Aggregate Demand and Aggregate Supply

Aggregate Demand and Aggregate Supply

Aggregate Demand and Aggregate Supply The Learning Objectives in this presentation are covered in Chapter 20: Aggregate Demand and Aggregate Supply LEARNING OBJECTIVES 1. Aggregate Demand (AD) has 5 Learning Objectives 2. Aggregate Supply (AS) also has 5 3. Macroeconomic Equilibrium in the AD/AS Model has 2 2

Making the Connection The Aggregate Demand and Aggregate Supply Models help explain short-run fluctuations in Output, Prices and Employment. Today, many economies, including the US, the UK and the Eurozone are suffering from weak GDP and high unemployment; some are still in recession. Most economists think the cause is a lack of Aggregate Demand (low levels of spending) 3

Aggregate Demand (AD) LEARNING OBJECTIVES 1. To understand Aggregate Demand (AD) is its components 2. To understand why the AD Curve Slopes Downwards 3. To identify the difference between a Movement Along the Curve and a Shift in the Curve 4. To identify the variables that shift the AD curve 5. To understand the impact of macroeconomic policy on AD 4

Components of Aggregate Demand LEARNING OBJECTIVE: (1) ONE Aggregate Demand is the total level of planned spending on goods and services in an economy by households, businesses, government and foreign parties. AD (also sums to expenditure based GDP) and has four components: Consumption (C) Investment (I) Government purchases (G) Net Exports (NX) If we let Y stand for AD, we can write the following: Y = C + I + G + NX 5

The Aggregate Demand Curve LEARNING OBJECTIVE: (1) ONE The AD Curve shows the level of planned demand for real output consistent with a particular price level relationship Price Level (P) P 2 P 1 AD Real GDP (Y) Y 2 Y 1 6

Why does the AD Curve Slope Downwards? LEARNING OBJECTIVE: (1) TWO There are three main reasons for an inverse relationship between AD and the price level in an economy (i.e. a downward slope): 1. The Wealth Effect Price Level (P) This affects consumption 2. The Interest Rate Effect This affects investment 3. The International trade Effect This affects net exports AD Real GDP (Y) 7

Why does the AD Curve Slope Downwards? LEARNING OBJECTIVE: (1) TWO How a Change in the price level affects Consumption The Wealth Effect When prices rise the money people have buys fewer goods and services, so real wealth is lower, people feel poorer and C goes down. P AD How a change in the price level affects Investment Interest Rate Effect A rise in prices leads to increased money demand and rising interest rates. Investment is thus affected negatively. P AD How a change in the price level affect Net exports International Trade Effect When prices rise, exports become more expensive and so foreign demand for them falls, at the same time imports become cheaper, thus net exports decline. P AD 8

Aggregate Demand Curve LEARNING OBJECTIVE: (1) TWO Changes in P cause movements up or down a given AD Curve An increase in P reduces the quantity of Goods and Services demanded because: The wealth effect (C) falls Price Level (P) P 2 A rise in the P from P1 to P2 causes a contraction in AD (moves up) The interest rate effect (I) falls The International Trade effect (NX) falls P 1 P 3 A fall in P from P1 to P3 causes an expansion in AD (moves down) AD Real GDP (Y) Y 2 Y 1 Y 3 9

Shifts of the AD Curve Vs. Movements Along it LEARNING OBJECTIVE: (1) THREE An important point to note is that the AD Curve holding everything else constant tells us the relationship between the Price Level and the quantity of real GDP demanded in an economy Only a change in the price level will cause a movement along an existing AD curve. When any variable, other than price, changes and affects the willingness of firms, households and government to spend, then the AD will shift. 10

Why might the AD Curve Shift? LEARNING OBJECTIVE: (1) THREE Any event that changes C, I, G, or NX except a change in P will cause a shift the AD Curve. Price Level (P) P 1 AD 1 AD 2 Y 1 Y 2 Real GDP (Y) 11

Variables that Shift the AD Curve LEARNING OBJECTIVE: (1) FOUR The variables that cause the AD curve to shift fall into four categories: Changes in 1. Business and household expectations 2. Household wealth 3. Foreign variables 4. Government and Central Bank macroeconomic policies 12

Variables that Shift the AD Curve (1) LEARNING OBJECTIVE: (1) FOUR 1. Changes in the expectations of businesses and households Household/business optimism or confidence about future income/profitability has a powerful affect on their spending and is affected by expectations about the future growth of the economy and inflation. 2. Changes in household wealth Wealth is the value of assets owned. Thus a change in house or share prices influences wealth and in turn also affects consumer confidence. 3. Changes in foreign variables A change in the value of the exchange rate and foreign income affects the demand for exports and the NX component of AD. 13

