Aggregate supply and aggregate demand Chapters 31, 32, and 33

1. Aggregate supply and aggregate demandChapters 31, 32, and 33 By Thuy Le

2. Chapter 31 Open-Economy Macroeconomics: Basic Concepts

3. Chapter 31 • Prior to this you’ve only studied closed economies • economies that do not interact with other economies in the world • In macroeconomics, many new situations arise when studying open economies • economies that interact freely with other economies around the world

4. Chapter 31 • An open economy allows for a greater flow of goods and services. Some terms to know are: • Exports: goods and services that are produced domestically and sold abroad • Imports: goods and services that are produced abroad and sold domestically • Net exports/Trade balance: the value of a nation’s exports minus the value of its imports

5. Chapter 31 • More terms to know: • balanced trade: a situation in which exports equal imports • trade deficit: an excess of imports over exports • trade surplus: an excess of exports over imports

6. Chapter 31 • There are many variables which can affect international trade. Some of them are: • Consumers’ preferences for foreign and domestic goods • Prices of goods at home and abroad • Incomes of consumers at home and abroad • The exchange rates at which foreign currency trades for domestic currency • Transportation costs • Government policies

7. Chapter 31 • Residents of an open economy participate in the market for goods and services, but they can also participate in the world financial market. • When talking about the flow of financial resources economists use the term net capital outflow, formerly known as net foreign investment. • the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners

8. Chapter 31 • There are many terms related to a country’s NCO. Some are: • Foreign direct investment: Domestic residents actively manage the foreign investment • Ex: Thuy, a U.S. resident, is the owner of the H.B. Reese Company and builds a plant in China so she can produce Reese’s cups on the cheap • Foreign portfolio investment: Domestic residents purchase foreign stocks or bonds, supplying loanable funds to a foreign firm. • Ex: Nick, a U.S. resident, purchases stocks of Adidas, his favorite German shoe company

9. Chapter 31 • NCO measures the imbalance in a country’s trade in assets: • When NCO > 0, there is capital outflow • When NCO < 0, there is capital inflow • It is important to remember that NCO will always equal NX. • Every transaction that affects NX also affects NCO by the same amount

10. Chapter 31 • Earlier, you learned about GDP equaling C + I + G + NX. This identity can now be used with NCO so we can relate the flow of trade to savings and investment. Y = C + I + G + NX is also true when written as Y – C – G = I + NX , and this can be rearranged to be S = I + NX since S = Y – C – G, which means S = I + NCO since NX = NCO

11. Chapter 33 • When S > I, the excess loanable funds flow abroad in the form of positive net capital outflow. • When S < I, foreigners are financing some of the country’s investment, and NCO < 0.

12. e x P P* Chapter 31 • In addition to NX and NCO, economists also look at two other variables when studying international transactions. They are: • nominal exchange rate: the rate at which a person can trade the currency of one country for the currency of another and • real exchange rate: the rate at which a person can trade the goods and services of one country for the goods and services of another P = domestic price P* = foreign price (in foreign currency) e = nominal exchange rate

13. Chapter 31 • Exchange rates change from time to time. When they do, a nation’s currency is said to be appreciating or depreciating. • Appreciation: an increase in the value of a currency as measured by the amount of foreign currency it can buy • Depreciation: a decrease in the value of a currency as measured by the amount of foreign currency it can buy

14. Chapter 31 • The simplest theory of exchange rates is the purchasing power parity, which is based on the law of one price. • The purchasing power parity: a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries

15. Chapter 32 A Macroeconomic Theory of the Open Market

16. Chapter 32 • The previous chapter explained the basic concepts and vocabulary of the open economy. • This chapter ties these concepts together into a theory of the open economy. • To understand open economies you have to focus on two main markets. • The loanable funds market • The foreign-currency exchange market

17. r S = saving r1 D = I + NCO LF Chapter 32 • The Market for Loanable Funds

18. S = NCO E E1 D = NX Dollars Chapter 32 • The Foreign Currency Exchange Market

19. Chapter 32 • The link between the two markets is NCO, which is included in two important identities • S = I + NCO • NCO = NX • NCO is part of the demand in loanable funds market and is the source of supply in the foreign currency exchange market. • All three graphs are commonly drawn together to show this relationship.

20. Chapter 32 • Many policies and events can affect the open market and in turn affect all three graphs. • Some possible things are: • Government budget deficits • Trade policies • Political instability/Capital flight

21. Chapter 32 • Budget deficits • Decreases the supply of loanable funds • Increases the RIR • Reduces NCO • Decreases the supply of dollars • Causes the dollar to appreciate

22. Chapter 32 • Trade policies: a government policy that directly influences the quantity of goods and services that a country imports or exports. Some examples are: • Tariff : a tax on imports • Import quota : a limit on the quantity of imports • “Voluntary export restrictions”: the government pressures another country to restrict its exports which is essentially the same as an import quota

23. Chapter 32 • Capitalflight: a large and sudden reduction in the demand for assets located in a country. • Capital flight • Increases NCO • Increases the demand for loanable funds • Increases the RIR • Increases the supply of dollars • Causes the dollar to depreciate

24. Chapter 33 Aggregate Demand and Aggregate Supply

25. Chapter 33 • Over the long run, real GDP grows about 3% per year on average. • In the short run, GDP fluctuates around its trend. • Recessions: periods of falling real incomes and rising unemployment • Depressions: severe recessions • Short-run economic fluctuations are often called business cycles.

26. Chapter 33 • There are three facts about economic fluctuations • Economic fluctuations are irregular and unpredictable. • Most macroeconomic quantities fluctuate together. • As output falls, unemployment rises.

27. Chapter 33 • Explaining these fluctuations is difficult, and the theory of economic fluctuations is controversial. • Most economists use the model of aggregate demand and aggregate supply to study fluctuations. • This model differs from the classical economic theories economists use to explain the long run.

28. Chapter 33 • The previous chapters are based on the ideas of classical economics • The Classical Dichotomy is the separation of variables into two groups: • Real: quantities, relative prices • Nominal: measured in terms of money • The neutrality of money: Changes in the money supply affect nominal but not real variables.

29. Chapter 33 • Most economists believe classical theory describes the world in the long run, but not the short run. • In the short run, changes in nominal variables (like the money supply or PL) can affect real variables (like Y or unemployment). • To study the short run, we use a new model.

30. P SRAS P1 AD Y Y1 Chapter 33 • The model of aggregate demand and aggregate supply

31. Chapter 33 • Terms to know: • aggregate-demand curve: a curve that shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level • aggregate-supply curve: a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level

32. Chapter 33 • The aggregate demand curve is downward sloping because of • The wealth effect • The exchange-rate effect • The interest-rate effect • AD will shift if there is a change in • GDP • Money supply

33. LRAS P SRAS Y Chapter 33 • The aggregate supply curve is • Upward-sloping in the short run • Vertical in the long run

34. LRAS P Y Chapter 33 • LRAS is vertical because • YN determined by the economy’s stocks of labor, capital, and natural resources, and on the level of technology. • An increase in P does not affect any of these, so it does not affect YN. YN

35. Chapter 33 • LRAS will shift if there is a change in • Any factors of production • Natural resources • Technology • SRAS will shift if • LRAS shifts • There is a change in price level/expectations • There is a supply shock

36. Chapter 33 • There are 3 theories of SRAS • The sticky wage theory • The sticky price theory • The misperceptions theory • The imperfections in these theories are temporary. Over time, • sticky wages and prices become flexible • misperceptions are corrected • In the LR, • PE = P • AS curve is vertical

37. Congratulations! You’ve learned everything there is to know in Chapters 31-33!