Eco 6351 Economics for Managers Chapter 11a. Aggregate Supply and Demand

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Eco 6351Economics for ManagersChapter 11a.
Aggregate Supply and Demand

• Prof. Vera Adamchik

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The macro economy
DETERMINANTS
OUTCOMES
MACRO ECONOMY
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Macro view

• The determinants of macro performance include
• Internal market forces Population growth,
  spending behavior, invention and innovation, and
  the like.
• External shocks Wars, natural disasters, trade
  disruptions, and so on.
• Policy levers Tax policy, government spending
  changes in the availability of money, and
  regulation.

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Potential GDP

• The quantity of real GDP supplied when
  unemployment is at its natural rate and there is
  full employment is called potential real GDP.
• Over the business cycle, employment fluctuates
  around full employment and real GDP fluctuates
  around potential GDP.

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Two time horizons

• To study the economy at full employment and over
  the business cycle, we distinguish two time
  frames
• - the macroeconomic long run,
• - the macroeconomic short run.

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• The macroeconomic long run is a time frame that
  is sufficiently long for economic forces to bring
  real GDP to potential (full-employment) GDP.
• The macroeconomic short run is a period during
  which real GDP has fallen below or risen above
  potential GDP. At the same time, the unemployment
  rate has risen above or fallen below the natural
  rate.

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The Aggregate Supply-Aggregate Demand model

• The AS-AD model enables us to understand three
  features of macroeconomic performance
• Growth of potential GDP
• Inflation
• Business cycle fluctuations

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Long-run aggregate supply

• The long-run aggregate supply is vertical because
  potential GDP is independent of the price level.
• A movement along the LRAS is accompanied by a
  change in two sets of prices the prices of goods
  and services and the prices of productive
  resources. When relative prices remain constant,
  real GDP also remains constant.

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Long-run aggregate supply
Long Run Aggregate Supply
Potential (Full Employment) GDP
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Aggregate demand

• Other things remaining the same, the higher
  the price level, the smaller is the quantity of
  real GDP demanded. This relationship between the
  quantity of real GDP demanded and the price level
  is called aggregate demand.

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Aggregate demand

• The AD curve is the relationship between the
  quantity of real GDP demanded and the price level
  in a given time-period, ceteris paribus.
• The AD curve is downward-sloping the higher the
  price level, the smaller is the quantity of real
  GDP demanded. Reasons real balances effect,
  foreign trade effect, interest rate effect.

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Aggregate demand
Higher prices
Lower prices
Aggregate demand
Less output demanded
More output demanded
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Stable or unstable

• The central concern of macroeconomic theory is
  whether the internal forces of the marketplace
  will generate desired outcomes.

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Classical theory

• Prevalent theory prior to the 1930s.
• The economy is stable because of its ability to
  self-adjust.
• The cornerstones of the Classical Theory are
  flexible prices and flexible wages.
• According to Classical economists, government
  intervention in a self-adjusting macroeconomy is
  unnecessary.

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Says Law

• According to Says Law, supply creates its own
  demand.
• Unsold goods will ultimately be sold when buyers
  and sellers find an acceptable price.
• In the labor market, some people will be
  unemployed, but can find new jobs if they are
  willing to accept lower wages.

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The Great Depression

• The Great Depression (1929-1939) was a stunning
  blow to Classical economists.
• In the Depressions worst year, 1933, the
  production of U.S. farms, factories, shops, and
  offices was only 70 percent of its 1929 level and
  25 percent of the labor force was unemployed.
• The science of economics had no solutions to the
  Great Depression.

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Inflation and Unemployment, 1900 1940
Unemployment
Prices
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The Keynesian revolution

• John Maynard Keynes provided an alternative to
  the Classical Theory.
• In 1936, Keynes published The General Theory of
  Employment, Interest, and Money.

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• Keynes asserted that the private economy was
  inherently unstable. No self-adjustment.
• In Keynes view, the inherent instability of the
  marketplace required government intervention
  (Policy levers).

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• Keynes focused primarily on the short term. He
  wanted to cure an immediate problem almost
  regardless of the long-term consequences of the
  cure. In the long run, said Keynes, were all
  dead.
• Keynes believed that after his cure for
  depression had restored the economy to a normal
  condition, the long-term problems of inflation
  and slow economic growth will return.

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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 a given
  time-period, ceteris paribus. That is, when the
  money wage rate and other resource prices remain
  constant.

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Short-run aggregate supply

• The aggregate supply curve is upward-sloping the
  output increases when price level rises.
• The aggregate supply curve is relatively flat
  when capacity is underutilized. It begins to
  slope upward as producers approach capacity.

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Shape of the SRAS curve

• Short-Run Aggregate Supply (SRAS) has three
  segments or ranges
• Horizontal range (Keynesian segment),
• Intermediate (Upward-sloping) range,
• Vertical range (Classical segment)

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Short-run aggregate supply
P
Vertical range
Price level
Horizontal range
Upward-sloping or intermediate range
Q
Real domestic output, GDP
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Macroeconomic equilibrium

• Macroeconomic equilibrium occurs when the
  quantity of real GDP demanded equals the quantity
  of real GDP supplied.

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Macroeconomic equilibriumin the long run and
the short run
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Macro-equilibrium Real output and the price
level
P
SRAS
Equilibrium in the Horizontal Range
Price Level
Pe
AD
Q
Qe
Q1
Q2
Real Domestic Output, GDP
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Macro-equilibrium Real output and the price
level
P
SRAS
Equilibrium in the Intermediate Range
Price Level
Pe
P1
AD
Q
Qe
Q1
Q2
Real Domestic Output, GDP
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Macro failure

• There are two potential problems with macro
  equilibrium undesirability and instability.

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Macro Failure

• Undesirability the price-output relationship at
  equilibrium may not satisfy our macroeconomic
  goals
• Undesirable Outcomes
• Unemployment
• Recession
• Inflation

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Three types of short-run macroeconomic equilibrium

• (1) below full-employment equilibrium (real GDP
  is less than potential GDP and there is a
  recessionary gap)
• (2) above full-employment equilibrium (real GDP
  exceeds potential GDP and there is an
  inflationary gap)
• (3) at full-employment equilibrium (real GDP
  equals potential GDP).

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Below FE equilibrium
Aggregate demand
Aggregate supply
E
PE
F
P
Equilibrium output
Full employment
QE
QF
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Macro failure

• Instability even if designated macro
  equilibrium is optimal, it may be displaced by
  macro disturbances.
• Shifts in aggregate supply and aggregate demand
  can upset a full employment equilibrium.

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Recurrent shifts

• Business cycles are a result of recurrent shifts
  of the aggregate supply and demand curves.
• There are lots of reasons to expect aggregate
  supply and aggregate to shift.

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Macro disturbances
(b) Demand shifts
(a) Supply shifts
AS1
AS0
AS0
AD0
G
F
P1
F
P
H
P
P2
AD0
AD1
Q2
QF
Q1
QF
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Origins of a recessionDemand shifts
AS0
E0
E1
AD0
AD1
Q1
QF
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Origins of a recessionSupply shifts
AS1
AS0
E2
E0
AD0
Q2
QF
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Origins of a recessionSupply and demand shift
AS1
AS0
E3
E0
AD0
AD1
Q3
QF