13_14:Aggregate Supply and Aggregate Demand

1
13_14Aggregate Supply andAggregate Demand

• What is the purpose of the aggregate
  supply-aggregate demand model?
• What determines aggregate supply and aggregate
  demand?
• This discussion follows nicely from the tutorial
  EIA
• I have included many extra slides to minimize the
  notes you will have to take.

2
The Aggregate Supply-Aggregate Demand Model

• The purpose of this model is
• to help understand and predict fluctuations of
  real GDP around potential GDP
• to understand and predict fluctuations in the
  price level
• next slide is a copy taken from lecture 8

3

4
Aggregate Supply

• The aggregate quantity of goods and services
  supplied is the sum of the quantities of final
  goods and services produced by all firms in the
  economy (real GDP).
• Aggregate supply is the relationship between the
  quantity of real GDP supplied and the price level.

5
Aggregate Supply

• The aggregate production function shows that the
  quantity of real GDP supplied is determined by
  the quantities of labor and capital and the state
  of technology.

6
Aggregate Supply

• Capital and technology are fixed at any point in
  time.
• However, labor is not fixed.
• Lower wages result in a greater quantity of labor
  demanded
• Higher wages result in a greater quantity of
  labor supplied

7
Aggregate Supply

• Full Employment
• Occurs at the wage rate that makes the quantity
  of labor demanded equal to the quantity of labor
  supplied

8
Aggregate Supply

• Natural Rate of Unemployment
• The unemployment rate that exists at full
  employment
• In 1997 it was about 5.5
• It is probably much lower (e.g. 4) today.

9
Aggregate Supply

• Potential GDP is the quantity of real GDP
  supplied when unemployment is at its natural rate
  and there is full employment.

10
Aggregate Supply

• Long-Run Aggregate Supply
• The macroeconomic long run is a time frame that
  is sufficiently long for forces that move real
  GDP toward potential GDP to have done their work
  so that full employment prevails.

11
Aggregate Supply

• Long-Run Aggregate Supply
• The long-run aggregate supply curve is the
  relationship between the quantity of real GDP
  supplied and the price level in the long run when
  real GDP equals potential GDP.

12
Long-Run Aggregate Supply
140
130
120
Price level (GDP deflator, 1992 100)
110
100
90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
13
Long-Run Aggregate Supply
LAS
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
Two Time Frames for Aggregate Supply

• We distinguish two time frames for aggregate
  supply
• Long-run aggregate supply
• Short-run aggregate supply

15
Aggregate Supply

• Long-Run Aggregate Supply
• Potential GDP is independent of the price level
  because the price level, wage rate, and other
  resource prices all change by the same percentage
  in the long-run.

16
Aggregate Supply

• Short-Run Aggregate Supply
• The macroeconomic short run is a period during
  which real GDP has fallen below or risen above
  potential GDP.
• The unemployment rate has risen above or fallen
  below the natural rate.

17
Aggregate Supply

• Short-Run Aggregate Supply
• The short-run aggregate supply curve is the
  relationship between the quantity of real GDP
  supplied and the price level in the short run
  when the money wage rate, other resource prices,
  and potential GDP remain constant.

18
Short-Run Aggregate Supply
Price Level Real GDP (GDP deflator) (trillions
of 1992 dollars)

• a 100 6.0
• b 105 6.5
• c 110 7.0
• d 115 7.5
• e 120 8.0

19
Short-Run Aggregate Supply
LAS
140
130
120
Price level (GDP deflator, 1992 100)
110
100
90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
20
Short-Run Aggregate Supply
LAS
140
130
SAS
120
e
Price level (GDP deflator, 1992 100)
d
110
c
b
100
a
90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
21
Short-Run Aggregate Supply
LAS
140
130
SAS
120
e
Price level (GDP deflator, 1992 100)
d
110
c
b
100
a
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)
22
Aggregate Supply

• Movements Along the LAS and SAS Curves
• When the price level rises, holding the money
  wage rate and other resource prices constant, the
  quantity of real GDP supplied increases and there
  is a movement along the SAS curve.

