AD and AS. AGGREGATE DEMAND (AD): The quantity of real GDP demanded (total quantity of G&S that all buyers in an economy want to buy) at different price.

AD and ASAD and AS

AGGREGATE DEMAND (AD): The quantity of real GDP demanded (total quantity of G&S that all buyers in an economy want to buy) at different price levels.

The price level is measured using the GDP deflator.

The quantity of real GDP demanded is composed of C+I+G+(X-M)

The AD curve is NOT the same as a market demand curve.

A market demand curve illustrates the total demand of all consumers for ONE particular product. The AD curves illustrates the total demand of all agents in the economy for all goods and services in the economy.

The AD Curve: Negatively sloped.The AD Curve: Negatively sloped.

1.1. Real Wealth EffectReal Wealth Effect. Real w. Real wealth is the ealth is the amount of money in the bank, bonds, stocks amount of money in the bank, bonds, stocks and other assets people own (ex: art) and other assets people own (ex: art) measured in terms of what they will buy.measured in terms of what they will buy.

People save and hold money, bonds and People save and hold money, bonds and stocks. One reason is to build up funds for stocks. One reason is to build up funds for future spending (ex: college fund or future spending (ex: college fund or retirement savings).retirement savings).

If price level ↑, real wealth ↓. People then If price level ↑, real wealth ↓. People then feel worse off and decrease their feel worse off and decrease their consumption of g&s. So the consumption of g&s. So the quantityquantity of real of real GDP demanded falls (downward movement GDP demanded falls (downward movement ALONG the AD curve)ALONG the AD curve)

If price level If price level ↓↓, real wealth , real wealth ↑↑. People . People feel better off and increase their feel better off and increase their spending on g&s. So the spending on g&s. So the quantityquantity of of real GDP demanded rises (upward real GDP demanded rises (upward movement ALONG the AD curve).movement ALONG the AD curve).

2.2. Interest rate effectInterest rate effect An ↑ in the PAn ↑ in the PL L means consumers and firms means consumers and firms

need more money for C and I, respectively. need more money for C and I, respectively. People then increase their borrowing.People then increase their borrowing.

The increase in borrowing (because of an The increase in borrowing (because of an increase in increase in money demandmoney demand) pushes up the ) pushes up the price of money...which is the interest rate.price of money...which is the interest rate.

As the interest gets higher it becomes too As the interest gets higher it becomes too costly to borrow and people tend to costly to borrow and people tend to decrease their expenditures financed by decrease their expenditures financed by borrowing (ex: houses, cars, luxury borrowing (ex: houses, cars, luxury vacations, renovations) and firms decrease vacations, renovations) and firms decrease their I. As a result, the quantity of real their I. As a result, the quantity of real GDP demanded falls.GDP demanded falls.

A ↓ in the PA ↓ in the PL L means consumers and firms means consumers and firms need less money for C and I, respectively. need less money for C and I, respectively. People then decrease their borrowing.People then decrease their borrowing.

The decrease in borrowing (because of a The decrease in borrowing (because of a decrease in decrease in money demandmoney demand) pushes down the ) pushes down the price of money...which is the interest rate.price of money...which is the interest rate.

As the interest gets lower it becomes As the interest gets lower it becomes cheaper to borrow and people tend to cheaper to borrow and people tend to increase their expenditures financed by increase their expenditures financed by borrowing (ex: houses, cars, luxury borrowing (ex: houses, cars, luxury vacations, renovations) and firms increase vacations, renovations) and firms increase their I. As a result, the quantity of real GDP their I. As a result, the quantity of real GDP demanded rises.demanded rises.

NOTENOTE: The interest rate effect can be : The interest rate effect can be tricky! tricky!

If changes in the price level are If changes in the price level are CAUSING the change in the interest rate CAUSING the change in the interest rate then the change in the interest rate is then the change in the interest rate is linked to a movement linked to a movement alongalong the AD the AD curve.curve.

BUT the government can change the BUT the government can change the level of the interest rate completely level of the interest rate completely separately from any changes in the price separately from any changes in the price level. In this case the change in the level. In this case the change in the interest rate will cause a interest rate will cause a SHIFTSHIFT of the of the AD curve.AD curve.