Variables that Shift the AD Curve (2) LEARNING OBJECTIVE: (1) FIVE 4. Changes in Government and Central Bank Policies Fiscal policy Refers to changes in government spending, welfare benefits and taxation and the amount the government borrows. Changes in federal income tax, corporate taxes, government purchases and transfer payments, all affect AD. Monetary policy The actions the central bank takes to manage the money supply and interest rates to pursue macroeconomic policy objectives. Changes in the interest rate affect the incentives of households and businesses to borrow and save. The availability of credit from banks will also affect borrowing to finance consumption or investment. 14

Shifts in the AD Curve to the Right (Summary) LEARNING OBJECTIVE: (1) FIVE Variables that Shift the AD Curve to the right: An increase in shifts the AD Curve right because Price Level (P) Government purchases These are components of aggregate demand Households expectations of their future incomes Consumption spending increases Firm s expectations of the future profitability of investment spending AD 1 AD 2 Real GDP (Y) Investment spending increases. 15

Shifts in the AD Curve to the Left (Summary) LEARNING OBJECTIVE: (1) FIVE Variables that Shift the AD Curve to the left: An increase in shifts the AD Curve left because Interest rates Price Level (P) raises the cost of borrowing, reducing consumption and investment Taxes they cause consumption and investment to fall The growth rate of domestic GDP relative to that of foreign GDP Exports will fall, reducing net exports The exchange rate (value of domestic currency) relative to foreign currencies. AD 2 AD 1 Real GDP (Y) Imports will rise and exports will fall, reducing net exports 16

LEARNING OBJECTIVE: (1) FIVE Making the Connection The UK economy shrank by a further 0.7% in Q2 of 2012, meaning that was the longest double dip recession in over 50 years. The immediate cause has been a decline in aggregate demand. Due to: A fall in consumer demand, resulting from high unemployment rates and a squeeze on real wages (frozen or even reduced); Inflation and tax rises; The government s austerity programme is curtailing fiscal expenditure; Export growth has been constrained by a slowing down in the global economy and especially in the Eurozone (the UK s main trading partner); Investment is being held back by pessimistic business sentiment and difficulties in raising finance. Source: The Sloman Economics News site: http://pearsonblog.campaignserver.co.uk/?tag=aggregate-demand 17

Situations to Consider LEARNING OBJECTIVE: (1) TWO to FIVE Explain how and why each of the following factors will influence current (short run) aggregate demand in the UAE: 1. Businesses become more optimistic about the future 2. The UAE Central Bank lowers interest rates 3. The UAE Government increases spending on infrastructure 4. Inflation rises within the UAE (be careful with this one!) 5. Lower real income in Asia (a key export market for the UAE) 6. There is a price collapse in the real estate sector 7. UAE stock markets fall sharply. 18

Aggregate Supply (AS) LEARNING OBJECTIVES 1. To understand the determinants of Long Run Aggregate Supply (LRAS) 2. To identify the variables that shift the LRAS Curve 3. To understand the determinants of Short Run Aggregate Supply (SRAS) 4. To understand why the SRAS curve slopes upwards 5. To identify the variables that shift the SRAS curve 19

Long Run Aggregate Supply LEARNING OBJECTIVE: (2) ONE LRAS LRAS is located at potential GDP it represents a level of real national output in the economy Potential GDP is assumed to be independent of the price level (money is neutral). LRAS is determined by the productive resources available to meet demand and by the productivity of the factor inputs (labour, land and capital). LRAS curve A curve that shows the relationship in the long run between the price level and the quantity of real GDP supplied. 20

The LRAS Curve LEARNING OBJECTIVE: (2) TWO The Long Run Aggregate Supply Curve (LRAS) Changes in the price level do not affect the level of AS in the long run. Therefore, the LRAS, is a vertical line at Price level (P) GDP deflator, 2000 = 100 LRAS 2007 LRAS 2008 LRAS 2009 the potential level of real GDP. An increase in the quantity and productivity of factors of production or an advance in technology causes an increase in the productive potential of 130 120 110 the economy. i.e. an outward shift in the LRAS curve. 11.7 12.0 12.3 Real GDP (Y) Trillions of 2000 $ dollars 21

Short-Run Aggregate Supply LEARNING OBJECTIVE: (2) THREE Measures the volume of goods and services produced within the economy at a given price level, it represents the ability of an economy to deliver goods and services to meet demand. SRAS is determined by the supply side performance of the economy, the productive capacity of the economy and the costs of production in each sector. There is a positive relationship between AS and the general price level. Rising prices are a signal for businesses to expand production to meet a higher level of AD, when prices are falling production may contract. 22

