? firms
  produce more
• increases as RGDP increases (reaching capacity)
• Long-Run Aggregate Supply (LRAS)
• all costs and prices are free to vary
• LRAS is VERTICAL _at_ potential real GDP why??
• LR wages prices adjust and we no longer have
  higher profits