Ch. 11: Aggregate Supply and Demand

1. Ch. 11: Aggregate Supply and Demand • Derive AS/AD model • Understand consequences of change in AS/AD • Short run vs Long run • Effects on economic growth, prices, unemployment. • Different schools of thought in macroeconomics

2. Macroeconomic Long Run and Short Run The Macroeconomic LR • a 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. • Inflation rate =money growth rate minus the real GDP growth rate. The Macroeconomic SR • a period during which some money prices 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

3. 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

4. Aggregate Supply Long-Run Aggregate Supply • 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.

5. Determinants of LAS Labor market LAS Production function

6. Graphic analysis of changes in LAS

7. Determinants of LAS Effect of each on LAS • Increase in labor supply • immigration • taxes on employees • transfers (UI, SS) • population growth • retirement • Increase in labor demand • worker productivity (also affects PF) • taxes on employer payroll • Shifts in Production Function • capital/technology • human capital

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

9. Graphic analysis of changes in LAS(change in Labor Demand)

10. Graphic analysis of changes in LAS(Change in Production Function)

11. Aggregate Supply Short-Run Aggregate Supply • the relationship between real GDP supplied and the price level when the money wage rate, the prices of other resources, and potential GDP remain constant. • A 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.

12. Short Run Aggregate Supply Labor market SAS Production function

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

14. Aggregate Supply Changes in Aggregate Supply • When potential GDP increases, both the LAS and SAS curves shift rightward. • Potential GDP changes, for three reasons: • The full-employment quantity of labor changes • The quantity of capital (physical or human) changes • Technology advances

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

16. 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.

17. 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 policy and monetary policy • The world economy

18. Aggregate Demand The Aggregate Demand Curve • plots the quantity of real GDP demanded against P. • slopes downward for 2 reasons: • Wealth effect • Substitution effects

19. Aggregate Demand • Wealth Effect • P increases  real wealth decreases  C decreases  AD decreases • Substitution Effects 1. Intertemporal • P increases  interest rate increases  C & I decrease  AD decreases 2. International • P increases  imports increase, exports decrease  AD decreases

20. 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 AD.

21. Shifts in Aggregate Demand Fiscal Policy • setting 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

22. 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.

23. Shifts in Aggregate Demand The World Economy • A weaker dollar  exports increase; imports decrease  AD rises • An increase in foreign income I increases the demand for U.S. exports  increases aggregate demand.

24. Shifts in Aggregate Demand Summary: Fiscal policy Monetary policy Value of $ Foreign income

25. Macroeconomic Equilibrium SR Equilibrium: SAS=AD GDP can be above, below, or at potential GDP LR equilibrium LAS=SAS=AD

26. Macroeconomic Equilibrium • Graphical illustration of SR equilibria with • GDP>potential GDP (inflationary gap) • 2. GDP<potential GDP (recessionary gap) • 3. GDP=potential GDP (LR equilibrium)

27. Transition from GDP>potential GDP to LR equilibriumemployment > equil. employment (unemployment < natural rate) real wage < equil. real wage upward pressure on real waqes SAS shifts left until GDP=potential GDP

28. Transition from GDP<potential GDP to LR equilibriumemployment < equil. employment (unemployment > natural rate) real wage > equil. real wage downward pressure on real waqes SAS shifts left until GDP=potential GDP

29. SR/LR effect of changes in AD Effect of Increase in AD on real wage, prices, real GDP unemployment and employment.

30. SR/LR effect of changes in AD Effect of decrease in AD on real wage, prices, real GDP unemployment and employment.

31. Effect of changes in LAS

32. Macroeconomic Schools of Thought • Three broad schools of thought: • Classical • believes the economy is self-regulating and always at full employment. • Keynesian • Due to sticky wages/prices, the economy would rarely operate at full employment and that to achieve and maintain full employment, active help from fiscal policy and monetary policy is required • Monetarist • economy 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