13 The Aggregate Demand and Aggregate Supply Model

pg 402-437

Misconception - Recession are inevitable and occurs every few years.

What is aggregate demand-aggregate supply mode?

In macroeconomics, there two major paths of study.

1. Long-run growth and development. (5-10 years)
2. Short-run fluctuations, or business cycles. (5 years or less)

The model we used to study business cycles is the AD-AS model.

• Aggregate demand is the total demand for final goods and servics in an economy.
• Aggregate supply is the total supply for final goods and servics in an economy.

What is agggregate demand?

There are four major pieces in agggregate demand: consumption (C), investment (I), government spending (G), and net exports (NX).

$AD = C + I + G + NX$

Graph (price level as y-axis, and real GDP as x-axis)

The Slope of the Aggregate Demand Curve

• The wealth Effect - the change in the quantity of AD that results from wealth change due to price level change.

Wealth is the net value of one's accumulated assets

• The Interest Rate Effect - a change in the price level leads to a change in interest rates and therefore in the quantity of aggregate demand.
• The International Trade Effect - a change in the price level leads to a change in the quantity of net export demanded.

Shifts in Aggregate Demand

• Shift in Consumption - change in wealth not caused by price level, consumer confidence (expectations), and taxes.
• Shift in Investment - interest rate
• Shift in Governement Spending - policies
• Shift in Net Exports -
  1. Foreign Income - AD shift right as foreign income increase.
  2. Exchange Rate - When dollar is week, foreign currency buy more us dollars, exports increases, AD shift right. When dollar is strong, exports falls, AD shift left

Other factors that shift AD curve

• Distribution of Income - the more equal, or the less degree of income inequality, AD shift right.
• Monetary & Fiscal Policies
  • Expansionary policy $\Rightarrow$ AD shift right
  • Contractionary policy $\Rightarrow$ AD shift left

What is agggregate supply?

In macroeconomics, the long run is a period of time sufficient for all prices to adjust. The short run is the period of time in which some prices have net yet adjusted.

Long-Run Aggregate Supply

The long-run output of economy depends on resources, technology, and institutions. In the short-run, there may be fluctuations in real GDP, but in the long run the economy moves toward full-employment output ($Y^*$). The price level does not affect long-run aggregate supply.

Figure 13.7
The long-run aggregate supply curve
THe LRAS curve is vertical at $Y^*$ because in the long run the price level does not affect the quantity of aggregate supply. $Y^*$ is full-employment output, where the unemployment rate ($u$) is equal to the natural rate ($u^*$).

Shift in the Long-Run Aggregate Supply

The factors that shift long-run aggregate supply are the same factors that determine economic growth: resources, technology, and institutions.

Short-Run Aggregate Supply

In short-run there is a positive relationship between the price level and the quantity of aggregate supply. There are three reasons for this relationship: inflexible input prices, menu costs, and money illusion.

Figure 13.9
The Short-Run Aggregate Supply Curve
The positive slope of the short-run aggregate supply curve indicate that increases in the economy's price level lead to an increase in quantity of aggregate supply in the short run. For example, if the price level rises form 100 to 110, the quantity of aggregate supply rises from \$ 18 trillion ton $ 19 trillion in the short run. The reason is that some prices are sticky in the short run.

Shifts in Short-Run Aggregate Supply

The primary cause of shift in short run aggregate supply is changes in input or resource prices.

• Unions negatiating wages
• Supply shock - supprise events that change a firm's production costs. (Negative or Positive)
• Change to the amount of resource, or how we use the resource (productivity)
• Change to wages - as wages increases, SRAS shift left

How does the aggregate demand-aggregate supply model help us understand the economy?

The economy tends to move to the point at which aggregate demand is equal to aggregate supply.

Equilibrium in the Aggregate Demand-Aggregate Supply Model

$LRAS = SRAS = AD$

Five steps to assess the impact of the change on real GDP, unemployment and the price level.

1. Begin with the model in long-run equilibrium.
2. Determine which curves(s) are affected by the changes, and identify the directions of changes
3. Shift the curve in appropriate directions.
4. Determine the new short-run and/or long-run equilibrium points.
5. Compare the new equilibrium points with the starting point.

LRAS - our potential output (being on the PPF)
if SR equilibrium < LR equilibrium $\Rightarrow$ Recession
if SR equilibrium > LR equilibrium $\Rightarrow$ Expansion

Adjustments to Shift in Long-Run Aggregate Supply

Adjustments to Shift in Short-Run Aggregate Supply

Adjustments to Shift in Aggregate Demand

Summary of Results from Aggregate Demand Shifts

Increase in Agggregate Demand

Decrease in Agggregate Demand