Download pdf - Aggregate Demand and Aggregate - eRutledge5 Components of Aggregate Demand › Aggregate Demand is the total level of planned spending on goods and services in an economy by households,

AggregateDemandandAggregateSupply

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Aggregate Demand and Aggregate Supply

LEARNING OBJECTIVES

1. AggregateDemand(AD)has5 LearningObjectives

2. AggregateSupply(AS)alsohas5

3. MacroeconomicEquilibriumintheAD/ASModelhas2

The Learning Objectives in this presentation

are covered in Chapter 20:

Aggregate Demand and Aggregate Supply

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Today, many economies, including the US, the UK and the Eurozone are suffering from weak GDP and high unemployment; some are still in recession.

Most economists think the cause is a lack of Aggregate Demand (low levels of spending)

The Aggregate Demand and Aggregate Supply Models help explain short-run fluctuations in Output, Prices and Employment.

Making theConnection

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Aggregate Demand (AD)

LEARNING OBJECTIVES

1. TounderstandAggregateDemand(AD)isitscomponents

2. TounderstandwhytheADCurveSlopesDownwards

3. ToidentifythedifferencebetweenaMovementAlongtheCurveandaShiftintheCurve

4. ToidentifythevariablesthatshifttheADcurve

5. TounderstandtheimpactofmacroeconomicpolicyonAD

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Components of Aggregate Demand

› AggregateDemandisthetotallevelofplannedspendingongoodsandservicesinaneconomybyhouseholds,businesses,governmentandforeignparties.AD(alsosumstoexpenditurebasedGDP)andhasfourcomponents:

› Consumption(C)

› Investment(I)

› Governmentpurchases(G)

› NetExports(NX)

› IfweletY standforAD,wecanwritethefollowing:

› Y=C+I+G+NX

LEARNING OBJECTIVE: (1) ONESee Chapter 20 for more details

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The Aggregate Demand Curve

› TheADCurveshowsthelevelofplanneddemandforrealoutputconsistentwithaparticularpricelevelrelationship

Price Level (P)

Real GDP (Y)

Y1Y2

P2

P1

AD


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Why does the AD Curve Slope Downwards?

TherearethreemainreasonsforaninverserelationshipbetweenADandthepricelevelinaneconomy(i.e.adownwardslope):

1. TheWealthEffect

› Thisaffectsconsumption

2. TheInterestRateEffect

› Thisaffectsinvestment

3. TheInternational‐tradeEffect

› Thisaffectsnetexports

Price Level (P)

Real GDP (Y)

AD

LEARNING OBJECTIVE: (1) TWOSee Chapter 20 for more details

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Why does the AD Curve Slope Downwards?

HowaChangeinthepricelevelaffectsConsumption |TheWealthEffect

› Whenpricesrisethemoneypeoplehavebuysfewergoodsandservices,sorealwealthislower,peoplefeelpoorerandCgoesdown. P⬆∴ AD⬇

HowachangeinthepricelevelaffectsInvestment |Interest‐RateEffect

› Ariseinpricesleadstoincreasedmoneydemandandrisinginterestrates.Investmentis

thusaffectednegatively. P⬆∴ AD⬇

HowachangeinthepricelevelaffectNetexports| International‐TradeEffect

› Whenpricesrise,exportsbecomemoreexpensiveandsoforeigndemandforthemfalls,

atthesametimeimportsbecomecheaper,thusnetexportsdecline.P⬆∴ AD⬇


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Aggregate Demand Curve

› ChangesinP causemovements up ordownagivenADCurve

› AnincreaseinP reducesthequantityofGoodsandServicesdemandedbecause:

› Thewealtheffect

(C)falls

› Theinterest‐rate

effect(I)falls

› TheInternational‐Trade

effect(NX)falls

Price Level (P)

Real GDP (Y)

Y1Y2

P2

P1

AD

Y3

P3

A rise in the P from P1 to P2 causes a contraction in AD (moves up)

A fall in P from P1 to P3 causes an expansion in AD (moves down)


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Shifts of the AD Curve Vs. Movements Along it

› AnimportantpointtonoteisthattheADCurve– holdingeverythingelseconstant – tellsustherelationshipbetween

› thePriceLeveland thequantity ofrealGDPdemandedinaneconomy

› OnlyachangeinthepricelevelwillcauseamovementalonganexistingADcurve.

