Aggregate Supply & Aggregate Demand

Aggregate Supply
The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output.

Similar to the Supply curve in a goods market, except now we are talking about macroeconomic aggregates.
Real GDP for Aggregate Output How do measure aggregate output? The GDP Deflator for Aggregate Price Level aggregate price level?

SHORT-RUN Aggregate Supply

Short-Run: The time period where many production costs can be taken as fixed. The short-run aggregate supply curve is upward-sloping because nominal wages (or prices) are sticky in the short run.
Producers are motivated & signaled by profits. a higher aggregate price level leads to higher profits and increased aggregate output in the short run (and vice versa).

The Short-Run Aggregate Supply Curve

Recall: What Shifts Supply & Demand

Shifting Short-Run Aggregate Supply

Input Costs:
Commodity Prices (Oil and otherwise) Nominal Wages (COLAs, Healthcare Costs)

Productivity:
Produce more output with the same inputs Increase in technology Change in regulation Natural Disaster

Profits Change at Every Price Curve Shifts!

A Decrease in SRAS: Shift Left

An Increase in SRAS: Shift Right

LONG-RUN Aggregate Supply

Long-Run: The time period where all prices including nominal wages are fully flexible. The long-run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible.

LONG-RUN Aggregate Supply

The Long-Run Aggregate Supply curve (LRAS) is vertical because changes in the aggregate price level have no effect on aggregate output in the long run.
How can this be?

What would happen to the profitability of firms if all prices dropped by the same %. What if every rise in commodity price was offset by a decrease in wages?

Potential Output
Potential Output: The level of real GDP the economy would produce if all prices, including wages, were fully flexible.
Land & Physical Capital Y(Long Run Real Output) = F(Capital, Labor, Human Capital, Technology) Labor & Human Capital Technology

Recall: Determined by the Factors of Production The Aggregate Production Function

What equation describes this level?

Y = F ( K, L, H, T )

The Long-Run Aggregate Supply Curve

Actual vs. Potential Output

Growth and Potential Output

What causes potential output to grow or change over time? Aggregate Production Function This is the Economic Growth story from Ch.8 Changes to Physical and Human Capital as well as changes in Technology increase Potential Output over time.

Actual vs. Potential Output

Technology and Productivity

Economic Growth Shifts LRAS Right

Short-Run to the Long-Run

At any point in time the economy is either operating on the SRAS or the LRAS. It is possible to be on both the SRAS and LRAS at their intersection, but as shown before this is rarely the case 3 or 4 times in last 30 years.

LRAS helps us understand how the SRAS So if it is rarely on the LRAS why do we even will shift and change when the economy is put it on the graph? not operating on the LRAS curve.

From Short-Run to Long-Run

Leftward Shift of the Short-run Aggregate Supply Curve

From Short-Run to Long-Run

Rightward Shift of the Short-run Aggregate Supply Curve

Aggregate Demand
The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, and the government. Aggregate Demand is downward/negatively sloped just as before. We have more specific names for why it is negatively sloped.

The Wealth Effect

Wealth Effect: The effect on consumer spending caused by the effect of a change in the aggregate price level on the purchasing power of consumers ASSETS.
Higher prices mean you cannot buy as much stuff with the same assets. This is the similar to what would happen if your wealth went down.

MOVEMENT ALONG!

The Interest Rate Effect

Interest Rate Effect: The effect on consumer spending caused by the effect on the purchasing power of consumers and firms MONEY HOLDINGs.
Higher prices mean you need more cash to maintain the same level of purchasing.
Increased borrowing drives interest rates up Households save more and consume less Invesment spending falls

MOVEMENT ALONG!

The Aggregate Demand Curve

Shifting Aggregate Demand

Changes in Expectations:
Positive or Negative

Changes in Wealth:
Changes in wealth unrelated to the wealth effect Housing boom -- lead to home equity loans Stock market boom higher asset value of savings

Changes in the Stock of Physical Capital:

High level of capital lower investment spending Low level of capital higher investment spending

A Decrease in AD: Shift Left

An Increase in AD: Shift Right

End of Chapter 10 Part 1 Next Time:

1. Marginal Propensity to Consume/Save 2. Multipliers 3. The AS-AD Model of the Economy

Government Policy
Fiscal Policy: Affects aggregate demand directly through government purchases, and indirectly through changes in taxes and transfer payments. Monetary Policy: Affects aggregate demand indirectly through changes in interest rates.

