Download - Aggregate Demand/Aggregate Supply The Alpha and Omega of Macroeconomics Graphs

Aggregate Demand/Aggregate Supply

The Alpha and Omega of Macroeconomics Graphs

Consumption

Capital

Production Possibilities Curve/Gross Domestic Product Connection

.A

10

5

Assume this economy is fully employing all of its resources in the least costly way (Productive Efficiency) and chooses to produce at point “A” (Allocative Efficiency)

Assume this economy can produce 5 Capital goods and servicesAnd 10 consumption goods and services

Assume one capital G/S costs $5.00 and 1 consumption G/S costs $1.00

What is this economy’s GDP?

5 Capital G/S X $5.00 = $25.0010 Consumption G/S x $1.00 = $10.00

GDP - $35.00

This GDP represents Full-Employment or “Potential GDP”.

Real GDP

PriceLevel

LRAS

$35FE ***Point “A” on the PPC is the same

thing as Full Employment Real GDPRepresented by LRAS – only expressedIn $$$$$$***

Aggregate Demand/Aggregate Supply

Price Level

Real GDPFE RGDP

LRAS

0

Between 0 and FE RGDP is a large range of Dollar value of GDP. EVERYONE of these Points to the LEFT of FE RGDP will represent RGDP values that are LESS than our Full-Employment POTENTIAL RGDP.

Price Level

Real GDPFE RGDP

LRAS

0

REMEMBER: To Calculate RGDP we take Nominal GDP (Price x Quantity) and factor out changes in Price relative to a base year.

Price Level

Real GDPFE RGDP

LRAS

PL1

RGDP1

This is ACTUAL RGDP This is POTENTIAL RGDP

Price Level

Real GDPFE RGDP

LRAS

PL1

RGDP1

If the economy was producing this amount of RGDP relative to the FE RGDP it is in serious trouble. It is way inside its productive capacity. Resource prices (Input prices) and wage rates are going to be low because there is VERY high Unemployment and a high supply of unused resources (Inputs)

Price Level

Real GDPFE RGDP

LRAS

RGDP1

PL1

RGDP2

If we move to the production of RGDP2 we can see the economy is using MORE of its slack resources to produce RGDP (Inputs AND people) BUT the Price Level is steady…This is because we STILL have relatively HIGH Unemployment and there is still enough slack resources to keep their prices Low.

Price Level

Real GDPFE RGDP

LRAS

PL1

RGDP1RGDP2 RGDP3

This will continue over a range of RGDP production…

Price Level

Real GDPFE RGDP

LRAS

PL1

RGDP1RGDP2 RGDP3RGDP4

This will continue over a range of RGDP production until we come to this next important point…

Price Level

Real GDPFE RGDP

LRAS

PL1

RGDP1RGDP2 RGDP3RGDP4RGDP5

What we have constructed so far is a range of production of RGDP that the economy CAN produce, but is not desirable…In the LONG RUN we hope to be at FE RGDP, but because of the current conditions the economy, in the SHORT RUN, can produce any one of these RGDP levels

Price Level

Real GDPFE RGDP

LRAS

PL1


Hence, we have ONE part of our SHORT RUN AGGREGATE SUPPLY CURVE---The Horizontal, or Keynesian, Range.

Price Level

Real GDPFE RGDP

LRAS

PL1


This will continue over a range of RGDP production…

UNTIL….

Price Level

Real GDPFE RGDP

LRAS

PL1

RGDP1RGDP2 RGDP3RGDP4RGDP5RGDP6

…We reach RGDP6…Notice that NOW the Price Level INCREASES to PL2…As we move closer to FE RGDP we are getting to LOWER levels of Unemployment and are using more input resources so now these limited resources are beginning to become MORE scarce. When inputs and wages start to rise, what happens to the Cost of Production?? INCREASES…

PL2

Price Level

Real GDPFE RGDP

LRAS

PL1

RGDP1RGDP2 RGDP3RGDP4RGDP5RGDP6RGDP7

Producers need to get a higher price to reflect the increasing input costs. The Producers will INCREASE the Quantity Supplied of RGDP when the Price Level INCREASES…

PL2

PL3

Price Level

Real GDPFE RGDP

LRAS

PL1


RGDP8

PL2

PL3

PL4

THIS POINT IS VERY IMPORTANT!!!!

