Study Guides (248,297)
Canada (121,466)
Economics (390)
EC140 (70)

Aggregate Supply and Demand

56 Pages
Unlock Document

Justin Smith

Econ  140   Winter  2014   Jus▯n  Smith   Wilfrid  Laurier  University   AGGREGATE  DEMAND,  AGGREGATE   SUPPLY:  EQUILIBRIUM  OUTPUT   AND  PRICE  LEVEL   1 Introduc▯on   •  In  this  sec▯on  we  learn  about  aggregate   supply  and  demand   – The  supply  and  demand  for  the  whole  economy   •  Why  learn  this  model?   – Explains  infla▯on   – Explains  business  cycles   – Explains  economic  growth   – Useful  for  assessing  the  effects  of  policy  changes   •  This  model  uses  concepts  we  learned  in  the   short  run  Keynesian  Aggregate  Expenditure   Model   Aggregate  Supply   Quan▯ty  Supplied  and  Supply   •  Quan▯ty  of  real  GDP  supplied:  the  total   quan▯ty  that  firms  plan  to  produce  during  a   given  period.     •  Aggregate  supply  (AS):  is  the  rela▯onship   between  the  quan▯ty  of  real  GDP  supplied   and  the  price  level.   – Long-­‐run  AS   • factors  of  produc▯on,  poten▯al  GDP  can  vary    of  other   – Short-­‐run  AS   •  Short  run:  period  of  ▯me  when  wages,  prices  of  other   factors  of  produc▯on,  poten▯al  GDP  are  fixed     Short  Run  Aggregate  Supply   •  Short-­‐run  AS  (SRAS):  the  rela▯onship  between   the  quan▯ty  of  real  GDP  supplied  and  the   price  level  when  the  money  wage  rate,  the   prices  of  other  resources,  and  poten▯al  GDP   remain  constant.   •  The  SRAS  is  upward  sloping.   – When  price  rises:   •  Wages  remain  constant   •  Profits  increase  (due  to  revenue  per  unit  increase)   •  Signals  firms  to  produce  more   •  GDP  expands   Short  Run  Aggregate  Supply   •  In  SR,  the  quan▯ty   of  real  GDP  supplied   increases  if  the  price   level  rises.   •  A  rise  in  the  price   level  with  no  change   in  wage  rates   induces  firms  to   increase  produc▯on   – The  SRAS  curve   slopes  upward.   Long  Run  Aggregate  Supply   •  Long-­‐run  AS:  the  rela▯onship  between  the   quan▯ty  of  real  GDP  supplied  and  the  price  level   when  wages  and  prices  of  other  inputs  are   variable,  and  real  GDP  =  poten▯al  GDP.   •  LRAS  is  ver▯cal   – When  prices  rise   •  Profits  rise  ini▯ally  (extra  revenue  per  unit)   •  Firms  produce  more   •  Wages  rise  to  match  price  increases  (costs  per  unit  increase)   –  Profits  fall   •  Produc▯on  falls  back  to  its  original  level   – So  the  long-­‐run  aggregate  supply  curve  (LRAS)  is   ver▯cal  at  poten▯al  GDP   •  As  long  as  poten▯al  GDP  remains  constant,  we  get  only   infla▯on   Long  Run  Aggregate  Supply   LRAS •  In  the  long  run,  RGPP   =  poten▯al  GDP   SRAS 2 SRAS 1 •  In  the  LR,  wages   adjust  to  price   C B changes   – The  quan▯ty  of  real   A GDP  supplied  remains   at  poten▯al  GDP.   GDP Long  Run  Aggregate  Supply   •  Why  does  Aggregate  Supply  equal  poten▯al   GDP  in  the  long  run?   – If  GDP  >  poten▯al  GDP,  you  must  hire  the   structurally/fric▯onally  unemployed  or  make   people  work  over▯me   •  High  demand  on  limited  resources   – Cannot  sustain  this  without  paying  higher  wages   – Wages  will  dri▯  up,  firms  will  start  to  produce  less   •  Produc▯on  falls  to  its  more  sustainable  level   Changes  in  Aggregate  Supply   •  Aggregate  supply  changes  if  an  influence  on   produc▯on  plans  other  than  the  price  level   changes.   •  These  include:   – Poten▯al  GDP   – Money  wage  rate  and  other  factor  prices   Changes  in  Aggregate  Supply   •  When  poten▯al  GDP  increases,  both  the  LRAS   and  SRAS  curves  shi▯  rightward   •  Poten▯al  GDP  can  change,  for  three  reasons:   – The  full-­‐employment  quan▯ty  of  labour  changes   – The  quan▯ty  of  capital  (physical  or  human)   changes   – Technology  advances   Changes  in  Aggregate  Supply   •  Suppose  there  is  a   technological  advancement   that  increases  poten▯al  GDP   –  Can  produce  more  with   be▯er  tech   •  The  LRAS  curve  shi▯s   rightward     •  The  SRAS  curve  shi▯s  along   with  the  LRAS  curve.   –  Tech  increases  affect  both   short  and  long  term   produc▯on   •  The  same  would  occur  with   an  increase  in  full-­‐ employment  labour,  or   increase  in  capital   Changes  in  Aggregate  Supply   •  Suppose  there  is  a  rise   in  the  wage  rate   – SRAS  curve  moves    le▯ward   – Has  no  effect  on  LAS    curve   •  Wages  do  not  affect  the   poten▯al  amount  of   output   – In  LR,  prices  increase  to   match  the  increased   costs   •  Same  would  occur  for   increases  in  any  factor   price   Aggregate  Demand   •  Quan▯ty  of  RGDP  demanded  (Y):  the  total   amount  of  final  goods  and  services  produced   in  a  country  that  people,  businesses,   governments,  and  foreigners  plan  to  buy.   •  The  sum  of  consump▯on  expenditure,  C,   investment,  I,  government  expenditure,  G,   and  net  exports,  X  –  M.     Y  =  C  +  I  +  G  +  X  –  M.   Aggregate  Demand   •  Buying  plans  depend  on  many  factors  and   some  of  the  main  ones  are   –  The  price  level   –  Expecta▯ons   –  Fiscal  policy  and  monetary  policy   –  The  world  economy   Aggregate  Demand   •  Aggregate  demand  Curve  (AD):  the   rela▯onship  between  the  quan▯ty  of  real  GDP   demanded  and  the  price  level.     – The  AD  curve  plots  the  quan▯ty  of  real  GDP   demanded  against  the  price  level.   •  The  AD  curve  slopes  downward   – Wealth  Effects   – Subs▯tu▯on  Effects   Aggregate  Demand   •  The  AD  curve   slopes  downward   for  two  reasons:   ▯   Wealth  effect   ▯   Subs▯tu▯on   effects   Aggregate  Demand   Wealth  Effect   •   If  prices  increase,  other  things  equal,  real   wealth  falls  (value  of  money,  stocks,  etc.).   •  To  restore  real  wealth,  people  increase  saving   and  decrease  spending.   – Aggregate  Spending  declines   •  The  quan▯ty  of  real  GDP  demanded  decreases.   •  If  prices  decrease,  the  opposite  happens   Aggregate  Demand   Subs▯tu▯on  Effects            Intertemporal  subs▯tu▯on  effect     •  A  rise  in  the  price  level  decreases  the  value  of   money  and  raises  interest  rates.   – At  higher  prices,  people  need  more  money   – An  increase  in  money  demand  increases  its  price   •  The  price  of  holding  money  is  the  interest  rate   – Higher  interest  rates  increase  saving,  reduce   spending     •  A  fall  in  the  price  level  increases  the  real  value   of  money  and  lowers  the  interest  rate.   Aggregate  Demand   Interna▯onal  subs▯tu▯on  effect   •  A  rise  in  the  price  level  increases  the  price  of   domes▯c  goods  rela▯ve  to  foreign  goods.   – We  view  imports  as  rela▯vely  cheaper   – Foreigners  view  our  exports  as  rela▯vely  more   expensive   – Imports  increase  and  exports  decrease,  which   decreases  the  quan▯ty  of  real  GDP  demanded.   •  The  reverse  happens  for  a  fall  in  the  price   level   Aggregate  Demand   •  The  AD  curve  is  directly  connected  to  the   short-­‐run  Keynesian  model  we  discussed   •  AD  curve  is  the  set  of  equilibrium  points  from   the  short-­‐run  Keynesian  model  at  various   price  levels     •  The  equilibrium  GDP   from  the  Keynesian   model  corresponds  to  a   point  on  the  AD  curve   •  Recall,  in  the  Keynesian   model,  prices  were  fixed   •  Now,  we  consider  what   happens  when  prices   change  in  the  Keynesian   model   –  Recall  that  there  are   wealth  and  subs▯tu▯on   effects   •  Suppose  the  price  level   rises  from  110  to  130   – Wealth  and  subs▯tu▯on   effects  kick  in,  spending   drops   •  AE  curve  shi▯s  from   AE  downward  to  AE     0 1   – Eand  GDP  decreases     from  $1,200  to  $1,100   billion.   •  This  draws  out  the  AD   curve  from  B  to  A   •  Suppose  now  the   price  level  falls  from   110  to  90   – Wealth  and   subs▯tu▯on  effects   kick  in   •  AE  curve  shi▯s  up   from  AE to0  E  2 •  Equilibrium   expenditure  and  GDP   increases  from  $1,200   to  $1,300  billion   – Draws  out  AD  curve   from  point  B  to  C   •  Points  A,  B,  and  C   on  the  AD  curve   correspond  to  the   equilibrium   expenditure  points   A,  B,  and  C  at  the   AE  curve  and  the   45°  line.   Changes  in  Aggregate  Demand   •  A  change  in  any  influence  on  buying  plans   other  than  the  price  level  changes  aggregate   demand.     •  The  main  influences  on  aggregate  demand  are   – Expecta▯ons   – Fiscal  policy  and  monetary  policy   – The  world  economy   Aggregate  Demand   Expecta▯ons   •  Expecta▯ons  about  future  income,  future   infla▯on,  and  future  profits  change  aggregate   demand.   – Increases  in  expected  future  income  increase  people’s   consump▯on  today  and  increases  aggregate  demand.   – A  rise  in  the  expected  infla▯on  rate  makes  buying   goods  cheaper  today  and  increases  aggregate   demand.   – An  increase  in  expected  future  profits  boosts  firms’   investment,  which  increases  aggregate  demand.   Aggregate  Demand   Fiscal  Policy  and  Monetary  Policy   •  Fiscal  policy:  the  government’s  a▯empt  to   influence  the  economy  by  se▯ng  and  changing   taxes,  making  transfer  payments,  and  purchasing   goods
More Less

Related notes for EC140

Log In


Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.