Aggregate Supply and Aggregate Demand

1
Aggregate Supply andAggregate Demand

• What determines aggregate supply and aggregate
  demand?
• What is the definition of macroeconomic
  equilibrium?

2
Important Concepts

• Potential GDP
• Long-Run Aggregate Supply, LAS
• Short-Run Aggregate Supply, SAS
• Aggregate Demand, AD
• Short-run and Long-run equilibrium

3
Aggregate Demand

• The aggregate quantity of goods and services
  demanded is the sum of planned
• Consumption by households, C,
• Investment spending by firms, I,
• Government spending, G,
• Net exports to the R.O.W., (X - M).
• AD C I G X - M

4
The Aggregate Demand Curve
140
130
120
Price level (GDP deflator, 1992 100)
110
100
90
AD
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
5
Why the Aggregate Demand Curve Slopes Downward

• The aggregate demand curve slopes downward
  because of
• Wealth effects.
• Substitution effects.

6
Changes inAggregate Demand

• There are three main factors that cause the
  aggregate demand curve to shift
• 1. Expectations
• 2. Fiscal policy and Monetary policy
• 3. International factors

7
Expectations

• Expectations about
• future incomes
• future inflation
• future profits

8
Fiscal Policy

• Fiscal policy is the governments attempt to
  influence the economy by setting and changing
• Government spending and
• Taxes
• These decisions are made by Congress in
  consultation with the President.

9
Monetary Policy

• Decisions about the money supply and interest
  rates are made by the central bank.
• The Feds attempt to influence the economy by
  varying the money supply and interest rates is
  called monetary policy.

10
International Factors

• The two main international factors are
• the foreign exchange rate, and
• income in the Rest of the World (R.O.W.)

11
Potential GDP

• Potential GDP is the value of production when all
  the economy's resources are fully employed.
• Unemployment is at its natural rate and the
  economy is at full employment.

12
Potential GDP (Yp )Yp f(hNn, K, NR, T)

• where
• Nn the number of workers at full employment.
• h the average number of hours worked.
• K the capital stock.
• NR the natural resources used.
• T the state of technology.

13
The 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
What is a Supply Curve?

• The supply curve is the profit maximizing output
  at each price. It is where MC MR.
• A supply curve shifts when input costs change.

15
Aggregate Supply

• Aggregate supply is the relationship between the
  desired quantity of real GDP supplied and the
  price level.

16
The Short-Run Aggregate Supply

• Prices of goods and services change freely.
• Prices of factors of production (including the
  wage rate) do not change - - in the short-run.

17
Short-run Aggregate Supply
140
130
SAS
120
Price level (GDP deflator, 1992 100)
110
c
b
a
100
90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
18
What shifts the SAS?

• The SAS shifts when the cost per unit of input
  changes.

19
What happens when the economy is not at Potential
GDP?

• What happens when there is too much or too little
  unemployment?

20
What happens when Y gt Yp?

• UN lt UNn and there is a shortage of labor and
  wages rise.
• What does this do to the cost of production? It
  increases.
• This shifts supply curves up. The SAS shifts
  left.

21
SAS Curve shifts up.
140
SAS
130
SAS
120
Price level (GDP deflator, 1992 100)
110
100
AD
90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
22
What happens when Y lt Yp?

• UN gt UNn and there is an excess of labor and
  wages might fall.
• What would this do to the cost of production? It
  would decrease.
• This shifts supply curves down. The SAS shifts
  right.

23
SAS Curve shifts down.
SAS
140
SAS
130
120
Price level (GDP deflator, 1992 100)
110
100
AD
90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
24
What happens when Y Yp?

• UN UNn and there is just the right amount of
  labor and wages are stable.
• What does this do to the cost of production?
  Nothing.
• This shifts supply curves do not shift. The SAS
  is stable.

25
SAS Curve is stable.
140
130
SAS
120
Price level (GDP deflator, 1992 100)
110
100
AD
90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
26
At Equilibrium
LAS
140
130
SAS
120
Price level (GDP deflator, 1992 100)
110
100
90
AD
6.0
7.0
8.0
6.5
7.5
Real GDP (trillions of 1992 dollars)
27
Returning to equilibrium.
LAS
140
SAS
130
SAS
120
Price level (GDP deflator, 1992 100)
110
100
AD
90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
28
Returning to equilibrium.
LAS
SAS
140
SAS
130
120
Price level (GDP deflator, 1992 100)
110
100
AD
90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)
29
The Long-Run Aggregate Supply

• In the long run, Aggregate Supply is equal to
  Potential GDP
• LAS is independent of the price level.
• The reason is because prices of output and the
  prices of inputs, relative to each other, will
  remain constant.