› Whenanyvariable,otherthanprice,changesandaffectsthewillingnessoffirms,householdsandgovernmenttospend,thentheADwillshift.

LEARNING OBJECTIVE: (1) THREESee Chapter 20 for more details

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Why might the AD Curve Shift?

AnyeventthatchangesC,I,G,orNX – exceptachangeinP – willcauseashifttheADCurve.

Price Level (P)

Real GDP (Y)

Y1 Y2

P1

AD1 AD2


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Variables that Shift the AD Curve

ThevariablesthatcausetheADcurvetoshiftfallintofourcategories:

Changesin…

1. Businessandhouseholdexpectations

2. Householdwealth

3. Foreignvariables

4. GovernmentandCentralBankmacroeconomicpolicies

LEARNING OBJECTIVE: (1) FOURSee Chapter 20 for more details

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Variables that Shift the AD Curve (1)

1. Changesintheexpectationsofbusinessesandhouseholds

› Household/businessoptimismorconfidenceaboutfutureincome/profitabilityhasa

powerfulaffectontheirspending andisaffectedbyexpectationsaboutthefuture

growthoftheeconomyandinflation.

2. Changesinhouseholdwealth

› Wealthisthevalueofassetsowned.Thusachangeinhouseorsharepricesinfluences

wealthandinturnalsoaffectsconsumerconfidence.

3. Changesinforeignvariables

› Achangeinthevalueoftheexchangerateandforeignincomeaffectsthedemandfor

exportsandtheNXcomponentofAD.


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4. ChangesinGovernmentandCentralBankPolicies

› Fiscalpolicy|Referstochangesingovernmentspending,welfarebenefitsand

taxationandtheamountthegovernmentborrows.

› Changesinfederalincometax,corporatetaxes,governmentpurchasesandtransferpayments,allaffectAD.

› Monetarypolicy|Theactionsthecentralbanktakestomanagethemoneysupplyandinterestratestopursuemacroeconomicpolicyobjectives.

› Changesintheinterestrateaffecttheincentivesofhouseholdsandbusinessesto

borrowandsave.

› Theavailabilityofcreditfrombankswillalsoaffectborrowingtofinanceconsumptionorinvestment.

Variables that Shift the AD Curve (2)LEARNING OBJECTIVE: (1) FIVESee Chapter 20 for more details

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Shifts in the AD Curve to the Right (Summary)

VariablesthatShifttheADCurvetotheright:

Price Level (P)

Real GDP (Y)

AD1 AD2

Anincreasein…

Governmentpurchases

Households’expectationsoftheirfutureincomes

Firm’sexpectationsofthefutureprofitabilityofinvestmentspending

shiftstheADCurveright because…

Thesearecomponentsofaggregatedemand

Consumptionspendingincreases

Investmentspendingincreases.

LEARNING OBJECTIVE: (1) FIVESee Chapter 20 for more details

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Shifts in the AD Curve to the Left (Summary)

VariablesthatShifttheADCurvetotheleft:

Price Level (P)

Real GDP (Y)

AD2 AD1

Anincreasein…

Interestrates

Taxes

ThegrowthrateofdomesticGDPrelativetothatofforeignGDP

Theexchangerate(valueofdomesticcurrency)relativetoforeigncurrencies.

shiftstheADCurveleft because…

raisesthecostofborrowing,reducingconsumptionandinvestment

theycauseconsumptionandinvestmenttofall

Exportswillfall,reducingnetexports

Importswillriseandexportswillfall,reducingnetexports


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Theimmediatecausehasbeenadeclineinaggregatedemand.Dueto:

› Afallinconsumerdemand,resultingfromhigh unemploymentratesandasqueezeonrealwages(frozenorevenreduced);

› Inflationandtaxrises;

› Thegovernment’sausterityprogrammeiscurtailingfiscalexpenditure;

› ExportgrowthhasbeenconstrainedbyaslowingdownintheglobaleconomyandespeciallyintheEurozone(theUK’smaintradingpartner);

› Investmentisbeingheldbackbypessimisticbusinesssentimentanddifficultiesinraisingfinance.

| Source: The Sloman Economics News site: http://pearsonblog.campaignserver.co.uk/?tag=aggregate-demand


The UK economy shrank by a further 0.7% in Q2 of 2012, meaning that was the longest “double dip” recession in over 50 years.


