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Understanding Short Run Aggregate Demand & Supply Equilibrium

Learn about effects of Real Balance, Interest Rate, Foreign Purchase Effects on Aggregate Demand and components like Consumption, Investment, Government Spending, Net Exports. Understand Short Run Aggregate Supply determinants, equilibrium, and factors affecting GDP. Explore Potential GDP and Short Run Equilibrium concepts and how they impact employment and inflation.

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Understanding Short Run Aggregate Demand & Supply Equilibrium

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  1. Chapter 7 Short Run Aggregate Demand and Aggregate Supply

  2. Aggregate Demand • Effects • Real Balance Effect - Price falls, increases purchasing power, we buy more • Interest rate Effect - As price falls, interest rates fall, we borrow and spend more • Foreign purchase Effect - As prices fall foreigner my more of our goods and we buy less of theirs

  3. Consumption • C = f(income, interest rates) • Characteristic • Largest • Most stable • Done by the households • MPC • MPS • MPC+MPS=1 • Determinants • Wealth • Price level • Expectations • Debt • Taxation

  4. Investment • I = f(interest rates, Expected profits) • Investment demand (MEI) – shows the relationship between interest rates and Investment • Real interest rate = nominal interest rate – inflation rate • Expected rate of return • Expected Profits – accelerator principle: GDP up, Profits up, I up • Characteristics • Done by the Business sector • Unstable – drastic change • Components: I = Ir + In • Ir = replacement investment: depreciation • In = new investment: growth • Types • Plant and equipment • Inventories • Residential construction

  5. Investment Continued • Determinants • Business conditions • Technology • Excess capacity • Business taxes • Capital costs • Capital stock

  6. Government Spending • G = f(Votes) • Characteristics • 2nd largest • Determinants • Policy • Unexpected events • War

  7. Net Exports • (X-M) = f(Exchange rates) • Characteristic • Smallest • Determinants • Income in other countries

  8. Short run Aggregate Supply • Nation’s total amount of goods produced for sale at various price levels • Ranges • Horizontal (Price is constant) • Intermediate (P and Y change) • Vertical - capacity (P increases, Y constant)

  9. AS Determinants (Shifts AS) • Changes in resource prices (quantity of resources) • Wages • Immigration • Unions • Minimum wage • Interest rates • Rent • Changes in productivity (quality of resources) • Education • Technology • Changes in legislation (institutional changes) • Taxes • Regulations • Laws • Government policy • Trade barriers • Supply shocks • Beneficial – shift the SRAS and LRAS outward • Good harvests • New resource discovery • Adverse - shift the SRAS and LRAS inward • Bad weather (Drought) • OPEC increases the price of oil • Natural disasters and war

  10. Short run Equilibrium • Period of time when at least one resource price is fixed by agreement

  11. Potential GDP • Maximum sustainable output level given set resources • Full employment - Natural Rate of Unemployment • No cyclical unemployment • NAIRU • Natural Rate of Unemployment – Rate that occurs at the natural output level • 4% to 6% (now 5.2%) • Cyclical unemployment is zero • Expected (Anticipated) price level • Capacity Utilization Rate is at 80%

  12. Short Run Equilibrium • No Gap: Actual GDP = potential GDP • Contractionary (recessionary) Gap = potentialGDP > Actual GDP • Underutilized resources - Idle workers, lower than capacity capital use, labor in great supply • Unemployment • Nominal wages are fixed by contracts • Causes • Decreased AD – Une up, inflation down • Decreased AS – Une up, inflation up • Remedy • Increasing AD and/or SRAS • Expansionary (inflationary) Gap = potential GDP < Actual GDP • Overutilized resources - Overtime work, Greater than capacity capital use, labor in short supply • Overemployment (possible inflation) • Nominal wages are fixed by contracts. • Causes • Increased AD – Une down, inflation up • Increased AS – Une down, inflation down • Remedy • Decreasing AD and/or SRAS

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