Chapter 10 AGGREGATE SUPPLY AND AGGREGATE DEMAND (Part 1) Objectives Explain what determines aggregate supply in the long run and in the short run Explain what determines aggregate demand Explain how real GDP and the price level are determined and what causes growth, inflation, and cycles Discuss the main schools of thought in macroeconomics today Aggregate Supply The relationship between the quantity of real GDP supplied (Y) and the price level (P). We look at the labor market and distinguish between the long-run and the short-run: Long-run aggregate supply (all prices are flexible) Short-run aggregate supply (some prices are fixed) 1
Long-Run Aggregate Supply Long-run aggregate supply is the relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP the economy is at full employment chapter 6. Potential GDP is independent of the price level. Recall from chapter 6, what determines potential real GDP: physical capital(k), labor(l), and technology. So the long-run aggregate supply curve (LAS) is vertical at potential GDP. Long Run Aggregate Supply Potential GDP is independent of the price level. Changes in K, L and technology shift the curve. The LAS curve shifts over time as the economy grows K, L and technology decrease K, L and technology increase Short - Run Aggregate Supply The relationship between the quantity of real GDP supplied and the price level when the money wage rate, prices of other resources, and potential GDP remain constant (i.e., we assume product prices can change but input prices are fixed in the short-run). A rise in the price level with no change in the money wage rate and other factor prices will increase firm profit, firms produce more and the quantity of real GDP supplied increases the Pepsi plant example on page 243. The short-run aggregate supply curve (SAS) is upward sloping. 2
Short-Run and Long-Run Aggregate Supply This figure shows the LAS curve. P is on the vertical axis and real GDP(Y) in the horizontal. In the long run, the quantity of real GDP supplied is potential GDP. In the long-run ALL wages and prices are flexible (no fixed prices) As the price level rises and the money wage rate changes by the same percentage, the quantity of real GDP supplied remains at potential GDP the Pepsi plant example on page 242. Aggregate Supply In the short run, the quantity of real GDP supplied increases if the price level rises. The SAS curve slopes upward. A rise in the price level with no change in the money wage rate or other factor costs increases profits and firms increase production. The SAS curve is drawn for a given money wage and factor costs. Aggregate Supply With a given money wage rate, the SAS curve cuts the LAS curve at potential GDP. The price level is 110. With the given money wage rate, as the price level falls below 110... the quantity of real GDP supplied decreases along the SAS curve. 3
Aggregate Supply With the given money wage rate, as the price level rises above 110 the quantity of real GDP supplied increases along the SAS curve. Real GDP exceeds potential GDP. What Causes Changes in Aggregate Supply? Short-run aggregate supply changes if: The cost of production such as the money (nominal) wage rate and/or other factor costs change. Long-run aggregate supply changes if: If there is a change in potential GDP Change in Wage Rate or Other Factor Costs The economy is at full employment and the price level (P) = 110. What happens if there is an increase in the nominal wage rate or other input costs: the cost of production increases and producers supply less. Short-run aggregate supply decreases, i.e., the SAS curve shifts upward to the left. Long-run aggregate supply does not change. 4
Change in Long-Run Aggregate Supply Effect of an increase in potential GDP. The LAS curve shifts rightward and the SAS curve shifts along with the LAS curve. The quantity of real GDP demanded, AD, is the total amount of final goods and services produced in the United States that people, businesses, governments, and foreigners plan to buy. That is, AD = AE = C + I + G + X M. Y = Real GDP = Total Production At Equilibrium: Y = AD Y = C + I + G + X M. Factors that Affect The price level (movement along the curve) Wealth Expectations Fiscal policy and monetary policy The world economy shift the curve 5
The Curve Aggregate demand is the relationship between the quantity of real GDP demanded and the price level. This is also presented in chapter 11. The AD curve slopes downward for two reasons: Wealth effect Substitution effects Wealth Effect Let W = nominal wealth, money bonds and stocks, etc. A rise in the price level, decreases real wealth (W/P) To restore their real wealth, households increase saving and decrease spending - S and C. The quantity of real GDP demanded decreases. P => (W/P) => S and C => AD Similarly, a fall in the price level, other things remaining the same, increases real wealth, which increases the quantity of real GDP demanded. P => (W/P) => S and C => AD 6
Substitution Effects (1) Intertemporal substitution effect: A rise in the price level, other things remaining the same, decreases the real value of the money supply and raises the interest rate. When the interest rate rises, households and business firms borrow less and spend less, so the quantity of real GDP demanded decreases. P => (M/P) => interest rate => C and I => AD Substitution Effects (1) Intertemporal substitution effect: Similarly, a fall in the price level, other things remaining the same, increases the real value of the money supply and lowers the interest rate. When the interest rate falls, households and business firms borrow and spend more, so the quantity of real GDP demanded increases. P => (M/P) => interest rate => C and I => AD (2) International substitution effect: A rise in the price level increases the price of domestic goods relative to foreign goods. So imports increase and exports decrease, which decreases the quantity of real GDP demanded. P => imports and X => AD Similarly, a fall in the price level, other things remaining the same, increases the quantity of real GDP demanded. P => imports and X => AD 7
Deriving the Aggregate Demand Curve From the AE Curve A rise in price level from 110 to 130 shifts the AE curve from AE 0 downward to AE 1 because of the wealth and substitution effects and decreases the equilibrium expenditure from $16 trillion to $15 trillion. Deriving the Aggregate Demand Curve the rise in the price level lowers equilibrium expenditure brings a movement up along the AD curve from point B to point A. Deriving the Aggregate Demand Curve A fall in price level from 110 to 90 shifts the AE curve from AE 0 upward to AE 2 and increases equilibrium expenditure from $16 trillion to $17 trillion. 8
Deriving the Aggregate Demand Curve The fall in the price level that increases equilibrium expenditure brings a movement down along the AD curve from point B to point C. Deriving the Aggregate Demand Curve Points A, B, and C on the AD curve correspond to the equilibrium expenditure points A, B, and C at the intersection of the AE curve and the 45 line. Changes in factors that shift the AD curve. A change in any influence on aggregate expenditure other than the price level changes aggregate demand shifts the curve. The main influences on aggregate demand are Expectations Fiscal policy and monetary policy The world economy W (wealth) 9
Expectations Expectations about: (1) future income, (2) future inflation, (3) and future profits change aggregate demand shift the curve.. Increase in expected future income increase people s consumption today (C ) and increases aggregate demand. A rise in the expected inflation rate makes buying goods cheaper today and increases aggregate demand (C and I ). An increase in expected future profits boosts firms investment, which increases aggregate demand (I ) Fiscal Policy and Monetary Policy Fiscal policy is the government s attempt to influence the economy by changing taxes, making transfer payments, and purchasing goods and services. A tax cut or an increase in transfer payments increases households disposable income, increasing consumption expenditure and aggregate demand. An increase in government expenditure (G) increases aggregate demand. Monetary policy The Fed s attempt to influence the economy by changing the interest rate and adjusting the quantity of money. An increase in the quantity of money reduces interest rates and the cost of borrowing, increasing C and I expenditure and aggregate demand. 10
The World Economy The world economy influences aggregate demand in two ways: A fall in the foreign exchange rate lowers the price of domestic goods and services relative to foreign goods and services, which increases exports, decreases imports, and increases aggregate demand. (we cover this in detail later) An increase in foreign income increases the demand for U.S. exports and increases aggregate demand. This figure illustrates changes in aggregate demand. When aggregate demand increases, the AD curve shifts rightward and when aggregate demand decreases, the AD curve shifts leftward. 11