Aggregate Supply, Aggregate Demand, Classical, Keynesian

Condensed version of 4 chapters.Aggregate Supply, Aggregate Demand, Classical, KeynesianGDP 2007 to 2010

OK One more time..Component parts of GDP?C + I + G + (X-M) = GDP

Long-Run Aggregate Supply Curve (LRAS)A vertical line representing the real output of goods and services after full adjustment has occurredIt represents the real GDP of the economy under conditions of full employment; the economy is on its production possibilities curve

The Production Possibilities and the Economys Long-Run Aggregate Supply Curve

55Output Growth and the Long-Run Aggregate Supply Curve (cont'd)LRAS is verticalInput prices fully adjust to changes in output pricesSuppliers have no incentive to increase outputUnemployment is at the natural rateDetermined by endowments and technology (or existing resources) Growth is shown by outward shifts of either the production possibilities curve or the LRAS curve caused byGrowth of population and the labor-force participation rateCapital accumulationImprovements in technology

6610What is AD and why slope downward?AD = C + I + G + (X-M)

Think: Why does AD slope downward?Real domestic output, GDPADPrice levelVertical axis representsPrice level for ALL final goodsAnd servicesThe aggregate price levelIs measured by either GDPDeflator or CPIThe horizontal axis representsthe real quantity of all G&Spurchased as measured by thelevel of REAL GDPFigure 10-4 The Aggregate Demand CurveAs the price level rises, real GDP declines

99There are 3 Reasons that cause the AggregateDemand Curve to be downward sloping.

Real Balance Effect (Wealth effect)Interest Rate EffectInternational Trade EffectReal Balance EffectWealth effect= as price level falls, the real wealth people hold increases and they can consumer more.

2) Real Balance Effect (or wealth effect) Higher price level means less consumption spending.

Real Balance Effect

The change in the purchasing power of dollar-

Relates to assets that result from a change in the price level12Interest Rate EffectInverse relationship between price level and quantity demanded of GDP .Price level falls (bundle of goods costs less) rest of money into savings, more money available for borrowing interest rate down.

Think of money as stationary demand drives up price of money. Factors That Change Aggregate Demand & Consumption/Interest Rates Interest Rate C AD Interest Rate C AD

14Interest Rate continuedNow if bundle of goods increases want to purchase interest sensitive good, cost to borrow is up.An increase in money demand will drive up the price paid for its use use of money = interest rateAs price level rises, houses and firms require more money to handle transactions

International Trade Effect (Open Economy Effect) FYI: An open economy is global, a closed economy is domestic.The Open Economy EffectHigher price levels result in foreigners desiring to buy fewer American-made goods while Americans desire more foreign-made goods (i.e., net exports fall).Decrease in price level leads domestic goods to be cheaper- Means foreigners want to purchase more and exports increase.

When Demand for exports decreases, this is an unfavorable balance of trade (imports exceed exports)

161625Reminder about PLDefinition below:Price level is the weighted average of the prices of al final goods and services produced in an economy.

PL is measured by CPI (most common)GDP deflator (govt prefers because it yields a lower figure)Price Level Stability = steadiness of the PL from one period to the next. (low annual rate of inflation = price stabilityCan take your $20 dollars and know what you can buy.

Changes in ADChange in PL will change amount of aggregate spending which changes amount of real GDP

PL

Change in one of determinants of AD (C+I+G+X-M) which directly affects real GDP.(consumption GDP Change in any of the component parts of AD (C + I + G + Net Exports)

GDPGDPABPL is made up of CPI or GDP deflatorPLDifference between Quantity of AD and Change of ADQAD = movement up or down as result of price level changing (ONLY)

Change in AD =Change in any of the component parts of AD (C + I + G + Net Exports)DETERMINANTS OF AGGREGATE DEMANDChange in Consumer SpendingConsumer WealthConsumer Expectations (expect higher prices) Interest rate (interest sensitive durables) TaxesChanges in Investment SpendingReal Interest Rates (rates high- not much I taking place) Expected Future Sales (health of economy- confidence is big)Business Taxes (higher taxes less profit)

Factors That Change Aggregate Demand & Investment/ Business TaxesBusiness taxes I ADBusiness taxes I AD

22Government SpendingThis will be discussed further, but anytime government spends, it has an affect on GDP.Infrastructure Health CareSupplies for militaryEducationEtc.Net Export Spending

National Income Abroad-(when foreign nations do well, their incomes are higher- can buy more U.S. goods and services. U.S. exports rise)

