Ch. 10: Aggregate Supply and Demand

Derive AS/AD model Understand cause & consequences of change in AS/AD

• Short run vs Long run• Effects on economic growth, prices, unemployment.

Different schools of thought in macroeconomics

Macroeconomic Long Run and Short Run

The Macroeconomic LRa time frame that is sufficiently long for the real wage rate

to have adjusted to achieve full employment: Real GDP = potential GDP. Unemployment=natural unemployment rate. Price level determined by quantity of money (equation of

exchange) Inflation rate =money growth rate minus the real GDP growth rate.

The Macroeconomic SRa period during which some prices or wages are sticky so

Real GDP might be below, above, or at potential GDP. The unemployment rate might be above, below, or at the natural

unemployment rate

Aggregate Supply

The quantity of real GDP supplied is the total quantity that firms plan to produce during a given period. It depends on

The quantity of the labor employed The quantity of physical and human capital State of technology

Two time frames associated with different states of the labor market:

Long-run aggregate supply Short-run aggregate supply

Aggregate Supply

Long-Run Aggregate Supply (LAS)the relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP.Potential GDP is determined by

•Production function•Labor market•Independent of price level

LR aggregate supply curve (LAS) is vertical at potential GDP.

Determinants of LASLabor market

Production function

LAS

Real Wage

Real GDP

Price Level

Labor hours

Labor hours

Real GDP

Determinants of LASChange in labor supply

• immigration• taxes on employees• transfers (UI, SS)• population growth• retirement

Change in labor demand• worker productivity (also affects PF)• taxes on employer payroll

Shifts in Production Function• capital/technology (also affects LD)• human capital

Graphic analysis of changes in LAS(Change in Labor Supply)

Effect on • Real wage• Employment • productivity

Graphic analysis of changes in LAS(increase in labor productivity)

Effect on • Real wage• Employment • Productivity

Aggregate Supply

Short-Run Aggregate Supply (SAS)Shows relationship between real GDP supplied and the price level, ceteris paribusA rise in the price level with no change in the money wage rate and other factor prices increases the quantity of real GDP supplied.

• as P rises, real wage declines, firms want to hire more employees (movement along labor demand curve)

The short-run aggregate supply curve (SAS) is upward sloping.

Short Run Aggregate SupplyLabor market

Production function

SAS

As P rises, RW falls, L rises; RGDP rises

Aggregate Supply

Along the SAS curve, real GDP supplied might be above potential GDP…or below potential GDP.

Aggregate Supply

An increase in potential GDP shifts the LAS curve and the SAS curve shifts along with the LAS curve.

Aggregate Supply

A rise in the money wage rate Decreases short-run

aggregate supply and shifts the SAS curve leftward. Has no effect on long-

run aggregate supply.

Aggregate Demand

AD is the total amount of final goods and services produced in the United States that people, businesses, governments, and foreigners plan to buy.AD= C + I + G + (X – M.)AD depends on

The price level Expectations about future Changes in wealth Fiscal and monetary policy The world economy

Aggregate Demand

The Aggregate Demand Curveplots the quantity of real GDP demanded against P.slopes downward for 2 reasons:

Wealth effect Substitution effects

Aggregate Demand

Wealth EffectP increases

real wealth decr C decr AD decr

Substitution Effects•Intertemporal P incr

int rate incr C & I decr AD decr• InternationalP incr

imports incr, exports decr AD decr

Shifts in Aggregate Demand

Expectations about future• Increases in expected future income

increases C today increases AD.

• Increase in expected future inflation buying goods cheaper today increases AD.

• Increase in expected future profits investment increases

increases AD

Shifts in Aggregate Demand

Fiscal Policysetting and changing taxes, transfer payments, and purchasing goods and services.An income tax cut or increase in transfers

increases disposable income (income-taxes+ transfers) increases C increases AD

An increase in government spending increases G increases AD

Shifts in Aggregate Demand

Monetary policy changes in interest rates and the quantity of money in the economy.An increase in the money supply reduces interest rates and increases aggregate demand.

Shifts in Aggregate Demand

Summary:Fiscal policyMonetary policyValue of $Foreign income

Macroeconomic Equilibrium

SR Equilibrium:SAS=ADGDP can be above, below, or at potential GDP

LR equilibriumLAS=SAS=AD

Macroeconomic Equilibrium

Graphical illustration of SR equilibria with

1. GDP>potential GDP (inflationary gap)

2. GDP<potential GDP (recessionary gap)

3. GDP=potential GDP (LR equilibrium)

• Transition from GDP>potential GDP to LR equilibrium (inflationary gap)

• Initially: • empl > equil. Empl• unempl < natural rate• R-wage < equil. R-wage• upward pressure on R-waqes

• SAS shifts left until GDP=potential GDP• As economy moves to LR Equilibrium:

Employment falls, Unemployment rises,Real wage rises, Real GDP falls

• Transition from GDP<potential GDP to LR equilibrium (recessionary gap)

• Initially: • empl < equil. Empl• unempl > natural rate• R-wage > equil. R-wage• downward pressure on R-waqes

• SAS shifts left until GDP=potential GDP• As economy moves to LR Equilibrium:

Employment rises Unemployment fallsReal wage falls Real GDP rises

SR/LR effect of changes in AD

Effect of Increase in AD on real wage, prices, real GDP unemployment and employment.

Macroeconomic Schools of Thought

Three broad schools of thought: Classical

believes the economy is self-regulating and always at full employment.

KeynesianDue to sticky wages/prices, the economy would rarely operate at full employment.To achieve and maintain full employment, active help from fiscal policy and monetary policy is required

Monetaristeconomy is self-regulating and that it will normally operate at full employment, provided that monetary policy is not erratic and that the pace of money growth is kept steady