3.3. International trade effect.International trade effect. An ↑ in the PAn ↑ in the PLL means the price of means the price of

domestic goods is changing relative domestic goods is changing relative to the prices of foreign goods…to the prices of foreign goods…foreign goods could be more foreign goods could be more attractive due to this change in attractive due to this change in relative prices. Thus M ↑ and X relative prices. Thus M ↑ and X (which are relatively more (which are relatively more expensive to the foreigners buying expensive to the foreigners buying them) ↓. Domestic goods are them) ↓. Domestic goods are substituted by foreign goods.substituted by foreign goods.

A A ↓↓ in the P in the PLL means the price of means the price of domestic goods is changing relative domestic goods is changing relative to the prices of foreign goods…to the prices of foreign goods…foreign goods could be less foreign goods could be less attractive due to this change in attractive due to this change in relative prices. Thus M relative prices. Thus M ↓↓ and X and X (which are relatively cheaper to the (which are relatively cheaper to the foreigners buying them) foreigners buying them) ↑↑. Foreign . Foreign made goods are substituted by made goods are substituted by domestic goods (by both domestic domestic goods (by both domestic and foreign consumers).and foreign consumers).

Shifts in the AD curveShifts in the AD curve Rightward shift of AD means that for Rightward shift of AD means that for

any particular any particular PPLL, a larger amount of , a larger amount of real GDP is demanded.real GDP is demanded.

Leftward shift of AD means that for any Leftward shift of AD means that for any particular particular PPLL, a smaller amount of real , a smaller amount of real GDP is demanded.GDP is demanded.

Since AD = C + I + G + (X-M), Since AD = C + I + G + (X-M), anything that causes a change in any of anything that causes a change in any of the components of AD, will cause AD to the components of AD, will cause AD to shift.shift.

Factors causing a change in CFactors causing a change in C WealthWealth. An . An ↑ ↑ in wealth (ex: value of homes) makes in wealth (ex: value of homes) makes

people feel wealthier, so they increase C expenditures.people feel wealthier, so they increase C expenditures. ExpectationsExpectations about future income and the economy. about future income and the economy.

Expectations of increasing incomes in the future or Expectations of increasing incomes in the future or optimistic expectations about the economy will optimistic expectations about the economy will increase spending by consumers because they know increase spending by consumers because they know they will have more money.they will have more money.

Interest ratesInterest rates. Some consumer spending is financed . Some consumer spending is financed by borrowing and thus sensitive to interest rate by borrowing and thus sensitive to interest rate changes. If changes. If ii ↓, ↓, borrowing becomes less expensiveborrowing becomes less expensive and and C increases.C increases.

Personal income taxesPersonal income taxes. If the gov decides to . If the gov decides to ↑ ↑ taxes taxes paid by households, then their disposable income paid by households, then their disposable income decreases and C spending drops.decreases and C spending drops.

Household indebtednessHousehold indebtedness. Indebtedness . Indebtedness is how much money people owe from is how much money people owe from taking out loans in the past (ex: taking out loans in the past (ex: mortgages, credit cards). mortgages, credit cards). If cons are able If cons are able to lower their debt payments more money to lower their debt payments more money can be spent on C and AD will rise and can be spent on C and AD will rise and shift right.shift right.

Attitudes towards spendingAttitudes towards spending. In . In different periods of time, households may different periods of time, households may become more comfortable with spending become more comfortable with spending more. After a war or a major national more. After a war or a major national calamity they may become more cautious calamity they may become more cautious and decide to spend less.and decide to spend less.

Factors causing a change in IFactors causing a change in I Expectations about future salesExpectations about future sales. . Higher Higher

profit expectations will lead to higher I and profit expectations will lead to higher I and thus ↑ AD. It will shift right. Lower profit thus ↑ AD. It will shift right. Lower profit expectations will lower I and thus ↓ AD. It expectations will lower I and thus ↓ AD. It will then shift left.will then shift left.