30
Changes in Long-Run Aggregate Supply

• LAS, or Potential GDP, shifts right if there is
  an increase in the factors of production or an
  improvement in technology.
• The SAS curve will shift with the LAS curve.

31
Shift in both LAS and SAS
LAS0
LAS1
140
SAS0
SAS1
130
120
Price level (GDP deflator, 1992 100)
110
100
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
32
Influences on Short-Run Aggregate Supply

• The SAS curve shifts with the LAS.
• The SAS will also shift with a change in
• the money wage rate,
• prices of other factors of production.

33
LAS and SAS
LAS
140
130
SAS
120
Price level (GDP deflator, 1992 100)
110
100
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)
34
Macroeconomic Equilibrium

• Macroeconomic equilibrium is where aggregate
  demand aggregate supply.
• There is an equilibrium for both
• the long run and short run.

35
Short-Run and Long-Run Macroeconomic Equilibrium

• Long-run macroeconomic equilibrium occurs when
  real GDP equals potential GDP.
• This implies that AD SAS LRAS.
• Short-run equilibrium can occur at a real GDP
  other than potential GDP.
• This implies that AD SAS ? LRAS.

36
Equilibrium Below Full Employment
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)
37
Equilibrium Above Full Employment
LAS
140
130
SAS2
Inflationary gap
120
Price level (GDP deflator, 1992 100)
Above full-employment equilibrium
c
110
100
AD2
90
7.0
7.2
Real GDP (trillions of 1992 dollars)
38
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
39
Long-Term Growthand Inflation

• Long-term economic growth occurs when the
  long-run aggregate supply curve shifts to the
  right.
• Inflation occurs when aggregate demand increases
  faster than long-run aggregate supply.

40
Inflation and Money Growth

• The pace at which the aggregate demand curve
  shifts is determined mainly by the growth rate of
  the money supply.
• Rapid increases in the quantity of money relative
  to economic growth cause rapid inflation.

41
AD shifts faster than AS
140
SAS2
SAS0
SAS1
130
120
AD2
Price level (GDP deflator, 1992 100)
110
AD1
100
AD0
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
42
Shock to Aggregate Demand

• Suppose the economy is at a full-employment
  equilibrium.
• Something causes AD to increase.
• Real GDP and the price level will increase in the
  short run.

43
Increase in AD
LAS
Short-run effect
140
130
SAS0
115
Price level (GDP deflator, 1992 100)
110
100
AD1
90
AD0
6.0
7.0
7.5
Real GDP (trillions of 1992 dollars)
44
The Return toLong-Run Equilibrium

• The short-run equilibrium is above full
  employment.
• Prices and output have increased, but wage rates
  have not.
• In the long run, wage rates will increase.

45
Return to Equilibrium
LAS
Long-run effect
140
SAS1
130
SAS0
125
115
Price level (GDP deflator, 1992 100)
100
AD1
90
6.0
7.0
7.5
Real GDP (trillions of 1992 dollars)
46
The New Long-Run Equilibrium

• In the long-run, what has happened to output and
  prices?

47
A shock to SAS
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)
48
Anti-Stagflation Policies

• What will happen if there is no policy response?
• What will happen if there is a policy response?

49
Long-Term Growth, Inflation, and Cycles inthe
U.S. Economy

• The economy is continuously changing.
• The AD-AS model helps us understand what is going
  on at a point in time.
• Lets consider 1960 to the present.

50
The Economy, 1960-1996

• The three important features of the economys
  path are
• Long-term growth
• Inflation
• Business Cycles

51
The Economy 1960-1998
52
Did You Learn?

• Why the LAS is vertical?
• Why the SAS has a positive slope?
• Why when GDP is greater (less) than LAS, the SAS
  shifts up (down)?
• Why the AD is downward sloping?
• What "exogenous" factors will shift the AD curve?
• What policies will shift the AD curve?
• About the "gaps" and the business cycle?
• What will shock the SAS curve?