Exchange Rates- Price of one nations currency in terms of another. Dollar vs EuroOur currency appreciates if it takes more foreign $ to buy it.. (depreciates if it takes more of ours to buy theirs.) $1.00 to $1.25 Euro.Depreciation of nations currency makes foreign goods more expensive (but attracts foreigners to buy our goods.) Our exports rise. *this is why the Fed has not worried about our low dollar valuation.Long-Run Equilibrium and the Price LevelFor the economy as a whole, long-run equilibrium occurs at the price level where the aggregate demand curve (AD) crosses the long-run aggregate supply curve (LRAS).252537Long-Run Equilibrium and the Price LevelFor the economy as a whole, long-run equilibrium occurs at the price level where the aggregate demand curve (AD) crosses the long-run aggregate supply curve (LRAS).

262637Aggregate SupplyShort RunIn short run input prices and output prices are fixed (referred to as immediate SR)Regular SR = SRAS input prices fixed but output can vary.* Example: wages/contracts fixed and little adjustment can occur until either laid off or contract renewal.

Long RunLong run supply curve is vertical.Full employment and capacity has been reached*wages and prices are flexible and the profit level will adjust to give firms the right profit level and firm has no incentive to produce beyond Qf.SRASPeriod where adjustment occurs.AD and SRAS

29LRAS = long-run aggregate supply

(a period when nominal wages and other resource prices respond to price-level changes)LRAS is a vertical line reflecting that LR Aggregate Supply is not affected by changes in PL.The LRAS is labeled as the natural level of real GDP The natural level of real GDP is defined as the level of real GDP that arises when the economy is fully employing all of its available input resources ( We are in agreement that it hovers around 5%)

Equilibrium States of the Economy

During the time an economy moves from one equilibrium to another, it is said to be in disequilibrium.31RealRateOfInterestMoney SupplyD1D2Can a Change in Money Supply Change AD?Probably but it is a chain of events.MS changes, then Interest Rates, then chance in consumptionand investment. Then Change in ADLong Run Aggregate SupplyPrice levelReal domestic output, GDPQPLRASLRLong-runAggregateSupplyQfFull-EmploymentLRAS Goods & Services(real GDP)Price levelP 100YFSRAS1AD1Unanticipated Increase in Aggregate DemandIn response to an unanticipated increase in AD for goods & services (shift from AD1 to AD2), prices will rise to P105 and output will temporarily exceed full-employment capacity (increases to Y2).P 105Y2AD2Short-run effects of an unanticipated increase in ADLRAS1 Goods & Services(real GDP)Price levelYFADP 1SRAS1YF1SRAS2YF2LRAS2YF2Here we illustrate the impact of economic growth due to capital formation or a technological advancement, for example.Both LRAS and SRAS increase (to LRAS2 and SRAS2); the full employment output of the economy expands from YF1 to YF2.P 2Growth in Aggregate SupplyA sustainable, higher level of real output and real income is the result. ***If the money supply is held constant, a new long-run equilibrium will emerge at a larger output rate (YF2) and lower price level (P2).LRAS Goods & Services(real GDP)Price levelADYFP 100SRAS1 (Pr1)AP 110Y2The higher resource prices shift the SRAS curve to the left; in the short-run, the price level rises to P110 and output falls to Y2.What happens in the long-run depends on whether the reduction in the supply of resources is temporary or permanent. Effects of Adverse Supply ShockIf temporary, resource prices fall in the future, permitting the economy to return to its original equilibrium (A).If permanent, the productive potential of the economy will shrink (LRAS shifts to the left) and (B) will become the long-run equilibrium.SRAS2 (Pr2)BPrice LevelReal Domestic Output, GDPQPASAD1INCREASES IN AD: DEMAND-PULL INFLATIONP2P1AD2QfQ1Q2Price LevelReal Domestic Output, GDPQPAS1AD1DECREASES IN AS: COST-PUSH INFLATIONP2QfQ1abAS2P1

Non-governmental actions that shift AS Shift AS left:Raw materials cost riseWages rise faster than productivityWorker productivity decreasesObsolescenceWars Natural disasters

Fiscal PolicyGovernmental actions that shift ADShift AD right:Govt spending increasesTaxes decreasesMoney Supply increasesShift AD left:G decreasesT increasesMS decreases

KILEY SAYS THAT'S ALL!

Long run growth
P
Y
x
P1
Yf1
AD1
Yf2
LRAS1
AS1
AS2
AD2
LRAS2
P2
Consumergoods
Capitalgoods
PPC shifts out andLRAS shifts right.