23
Movements Along The Aggregate Supply Curves
LAS
140
130
SAS
120
Price level (GDP deflator, 1992 100)
110
100
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
24
Movements Along The Aggregate Supply Curves
LAS
140
130
SAS
120
Price level (GDP deflator, 1992 100)
110
100
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
25
Movements Along The Aggregate Supply Curves
LAS
Price level rises and money wage rate rises by
the same percentage
140
130
SAS
120
Price level (GDP deflator, 1992 100)
110
Price level rises and money wage rate is unchanged
100
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
26
Aggregate Supply

• Changes in Aggregate Supply
• Occurs when influences on production other than
  the price level change

27
Aggregate Supply

• Potential GDP changes as a result of
• 1) Changes in the full-employment quantity of
  labor
• 2) Changes in the quantity of capital
• 3) Advances in technology

28
A Change in Potential GDP
LAS
140
130
SAS0
120
Price level (GDP deflator, 1992 100)
110
100
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
29
A Change in Potential GDP
LAS0
LAS1
140
Increase in potential GDP
130
SAS0
120
SAS1
Price level (GDP deflator, 1992 100)
110
100
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
30
Aggregate Supply

• Changes in the money wage rate changes short-run
  aggregate supply but does not change long-run
  aggregate supply.

31
A Change in the Money Wage Rate
LAS
140
130
SAS0
120
Price level (GDP deflator, 1992 100)
110
a
100
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
32
A Change in the Money Wage Rate
LAS
140
SAS2
130
SAS0
120
b
Price level (GDP deflator, 1992 100)
110
a
100
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
33
Aggregate Demand

• The quantity of real GDP demanded is the sum of
  the real consumption expenditure (C), investment
  (I), government purchases (G), and exports (X)
  minus imports (M).

Y C I G X M
34
Aggregate Demand

• Aggregate demand is the relationship between the
  quantity of real GDP demanded and the general
  price level.
• Important The aggregate demand schedule is not a
  relationship based upon the relative prices of
  goods such as apples and pears.

35
Aggregate Demand
Price Level Real GDP (GDP deflator) (trillions
of 1992 dollars)

• a' 90 8.0
• b' 100 7.5
• c' 110 7.0
• d' 120 6.5
• e' 130 6.0

36
Aggregate Demand
140
130
120
Price level (GDP deflator, 1992 100)
110
100
90
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
37
Aggregate Demand
140
e'
130
d'
120
Price level (GDP deflator, 1992 100)
c'
110
b'
100
e'
90
AD
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
38
Aggregate Demand
140
e'
130
d'
120
Price level (GDP deflator, 1992 100)
c'
110
b'
100
e'
90
AD
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
39
Aggregate Demand

• The two reasons the demand curve sloped downward
  are
• 1) Wealth effect
• Changes in the price level, with other things
  remaining the same, change real wealth.
• People try to restore wealth by increasing saving
  and decreasing consumption.

40
Aggregate Demand

• The two reasons the demand curve sloped downward
  are
• 2) Substitution effects
• People substitute future consumption for present
  consumption as a result of higher interest rates.
• A change in prices cause consumers to spend less
  on domestic items and more on imported items.

41
Aggregate Demand

• Changes in the Quantity of Real GDP Demanded
• When the price level changes, other things
  remaining the same, the quantity of real GDP
  demanded changes and there is movement along the
  aggregate demand curve.

42
Aggregate Demand

• Changes in Aggregate Demand
• A change in any factor than influences buying
  plans other than the price level

43
Aggregate Demand

• The factors that influence buying plans other
  than the price level and bring a change in
  aggregate demand are
• 1) Expectations
• 2) Fiscal policy and monetary policy
• 3) The world economy

44
Aggregate Demand

• Expectations
• Expectations about future incomes, inflation and
  profits influence buying plans today.

45
Aggregate Demand

• Fiscal Policy and Monetary Policy
• Fiscal policy is the governments attempt to
  influence the economy by setting and changing
  taxes, transfer payments, and government
  purchases.

46
Aggregate Demand

• Fiscal Policy and Monetary Policy
• These influence a households disposable income.
• Disposable income equals aggregate income minus
  taxes plus transfer payments.

47
Aggregate Demand

• Fiscal Policy and Monetary Policy
• Monetary policy consists of changes in interest
  rates and in the quantity of money in the economy.