Expansionary vs. Contractionary

Expansionary Fiscal/Monetary Policy:
Shifts Aggregate Demand to the RIGHT

Contractionary Fiscal/Monetary Policy:

Shifts Aggregate Demand to the LEFT

Marginal Propensity to Consume (MPC)

Marginal Propensity to Consume (MPC): The increase in consumer spending when disposable income rises by $1.

Example: If your disposable income went up $1000 and you spent $600 of that additional income.

Consumer Spending $600 MPC = 0.60 Disposable Income $1000

Marginal Propensity to Save (MPS)

Marginal Propensity to Save (MPS): The increase in household savings when disposable income rises by $1.
Household Savings MPS = 1 MPC Disposable Income
Example: If your disposable income went up $1000 and you saved $400 of that additional income.

$400 MPS 0.4 $1000 MPS 1-MPC 1-0.6 0.4

MPC and Rounds of Spending

Consider a $50 billion increase in investment spending.
Which curve shifts? AD or SRAS? AD Shifts RightBut, how far does it shift?

Round 1: $50 Billion Investment Spending Round 2: Increased Output Flows Back to Households as Disposable Income and they spend: MPC x $50 Billion = $30 Billion

MPC and Rounds of Spending

Round 3: That $30 Billion of Consumption induces firms to increase output again.Which flows back to households through wages and profits which increases DI of which they spend: MPC x $30 Billion = $18 Billion or MPC x MPC x $50 Billion = $18 Billion

This goes on and on and on.

MPC and Rounds of Spending

AAS & The Multiplier

Autonomous Change in Aggregate Spending (AAS): Initial change in the desired level of spending by firms, households, or government at a given level of real GDP. The Multiplier: Ratio of the total change in real GDP caused by AAS to the initial size of the AAS.
Y 1 Multiplier = AAS 1 MPC

The Total Increase in Real GDP

The Total Increase in Real GDP from a change in AAS is given by:
1 Y AAS 1 MPC Our Example:

1 Y $50 Billion Investment 1 0.60 =$50 Billion 2.5 $125 Billion

AAS and the Multiplier

Practice Problem
1.Assume the MPC is 0.75. What is the value of the Multiplier? 2.Assume Investment Spending increases by $20 Billion and the MPC is 0.75. Calculate the first through the fourth rounds of spending in the economy. 3.Assume investment spending increases by $20 Billion and the MPC is 0.75. Calculate the total change in GDP arising from this increase in investment spending.

The AS-AD Model

The AS-AD Model simply uses the Aggregate Supply curve and the Aggregate Demand curve to analyze economic fluctuations.

Short-Run Macro Equilibrium

The economy is in short-run macroeconomic equilibrium when the quantity of aggregate output supplied is equal to the quantity demanded. The short-run equilibrium aggregate price level is the aggregate price level in the short-run macroeconomic equilibrium.

Short-run equilibrium aggregate output is the quantity of aggregate output produced in the shortrun macroeconomic equilibrium.

Shifts of SRAS

Stagflation: Combination of inflation and falling output.

Shifts of SRAS

Shifts of AD

Shifts of AD

Long-Run Macro Equilibrium

Long-run macroeconomic equilibrium when the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve.

Negative Demand Shock

Recessionary gap

Positive Demand Shock

Inflationary gap

Self-Correcting
In the long run the economy is self correcting: shocks to aggregate demand do not affect aggregate output in the long run.

Negative Supply Shocks

Negative Supply Shocks Pose a Policy Dilemma: A policy that stabilizes aggregate output by increasing aggregate demand will lead to inflation, but a policy that stabilizes prices by reducing aggregate demand will deepen the output slump.

Negative Supply Shocks

Must Balance Between Unemployment and Inflation! Active stabilization policy, using fiscal or monetary policy to offset demand shocks:
Fiscal policy affects aggregate demand directly through government purchases and indirectly through changes in taxes or government transfers that affect consumer spending. Monetary policy affects aggregate demand indirectly through changes in the interest rate that affect consumer and investment spending.