Changes in business taxesChanges in business taxes. If the gov ↓ . If the gov ↓ taxes on profits of businesses (fiscal policy), taxes on profits of businesses (fiscal policy), firms’ after-tax profits increase, which ↑ I, as firms’ after-tax profits increase, which ↑ I, as firms have more money to spend. An ↑ in firms have more money to spend. An ↑ in taxes will ↓ I, as firms will have less money to taxes will ↓ I, as firms will have less money to spend.spend.

Legal/institutional changesLegal/institutional changes. Sometimes the . Sometimes the legal and institutional environment in which legal and institutional environment in which firms operate has an impact on I spending. firms operate has an impact on I spending. Ex: access to credit, property rights.Ex: access to credit, property rights.

Changes in interest rates.Changes in interest rates. An An ↑↑ in interest in interest rates makes borrowing more expensive and I rates makes borrowing more expensive and I tends to fall. A ↓ in interest rates makes tends to fall. A ↓ in interest rates makes borrowing less expensive, so firms tends to borrowing less expensive, so firms tends to increase their I.increase their I.

Factors causing a change in GFactors causing a change in G Changes in political prioritiesChanges in political priorities. . The gov may The gov may

decide to decide to ↑↑ or ↓ its expenditures in response to or ↓ its expenditures in response to changes in its priorities.changes in its priorities.

Efforts to influence AD through Fiscal Efforts to influence AD through Fiscal policypolicy:: Expansionary FP: ↓ taxes and/or Expansionary FP: ↓ taxes and/or ↑↑ gov expenditures gov expenditures

= more overall spending, AD shifts right.= more overall spending, AD shifts right. Contractionary FP: Contractionary FP: ↑↑ taxes and/or ↓ gov taxes and/or ↓ gov

expenditures = less overall spending, AD shifts left.expenditures = less overall spending, AD shifts left.

Factors causing a change in X-MFactors causing a change in X-M Changes in real GDP abroadChanges in real GDP abroad. . If GDP in If GDP in

foreign countries is rising they buy more of foreign countries is rising they buy more of all goods including goods they buy from us, all goods including goods they buy from us, so our AD will ↑ and shift right. If GDP in so our AD will ↑ and shift right. If GDP in foreign countries is falling they buy less of all foreign countries is falling they buy less of all goods including goods they buy from us, so goods including goods they buy from us, so our AD will ↓ and shift left.our AD will ↓ and shift left.

Changes in exchange ratesChanges in exchange rates. If the . If the exchange rate (the price you pay using your exchange rate (the price you pay using your own currency to buy another currency) goes own currency to buy another currency) goes up then it takes more of your currency to buy up then it takes more of your currency to buy foreign goods, M will ↓ but X ↑ as it is easier foreign goods, M will ↓ but X ↑ as it is easier for foreigners to buy our currency. So (X-for foreigners to buy our currency. So (X-M)↑, and AD shifts right. If the exchange rate M)↑, and AD shifts right. If the exchange rate (price of foreign currency) goes down it takes (price of foreign currency) goes down it takes less domestic currency to buy foreign goods. less domestic currency to buy foreign goods. M↑ and X↓ as it costs more in terms of M↑ and X↓ as it costs more in terms of foreign currency to buy our goods. (X-M)↓ foreign currency to buy our goods. (X-M)↓ and AD shifts left.and AD shifts left.

Aggregate Supply (AS)Aggregate Supply (AS)Short run and long run in macroeconomics.Short run and long run in macroeconomics. Short runShort run: the period of time during which the : the period of time during which the

nominal prices of resources, in particular wages, nominal prices of resources, in particular wages, do not change in response to changes in the do not change in response to changes in the price level. That is, resource prices are constant.price level. That is, resource prices are constant.

Long runLong run: the period of time in which the : the period of time in which the nominal prices of all resources, including wages, nominal prices of all resources, including wages, change in response to changes in the price level.change in response to changes in the price level.

In the short run, wages are constant, whereas in In the short run, wages are constant, whereas in the long run wages change in response to the long run wages change in response to changes in changes in PPLL..

AS is the total quantity of G&S produced in AS is the total quantity of G&S produced in an economy at different price levels. an economy at different price levels.

The short run AS (SRAS) curve shows the The short run AS (SRAS) curve shows the relationship between the price level and the relationship between the price level and the quantity of real GDP produced by firms when quantity of real GDP produced by firms when resource prices (wages) do not change.resource prices (wages) do not change.

