Aggregate Supply and Aggregate Demand Chapter 28

Quantity of Real GDP Supplied (ϒS) The total amount of final goods and services that firms in the United States plan to produce Depends on the quantities of Labor employed Capital, human capital, and the state of technology Land and natural resources Entrepreneurial talent

Short Run Aggregate Supply The relationship between the quantity of real GDP supplied and the price level when all other influences on production plans remain the same Price Level ϒ SRAS

Short Run Aggregate Supply SRAS is upward sloping because as price levels rise, real wage rates fall, causing firms to employ more labor, which causes real GDP to increase. Price Level ϒ SRAS

Shape of SRAS SRAS can be divided up into 3 segments based on the lag between a change in the price of goods and the price of their inputs PL SRAS III II I GDP

Shape of SRAS – Region I If the economy is in a recession with low production, there are many unemployed resources Increasing output puts little pressure on the overall price level This causes SRAS to be relatively horizontal PL SRAS III II I GDP

Shape of SRAS – Region II As real GDP increases into the 2nd region, available resources become harder to find, causing input costs to rise, which causes price levels to rise steadily Most of the time, the economy operates within this region. Thus, SRAS is often drawn as being upward sloping, as in the previous slides PL SRAS III II I GDP

Shape of SRAS – Region III If the economy grows and approaches capacity, firms can’t find unemployed inputs This causes input costs and price levels to rise much more rapidly SRAS is nearly vertical PL SRAS III II I GDP

Comparing Schools of Thought Classical Macroeconomics Keynesian Macroeconomics Believe that the market gravitates toward full employment Cornerstone of philosophy is a vertical AS curve (LRAS) Believe that the economy often resembles a recessionary situation with low output Cornerstone of philosophy is a horizontal AS supply (region I)

Potential GDP Potential GDP = GDP at full employment Fixed Value Equivalent to the long run aggregate supply (LRAS) Price Level ϒ LRAS

Comparing SRAS and LRAS Nominal wage rates remain constant along curve Prices of other resources remain constant Nominal wage rates change proportionally with price level Prices of other resources change proportionally with price level LRAS Price Level ϒ SRAS

Shutdowns and Startups When price levels rise and nominal wage rates remain constant (short run), fewer firms shutdown temporarily/more firms startup, thereby increasing the real GDP

Changes in Aggregate Supply Change in… Increase Decrease Potential GDP (ex. investment in factors of production) Nominal Wage Rate Prices of Resources Supply-Side Taxes

Changes in Aggregate Supply Change in… Increase Decrease Potential GDP (ex. investment in factors of production) Shifts SRAS right Shifts LRAS right Shifts SRAS left Shifts LRAS left Nominal Wage Rate Prices of Resources Supply-Side Taxes

Changes in Aggregate Supply Change in… Increase Decrease Potential GDP (ex. investment in factors of production) Shifts SRAS right Shifts LRAS right Shifts SRAS left Shifts LRAS left Nominal Wage Rate Doesn’t shift LRAS Prices of Resources Supply-Side Taxes

Changes in Aggregate Supply Change in… Increase Decrease Potential GDP (ex. investment in factors of production) Shifts SRAS right Shifts LRAS right Shifts SRAS left Shifts LRAS left Nominal Wage Rate Doesn’t shift LRAS Prices of Resources Supply-Side Taxes

Changes in Aggregate Supply Change in… Increase Decrease Potential GDP (ex. investment in factors of production) Shifts SRAS right Shifts LRAS right Shifts SRAS left Shifts LRAS left Nominal Wage Rate Doesn’t shift LRAS Prices of Resources Supply-Side Taxes

Quantity of Real GDP Demanded (ϒD) The total amount of final goods and services produced in the United States that people, businesses, governments, and foreigners plan to buy ϒD = C + I + G + X – M Price level impacts ϒD because it brings about a change in the… Value of Money (1/PL) Real Interest Rate (r%) Real Prices of Exports (X) and Imports (M)

Value of Money = 1/PL When PL increases, the value of a dollar decreases This causes real GDP to decrease, since you can’t purchase as much (GDP = PxQ)

Real Interest Rates (r%) When PL increases, MD increases, which raises i%. An increase in MD causes SLF to decrease, which in turn raises r%. Because of higher interest rates, people invest less in new capital, causing GDP to decrease

Real Prices of Exports (X) and Imports (M) When US PL increases, prices of foreign produced goods are comparably cheaper. Thus, people purchase more imports and fewer exports, decreasing GDP.

