Model of the Economy Aggregate Demand can be defined in terms of GDP ◦Planned C+I+G+NX on goods and services ◦Aggregate Demand curve is an inverse curve or function between price level and output.  As price level (inflation) rises the level of output decreases  Three factors that affect aggregate demand. ◦ Interest rate effect ◦ Wealth affect (Real Balance Effect) ◦ Net export effect

Model of the Economy The Interest Rate Effect ◦Decrease in households and businesses plans to buy capital and consumer durables because a price level increases with the increase in interest rate. ◦A price level increase with decrease the purchasing power of money. ◦With smaller amounts of money available financial institutions raise the interest rate.

Model of the Economy Wealth effect (Real Balance Effect) ◦A decrease in the real value of cash balances as price level increases. ◦People faced with this decrease in real wealth, people decrease consumption and increase saving to restore their wealth to desired levels

Model of the Economy The net export effect ◦Decrease in domestic output demanded with an increase in domestic price level because domestic products are more expansive to foreign buyers and foreign goods are less expansive to domestic consumers.

Model of the Economy We have a downward sloping Aggregate demand curve Different from the single commodity demand curve.

Model of the Economy Things that shift the Aggregate Demand Curve ◦Expectations about future prices  Profit  Income  Inflation ◦Fiscal policy and or monetary policy  Changing taxes  Transfer payments  Government expenditure  Interest rate ◦State of the World economy  Foreign exchange rate  Foreign income

Model of the Economy Aggregate Supply is the quantity of output that firms are willing and able to produce for the economy ◦Long run – level of output depends on the capital, human capital, labor force, and the level of technology ◦Short run – amount of labor employed with a given level of Capital and technology

Model of the Economy Aggregate Supply Curve ◦Relationship between total quantity of output supplied by all firms and the overall price level. ◦Not the supply of all Supply curves in the economy PL Real GDP SRAS

Model of the Economy Aggregate supply curve (LRAS, SRAS) ◦Or Real GDP ◦Depends on the quantity of labor, the quantity of Capital, and level of Technology Short Run (SRAS), Capital and Technology are fixed ◦Only quantity of Labor changes ◦If Money wage, resource prices, and potential GDP are constant. ◦As overall price level increases firms will produce more output ◦SRAS – can be shaped horizontally, vertically or with a positive slope.

Model of the Economy Long Run Aggregate Supply Curve or LRAS is a vertical line at Full Employment or Potential GDP ◦Represents Potential GDP.  All resources are being used efficiently  Full employment or natural rate of unemployment PL Real GDP LRAS

Model of the Economy Short Run Equilibrium vs long run equilibrium. ◦Macroeconomic equilibrium  When quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection. Ex. Of Long run equilibrium Ex.’s of Short Run Equilibrium

Model of the Economy Adjustments towards full employment. ◦inflationary gap  A gap that exists when real GDP exceeds potential GDP and that brings a rising price level. ◦recessionary gap  A gap that exists when potential GDP exceeds real GDP and that brings falling prices.