1. Ch. 10: Aggregate Supply and Demand
Derive AS/AD model
Understand cause & 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 (equation of exchange)
Inflation rate =money growth rate minus the real GDP growth rate.
The Macroeconomic SR
a period during which some prices or wages 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 (LAS)
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 Real Wage Price Level Labor market LAS Labor hours
Real GDP
Production function
Real GDP
Labor hours

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

7. Graphic analysis of changes in LAS (Change in Labor Supply)
Effect on
Real wage
Employment
productivity

8. Graphic analysis of changes in LAS (increase in labor productivity)
Effect on
Real wage
Employment
Productivity

9. Aggregate Supply Short-Run Aggregate Supply (SAS)
Shows relationship between real GDP supplied and the price level, ceteris paribus
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.

10. Short Run Aggregate Supply
Labor market
SAS
Production function
As P rises, RW falls, L rises;
RGDP rises

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

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

13. 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.

14. 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 and monetary policy
The world economy

15. Aggregate Demand The Aggregate Demand Curve
plots the quantity of real GDP demanded against P.
slopes downward for 2 reasons:
Wealth effect
Substitution effects
Start here 8 a.m

16. Aggregate Demand Wealth Effect
P increases  real wealth decr  C decr  AD decr
Substitution Effects
Intertemporal
P incr  int rate incr  C & I decr  AD decr
International
P incr  imports incr, exports decr  AD decr
Start here

17. 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
 increases AD

18. 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

19. 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.

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

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

22. 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)

23. SAS shifts left until GDP=potential GDP
Transition from GDP>potential GDP to LR equilibrium (inflationary gap)
Initially:
empl > equil. Empl
unempl < natural rate
R-wage < equil. R-wage
upward pressure on R-waqes
SAS shifts left until GDP=potential GDP
As economy moves to LR Equilibrium:
Employment falls, Unemployment rises,
Real wage rises, Real GDP falls

24. SAS shifts left until GDP=potential GDP
Transition from GDP<potential GDP to LR equilibrium (recessionary gap)
Initially:
empl < equil. Empl
unempl > natural rate
R-wage > equil. R-wage
downward pressure on R-waqes
SAS shifts left until GDP=potential GDP
As economy moves to LR Equilibrium:
Employment rises Unemployment falls
Real wage falls Real GDP rises

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

26. 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.
To achieve and maintain full employment, active help from fiscal policy and monetary policy is required
Monetarist
economy is self-regulating and it will normally operate at full employment, provided that monetary policy is not erratic and that the pace of money growth is kept steady