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Situations to Consider…

Explainhow and why eachofthefollowingfactorswillinfluencecurrent(short‐run)aggregatedemandintheUAE:

1. Businessesbecomemoreoptimisticaboutthefuture

2. TheUAECentralBanklowersinterestrates

3. TheUAEGovernmentincreasesspendingoninfrastructure

4. InflationriseswithintheUAE(becarefulwiththisone!)

5. LowerrealincomeinAsia(akeyexportmarketfortheUAE)

6. Thereisapricecollapseintherealestatesector

7. UAEstockmarketsfallsharply.

LEARNING OBJECTIVE: (1) TWO to FIVE

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Aggregate Supply (AS)

LEARNING OBJECTIVES

1. TounderstandthedeterminantsofLong‐RunAggregateSupply(LRAS)

2. ToidentifythevariablesthatshifttheLRASCurve

3. TounderstandthedeterminantsofShort‐RunAggregateSupply(SRAS)

4. TounderstandwhytheSRAScurveslopesupwards

5. ToidentifythevariablesthatshifttheSRAScurve

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Long Run Aggregate Supply

› LRAS

› LRASislocatedatpotentialGDP– itrepresentsalevelofrealnationaloutputintheeconomy

› PotentialGDPisassumedtobeindependentofthepricelevel(moneyisneutral).

› LRASisdeterminedbytheproductiveresourcesavailabletomeetdemandandbytheproductivityofthefactorinputs(labour,landandcapital).

› LRAScurve

› AcurvethatshowstherelationshipinthelongrunbetweenthepricelevelandthequantityofrealGDPsupplied.


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TheLong‐RunAggregateSupplyCurve(LRAS)

Changesinthepriceleveldonotaffect

thelevelofAS inthelongrun.

Therefore,theLRAS,isaverticallineat

thepotentiallevelofrealGDP.

Anincreaseinthequantityand

productivityoffactorsofproduction

oranadvanceintechnologycausesan

increaseintheproductivepotentialof

theeconomy.

i.e.anoutwardshiftintheLRAScurve.

The LRAS Curve

Price level (P)GDP deflator, 2000 = 100

Real GDP (Y)Trillions of 2000 $ dollars

12.0

120

LRAS2007

11.7

130

110

12.3

LRAS2008 LRAS2009


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Short-Run Aggregate Supply

› Measuresthe volumeofgoodsandservices producedwithintheeconomyatagivenpricelevel,itrepresentstheabilityofaneconomytodelivergoodsandservicestomeetdemand.

› SRASisdeterminedbythesupplysideperformanceoftheeconomy,theproductivecapacityoftheeconomyandthecostsofproductionineachsector.

› ThereisapositiverelationshipbetweenASandthegeneralpricelevel.

› RisingpricesareasignalforbusinessestoexpandproductiontomeetahigherlevelofAD,whenpricesarefallingproductionmaycontract.


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Short-run Aggregate Supply Curve

TheShort‐runAggregateSupplyCurve(SRAS)

› Showstherelationshipinthe

shortrunbetweenthe

pricelevelandthequantity

ofrealGDPsuppliedbyfirms.

Price level (P)

Real GDP (Y)Y1

P2

P1

SRAS

Y2


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Why does the SRAS Curve Slope Upwards?

Factorsforwhyashort‐runaggregatesupplycurveslopesupwardinclude:

› Contractsmakesomewagesandprices“sticky.”

» Assomeproductioncostsareunchangedanincreaseinthepriceofthegoodsoldwill

givethefirmthechancetoincreaseprofitsbyincreasingitsprice.

› Firmsareoftenslowtoadjustwages

› Menucostsmakesomepricessticky

» Assomefirmshavelowerpricesthanothers,thuswhenpricelevelisincreasingthis

firmmightfinditssalesincreasingandthusadjustathigherproductionlevels.The

oppositealsoholds.