48
Aggregate Demand

• The World Economy
• The exchange rate and foreign income affect
  aggregate demand.

49
Changes in Aggregate Demand
140
130
120
Price level (GDP deflator, 1992 100)
110
100
90
AD0
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
50
Changes in Aggregate Demand
140
Increase in aggregate demand
130
120
Price level (GDP deflator, 1992 100)
110
100
AD1
90
AD0
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
51
Changes in Aggregate Demand
140
Increase in aggregate demand
130
120
Price level (GDP deflator, 1992 100)
110
100
AD1
Decrease in aggregate demand
90
AD0
AD2
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
52
Changes in Aggregate Demand
Aggregate demand Decreases if
Increases if

• Expected future incomes, inflation, or profits
  decrease
• Fiscal policy decreases government purchases,
  increases taxes, or decreases transfer payments

• Expected future incomes, inflation, or profits
  increase
• Fiscal policy increases government purchases,
  decreases taxes, or increases transfer payments

53
Changes in Aggregate Demand
Aggregate demand Decreases if
Increases if

• Monetary policy decreases the quantity of money
  and increases interest rates
• The exchange rate increases or foreign income
  decreases

• Monetary policy increases the quantity of money
  and decreases interest rates
• The exchange rate decreases or foreign income
  increases

54
Macroeconomic Equilibrium

• Short-Run Macroeconomic Equilibrium
• Occurs when the quantity of real GDP demanded
  equals the quantity of real GDP supplied

55
Short-Run Equilibrium
140
130
120
Price level (GDP deflator, 1992 100)
110
100
90
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
56
Short-Run Equilibrium
140
130
SAS
120
e
Price level (GDP deflator, 1992 100)
d
110
c
b
100
a
90
AD
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
57
Short-Run Equilibrium
140
e'
130
SAS
d'
120
e
Price level (GDP deflator, 1992 100)
c'
d
110
c
b'
b
100
a
e'
90
AD
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
58
Short-Run Equilibrium
140
Firms cut production and prices
e'
130
SAS
d'
120
e
Price level (GDP deflator, 1992 100)
c'
d
110
c
b'
b
100
a
e'
90
AD
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
59
Short-Run Equilibrium
140
Firms cut production and prices
e'
130
SAS
d'
120
e
Price level (GDP deflator, 1992 100)
c'
c'
d
110
c
b'
b
100
a
e'
Firms increase production and prices
90
AD
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
60
Short-Run Equilibrium
140
e'
130
SAS
d'
120
e
Price level (GDP deflator, 1992 100)
c'
c'
d
110
Short-run macroeconomic equilibrium
c
b'
b
100
a
e'
90
AD
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
61
Macroeconomic Equilibrium

• Long-Run Macroeconomic Equilibrium
• Occurs when real GDP equals potential GDP, (i.e.
  the economy is on its long-run aggregate supply
  curve)

62
Long-Run Equilibrium
140
130
120
Price level (GDP deflator, 1992 100)
110
100
90
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
63
Long-Run Equilibrium
140
130
SAS
120
Price level (GDP deflator, 1992 100)
110
In the long run, money wage adjusts
100
90
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
64
Long-Run Equilibrium
140
130
SAS
120
Price level (GDP deflator, 1992 100)
110
In the long run, money wage adjusts
100
90
AD
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
65
Long-Run Equilibrium
LAS
140
130
SAS
120
Price level (GDP deflator, 1992 100)
110
In the long run, money wage adjusts
100
90
AD
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
66
Macroeconomic Equilibrium

• In the long run, the main influence on aggregate
  demand is the growth rate of the quantity of
  money.
• Real GDP fluctuates around potential GDP in a
  business cycle.
• Inflation fluctuates at the same time.

67
Macroeconomic Equilibrium

• Business Cycles
• Occur because aggregate demand and short-run
  aggregate supply fluctuate but the money wage
  rate does not adjust quickly enough to keep real
  GDP at potential GDP.

68
Macroeconomic Equilibrium

• Below Full-employment Equilibrium
• A macroeconomic equilibrium in which potential
  GDP exceeds real GDP
• The difference is called a recessionary gap.