Price Level

Real GDPFE RGDP

LRAS

PL1


RGDP8

PL2

PL3

PL4

At this point, ACTUAL RGDP is EQUAL to POTENTIAL RGDP…This economy’s ability to Produce RGDP in the SHORT RUN is now EQUAL to the Economy’s ability to Product RGDP in the LONG-RUN…

Price Level

Real GDPFE RGDP

LRAS

PL1


RGDP8

RGDP9

PL2

PL3

PL4

PL5

What about this NEXT point? Can our economy produce at this point?

Price Level

Real GDPFE RGDP

LRAS

PL1


RGDP8

RGDP9

PL2

PL3

PL4

PL5

IN THE SHORT RUN it can, but it will NOT be sustainable…Now Unemployment is BELOW the Natural Rate of Unemployment and Inputs are very scarce. The pressure on wages will INCREASE. The economy is up against a wall. There will not be any increase in Quantity Supplied at this point.

Price Level

Real GDPFE RGDP

LRAS

PL1


RGDP8

RGDP9

PL2

PL3

PL4

PL5

This Range of the SHORT RUN AGGREGATE SUPPLY CURVE is called the INTERMEDIATE RANGE…

Price Level

Real GDPFE RGDP

LRAS

PL1


RGDP8

RGDP9

PL2

PL3

PL4

PL5

PL6

We have reach the END of this economy’s ability to Produce RGDP….The SHORT RUN AGGREGATE SUPPLY CURVE Becomes VERTICAL and Parallels the LRAS CURVE…

Price Level

Real GDPFE RGDP

LRAS

PL1


RGDP8

RGDP9

PL2

PL3

PL4

PL5

PL6

PL7 SRAS

The VERTICAL RANGE of the SRAS Curve is called the Classical Range…More on what the Classical and Keynesian Range mean later….

Classical Range

Price Level

Real GDPFE RGDP

LRAS

PL1


RGDP8

RGDP9

PL2

PL3

PL4

PL5

PL6

PL7 SRAS

Let’s take away all the “stuff” and see what we are left with….

Classical Range

Price Level

Real GDPFE RGDP

LRAS

SRAS

This is how I like to represent the “SUPPLY-SIDE” of the Economy. There are 3 distinct sections to the SRAS curve and it extends beyond the LRAS curve and then becomes vertical again….This just shows that an economy CAN produce beyond it productive capacity, but does so at it’s peril…Now we will insert an Aggregate Demand Curve and start with serious analysis on the economy.

Aggregate Supply (AS) ShiftersChanges in spending not caused by Price Level

Changes in INPUT prices for land, labor, capital, and entrepreneurship

THE FACTORS OF PRODUCTION

1. Before the Change

2. The change

3. After the change

Change in Market Power (unions, presence of monopolies)


2. The change

3. After the change

Change in Productivity 1. Before the Change

2. The change

3. After the change

Change in Government policies – business taxes, subsudies, regulations

Change in value of currency


2. The change

3. After the change

Pric

e Le

vel

Pric

e Le

vel

Pric

e Le

vel

Pric

e Le

vel

GDP

GDP

GDP

GDP

(AS)

(AS)

(AS)

(AS)

Price Level

Real GDP

SRAS

Aggregate Demand /Aggregate Supply

SRAS1

Unions grow more aggressive; wage rate increases.

Price Level

Real GDP

SRAS


SRAS1

OPEC successfully increases oil price

Price Level

Real GDP

SRAS


SRAS1

Labor productivity increases dramatically

Price Level

Real GDP

SRAS


SRAS1

Giant natural gas discovery decreases energy prices.