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Movements along the SRAS Curve

ShiftsoftheSRASCurvevs.MovementsAlongtheCurve

Itisimportanttorememberthedifferencebetween:

› ashiftinacurveandamovementalongacurve.

› ChangesinaggregatedemandcauseeitheracontractionorexpansionalongtheSRAScurve,e.g.anincreaseindemandshouldleadtoanexpansionofaggregatesupplyintheeconomy.


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AmovementalongtheSRASCurve

Ariseinthepricelevelwill cause

anexpansionofaggregatesupply

intheeconomy

Producersarerespondingto

higherprices(drivenupby

increaseddemand)

RealGDPwillincreasefromY1

toY2

A Movement Along the SRAS Curve

Price level (P)

Real GDP (Y)Y1

P2

P1

SRAS

Y2

1a

1b

1c

AD1

AD2


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Variables that Shift the SRAS Curve

VariablesThatShifttheShort‐RunAggregateSupplyCurve

1. ChangesinthesizeandqualityoftheLaborForce

2. Changesinthesizeandqualityofthecapitalstockthroughinvestment

3. Technologicalchange

4. Changesinexpectationsaboutprices(inflation)

5. AdjustmentsofworkersandfirmstoerrorsinpastexpectationsaboutthePriceLevel

6. UnexpectedChangesinthepriceofanimportantnaturalresource

7. Supplyshock|Anunexpectedeventthatcausestheshort‐runaggregatesupplycurvetoshift.


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Shifts in the SRAS

ShiftsintheSRASCurvecanresultfromexpectedchangesinpricelevels

Iffirmsandworkersexpectthat

thepricelevelwillbe3percent

higherin2013thanin2012…

…theSRAS curvewillshifttothe

lefttoreflectfirmandworker

expectationsofrisingcosts.

11

12



10.0

103

100

SRAS2013 SRAS2012

11

12


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Shifts in the AS Curve to the Right (Summary)

VariablesthatShifttheShort‐runASCurve(SRAS)totheright:

Price Level (P)

Real GDP (Y)

SRAS1 SRAS2

Anincreasein…

Thelabourforceorthecapitalstock

Productivity

shiftstheSRASCurveright because…

Moreoutputcanbeproducedateverypricelevel

Costofproducingoutputwillfall


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Shifts in the AS Curve to the Left (Summary)

VariablesthatShifttheShort‐runASCurve(SRAS)totheleft:

Anincreasein…

Theexpectedfuturepricelevel

Workersandfirmsadjustingtohavingpreviouslyunderestimatedthepricelevel

Theexpectedpriceofanimportantnaturalresource

shiftstheSRASCurveleft because…

Workersandfirmsincreasewagesandprices

Workersandfirmsincreasewagesandprices

Costofproducingoutputrises.

Price Level (P)

Real GDP (Y)

SRAS2 SRAS1


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Macroeconomic Equilibrium – AD/AS Model

LEARNING OBJECTIVES

1. LearnhowtousetheAD/ASmodeltoillustratethedifferencebetweenShort‐runandLong‐runmacroeconomicequilibrium

2. LearnhowtousetheDynamicAD/ASmodeltoanalysemacroeconomicconditions

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Long-run Macroeconomic Equilibrium

Long‐RunMacroeconomicEquilibrium


Real GDP (Y)Trillions of 2000 dollars$10.0

100

ADSRAS

LRAS


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Long and Short Run Macroeconomic Equilibrium

Recessions,Expansions,and SupplyShocks

Becausethefullanalysisoftheaggregatedemandandaggregatesupplymodelcanbecomplicated,webeginwithasimplifiedcase,usingtwoassumptions:

› Theeconomyhasnotbeenexperiencinganyinflation

› Thepriceleveliscurrently100,andworkersandfirmsexpectittoremainat100in

thefuture.

› Theeconomyisnotexperiencinganylong‐rungrowth

› PotentialrealGDPis$10.0trillionandwillremainatthatlevelinthefuture.


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Recession |TheShort‐RunandLong‐RunEffectsofadecrease inAD

1. AdeclineininvestmentshiftsAD

totheleft,causingarecession.

2. Asfirmsandworkersadjustto

thepricelevelbeinglowerthan

theyhadexpected,costswillfall

andcauseSRAStoshifttotheright.