69
Macroeconomic Equilibrium

• Long-Run Equilibrium
• Occurs when real GDP equals potential GDP.

70
Macroeconomic Equilibrium

• Above Full-employment Equilibrium
• A macroeconomic equilibrium in which real GDP
  exceeds potential GDP
• The difference is called a inflationary gap.

71
The Business Cycle
LAS
140
Recessionary gap
130
SAS0
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)
72
The Business Cycle
Fluctuations in real GDP
7.2
Real GDP (trillions of 1992 dollars)
7.0
6.8
1
2
3
0
4
Year
73
The Business Cycle
Fluctuations in real GDP
7.2
Potential GDP
Real GDP (trillions of 1992 dollars)
7.0
6.8
1
2
3
0
4
Year
74
The Business Cycle
Fluctuations in real GDP
7.2
Recesssionary gap
Potential GDP
Real GDP (trillions of 1992 dollars)
7.0
Actual GDP
6.8
a
1
2
3
0
4
Year
75
The Business Cycle
LAS
140
Full employment
130
SAS1
120
Price level (GDP deflator, 1992 100)
110
b
Long-run equilibrium
100
90
AD1
6.8
7.0
7.2
Real GDP (trillions of 1992 dollars)
76
The Business Cycle
Fluctuations in real GDP
7.2
Recesssionary gap
Potential GDP
Real GDP (trillions of 1992 dollars)
7.0
Actual GDP
6.8
a
1
2
3
0
4
Year
77
The Business Cycle
Fluctuations in real GDP
7.2
Recesssionary gap
Full employment
Potential GDP
Real GDP (trillions of 1992 dollars)
7.0
b
Actual GDP
6.8
a
1
2
3
0
4
Year
78
The Business Cycle
LAS
140
130
SAS2
Inflationary gap
120
Price level (GDP deflator, 1992 100)
Above full-employment equilibrium
110
c
100
AD2
90
7.0
7.2
Real GDP (trillions of 1992 dollars)
79
The Business Cycle
Fluctuations in real GDP
7.2
Recesssionary gap
Full employment
Potential GDP
Potential GDP
Real GDP (trillions of 1992 dollars)
7.0
b
Actual GDP
6.8
a
1
2
3
0
4
Year
80
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
81
Macroeconomic Equilibrium

• Fluctuations is Aggregate Demand
• Real GDP sometimes fluctuates as a result of
  changes in aggregate demand.

82
An Increase in Aggregate Demand
LAS
Short-run effect
140
130
SAS0
Price level (GDP deflator, 1992 100)
115
110
100
90
AD0
6.0
7.0
7.5
Real GDP (trillions of 1992 dollars)
83
An Increase in Aggregate Demand
LAS
Short-run effect
140
130
SAS0
Price level (GDP deflator, 1992 100)
115
110
100
AD1
90
AD0
6.0
7.0
7.5
Real GDP (trillions of 1992 dollars)
84
An Increase in Aggregate Demand
LAS
Long-run effect
140
130
SAS0
Price level (GDP deflator, 1992 100)
115
100
AD1
90
6.0
7.0
7.5
Real GDP (trillions of 1992 dollars)
85
An Increase in Aggregate Demand
LAS
Long-run effect
140
SAS1
130
SAS0
125
Price level (GDP deflator, 1992 100)
115
100
AD1
90
6.0
7.0
7.5
Real GDP (trillions of 1992 dollars)
86
Macroeconomic Equilibrium

• An economy cannot produce in excess of potential
  forever.
• Workers begin to demand higher wages
• Eventually, wage rates rise by the same
  percentage as the price level.

87
Macroeconomic Equilibrium

• Fluctuations in Aggregate Supply
• Fluctuations in short-run aggregate supply can
  bring fluctuations in real GDP around potential
  GDP.
• A decrease in aggregate supply can lead to a
  recession and inflation stagflation.

88
A Decrease in Aggregate Supply
LAS
140
130
SAS0
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)
89
A Decrease in Aggregate Supply
LAS
An oil price rise decreases short-run aggregate
supply
140
SAS1
130
SAS0
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)
90
Aggregate Supply and Aggregate Demand 19601996