Aggregate Demand The relationship between the quantity of real GDP demanded and the price level when all other influences on expenditure plans remain the same PL ϒ AD

Changes in Aggregate Demand Change In… Increase Decrease Expectations about Future (Income, Profits, Inflation) Fiscal Policy We will study this more in Chp 31 Monetary Policy – Interest Rate Quantity of Money Foreign Exchange Rate Foreign Income

Changes in Aggregate Demand Change In… Increase Decrease Expectations about Future (Income, Profits, Inflation) Shifts AD right Shifts AD left Fiscal Policy We will study this more in Chp 31 Monetary Policy – Interest Rate Quantity of Money Foreign Exchange Rate Foreign Income

Changes in Aggregate Demand Change In… Increase Decrease Expectations about Future (Income, Profits, Inflation) Shifts AD right Shifts AD left Fiscal Policy We will study this more in Chp 31 Monetary Policy – Interest Rate Quantity of Money Foreign Exchange Rate Foreign Income

Changes in Aggregate Demand Change In… Increase Decrease Expectations about Future (Income, Profits, Inflation) Shifts AD right Shifts AD left Fiscal Policy We will study this more in Chp 31 Monetary Policy – Interest Rate Quantity of Money Foreign Exchange Rate Foreign Income

Changes in Aggregate Demand Change In… Increase Decrease Expectations about Future (Income, Profits, Inflation) Shifts AD right Shifts AD left Fiscal Policy We will study this more in Chp 31 Monetary Policy – Interest Rate Quantity of Money Foreign Exchange Rate (We’ll study more in Chp 33) Foreign Income

Changes in Aggregate Demand Change In… Increase Decrease Expectations about Future (Income, Profits, Inflation) Shifts AD right Shifts AD left Fiscal Policy We will study this more in Chp 31 Monetary Policy – Interest Rate Quantity of Money Foreign Exchange Rate (We’ll study more in Chp 33) Foreign Income

Other Things that Impact AD Anything that affects C + I + G + NX Change Increase Decrease Income (C) Interest Rates (I) Taxes (C) Transfer Payments (C) Exports (X) Start class here

Things that Impact AD Anything that affects C + I + G + NX Change Increase Decrease Income (C) AD shifts right AD shifts left Interest Rates (I) Taxes (C) Transfer Payments (C) Exports (X)

Things that Impact AD Anything that affects C + I + G + NX Change Increase Decrease Income (C) AD shifts right AD shifts left Interest Rates (I) Taxes (C) Transfer Payments (C) Exports (X)

Things that Impact AD Anything that affects C + I + G + NX Change Increase Decrease Income (C) AD shifts right AD shifts left Interest Rates (I) Taxes (C) Transfer Payments (C) Exports (X)

Things that Impact AD Anything that affects C + I + G + NX Change Increase Decrease Income (C) AD shifts right AD shifts left Interest Rates (I) Taxes (C) Transfer Payments (C) Exports (X)

Things that Impact AD Anything that affects C + I + G + NX Change Increase Decrease Income (C) AD shifts right AD shifts left Interest Rates (I) Taxes (C) Transfer Payments (C) Exports (X)

AS, AD and Employment Levels How is employment related to the x-axis (real GDP)? PL ϒ AD SRAS

Macroeconomic Equilibrium Occurs where SRAS = AD PL Real GDP AD SRAS PL1 ϒ1

Macroeconomic Equilibrium when AD Increases When AD shifts to the right GDP increases Price levels rise, causing inflation Employment increases (unemployment decreases) Known as Demand-Pull Inflation PL Real GDP AD1 SRAS PL2 PL1 AD2 ϒ1 ϒ2

Macroeconomic Equilibrium when AD Decreases When AD shifts to the left GDP falls Price levels fall, causing deflation Employment decreases (unemployment increases) PL Real GDP AD1 SRAS PL1 PL2 AD2 ϒ2 ϒ1

Supply Shocks An economy-wide phenomenon that affects the costs of firms, positively or negatively Anything that causes AS to shift Positive shocks result from increased productivity or lower input costs Negative shocks usually occur when economy-wide input prices suddenly increase

Macroeconomic Equilibrium when SRAS Increases When SRAS shifts to the right GDP increases Price levels fall, causing deflation Employment increases (unemployment decreases) Known as a supply-side boom and is the best case scenario PL Real GDP AD1 SRAS1 SRAS2 PL1 PL2 ϒ1 ϒ2

Macroeconomic Equilibrium when SRAS Decreases When SRAS shifts to the left GDP decreases Price levels rise, causing inflation Employment decreases (unemployment increases) Known as stagflation PL GDP SRAS2 AD1 SRAS1 PL2 PL1 ϒ2 ϒ1

Stagflation A combination of recession (falling real GDP) and inflation (rising price level) Occurs when AS decreases Worst case scenario in terms of AS and AD shifts Also known as cost-push inflation Occurred in the mid-1970’s

