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
Dec 26, 2015
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
Macroeconomic Long Run and Short Run
The Macroeconomic LRa 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 SRa 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
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
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.
Determinants of LAS
Labor market
Production function
LAS
Real Wage
Real GDP
Price Level
Labor hours
Labor hours
Real GDP
Determinants of LAS
Change in labor supply
• 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
Graphic analysis of changes in LAS(Change in Labor Supply)
Effect on •Real wage•Employment •productivity
Graphic analysis of changes in LAS(change in Labor Demand)
Effect on •Real wage•Employment •Productivity
Graphic analysis of changes in LAS(Change in Production Function)
Effect on •Real wage•Employment •productivity
Aggregate Supply
Short-Run Aggregate Supply (SAS)the relationship between real GDP supplied and the price level when the money wage rate, the prices of other resources, and potential GDP remain constant.
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.
Short Run Aggregate Supply
Labor market
Production function
SAS
As P rises, RW falls, L rises; RGDP rises
Aggregate Supply
Along the SAS curve, real GDP supplied might be above potential GDP…
or below potential GDP.
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.
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 policy and monetary policy The world economy
Aggregate Demand
The Aggregate Demand Curveplots the quantity of real GDP demanded against P.
slopes downward for 2 reasons:
Wealth effect Substitution effects
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
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
Shifts in Aggregate Demand
Fiscal Policysetting 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
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.
Shifts in Aggregate Demand
Summary:Fiscal policyMonetary policyValue of $Foreign income
Macroeconomic Equilibrium
SR Equilibrium:SAS=AD
GDP can be above, below, or at potential GDP
LR equilibriumLAS=SAS=AD
Macroeconomic Equilibrium
Graphical illustration of SR equilibria with
1.GDP>potential GDP (inflationary gap)
2. GDP<potential GDP (recessionary gap)
3. GDP=potential GDP (LR equilibrium)
•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
•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 fallsReal wage falls Real GDP rises
SR/LR effect of changes in AD
Effect of Increase in AD on real wage, prices, real GDP unemployment and employment.
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 and that to achieve and maintain full employment, active help from fiscal policy and monetary policy is required
Monetarist
economy is self-regulating and that it will normally operate at full employment, provided that monetary policy is not erratic and that the pace of money growth is kept steady