Short-run Aggregate Supply Curve LEARNING OBJECTIVE: (2) FOUR The Short run Aggregate Supply Curve (SRAS) Shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms. Price level (P) SRAS P2 P1 Y1 Y2 Real GDP (Y) 23

Why does the SRAS Curve Slope Upwards? LEARNING OBJECTIVE: (2) FOUR Factors for why a short run aggregate supply curve slopes upward include: Contracts make some wages and prices sticky.» As some production costs are unchanged an increase in the price of the good sold will give the firm the chance to increase profits by increasing its price. Firms are often slow to adjust wages Menu costs make some prices sticky» As some firms have lower prices than others, thus when price level is increasing this firm might find its sales increasing and thus adjust at higher production levels. The opposite also holds. 24

Movements along the SRAS Curve LEARNING OBJECTIVE: (2) FOUR Shifts of the SRAS Curve vs. Movements Along the Curve It is important to remember the difference between: a shift in a curve and a movement along a curve. Changes in aggregate demand cause either a contraction or expansion along the SRAS curve, e.g. an increase in demand should lead to an expansion of aggregate supply in the economy. 25

A Movement Along the SRAS Curve LEARNING OBJECTIVE: (2) FOUR A movement along the SRAS Curve 1a A rise in the price level will cause Price level (P) an expansion of aggregate supply in the economy SRAS 1b Producers are responding to higher prices (driven up by increased demand) P2 P1 1c Real GDP will increase from Y1 to Y2 AD 2 AD 1 Y1 Y2 Real GDP (Y) 26

Variables that Shift the SRAS Curve LEARNING OBJECTIVE: (2) FIVE Variables That Shift the Short Run Aggregate Supply Curve 1. Changes in the size and quality of the Labor Force 2. Changes in the size and quality of the capital stock through investment 3. Technological change 4. Changes in expectations about prices (inflation) 5. Adjustments of workers and firms to errors in past expectations about the Price Level 6. Unexpected Changes in the price of an important natural resource 7. Supply shock An unexpected event that causes the short run aggregate supply curve to shift. 27

Shifts in the SRAS LEARNING OBJECTIVE: (2) FIVE Shifts in the SRAS Curve can result from expected changes in price levels 1 If firms and workers expect that the price level will be 3 percent higher in 2013 than in 2012 Price level (P) GDP deflator, 2000 = 100 SRAS 2013 SRAS 2012 12 12 the SRAS curve will shift to the left to reflect firm and worker expectations of rising costs. 103 100 1 10.0 Real GDP (Y) Trillions of 2000 $ dollars 28

Shifts in the AS Curve to the Right (Summary) LEARNING OBJECTIVE: (2) FIVE Variables that Shift the Short run AS Curve (SRAS) to the right: An increase in shifts the SRAS Curve right because Price Level (P) SRAS 1 SRAS 2 The labour force or the capital stock More output can be produced at every price level Productivity Cost of producing output will fall Real GDP (Y) 29

Shifts in the AS Curve to the Left (Summary) LEARNING OBJECTIVE: (2) FIVE Variables that Shift the Short run AS Curve (SRAS) to the left: An increase in shifts the SRAS Curve left because Price Level (P) The expected future price level SRAS 2 SRAS 1 Workers and firms increase wages and prices Workers and firms adjusting to having previously underestimated the price level Workers and firms increase wages and prices The expected price of an important natural resource Real GDP (Y) Cost of producing output rises. 30

Macroeconomic Equilibrium AD/AS Model LEARNING OBJECTIVES 1. Learn how to use the AD/AS model to illustrate the difference between Short run and Long run macroeconomic equilibrium 2. Learn how to use the Dynamic AD/AS model to analyse macroeconomic conditions 31

Long-run Macroeconomic Equilibrium LEARNING OBJECTIVE: (3) ONE Long Run Macroeconomic Equilibrium Price level (P) GDP deflator, 2000 = 100 LRAS 100 SRAS $10.0 AD Real GDP (Y) Trillions of 2000 dollars 32

Long and Short Run Macroeconomic Equilibrium LEARNING OBJECTIVE: (3) ONE Recessions, Expansions, and Supply Shocks Because the full analysis of the aggregate demand and aggregate supply model can be complicated, we begin with a simplified case, using two assumptions: The economy has not been experiencing any inflation The price level is currently 100, and workers and firms expect it to remain at 100 in the future. The economy is not experiencing any long run growth Potential real GDP is $10.0 trillion and will remain at that level in the future. 33