Price Level

Real GDP

SRAS


SRAS1

Computer technology brings new levels of efficiency to industry.

Price Level

Real GDP

SRAS


SRAS1

Research shows that improved schools have increased the skills of American workers and managers.

Price Level

Real GDP

SRAS


SRAS1

Government increases regulation of industry to address pollution problem

Price Level

Real GDP

SRAS


SRAS1

The dollar depreciates in foreign exchange markets

Price Level

Real GDP

SRAS


SRAS1

President announces cuts in farm and business subsidies.

Price Level

Real GDP

SRAS


SRAS1

Business taxes fall.

Price Level

Real GDP

SRAS


SRAS1

New low-cost means of extracting oil from shale is discovered

Introduction to Aggregate Demand

AD

GDP

Price Level

AD

GDP

Price Level

Why is Aggregate Demand Curve Downward Sloping

1.According to the AD curve, what is the relationship between Price Level and Real GDP?

There is an inverse relationship; the lower the price level, the higher the Real GDP or real output.

AD

GDP

Price Level


Explain how each of the following effects helps explain why the AD curve is downward sloping?

Interest Rate Effect

A lower price level decreases the demand for money, which decreases the interest rate and increases investment and interest sensitive components of consumption and, therefore, Real GDP or real output.

AD

GDP

Price Level


Wealth Effect or Real Balance Effect

As the price level falls, cash balances will buy more so people will spend more, thus increasing Real GDP or Real Output.

AD

GDP

Price Level


Net Export or International Trade Effect

A lower U.S. price level means prices for goods produced in the U.S. are lower relative to the prices in foreign countries. Thus people will buy more U.S. produced goods and fewer foreign produced goods. This increases net exports, a component of GDP

Aggregate Demand (AD) ShiftersChanges in spending not caused by Price Level


2. The change

3. After the change

Change in Net Exports (Nx) caused by a change in national income abroad, or exchange rate of money


2. The change

3. After the change

Change in Government (G) spending


2. The change

3. After the change

Change in Investment (I) caused by a change in interest rates, profit expectations, business taxes, technology, or excess capacity


2. The change

3. After the change

Change in consumer spending (C) caused by a change in wealth, expectations, indebtedness, personal taxes

Pl

Pric

e Le

vel

GDP

(AD)

Pl

Pric

e Le

vel

GDP

(AD)

GDP

(AD)Pric

e

Le

vel

Pric

e

Le

vel

GDP

(AD)

Pric

e

Le

vel

GDP

(AD)

Bottom Line of Aggregate Demand

(AD)Aggregate Demand is driven by the

Components of GDP

AD = C + I + G + N(x)

When one of these variables change, either positively or negatively

(increase or decrease), AD curve will move right or left

In the slides that follow, read the situation and determine if it causes an increase, decrease or

no change in AD. DO NOT CLICK ON THE YELLOW BARS.

They are hot linked and will take you to a different part of the PPT. Just choose in your mind the direction you think AD will

shift

Increase AD

Decrease AD

No Change in AD

Situation: Congress cuts taxes.

PriceLevel

Real GDP

AD ADAD

A B C

Always start at curve B. Click the correct curve to go to the next slide.

Increase AD

Decrease AD

No Change in AD

Situation: Investment spending decreases.

PriceLevel

Real GDP

AD ADAD

A B C


Increase AD

Decrease AD

No Change in AD

Situation: Government spending increases; President promises no tax increases.

PriceLevel

Real GDP

AD ADAD

A B C


Increase AD

Decrease AD

No Change in AD

Situation: Survey shows consumer confidence jumps.

PriceLevel

Real GDP

AD ADAD

A B C


Increase AD

Decrease AD

No Change in AD

Situation: Stock market collapses; investors lose billions.