SRAS curve is upward sloping because of SRAS curve is upward sloping because of firm profitability. As Pfirm profitability. As PLL ↑, ↑, with nominal wages with nominal wages constant, firms’ profits increase. As constant, firms’ profits increase. As production becomes more profitable, firms production becomes more profitable, firms increase the quantity of output they produce. increase the quantity of output they produce. As PAs PLL ↓, firm profitability falls and output ↓, firm profitability falls and output decreases.decreases.

Shifts in the SRAS curveShifts in the SRAS curve A number of factors other than the PA number of factors other than the PLL

can cause shifts of the SRAS curve.can cause shifts of the SRAS curve. A rightward shift of the SRAS curve A rightward shift of the SRAS curve

means that for any particular price means that for any particular price level, firms produce a larger quantity of level, firms produce a larger quantity of real GDP.real GDP.

A leftward shift of the SRAS curve A leftward shift of the SRAS curve means that for any particular price means that for any particular price level, firms produce a smaller quantity level, firms produce a smaller quantity of real GDPof real GDP

Factors that influence firms’ production Factors that influence firms’ production costscosts

Changes in wagesChanges in wages. Wages constitute a major . Wages constitute a major portion of firms’ costs of production. They can portion of firms’ costs of production. They can change as a result of a change in minimum wage change as a result of a change in minimum wage legislation or as a result of labour union legislation or as a result of labour union negotiations with employers. If nominal wages negotiations with employers. If nominal wages ↑ ↑ (with P(with PLL constant), firms’ costs constant), firms’ costs ↑ ↑ and SRAS shifts and SRAS shifts left. If nominal wages ↓ (with Pleft. If nominal wages ↓ (with PLL constant), firms’ constant), firms’ costs ↓ and SRAS shifts right.costs ↓ and SRAS shifts right.

Changes in non-labour resource pricesChanges in non-labour resource prices. Ex: . Ex: changes in the price of oil, equipment, capital changes in the price of oil, equipment, capital goods,... They have the same impact on SRAS as goods,... They have the same impact on SRAS as a change in wages.a change in wages.

Changes in business taxesChanges in business taxes. These are . These are taxes on firms’ profits and are treated by taxes on firms’ profits and are treated by firms as a cost of production. If taxes firms as a cost of production. If taxes ↑ ↑ = = production costs production costs ↑ ↑ and SRAS shifts to the and SRAS shifts to the left. If taxes left. If taxes ↓ ↓ = production costs = production costs ↓ ↓ and and SRAS shifts to the right.SRAS shifts to the right.

Changes in subsidies offered to Changes in subsidies offered to businessesbusinesses. These are money transferred . These are money transferred from the gov to firms, so they have the from the gov to firms, so they have the opposite effect to taxes.opposite effect to taxes.

Supply shocksSupply shocks Events that have a sudden and strong impact Events that have a sudden and strong impact

on SRAS.on SRAS. Negative supply shocksNegative supply shocks. A war can result in the . A war can result in the

destruction of physical capital and disruption of destruction of physical capital and disruption of the economy, which reduces output produced and the economy, which reduces output produced and shifts the SRAS curve to the left. Unfavourable shifts the SRAS curve to the left. Unfavourable weather conditions can decrease agricultural weather conditions can decrease agricultural output, shifting SRAS to the left. A sudden output, shifting SRAS to the left. A sudden increase in the price of a major input such as oil, increase in the price of a major input such as oil, increases firms’ production costs, shifting SRAS increases firms’ production costs, shifting SRAS curve to the left.curve to the left.

Positive supply shocksPositive supply shocks. Oil discovery or good . Oil discovery or good weather conditions lead to an increase in SRAS weather conditions lead to an increase in SRAS and a rightward shift of the SRAS curve. and a rightward shift of the SRAS curve.

In the long-run, all resource prices In the long-run, all resource prices change so as to match changes in the Pchange so as to match changes in the PLL..

