Ch 4 Aggregate Demand & Aggregate Supply

8/8/2019 Ch 4 Aggregate Demand & Aggregate Supply

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CHAPTER

AGGREGATE

DEMAND

AND

AGGREGATE

SUPPLY


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Aggregate Demand

The Aggregate Supply Curve

Aggregate supply is the relationship between the quantity

of real GDP supplied and the price level.

The aggregate supply (AS) curve plots the quantity of realGDP supplied against the price level.


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Aggregate Supply

Aggregate Supply Fundamentals

The aggregate quantity of goods and services supplieddepends on three factors:

The quantity of labor (L )

The quantity of capital (K )

The state of technology (T )

The aggregate production function shows how quantityof real GDP supplied, Y, depends on labor, capital, andtechnology.


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Aggregate Supply


The aggregate production function is written as theequation:

Y=F(L, K, T )

In words, the quantity of real GDP supplied depends on (isa function of) the quantity of labor employed, the quantityof capital, and the state of technology.

The larger is L, K, orT, the greater is Y.


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Aggregate Supply


Long-run aggregate supplyShort-run aggregate supply


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Aggregate Supply

Long-Run Aggregate Supply

The macroeconomic long run is a time frame that is

sufficiently long for all adjustments to be made so that realGDP equals potential GDP and there is full employment.

The long-run aggregate supply curve (LAS) is therelationship between the quantity of real GDP supplied

and the price level when real GDP equals potential GDP.


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Aggregate Supply

Graph shows an LAScurvewith potential GDP of $10trillion.

The LAScurve is verticalbecause potential GDP isindependent of the pricelevel.

Along the LAScurve allprices and wage rates varyby the same percentage.


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Aggregate Supply

Short-Run Aggregate Supply

The macroeconomic short run is a period during whichreal GDP has fallen below or risen above potential GDP.

At the same time, the unemployment rate has risen aboveor fallen below the natural unemployment rate.

The short-run aggregate supply curve (SAS) is therelationship between the quantity of real GDP supplied

and the price level in the short-run when the money wagerate, the prices of other resources, and potential GDPremain constant.


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Aggregate Supply

Along the SAScurve, risein the price level with nochange in the money

wage rate and other input prices increases thequantity of real GDPsuppliedthe SAS curveis upward sloping.


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Aggregate Supply

Along the SAScurve, real

GDP might be abovepotential GDP

or below potential GDP.


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Aggregate Supply

Movement along the

LASand SASCurves

A change in the price level

with an equal percentagechange in the moneywage causes a movementalong the LAScurve.

A change in the price levelwith no change in themoney wage causes amovement along the SAScurve.


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Aggregate Supply

Changes in Aggregate Supply

(i) Change in Potential GDP

When potential GDP increases, both the LASand SAS

curves shift rightward.Potential GDP changes, for three reasons

Change in the full-employment quantity of labor.

Change in the quantity of capital (physical or human). Advance in technology.


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Aggregate Supply


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Aggregate Supply

(ii) Change in the

money wage rate

A rise in the money

wage rate decreasesshort-run aggregatesupply and shifts theSAScurve leftward.

But it has no effect onlong-run aggregatesupply.


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Aggregate Demand

The quantity of real GDP demanded, Y, is the total amountof final goods and services produced in a country thatpeople, businesses, governments, and foreigners plan tobuy.

This quantity is the sum of consumption expenditures, C,investment, I, government purchases, G, and net exports,X M. That is:

Y=C+ I+ G+ X M


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Aggregate Demand

Buying plans depend on many factors and some of themain ones are:

The price level

Expectations

Fiscal and monetary policy

The world economy


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Aggregate Demand

The Aggregate Demand Curve

Aggregate demand is the relationship between the

quantity of real GDP demanded and the price level.

The aggregate demand (AD) curve plots the quantity ofreal GDP demanded against the price level.


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Aggregate Demand

The AD curve slopesdownward for tworeasons

A wealth effect

Substitution effects


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Aggregate Demand

(i) Wealth effect

A rise in the price level, other things remaining the same,decreases the quantity of real wealth.

To restore their real wealth, people increase saving anddecrease spending, so the quantity of real GDP demandeddecreases.


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Aggregate Demand

Changes in Aggregate Demand

A change in any influence on buying plans other than theprice level changes aggregate demand.

The main influences on aggregate demand are

Expectations

Fiscal and monetary policy

The world economy.


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Changes in Aggregate Demand

(ii) Fiscal policy

A tax cut or an increase in transfer payments increaseshouseholds disposable income increases consumption

expenditure and increases aggregate demand.

Because government purchases of goods and servicesare one component of aggregate demand, an increase ingovernment purchases increases aggregate demand.


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Aggregate Demand

Monetary policy is changes in the interest rate andquantity of money.

An increase in the quantity of money increases buying

power and increases aggregate demand.

Acut in the interest rate increases expenditure andincreases aggregate demand.


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Aggregate Demand

(iii) The world economy influences aggregate demand intwo ways:

A fall in the foreign exchange rate lowers the price of

domestic goods and services relative to foreign goods andservices, increases exports, decreases imports, andincreases aggregate demand.

An increase in foreign income increases the demand for

exports and increases aggregate demand.


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Macroeconomic Equilibrium

Short-Run Macroeconomic Equilibrium

Short-run macroeconomic equilibrium occurs when the

quantity of real GDP demanded equals the quantity of realGDP supplied at the point of intersection of the AD curveand the SAScurve.


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If real GDP is belowequilibrium GDP,firms increaseproduction and raiseprices.

If real GDP is aboveequilibrium GDP,firms decrease

production and lowerprices.


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Long-Run Macroeconomic Equilibrium

Long-run macroeconomic equilibrium occurs when realGDP equals potential GDPwhen the economy is on itsLAS

curve.


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Long-run equilibriumoccurs where the ADand LAS curvesintersect and resultswhen the moneywage has adjusted toput the SAS curvethrough the long-run

equilibrium point.


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The Business Cycle

The business cycle occurs because aggregate demandand the short-run aggregate supply fluctuates.

1.Below full employment equilibrium

2.Full employment equilibrium

3.Above full employment equilibrium


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Abelow full-employmentequilibrium is anequilibrium in whichpotential GDP exceeds

real GDP.The amount by whichpotential GDP exceedsreal GDP is called arecessionary gap.


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Along-run equilibrium isan equilibrium in whichpotential GDP equalsreal GDP.


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An above full-employment equilibrium

is an equilibrium inwhich real GDP

exceeds potentialGDP.

The amount by whichreal GDP exceeds

potential GDP iscalled an inflationarygap.


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Economic Growth

and Inflation

Economic growth

occurs because thequantity of labor grows, capital isaccumulated, andtechnology advances,

all of which increasepotential GDP andbring a rightward shiftof the LAScurve.


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Inflation

Inflation occurs becausethe quantity of moneygrows faster thanpotential GDP, whichincreases AD by morethan long-run aggregatesupply.

The AD curve shiftsrightward faster than therightward shift of the LAScurve.


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Fluctuations in Aggregate

Demand

Starting at long-run

equilibrium, an increase inaggregate demand shiftsthe AD curve rightward.

Firms increase productionand rise pricesamovement along the SAScurve.


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Fluctuations in AggregateSupply

A rise in the price of oil

decreases short-runaggregate supply and theSAScurve shifts leftward.

Real GDP decreases andthe price level rises.

The combination ofrecession combined withinflation is called stagflation.


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Ch 4 Aggregate Demand & Aggregate Supply