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

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

The Macroeconomic SRa 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

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 Supplythe 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

Graphic analysis of changes in LAS

Determinants of LASEffect of each on LASIncrease 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

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

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

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

Aggregate Supply

Short-Run Aggregate Supplythe 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.

Short Run Aggregate SupplyLabor market

Production function

SAS

Aggregate Supply

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

or below potential GDP.

Aggregate Supply

Changes in Aggregate SupplyWhen 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

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 policy 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 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

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.

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

The World EconomyA weaker dollar

exports increase; imports decrease AD rises

An increase in foreign income I increases the demand for U.S. exports increases aggregate demand.

Shifts in Aggregate Demand

Summary:Fiscal policyMonetary policyValue of $Foreign income

Macroeconomic Equilibrium

SR Equilibrium:SAS=AD

GDP 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 equilibriumemployment > equil. employment

(unemployment < natural rate)real wage < equil. real wageupward pressure on real waqesSAS shifts left until GDP=potential GDP

Transition from GDP<potential GDP to LR equilibriumemployment < equil. employment

(unemployment > natural rate)real wage > equil. real wagedownward pressure on real waqesSAS shifts left until GDP=potential GDP

SR/LR effect of changes in AD

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

SR/LR effect of changes in AD

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

Effect of changes in LAS

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