Aggregate supply and aggregate demand Chapters 31, 32, and 33

AGGREGATE SUPPLY AND AGGREGATE DEMANDCHAPTERS 31, 32, AND 33By Thuy Le

CHAPTER 31Open-Economy Macroeconomics: Basic Concepts

CHAPTER 31

Prior to this you’ve only studied closed economies economies that do not interact with other

economies in the world

In macroeconomics, many new situations arise when studying open economies economies that interact freely with other economies

around the world

CHAPTER 31

An open economy allows for a greater flow of goods and services. Some terms to know are: Exports: goods and services that are produced

domestically and sold abroad Imports: goods and services that are produced

abroad and sold domestically Net exports/Trade balance: the value of a nation’s

exports minus the value of its imports

CHAPTER 31

More terms to know: balanced trade: a situation in which exports equal

imports trade deficit: an excess of imports over exports trade surplus: an excess of exports over imports

CHAPTER 31

There are many variables which can affect international trade. Some of them are: Consumers’ preferences for foreign and domestic

goods Prices of goods at home and abroad Incomes of consumers at home and abroad The exchange rates at which foreign currency trades

for domestic currency Transportation costs Government policies

CHAPTER 31

Residents of an open economy participate in the market for goods and services, but they can also participate in the world financial market.

When talking about the flow of financial resources economists use the term net capital outflow, formerly known as net foreign investment. the purchase of foreign assets by domestic residents

minus the purchase of domestic assets by foreigners

CHAPTER 31

There are many terms related to a country’s NCO. Some are: Foreign direct investment: Domestic residents

actively manage the foreign investment Ex: Thuy, a U.S. resident, is the owner of the H.B. Reese

Company and builds a plant in China so she can produce Reese’s cups on the cheap

Foreign portfolio investment: Domestic residents purchase foreign stocks or bonds, supplying loanable funds to a foreign firm. Ex: Nick, a U.S. resident, purchases stocks of Adidas, his

favorite German shoe company

CHAPTER 31

NCO measures the imbalance in a country’s trade in assets:

When NCO > 0, there is capital outflowWhen NCO < 0, there is capital inflow

It is important to remember that NCO will always equal NX. Every transaction that affects NX also affects NCO by

the same amount

CHAPTER 31

Earlier, you learned about GDP equaling C + I + G + NX. This identity can now be used with NCO so we can relate the flow of trade to savings and investment.Y = C + I + G + NX is also true when written as

Y – C – G = I + NX , and this can be rearranged to be

S = I + NX since S = Y – C – G, which means

S = I + NCO since NX = NCO

CHAPTER 33

When S > I, the excess loanable funds flow abroad in the form of positive net capital outflow.

When S < I, foreigners are financing some of the country’s investment, and NCO < 0.

CHAPTER 31 In addition to NX and NCO, economists also look

at two other variables when studying international transactions. They are: nominal exchange rate: the rate at which a person can trade

the currency of one country for the currency of another and

real exchange rate: the rate at which a person can trade the goods and services of one country for the goods and services of another

e x PP*

P = domestic priceP* = foreign price (in foreign

currency)e = nominal exchange rate

CHAPTER 31

Exchange rates change from time to time. When they do, a nation’s currency is said to be appreciating or depreciating. Appreciation: an increase in the value of a currency

as measured by the amount of foreign currency it can buy

Depreciation: a decrease in the value of a currency as measured by the amount of foreign currency it can buy

CHAPTER 31

The simplest theory of exchange rates is the purchasing power parity, which is based on the law of one price. The purchasing power parity: a theory of exchange

rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries

CHAPTER 32A Macroeconomic Theory of the Open Market

CHAPTER 32

The previous chapter explained the basic concepts and vocabulary of the open economy.

This chapter ties these concepts together into a theory of the open economy.

To understand open economies you have to focus on two main markets. The loanable funds market The foreign-currency exchange market

CHAPTER 32

The Market for Loanable Funds

D = I + NCO

r

LF

S = saving

r1

CHAPTER 32

The Foreign Currency Exchange MarketS = NCOE

Dollars

D = NX

E1

CHAPTER 32

The link between the two markets is NCO, which is included in two important identities S = I + NCO NCO = NX

NCO is part of the demand in loanable funds market and is the source of supply in the foreign currency exchange market.

All three graphs are commonly drawn together to show this relationship.

CHAPTER 32

Many policies and events can affect the open market and in turn affect all three graphs.

Some possible things are: Government budget deficits Trade policies Political instability/Capital flight

CHAPTER 32

Budget deficits Decreases the supply of loanable funds Increases the RIR Reduces NCO Decreases the supply of dollars Causes the dollar to appreciate

CHAPTER 32

Trade policies: a government policy that directly influences the quantity of goods and services that a country imports or exports. Some examples are: Tariff : a tax on imports Import quota : a limit on the quantity of imports “Voluntary export restrictions”: the government

pressures another country to restrict its exports which is essentially the same as an import quota

CHAPTER 32

Capital flight: a large and sudden reduction in the demand for assets located in a country.

Capital flight Increases NCO Increases the demand for loanable funds Increases the RIR Increases the supply of dollars Causes the dollar to depreciate

CHAPTER 33Aggregate Demand and Aggregate Supply

CHAPTER 33

Over the long run, real GDP grows about 3% per year on average.

In the short run, GDP fluctuates around its trend.Recessions: periods of falling real incomes

and rising unemploymentDepressions: severe recessions

Short-run economic fluctuations are often called business cycles.

CHAPTER 33

There are three facts about economic fluctuations Economic fluctuations are irregular and

unpredictable. Most macroeconomic quantities fluctuate together. As output falls, unemployment rises.

CHAPTER 33

Explaining these fluctuations is difficult, and the theory of economic fluctuations is controversial.

Most economists use the model of aggregate demand and aggregate supply to study fluctuations.

This model differs from the classical economic theories economists use to explain the long run.

CHAPTER 33

The previous chapters are based on the ideas of classical economics

The Classical Dichotomy is the separation of variables into two groups: Real: quantities, relative prices Nominal: measured in terms of money

The neutrality of money: Changes in the money supply affect nominal but not real variables.

CHAPTER 33

Most economists believe classical theory describes the world in the long run, but not the short run.

In the short run, changes in nominal variables (like the money supply or PL) can affect real variables (like Y or unemployment).

To study the short run, we use a new model.

CHAPTER 33

The model of aggregate demand and aggregate supply P

Y

AD

SRAS

P1

Y1

CHAPTER 33

Terms to know: aggregate-demand curve: a curve that shows the

quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level

aggregate-supply curve: a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level

CHAPTER 33

The aggregate demand curve is downward sloping because of The wealth effect The exchange-rate effect The interest-rate effect

AD will shift if there is a change in GDP Money supply

CHAPTER 33

The aggregate supply curve is Upward-sloping in the short run Vertical in the long run P

Y

SRAS

LRAS

CHAPTER 33

LRAS is vertical because YN determined by the economy’s stocks of labor, capital, and natural resources, and on the level of technology. An increase in P does not affect

any of these, so it does not affect YN.

P

Y

LRAS

YN

CHAPTER 33

LRAS will shift if there is a change in Any factors of production Natural resources Technology

SRAS will shift if LRAS shifts There is a change in price level/expectations There is a supply shock

CHAPTER 33

There are 3 theories of SRAS The sticky wage theory The sticky price theory The misperceptions theory

The imperfections in these theories are temporary. Over time, sticky wages and prices become flexible misperceptions are corrected

In the LR, PE = P AS curve is vertical

Congratulations! You’ve learned

everything there is to know in

Chapters 31-33!