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Aggregate Supply and Demand

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Department
Economics
Course
EC140
Professor
Justin Smith
Semester
Winter

Description
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
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