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EC140 Lecture Notes - Aggregate Supply, Aggregate Demand, Monetary Policy

Course Code
Rizwan Tahir

of 12
Chapter 26: Aggregate Demand, Aggregate Supply:
Equilibrium Output and Price Level
Tuesday, February 05, 2013
1:05 PM
Aggregate Supply
Quantity Supplied and Supply
Quantity of real GDP supplied: the total quantity that firms plan to produce
during a given period
Aggregate supply (AS): the relationship between the quantity of real GDP
supplied and price level
Long run AS
Long run: period of time when wages, prices of other factors of
production, potential GDP can vary
Short run AS
Short run: period of time when wages, prices of other factors of
production, potential GDP are fixed
Short Run Aggregate Supply (SRAS)
The relationships between quantity of real GDP supplied and the price level
when the money wage rate, the prices of other resources and
potential GDP remain constant
The SRAS is upward sloping
When prices rises: wages remain constant, profits increase (due to
revenue increase), signals firms to produce more, GDP expands
In short run, quantity of real GDP supplied increase if price level rises
Rise in price level with no change in wage rates induces firms to increase
Therefore, SRAS curve slopes upward
Long Run Aggregate Supply (LRAS)
The relationship between the quantity of real GDP supplied and price level
when wages and prices of other inputs are variable, and real GDP =
potential GDP
LRAS is vertical
When prices rise: profits rise initially (extra revenues), firms produce
more, wages rise to match price increases (costs increase- profits fall),
production falls back to its original level
So long run aggregate supply curve (LRAS) is vertical at potential GDP
As long as potential GDP remains constant, we get only pure
In the long run, RGDP = potential GDP
In the long run, wages adjust perfectly to price changes
Ex. they change by same percentage
Quantity of real GDP supplied remains at potential GDP
Why does aggregate supply = potential GDP in the long run?
If GDP > potential GDP, must hire structurally/frictionally unemployed
or make people work overtime
High demand on limited resources
Cannot sustain this without paying higher wages
Wages will drift up, firms start to produce less
Production falls to its more sustainable level
Changes in Aggregate Supply
Aggregate supply changes if influence on production plans other than price
level changes
Include: potential GDP, money wage rate and other factor prices
When potential GDP increases, both LRAS and SRAS curves shift rightward
Potential GDP can change for three reasons:
Full employment quantity of labour changes
Quantity of capital (physical or human) changes
technology advances
Suppose there is technological advancement that increases potential GDP
Can produce more with better technology
LRAS curve shifts rightward
SRAS curve shifts along with LRAS curve
Technology increases affect both short and long term production
Same would occur with increase in full-employment labour, or increase in
Aggregate Demand
Quantity of RGDP demanded (Y): l the total amount of final goods and
services produced in a country that people, businesses, governments and
foreigners plan to buy
Sum of consumption expenditure (C ) , investment (I), government
expenditure (G), and net exports (X-M)
Y = C + I + G + X - M
Buying plans depend on many factors
Price level, expectations, fiscal policy and monetary policy, world
Aggregate demand curve (AD): the relationships between quantity of real
GDP demanded and price level
AD curve plots quantity of real GDP demanded against price level
AD curve slopes downward
Wealth effects, substitution effects
Wealth effect: