ECON 212: ELEMENTS OF ECONOMICS II Univ. Of Ghana, Legon Lecture 8: Aggregate Demand Aggregate Supply Dr. Priscilla T. Baffour

ECON 212: ELEMENTS OF ECONOMICS II Univ. Of Ghana, Legon Lecture 8: Aggregate Demand Aggregate Supply Dr. Priscilla T. Baffour

Sections 1. Relaxing a Temporal Assumption Price Level is no longer fixed. More realistically Prices vary. 2. Aggregate Demand Shifts in AE: The Role of Price changes Aggregate Demand Curve: derivation, slope, points off and shifts in AD 3. Aggregate Supply : slope and shifts in AS 4. Macroeconomic Equilibrium 5. Changes in GDP and the Price Level Aggregate Demand Shocks Aggregate Supply Shocks

Learning Outcomes Aggregate demand is the level of desired real domestic spending at each price level. The aggregate demand curve plots the negative relationship between GDP and the price level. An exogenous change in autonomous spending (a demand shock) shifts the aggregate demand curve horizontally by the multiplier times the initial change in spending.

Learning Outcomes The aggregate supply curve reflects a positive relationship between output and the price level, for given input prices. An exogenous change in input prices or technology (a supply shock) shifts the short-run aggregate supply curve. The equilibrium level of GDP and the price level are determined where aggregate demand and supply are equal.

Aggregate Spending and the Price Level Changes in the price level affects the AE curve and therefore causes it to shift and equilibrium GDP to change. We can therefore derive a relationship between the price level and the GDP Why and How does changes in the Price level affect AE? When the price level changes it affects the level of desired consumption spending through its impact on the wealth of asset (money denominated) holders net exports Through its impact on export demand Through its effect on relative prices and import demand

Aggregate Spending and the Price Level Level of Desired Consumption spending When prices change it affects the level of desired consumption spending by; affecting the wealth of holders of assets denominated in money terms P Real value of outside assets denominated in monetary units in the real value of private sector wealth in savings to restore real wealth desired private consumption spending (C) downward shift of AE curve Real GDP or national output.

Level of Net Exports Aggregate Spending and the Price Level When prices change it affects the level of net export spending; An increase in price level means domestically produced goods are relatively more expensive than imports, thereby encouraging imports An increase in the price level implies that the price of exports to foreign sector consumers is relatively higher, thereby discouraging export demand In both cases net exports spending declines thereby shifting the AE curve downwards and leading to a decline in real GDP or national output

Aggregate Spending and the Price Level Money supply effect Recall aggregate demand in the relationship between the price leve and the aggregate demand all things held constant. One of such factors held constant in the nominal money supply. How the can the nominal Ms be used to explain the downward sloping AD Increase in Price level with a given MS leads to decease in the reals Ms leading to a reduction in purchasing power hence a reduction in AD.

Aggregate Spending and the Price Level Changes in the price level cause the AE curve to shift and equilibrium GDP to change. The initial AE curve is AE 0 and GDP is at Y 1. An increase in the price level reduces desired expenditure and thus causes the AE curve to shift down to AE 1. As a result GDP falls to Y 1.The reverse happens for a fall in the price level.

Desired Expenditure Aggregate Spending and the Price Level AE = Y AE 0 AE 1 E 0 E 1 0 45 o Y 1 Y 0 Real National Income [GDP]

Desired Expenditure The AD Curve and the AE Curve AE = Y AE 0 E 0 AE 1 E 1 AE 2 E 2 0 45 o Y 2 Y 1 Y 0 Real National Income [GDP] [i]. Aggregate expenditure

The AD curve and the AE curve Equilibrium GDP is determined by the AE curve for each given price level. The level of GDP and its associated price level are then plotted to yield a point on the AD curve. When the price level is P 0 the AE curve is AE 0 and GDP is Y 0. Plotting Y 0 against P 0 yields the point E 0 on the AD curve. An increase in the price level to P 1 shifts the AE curve down to AE 1, producing GDP of Y 1 and this is represented by point E 1 on the AD curve. A further increase in the price level to P 2 shifts the AE curve down to AE 2, producing GDP of Y 2 and this is represented by point E 2 on the AD curve.

The AD Curve and the AE Curve P 2 E 2 P 1 E 1 P 0 E 0 0 Y 2 Y 1 Y 0 [ii]. Aggregate Demand AD Real National Income (GDP)

Desired Expenditure The AD Curve and the AE Curve E 0 AE = Y AE 0 E 1 AE 1 AE 2 E 2 [i]. Aggregate expenditure 45 o 0 Y 2 Y 1 Y 0 Real National Income [GDP] [ii]. Aggregate Demand E 2 P 2 E1 P 1 E 0 AD P 0 Real National Income [GDP]

Slope and Properties of AD Curve The AD is negatively sloped just like the individual demand curve under microeconomics As general price level increases AE declines because private consumption declines as households or the private sector saves more to restore real value of wealth As general price level decreases AE increase because private consumption increase as households or the private sector benefits from an increase in the real value of wealth However note that the properties of the AD curve are different from the individual demand curve

AD Curve vs. Individual Demand Curve AD Curve 1. movement along the AD curve is caused by changes in general price level. 2. The negative slope of the AD curve is due to changes in AE resulting from changes in desired consumption and net exports as general price level changes 3. Reflects total demand for aggregate output of goods and services Individual Demand Curve 1. movement along the individual demand curve is caused by changes in price of the commodity. 2. The negative slope of the individual demand curve is due to the substitution and income effect of a own price change (assuming all other prices and income is fixed) 3. Reflects individual demand for a particular goods or service

Price level Desired spending Points Off AD: Relationship between AE and AD curves AE=Y e 2 e 0 E 0 AE AE e 1 45 o 0 Y 1 Y 0 Y 2 Real GDP AD Desired spending less than output P 0 X E 0 Z Desired spending equal output 0 Desired spending exceeds output Y 1 Y 0 Y 2 Real GDP

Shifts in AD A change in autonomous consumption A change in investment A change in Government Spending and/or Taxes A change in Net exports Rightward Shift of AD Increase in autonomous consumption and/or Investment Spending and/or Government Spending and/or net exports, but a decrease in net taxes Leftward Shift of AD decrease in autonomous consumption and/or Investment Spending and/or Government Spending and/or net exports, but a increase in net taxes

The simple multiplier and shifts in the AD curve A change in autonomous expenditure changes equilibrium GDP for any given price level, and the simple multiplier measures the resulting horizontal shift in the aggregate demand curve. The original AE curve is at AE 0 with equilibrium at E 0, GDP=Y 0 and Price level=p 0 ; the yield point E 0 on AD 0. AE 0 shifts to AE 1 because of an autonomous expenditure increase A, and GDP increases to Y 1. With given price level P 0, the AD curve shifts rightward to E 1.

Desired Expenditure The Simple Multiplier and Shifts in the AD Curve [i]. Aggregate Expenditure AE = Y E 1 AE 1 AE 0 E 0 A 45 o 0 Y 0 Y 1 Real GDP Y 1

The Simple Multiplier and Shifts in the AD Curve [i]. Aggregate Demand E 0 E 1 P 0 Y AD 0 AD 1 0 Y 0 Y 1 Real GDP

Aggregate Supply This is the aggregate output of goods and services that are produced by all firms assuming that all will be sold at the going general price level. The AS curve relates the aggregate output of goods and services supplied to the price level There are two main types of AS curves, namely Short Run Aggregate Supply (SRAS) :shows the aggregate output of goods and services that all firms would like to produce and sell at each general price level assuming the prices of all inputs remain fixed. Long Run Aggregate Supply (LRAS) :shows the aggregate output of goods and services that all firms would like to produce and sell after the general price level and input prices have fully adjusted to any exogenous shift of AD.

A Short-run Aggregate Supply Curve SRAS Y Real GDP

A Short-run Aggregate Supply Curve SRAS P 0 Y 0 Real GDP

A Short-run Aggregate Supply Curve SRAS P 1 P 0 Y 0 Y 1 Real GDP

The short-run aggregate supply curve The SRAS curve is positively sloped. The positive slope shows that with prices of labour and other inputs given, total desired output and the price level will be positively associated. A rise in the price level from P 0 to P 1 will be associated with a rise in output supplied from Y 0 to Y 1. The slope of the SRAS curve is fairly flat at low levels of output and very steep at higher levels.