Practice Questions Sketch a graph of the aggregate demand and aggregate supply of McLandia. Describe the impact of the following on McLandia’s output and price level. Incomes increase Nominal wage rates increase Potential GDP decreases The Federal Reserve raises the discount rate The Federal Reserve buys bonds from commercial banks on the open market Incomes in other countries increase

Long Run Equilibrium Occurs where SRAS = LRAS = AD Only occurs at full employment LRAS PL ϒ SRAS AD

Unemployment and Real GDP As real GDP increases, unemployment decreases To the left of LRAS, employment is below full employment To the right of LRAS, employment is above full employment * Remember, full employment means no cyclical unemployment LRAS PL ϒ SRAS AD

Above Full-Employment Equilibrium When equilibrium real GDP exceeds potential GDP LRAS PL ϒ SRAS AD PL1 ϒ1

Above Full-Employment Equilibrium Results in an inflationary Gap Inflationary Gap: a gap that exists when real GDP exceeds potential GDP and that brings a rising price level. Without intervention, SRAS will shift left to return to the full-employment level of output, causing an increase in the price level. SRAS2 LRAS PL ϒ SRAS1 AD Inflationary Gap

Below Full-Employment Equilibrium When equilibrium real GDP is less than potential GDP LRAS PL ϒ SRAS AD PL1 ϒ1

Below Full-Employment Equilibrium Results in a Recessionary Gap Recessionary Gap: a gap that exists when real GDP is less than potential GDP and that brings a falling price level. Without intervention, SRAS will shift right to return to the full-employment level of output, causing a decrease in the price level. LRAS PL ϒ SRAS AD SRAS2 Recessionary Gap

Sample AP Question Assume that Australia and New Zealand are trading partners. Australia’s economy is currently in recession. Now assume that Australia begins to recover from its recession. Using a correctly labeled graph of aggregate demand and aggregate supply for New Zealand, show the impact of Australia’s rising income on each of the following in the short run. Aggregate demand in New Zealand. Explain. Output in New Zealand Using a correctly labeled graph of the money market for New Zealand, show the effect of the output change in part (1)(b) on the following. Demand for money. Explain. The nominal interest rate Assume that the price level in New Zealand rises. Given your answer to part (2)(b), explain what will happen to real interest rates. Although recovering, Australia remains in recession and its government takes no action. Indicate whether each of the following curves will shift to the left, shift to the right, or remain unchanged in the long run in Australia. Aggregate supply Aggregate demand 1a. AD will shift right 1b. Output will increase 2a. MD will increase as transactions increase 2b. i% increase 3. Indeterminate since i% = r% + pi%. If PL increase and i% increases, then you can’t know whether r% will increase or decrease. 4a. AS will shift right to overcome the recessionary gap 4b. AD will remain unchanged

Sample AP Question Assume that a country’s economy is operating at less than full employment. Draw a correctly labeled graph of aggregate demand and aggregate supply, and show each of the following. Long-run aggregate supply curve Current output and price level Assume that policy makers take no policy action and that prices and wages are flexible. Explain what will happen to each of the following. Short-run aggregate supply Employment Now assume that instead of taking no policy action, the government implements a special tax incentive to encourage individuals to increase saving for retirement. Draw a correctly labeled graph of the loanable funds market. Show how the real interest rate is affected. Given your answer in part (3), explain how aggregate supply is affected in the long run. 2a. Shifts right 2b. As PL falls, nominal wages will fall, causing employment to increase to full employment 3. SLF will increase, driving down r% 4. LRAS will shift to the right because lower r% will incentivize increased investment in factors of production, thus expanding potential GDP

Sample AP Question Assume that the United States economy is operating at less than full employment. Using a correctly labeled aggregate demand and aggregate supply graph, show the following. Full-employment output Current output Current price level Identify an open-market operation that could restore full employment in the short run. Using a correctly labeled graph of the money market, show how the open-market operation you identified in part (2) affects the interest rate in the short run. Explain how the change in the interest rate you identified in part (3) will affect aggregate demand. Show on the graph in part (1) how the change in the interest rate you identified in part (3) will affect output and price level. Instead of the open-market operation in part (2), suppose that no policy actions are taken to address the unemployment problem. With flexible prices and wages, explain how each of the following will eventually change. Short-run aggregate supply Output and price level 2.

Random Fun Wiki-Race: Start at a particular page on Wikipedia You must get to another specified page by only clicking on internal links You cannot type anything once the race has begun

Start at: “Adam Smith” Get to: “Stagflation” Wiki-Race #1 Start at: “Adam Smith” Get to: “Stagflation”

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Start at: “Hawaii” Get to: “Output Gap” (recessionary gap) Wiki-Race #7 Start at: “Hawaii” Get to: “Output Gap” (recessionary gap)