PriceLevel

Real GDP

AD ADAD

A B C


Increase AD

Decrease AD

No Change in AD

Situation: Productivity rises for the fourth straight year.

PriceLevel

Real GDP

AD ADAD

A B C


Increase AD

Decrease AD

No Change in AD

Situation: President/Congress cut defense spending by 20 percent; no increase in domestic spending.

PriceLevel

Real GDP

AD ADAD

A B C


Increase AD

Decrease AD

No Change in AD

Situation: Consumer indebtedness rises.

PriceLevel

Real GDP

AD ADAD

A B C


Increase AD

Decrease AD

No Change in AD

Situation: Dollar appreciates in foreign exchange markets.

PriceLevel

Real GDP

AD ADAD

A B C


Increase AD

Decrease AD

No Change in AD

Situation: Business profit expectations fall.

PriceLevel

Real GDP

AD ADAD

A B C


Increase AD

Decrease AD

No Change in AD

Situation: The price of imported resources skyrockets.

PriceLevel

Real GDP

AD ADAD

A B C


Increase AD

Decrease AD

No Change in AD

Situation: Consumers expect the price level to rise.

PriceLevel

Real GDP

AD ADAD

A B C


Increase AD

Decrease AD

No Change in AD

Situation: Consumer wealth plummets as stock prices fall.

PriceLevel

Real GDP

AD ADAD

A B C


Increase AD

Decrease AD

No Change in AD

Situation: Excess plant capacity decreases significantly.

PriceLevel

Real GDP

AD ADAD

A B C


Increase AD

Decrease AD

No Change in AD

Situation: Interest rates rise.

PriceLevel

Real GDP

AD ADAD

A B C


Increase AD

Decrease AD

No Change in AD

Situation: Foreign incomes fall.

PriceLevel

Real GDP

AD ADAD

A B C


Increase AD

Decrease AD

No Change in AD

Situation: Dollar value depreciates in foreign exchange markets.

PriceLevel

Real GDP

AD ADAD

A B C


PriceLevel

Real GDP

SRASLRAS

FERGDP

AD1

PL1

RGDP1

This AD/AS Model of the Economy shows an economy in TROUBLE…Aggregate Demand is intersecting Aggregate Supply on the HORIZONTAL section of SRAS...This economy is in a SEVERE RECESSON boardering on a DEPRESSION.

Unemployment Rate15%(?)

PriceLevel

Real GDP

SRASLRAS

FERGDP

AD1

PL1

RGDP1

A VERY large Recessionary Gap

This means it is currently producing a RGDP that is WAY inside its ability to produce RGDP .


PriceLevel

Real GDP

SRASLRAS

FERGDP

AD1

PL1

RGDP1

AD2

RGDP2

Aggregate Demand INCREASES from AD1 to AD2

Still a LARGE Recessionary GapBut not a large as before


PriceLevel

Real GDP

SRASLRAS

FERGDP

AD1

PL1

RGDP1

AD2

RGDP2

AD3

RGDP3


The Recessionary GapIs shrinking…


PriceLevel

Real GDP

SRASLRAS

FERGDP

AD1

PL1

RGDP1

AD2

RGDP2

AD3

RGDP3



As AD INCREASES from AD1 to AD3 the economy is INCREASING it’s RGDP but the Price Level is NOT INCREASING….WHY????

PriceLevel

Real GDP

SRASLRAS

FERGDP

AD1

PL1

RGDP1

AD2

RGDP2

AD3

RGDP3



Between RGDP1 and RGDP3 there are lots of under-employed resources ( excess inventories) AND PEOPLE---Unemployment is very high..When unemployment and Inventories are high there is little to NO pressure on prices to increase because there is plenty of “slack resources”. Even though RGDP is Increasing the is no upward pressure on the Price Level over this range of RGDP.

PriceLevel

Real GDP

SRASLRAS

FERGDP

AD1

PL1

RGDP1

AD2

RGDP2

AD3

RGDP4

AD4

RGDP3

PL2

Recessionary Gap

BUT….the story changes as the economy moves to AD4 . RGDP INCREASES but so does the PRICE LEVEL….As we approach Full-Employment (closer to where SRAS intersects LRAS) the economy has FEWER slack resources (inventories are decreasing) AND Unemployment is DECREASING more rapidly…There is INCREASING pressure on the PRICE LEVEL to INCREASE…


PriceLevel

Real GDP

SRASLRAS

FERGDP

AD1

PL1

RGDP1

AD2

RGDP2

AD3

RGDP4

AD4

RGDP3

PL2

Recessionary Gap

This is NOT dangerous for the Economy at this point…Actually it can be quite healthy…Increasing prices are GOOD for Business and Increasing wages are GOOD for Workers…

PriceLevel

Real GDP

SRASLRAS

FERGDP

AD1

PL1

RGDP1

AD2

RGDP2

AD3

RGDP4

AD4

RGDP3

PL2

AD5

PL3

RGDP5

As a matter of fact, when AD5 intersects SRAS and LRAS the Economy is considered to be at FULL-EMPLOYMENT---The Sweet Spot for this economy…The total demand for goods and services EQUALS the economy’s ability to produce those goods and services in the Short Run (SRAS) AND the Long Run (LRAS)

Unemployment Rate5%(?)=NRU

PriceLevel

Real GDP

SRASLRAS

FERGDP

AD1

PL1

RGDP1

AD2

RGDP2

AD3

RGDP4

AD4

RGDP3

PL2

AD5

PL3

RGDP5

At FULL-EMPLOYMENT we have eliminated the Recessionary Gap. A couple of KEY points about this Equilibrium:

1.The economy is at its Natural Rate of Unemployment (Frictional + Structural) with NO cyclical unemployment

PriceLevel

Real GDP

SRASLRAS

FERGDP

AD1

PL1

RGDP1

AD2

RGDP2

AD3

RGDP4

AD4

RGDP3

PL2

AD5

PL3

RGDP5

At FULL-EMPLOYMENT we have eliminated the Recessionary Gap. A couple of KEY points about this Equilibrium:

2. The Economy is at its: “NON-ACCCELERATING

INFLATION RATE OF UNEMPLOYMENT

(NAIRU)Fancy way of saying we are “Inflation Neutral” at the Natural Rate of Unemployment

(NRU)

PriceLevel

Real GDP

SRASLRAS

FERGDP

AD1

PL1

RGDP1

AD2

RGDP2

AD3

RGDP4

AD4

RGDP3

PL2

AD5

PL3

RGDP5

AD6

PL4

RGDP6

If the AD shifts to AD6 the economy has now gone beyond FULL-EMPLOYMENT and is now producing RGDP6 . The unemployment rate is now something LESS than the NRU (wages will start to increase faster)…The Economy is starting to overheat !(Demand for goods and services is GREATER than the economy’s ability to produce goods and services!...

Unemployment Rate3%-- less than theNRU

Infla

tiona

ryG

ap

PriceLevel

Real GDP

SRASLRAS

FERGDP

AD1

PL1

RGDP1

AD2

RGDP2

AD3

RGDP4

AD4

RGDP3

PL2

AD5

PL3

RGDP5

AD6

PL4

RGDP6

PL5

RGDP7

AD7

If AD increases to AD7 then we have a LARGE increase in PRICE LEVEL with NO increase in RGDP (RGDP7 = RGDP6 ) This economy is in TROUBLE---INFLATION Is the Problem of the Day….