Slope of AS The positive relation between total output supplied and price level depends on; How production costs are related to output How goods prices and output are related Costs and Output Unit costs are positively related to output and as such as firms desire to supply more aggregate output their units costs rise Prices and Output Price-taking firms produce more if prices rise because unit costs rise with output Price-setting firms will increase prices when aggregate output is expanded into a range where unit costs are rising.

This is caused by; Changes in productivity Shifts in AS Changes in input prices (cost of production) Productivity An increase in productivity implies that firms can supply more output at the same price and therefore the AS shifts down to the right. The opposite is also true Changes in Input Prices If input prices rise, the cost of production increases and therefore the profit of firms decline at the same price level. Firms will react by cutting down on production and therefore produce less aggregate output. This will shift SRAS upward to the left The opposite is also true.

Macroeconomic Equilibrium AD SRAS E 0 P 0 0 Y 0 Real GDP

Macroeconomic Equilibrium Macroeconomic equilibrium occurs at the intersection of the AD and SRAS curves and determines the equilibrium values for GDP and the price level. Equilibrium occurs at E 0 with GDP equal to Y 0 and the price level P 0. If the price level were P 1, below P 0, the desired output of firms would be Y 1 but desired demand would be Y 2, so desired spending would exceed desired production. Only at E 0 are desired plans of producers and consumers consistent.

Macroeconomic Equilibrium AD SRAS E 0 P 0 P 1 0 Y 1 Y 0 Y 2 Real GDP

Desired Expenditure The AE Curve and the Multiplier When the Price Level Varies AE=Y E 0 AE 0 [i]. Aggregate expenditure 45 o Y 0 Real GDP SARS [i]. Aggregate demand P 0 AD 0 Y 0 Real GDP

The AE curve and the multiplier when the price level varies An upward shift in AE is partly offset by the resulting rise in prices, so the multiplier is smaller than when prices are constant. There is an increase in autonomous expenditure A creating the initial shift 1. But prices then rise so the AE curves shifts part of the way back down as shown by 2. The economy moves from point E 0 to E 1.

Desired Expenditure The AE Curve and the Multiplier When the Price Level Varies E 1 AE=Y AE 1 A E 0 AE 0 [i]. Aggregate expenditure 45 o Y 0 Y 1 Real GDP SARS [i]. Aggregate demand P 0 E 0 E 1 AD 0 Y 0 Y 1 Real GDP

Desired Expenditure The AE Curve and the Multiplier When the Price Level Varies E 1 E 1 AE=Y AE 1 A E 0 AE 0 AE 1 [i]. Aggregate expenditure Y 45 o Y 0 Y 1 Y 1 Real GDP SARS [i]. Aggregate demand P 1 P 0 E 0 E 1 E 1 AD 1 AD 0 Y 0 Y 1 Y 1 Real GDP

AD Shocks AD shocks cause the price level and real GDP to change in the same direction. Real GDP and Price Level both rise with and increase in AD Real GDP and Price Level both decline with and decrease in AD The effect of a given shock to AD will be divided between a change in real GDP and a change in the price level depending on the conditions of the AS The steeper the AS curve, the greater is the price effect and the smaller is the output effect

AD Shocks : The Importance of the Shape of SRAS

Demand shocks when the SRAS curve is vertical

AS Shocks AS shocks cause the price level and real GDP to change in opposite directions An increase in AS (downward shift of AS curve) will cause a fall in general price level and an increase in real GDP or output An decrease in AS (upward shift of AS curve) will cause a rise in general price level and an decrease in real GDP or output Examples of AS shocks Oil Price Increases during 1973-74, 1979-80, during Gulf war in 1990, and during the late 2000s (i.e. 2007/08) Productivity gains from an upsurge of new technologies in late 1990s In Ghana during the droughts in 1982/83, energy crises in early 1980s, mid 2000s and 2011-2015.

Aggregate supply shocks