Ch. 10: Aggregate Supply and Demand

1. Ch. 10: Aggregate Supply and Demand • Derive AS/AD model • Understand cause & consequences of change in AS/AD • Short run vs Long run • Effects on economic growth, prices, unemployment. • Different schools of thought in macroeconomics

2. Macroeconomic Long Run and Short Run The Macroeconomic LR • a time frame that is sufficiently long for the real wage rate to have adjusted to achieve full employment: • Real GDP = potential GDP. • Unemployment=natural unemployment rate. • Price level determined by quantity of money (equation of exchange) • Inflation rate =money growth rate minus the real GDP growth rate. The Macroeconomic SR • a period during which some prices or wages are sticky so • Real GDP might be below, above, or at potential GDP. • The unemployment rate might be above, below, or at the natural unemployment rate

3. Aggregate Supply • The quantity of real GDP supplied is the total quantity that firms plan to produce during a given period. It depends on • The quantity of the labor employed • The quantity of physical and human capital • State of technology • Two time frames associated with different states of the labor market: • Long-run aggregate supply • Short-run aggregate supply

4. Aggregate Supply Long-Run Aggregate Supply (LAS) • the relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP. • Potential GDP is determined by • Production function • Labor market • Independent of price level • LR aggregate supply curve (LAS) is vertical at potential GDP.

5. Determinants of LAS Real Wage Price Level Labor market LAS Labor hours Real GDP Production function Real GDP Labor hours

6. Determinants of LAS • Change in labor supply • immigration • taxes on employees • transfers (UI, SS) • population growth • retirement • Change in labor demand • worker productivity (also affects PF) • taxes on employer payroll • Shifts in Production Function • capital/technology (also affects LD) • human capital

7. Graphic analysis of changes in LAS(Change in Labor Supply) • Effect on • Real wage • Employment • productivity

8. Graphic analysis of changes in LAS(increase in labor productivity) • Effect on • Real wage • Employment • Productivity

9. Aggregate Supply Short-Run Aggregate Supply (SAS) • Shows relationship between real GDP supplied and the price level, ceteris paribus • A rise in the price level with no change in the money wage rate and other factor prices increases the quantity of real GDP supplied. • as P rises, real wage declines, firms want to hire more employees (movement along labor demand curve) • The short-run aggregate supply curve (SAS) is upward sloping.

10. Short Run Aggregate Supply Labor market SAS Production function As P rises, RW falls, L rises; RGDP rises

11. Aggregate Supply Along the SAS curve, real GDP supplied might be above potential GDP… or below potential GDP.

12. Aggregate Supply An increase in potential GDP shifts the LAS curve and the SAS curve shifts along with the LAS curve.

13. Aggregate Supply A rise in the money wage rate • Decreases short-run aggregate supply and shifts the SAS curve leftward. • Has no effect on long- run aggregate supply.

14. Aggregate Demand • AD is the total amount of final goods and services produced in the United States that people, businesses, governments, and foreigners plan to buy. • AD= C + I + G + (X – M.) • AD depends on • The price level • Expectations about future • Changes in wealth • Fiscal and monetary policy • The world economy

15. Aggregate Demand The Aggregate Demand Curve • plots the quantity of real GDP demanded against P. • slopes downward for 2 reasons: • Wealth effect • Substitution effects

16. Aggregate Demand • Wealth Effect P increases  real wealth decr  C decr  AD decr • Substitution Effects • Intertemporal P incr int rate incr  C & I decr  AD decr • International P incr imports incr, exports decr  AD decr

17. Shifts in Aggregate Demand Expectations about future • Increases in expected future income  increases C today increases AD. • Increase in expected future inflation  buying goods cheaper today  increases AD. • Increase in expected future profits investment increases  increases AD

18. Shifts in Aggregate Demand Fiscal Policy • setting and changing taxes, transfer payments, and purchasing goods and services. • An income tax cut or increase in transfers increases disposable income (income-taxes+ transfers)  increases C  increases AD • An increase in government spending  increases G  increases AD

19. Shifts in Aggregate Demand Monetary policy • changes in interest rates and the quantity of money in the economy. • An increase in the money supply reduces interest rates and increases aggregate demand.

20. Shifts in Aggregate Demand Summary: Fiscal policy Monetary policy Value of $ Foreign income

21. Macroeconomic Equilibrium SR Equilibrium: SAS=AD GDP can be above, below, or at potential GDP LR equilibrium LAS=SAS=AD

22. Macroeconomic Equilibrium • Graphical illustration of SR equilibria with • GDP>potential GDP (inflationary gap) • 2. GDP<potential GDP (recessionary gap) • 3. GDP=potential GDP (LR equilibrium)

23. Transition from GDP>potential GDP to LR equilibrium (inflationary gap) • Initially: • empl > equil. Empl • unempl < natural rate • R-wage < equil. R-wage • upward pressure on R-waqes • SAS shifts left until GDP=potential GDP • As economy moves to LR Equilibrium: • Employment falls, Unemployment rises, • Real wage rises, Real GDP falls

24. Transition from GDP<potential GDP to LR equilibrium (recessionary gap) • Initially: • empl < equil. Empl • unempl > natural rate • R-wage > equil. R-wage • downward pressure on R-waqes • SAS shifts left until GDP=potential GDP • As economy moves to LR Equilibrium: • Employment rises Unemployment falls • Real wage falls Real GDP rises

25. SR/LR effect of changes in AD Effect of Increase in AD on real wage, prices, real GDP unemployment and employment.

26. Macroeconomic Schools of Thought • Three broad schools of thought: • Classical • believes the economy is self-regulating and always at full employment. • Keynesian • Due to sticky wages/prices, the economy would rarely operate at full employment. • To achieve and maintain full employment, active help from fiscal policy and monetary policy is required • Monetarist • economy is self-regulating and that it will normally operate at full employment, provided that monetary policy is not erratic and that the pace of money growth is kept steady