Infla

tion

ary

Gap

Price Level

Real GDPFeRGDP

LRASSRAS

AD

PL1

RGDP1

PL*


What happened to:

Price Level INC DEC

RGDP INC DEC

Unemployment INC DEC

AD1

Price Level

Real GDPFeRGDP

LRASSRAS

ADPL1

PL*

AD1


What happened to:

Price Level INC DEC

RGDP INC DEC


RGDP1

Price Level

Real GDPFeRGDP

LRASSRAS

AD

PL1

PL*


What happened to:

Price Level INC DEC

RGDP INC DEC


SRAS1

STAGFLATION

RGDP1

Price Level

Real GDPFeRGDP

LRASSRAS

AD

PL1

RGDP1

PL*


What happened to:

Price Level INC DEC

RGDP INC DEC


SRAS1

Directions for the next set of slides: Analyze the situation or event and

determine the effect on AD or short run AS. Shift the appropriate curve and

determine change in PL, Real GDP and Unemployment.

Price Level

Real GDPFeRGDP

LRAS SRAS

AD

PL1

RGDP1

PL*


What happened to:

Price Level INC DEC

RGDP INC DEC


AD1

Congress passes a tax cut for the middle class, and the president signs it.

Price Level

Real GDPFeRGDP

LRAS SRAS

AD

PL1

RGDP1

PL*


What happened to:

Price Level INC DEC

RGDP INC DEC


SRAS1

New oil discoveries cause large decreases in oil prices

Price Level

Real GDPFeRGDP

LRAS SRAS

AD

PL1

RGDP1

PL*


What happened to:

Price Level INC DEC

RGDP INC DEC


AD1

The government increases spending on schools, highways, and other public works

Price Level

Real GDPFeRGDP

LRASSRAS

AD

PL1

PL*


What happened to:

Price Level INC DEC

RGDP INC DEC


SRAS1

STAGFLATION

RGDP1

Production costs increase nationwide

Price Level

Real GDPFeRGDP

LRAS SRAS

AD

PL1

RGDP1

PL*


What happened to:

Price Level INC DEC

RGDP INC DEC


SRAS1

New technology and better education increase productivity.

Price Level

Real GDPFeRGDP

LRAS SRAS

AD

PL1

RGDP1

PL*


What happened to:

Price Level INC DEC

RGDP INC DEC


AD1

A new president makes consumers and businesses more confident about the future economy

Price Level

Real GDPFeRGDP

LRAS SRAS

AD

PL1

RGDP1

PL*


What happened to:

Price Level INC DEC

RGDP INC DEC


AD1

With the unemployment rate at five percent, the federal government reduces personal taxes and increases spending

Price Level

Real GDPFeRGDP

LRAS SRAS

AD

PL1

RGDP1

PL*


What happened to:

Price Level INC DEC

RGDP INC DEC


AD1

Foreign incomes increase

Price Level

Real GDPFeRGDP

LRASSRAS

ADPL1

PL*

AD1


What happened to:

Price Level INC DEC

RGDP INC DEC


RGDP1

Excess plant capacity increases.

Price Level

Real GDPFeRGDP

LRASSRAS

AD

PL1

RGDP1

PL*


What happened to:

Price Level INC DEC

RGDP INC DEC


SRAS1

Dollar appreciates; relative prices of imported resources fall.

Price Level

Real GDPFeRGDP

LRASSRAS

ADPL1

PL*

AD1


What happened to:

Price Level INC DEC

RGDP INC DEC


RGDP1

Consumer indebtedness increases; consumption falls

Price Level

Real GDPFeRGDP

LRASSRAS

ADPL1

PL*

AD1


What happened to:

Price Level INC DEC

RGDP INC DEC


RGDP1

Interest rates rise; business investment falls.

Price Level

Real GDPFeRGDP

LRASSRAS

AD

PL1

RGDP1

PL*


What happened to:

Price Level INC DEC

RGDP INC DEC


SRAS1

A new administration increases subsidies to businesses.

Price Level

Real GDPFeRGDP

LRAS SRAS

AD

PL1

RGDP1

PL*


What happened to:

Price Level INC DEC

RGDP INC DEC


AD1

Promising research increases business profit expectations.

Download - Aggregate Demand/Aggregate Supply The Alpha and Omega of Macroeconomics Graphs

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