3. EquilibriummovesfrompointB

backtopotentialGDPatpointC,

withalowerpricelevel.

Modelling a Recession



10

100

AD1 SRAS1LRASAD2 SRAS2

9.8

98

96

11

12

13

11 12

13

A

B

C


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Expansion |TheShort‐RunandLong‐RunEffectsofaincrease inAD

1. AnincreaseininvestmentshiftsAD

to theright,causinganinflationary

expansion.

2. Asfirmsandworkersadjustto

thepricelevelbeinghigherthan

theyhadexpected,costswillrise

andcauseSRAStoshifttotheleft.

3. EquilibriummovesfrompointB

backtopotentialGDPatpointC,

withahigherpricelevel.

Modelling an Expansion



10

106

AD2 SRAS2LRASAD1 SRAS1

10.3

103100

11

12

13

11 12

13

A

C

B


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Supply Shocks

› Asupplyshockisanyunexpectedeventaffectingcostsandpricesindifferentcountries.

› E.g.Ariseintheworldpriceofcrudeoilornaturalgas,foodstuffsorotherimportant

commodities

› AnASshockiseitheraninflationshockorashocktoacountry’spotentialnationaloutput.

› AdverseASshocksofbothtypesreduceoutputandincreaseinflationandcanincreasetheriskofstagflationforaneconomy.

› Stagflation |Acombinationofinflationandrecession,usuallyresultingfromasupplyshock.


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SupplyShocks |Short‐run effect

1. Anincreaseinoilpricesshiftsthe

SRAS totheleft…

2. …movingshort‐runequilibriumto

pointB,withlowerrealGDPanda

higherpricelevel.

Modelling Supply Shocks – Short-run



10

SRAS2LRASAD SRAS1

9.7

102

100

1112

A

B

11

12


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SupplyShocks |Long‐runeffect

1. Therecessioncausedbythesupply

shockeventuallyleadstofallingwages

andprices,shiftingSRASbacktoits

originalposition.

2. EquilibriummovesfrompointB back

topotentialGDPattheoriginalprice

level.

Modelling Supply Shocks – Long-run

11

12



10

SRAS1LRASAD SRAS2

9.7

102

100

11

12A

B


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WecancreateaDynamicAD/ASmodelbymakingthreechangestothebasicmodel.

› PotentialrealGDPincreasescontinually,shiftingthelong‐runaggregatesupplycurvetotheright.

› Duringmostyears,theaggregatedemandcurvewillbeshiftingtotheright.

› Exceptduringperiodswhenworkersandfirmsexpecthighratesofinflation,theshort‐runaggregatesupplycurvewillbeshiftingtotheright.

The Dynamic AD/AS ModelLEARNING OBJECTIVE: (3) TWOSee Chapter 20 for more details

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The Dynamic AD/AS Model

ADynamicAggregateDemandandAggregateSupply(AD/AS)Model

› Theeconomybeginsinequilibrium

atpointAwithSRAS1andAD1intersectingatapointonLRAS1

11



10

10o11

A

AD1

SRAS1

LRAS1


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WhatIstheUsualCauseofInflation?

› UsingDynamicAD/ASmodelto

understandinflation

› IfAD shiftstotherightmore

thanSRAS…

› …thepricelevelrises.

The Dynamic AD/AS Model

11

12



10

10o

AD1

SRAS1

LRAS1

11

A

12B

10.5

104

AD2

LRAS2

SRAS2


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The slow recovery from the 2008-2009 Recession:Case study of the USA.


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The more rapid recovery from 2010:Case study of the USA (continued)


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ACTUALREAL GDP

POTENTIAL REAL GDP

PRICE LEVEL

1974 $4.32 trillion $4.35 trillion 34.7

1975 $4.31 trillion $4.50 trillion 38.0

TheDynamicAD/ASModel

Showing the Oil Shock of 1974–1975By using a Dynamic Aggregate Demand and Aggregate Supply Graph

Putting it intoPractice

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Key Terms

» Aggregatedemandandaggregatesupplymodel

» Aggregatedemandcurve

» Fiscalpolicy

» Long‐runaggregatesupplycurve

» Menucosts

» Monetarypolicy

» Short‐runaggregatesupplycurve

» Stagflation

» Supplyshock