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Chapter 26.doc

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Rizwan Tahir

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 production • 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 inflation • 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 capital 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 economy 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: o Prices increase, other things equal, real wealth falls (value of money, stocks etc.) o To restore real wealth, people increase saving and decrease spending • Aggregate spending declines o Quantity of real GDP demanded decreases o Prices decrease, opposite happens • Substitution effects o intertemporal substitution effect (between two periods- present and future) • Rise in price level, other things equal, decreases value of money and raises interest rates  When interest rate rises, people spend less since it's more costly not to save money  Spending decreases now, in favour of future spending • Fall in price level increases real value of money and lowers interest rate o International substitution effect • Rise in price level, other things equal, increases price of domestic goods relative to foreign goods  Price of imports decreases, price of exports increases • Imports increases and exports decrease, which decreases quantity of real GDP demanded • Reverse happens for fall in price level • AD curve is directly connected to short-fun Keynesian model o Is set of equilibrium points from short-run Keynesian model at various price levels o Equilibrium GDP from Keynesian model (prices fixed) corresponds to point on AD curve • But when prices change in Keynesian model (wealth and substitution effects)... Points A, B, C on AD curve correspond to equilibrium expenditure points A, B, C at intersection of AE curve and 45° line Price level falls from 110 to 90 • spending increases Price level rises from 110 to 130 • Spending drops Changes in Aggregate Demand • Change in any influence on buying plans other than price level changes aggregate demand • Main influences: • Expectations, fiscal policy & monetary policy, world economy • Expectations • Expectations about future income, future inflation, future profits change aggregate demand • Increases in expected future income increase people's consumption today, increases aggregate demand • Rise in expected inflation rate makes buying goods cheaper today, increases aggregate demand • Increase in expected future profits boosts firms' investment, increases aggregate demand • Fiscal policy & Monetary Policy • Fiscal policy: government's attempt to influence economy by setting/changing taxes, making transfer pay
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