Modelling a Recession LEARNING OBJECTIVE: (3) ONE Recession The Short Run and Long Run Effects of a decrease in AD 1 1. A decline in investment shifts AD Price level (P) GDP deflator, 2000 = 100 to the left, causing a recession. 2. As firms and workers adjust to 12 AD 2 AD 1 LRAS SRAS1 SRAS2 the price level being lower than they had expected, costs will fall 1 12 and cause SRAS to shift to the right. 100 A 1 3 3. Equilibrium moves from point B 98 B back to potential GDP at point C, with a lower price level. 96 1 3 C 9.8 10 Real GDP (Y) Trillions of 2000 $ dollars 34

Modelling an Expansion LEARNING OBJECTIVE: (3) ONE Expansion The Short Run and Long Run Effects of a increase in AD 1 1. An increase in investment shifts AD Price level (P) GDP deflator, 2000 = 100 to the right, causing an inflationary expansion. AD 1 AD 2 LRAS SRAS2 SRAS1 2. As firms and workers adjust to 12 the price level being higher than they had expected, costs will rise 106 1 12 1 3 C and cause SRAS to shift to the left. 103 B 1 3 3. Equilibrium moves from point B 100 A back to potential GDP at point C, with a higher price level. 10 10.3 Real GDP (Y) Trillions of 2000 $ dollars 35

Supply Shocks LEARNING OBJECTIVE: (3) ONE A supply shock is any unexpected event affecting costs and prices in different countries. E.g. A rise in the world price of crude oil or natural gas, foodstuffs or other important commodities An AS shock is either an inflation shock or a shock to a country s potential national output. Adverse AS shocks of both types reduce output and increase inflation and can increase the risk of stagflation for an economy. Stagflation A combination of inflation and recession, usually resulting from a supply shock. 36

Modelling Supply Shocks Short-run LEARNING OBJECTIVE: (3) ONE Supply Shocks Short run effect Price level (P) GDP deflator, 2000 = 100 1 1. An increase in oil prices shifts the SRAS to the left LRAS SRAS 2 AD SRAS 1 12 2. moving short run equilibrium to point B, with lower real GDP and a higher price level. 102 1 2 B 1 100 A 9.7 10 Real GDP (Y) Trillions of 2000 $ dollars 37

Modelling Supply Shocks Long-run LEARNING OBJECTIVE: (3) ONE Supply Shocks Long run effect 1 1. The recession caused by the supply shock eventually leads to falling wages and prices, shifting SRAS back to its original position. 2. Equilibrium moves from point B back 12 to potential GDP at the original price level. 102 100 Price level (P) GDP deflator, 2000 = 100 LRAS SRAS 1 AD SRAS 2 B A 1 2 1 9.7 10 Real GDP (Y) Trillions of 2000 $ dollars 38

The Dynamic AD/AS Model LEARNING OBJECTIVE: (3) TWO We can create a Dynamic AD/AS model by making three changes to the basic model. Potential real GDP increases continually, shifting the long run aggregate supply curve to the right. During most years, the aggregate demand curve will be shifting to the right. Except during periods when workers and firms expect high rates of inflation, the short run aggregate supply curve will be shifting to the right. 39

The Dynamic AD/AS Model LEARNING OBJECTIVE: (3) TWO A Dynamic Aggregate Demand and Aggregate Supply (AD/AS) Model Price level (P) GDP deflator, 2000 = 100 1 The economy begins in equilibrium LRAS 1 at point A with SRAS 1 and AD 1 intersecting at a point on LRAS 1 10o 1 A SRAS 1 AD 1 10 Real GDP (Y) Trillions of 2000 $ dollars 40

The Dynamic AD/AS Model LEARNING OBJECTIVE: (3) TWO What Is the Usual Cause of Inflation? Using Dynamic AD/AS model to understand inflation Price level (P) GDP deflator, 2000 = 100 LRAS 1 1 LRAS 2 1 If AD shifts to the right more than SRAS 104 10o 12 A B the price level rises. 12 SRAS 1 AD 2 SRAS 2 AD 1 10 10.5 Real GDP (Y) Trillions of 2000 $ dollars 41

Making the Connection The slow recovery from the 2008-2009 Recession: Case study of the USA. 42

Making the Connection The more rapid recovery from 2010: Case study of the USA (continued) 43

Putting it into Practice Showing the Oil Shock of 1974 1975 By using a Dynamic Aggregate Demand and Aggregate Supply Graph The Dynamic AD/AS Model ACTUAL REAL GDP POTENTIAL REAL GDP PRICE LEVEL 1974 $4.32 trillion $4.35 trillion 34.7 1975 $4.31 trillion $4.50 trillion 38.0 44

Key Terms» Aggregate demand and aggregate supply model» Aggregate demand curve» Fiscal policy» Long run aggregate supply curve» Monetary policy» Short run aggregate supply curve» Stagflation» Supply shock» Menu costs 45