The LRAS curve is vertical at The LRAS curve is vertical at potential GDPpotential GDP (Y (YPP). In the long run, a ). In the long run, a change in the price level does not give change in the price level does not give rise to any change in the amount of rise to any change in the amount of output produced.output produced.

A movement along the LRAS curve A movement along the LRAS curve involves a change in two sets of prices:involves a change in two sets of prices: The price levelThe price level The prices of resourcesThe prices of resources

Long-Run Aggregate Long-Run Aggregate SupplySupply

An increase of 10% in PAn increase of 10% in PLL is matched by is matched by an increase of 10% in wages, so firms’ an increase of 10% in wages, so firms’ profits remain constant and there is no profits remain constant and there is no incentive to incentive to ↑ ↑ or ↓ the output level.or ↓ the output level.

Therefore, along the LRAS curve, as PTherefore, along the LRAS curve, as PLL changes, real GDP remains at potential changes, real GDP remains at potential GDP.GDP.

An important implication is that in the An important implication is that in the long run output gaps (when actual GDP long run output gaps (when actual GDP produced differs from potential GDP) produced differs from potential GDP) disappear and the economy moves disappear and the economy moves automatically towards FE equilibrium. automatically towards FE equilibrium. This represents the Neoclassical view.This represents the Neoclassical view.

Movements along the AS Movements along the AS curvescurves A rise in the PA rise in the PLL, with the prices of , with the prices of

resources held constant, brings an resources held constant, brings an increase in the quantity of real GDP increase in the quantity of real GDP supplied and a movement along the supplied and a movement along the SRAS curve.SRAS curve.

A rise in the PA rise in the PLL with equal percentage with equal percentage increases in the prices of resources increases in the prices of resources keeps the quantity of real GDP supplied keeps the quantity of real GDP supplied constant at potential GDP and brings a constant at potential GDP and brings a movement along the LRAS curve.movement along the LRAS curve.

Shifts in the LRAS curveShifts in the LRAS curve An economy can achieve some limited An economy can achieve some limited

growth (a shift of the LRAS curve) growth (a shift of the LRAS curve) through:through:

1.1. Increases in efficiency.Increases in efficiency.2.2. Reductions in the NRU.Reductions in the NRU.

The economy can continue to grow by The economy can continue to grow by increasing its production possibilities, increasing its production possibilities, that is:that is:

1.1. Increases in the quantities of the factors of Increases in the quantities of the factors of production. An increase in the quantity of production. An increase in the quantity of labour, the quantity of physical capital or the labour, the quantity of physical capital or the quantity of land means that the economy is quantity of land means that the economy is able to produce a larger quantity of real GDP.able to produce a larger quantity of real GDP.

2.2. Improvements in the quality of factors of Improvements in the quality of factors of production. For ex: greater levels of production. For ex: greater levels of education, skills or health contribute to a education, skills or health contribute to a more productive workforce, increasing more productive workforce, increasing the level of output produced.the level of output produced.

3.3. Improvements in technology. Improvements in technology. Technological change enables firms to Technological change enables firms to produce more from any given amount of produce more from any given amount of inputs.inputs.

If the LRAS shifts, then the SRAS also If the LRAS shifts, then the SRAS also shifts. This is because at any moment shifts. This is because at any moment in time the economy is always in time the economy is always producing on a SRAS curve.producing on a SRAS curve.

However, a shift in the SRAS curve However, a shift in the SRAS curve does not cause the LRAS to shift. does not cause the LRAS to shift. Changes in Changes in input pricesinput prices only shift the only shift the

SRAS without affecting the LRAS. An SRAS without affecting the LRAS. An increase in wages increases firms’ increase in wages increases firms’ production costs, shifting SRAS to the left, production costs, shifting SRAS to the left, but this does not affect potential GDP. The but this does not affect potential GDP. The same happens with an increase in the price same happens with an increase in the price of oil.of oil.

Certain events have only a Certain events have only a temporarytemporary impact on AS and these can shift the SRAS impact on AS and these can shift the SRAS for a short while, while leaving the LRAS for a short while, while leaving the LRAS unchanged. Ex: adverse wheather unchanged. Ex: adverse wheather conditions during one season that cause a conditions during one season that cause a drop in agricultural output.drop in agricultural output.