Chapter 26 Macroeconomics- The Aggregate Demand-Aggregate Supply Model

Macroeconomics Chapter 26: The Aggregate Demand-Aggregate Supply Model The Basics of the Aggregate Demand-Aggregate Supply Model • The model we use to study business cycles • Aggregate demand: the total demand for final goods and services in an economy. • Aggregate supply: the total supply of final goods and services in an economy. • The word “aggregate” means total. • We can use the aggregate demand–aggregate supply model to see how changes in either aggregate demand or aggregate supply (or both) affect real GDP, unemployment, and the price level. Aggregate demand • sum up spending from different sources in the economy. o Ex: domestic consumers (homes, cares, shoes), government (labor and resources) business firms (resources, etc) o Four main groups of aggregate demand: ▪ consumption (C) ▪ investment (I) ▪ government spending (G) ▪ net exports (NX) o AD = C + I + G + NX • Graphing aggregate demand o Horizontal axis: final quantities of final goods and services o Vertical axis: overall price level o aggregate demand does not slope downward for the same reason that individual demand curves slope downward (not impacted by substitution) o negative slope of the aggregate demand curve means that increases in the price level lead to decreases in the quantity of aggregate demand o The aggregate demand curve slopes downward because: ▪ When the price level increases, the real value of wealth falls and therefore buyers want to purchase less. ▪ When the price level increases, people save less, thus interest rates rise and investment falls. ▪ When the price level increases, U.S. exports become relatively more expensive for foreign buyers and they want to purchase less. o When the price level rises from 100 to 110, consumption (C) declines from the wealth effect, investment (I) declines via the interest rate effect, and net exports (NX) fall due to the international trade effect (movement ALONG curve) ▪ The Wealth Effect: change in the quantity of aggregate demand that results from wealth changes due to price-level changes • a rise in prices all over the economy reduces real wealth in the economy, and then the quantity of aggregate demand falls • ▪ most significant Interest Rate Effect: a change in the price level leads to a change in interest rates and therefore in the quantity of aggregate demand • When savings decline, quantity of investment also declines, impacting aggregate demand • ▪ Decreases in investment decreases aggregate demand International Trade Effect: a change in the price level leads to a change in the quantity of net exports demanded • When prices of US goods rise relative to foreign goods, US exports fall and imports rise • ^^ GDP shrinks • • Smaller impact Shifts in aggregate demand o Shift in consumption: more money, more consumption, more aggregate demand ▪ When wealth falls, consumption declines, so does aggregate demand ▪ This is applicable to changes in wealth NOT due to price level ▪ Expected future income: if people expect to make more in the future, they spend more today ▪ Consumer confidence index: uses survey data to estimate how consumers feel about the future direction of the economy (measures expected future income) o Shifts in investment: occurs when firms decide to increase or decrease spending on capital goods ▪ a decrease in investor confidence might lead to a decrease in investment and thus a decrease in aggregate demand. ▪ An increase in interest rates makes investment more expensive for firms, and so aggregate demand decreases ▪ More money = lower interest rates = higher aggregate demand o Shifts in government spending: new policies and purchases ▪ Often results from responses to economic conditions ▪ If consumption/investment fall, government may increase spending to counteract that o Shifts in net exports: when income of foreign people grows, demand for US goods increase ▪ Exchange rates impact aggregate demand by changing net exports ▪ When the value of the dollar rises relative to the currency of other nations, imports seem less expensive o Factors that shift aggregate demand: • Summarized impacts on aggregate demand: o Aggregate output increases, price level increases > Aggregate demand shifts to the right. o Aggregate output falls, unemployment rate falls > Aggregate demand shifts to the left. o An increase in the price level in the economy impacts the quantity of aggregate demand, but does not shift the aggregate demand curve. o If the price level in the United States decreases relative to the price level in other countries, net exports increases, and the quantity of aggregate demand will increase. o Lower expectations of future income shift the aggregate demand curve left Aggregate Supply • aggregate supply: the spending desires of an economy • Long-run: period of time sufficient for all prices to adjust • Short-run: only some prices change/adjust • Long-run aggregate supply: (LRAS) o economy’s price level (P) on the vertical axis and real GDP (Y) on the horizontal axis, long-run aggregate supply is a vertical line at Y*, which is full-employment output o full-employment output: the output produced in the economy when unemployment (u) is at the natural rate (u*). This is the output level that is sustainable for the long run in the economy o Shifts in the long-run aggregate supply: caused by the same factors that determine economic growth: resources, technology, and institutions. ▪ Leftward shift: unemployment rate has not changed but workers are less productive ▪ Aggregate output decreases > LRAS shifts to the left. ▪ New resources or technology > LRAS shifts right • ▪ Broken institutions > LRAS shifts left ▪ More unemployment benefits > LRAS shifts left ▪ Less labor force > LRAS shifts left Short-run aggregate supply: (SRAS) o positive relationship between the price level and the quantity of aggregate supply o input prices are sticky, because they “stick” at a certain level and take time to change (typically solidified by a contract) but output prices are flexible ▪ ^ Both impact how firms react when prices do move ▪ because your costs don’t rise but your revenues do, it makes sense for you to increase output. When firms raise output, GDP rises. o Menu costs ▪ If firms decide to increase output rather than print new menus, the quantity of aggregate supply increases o Money illusion: when people interpret nominal values as real values ▪ if output prices are falling but workers are reluctant to accept nominal pay decreases, they reinforce the stickiness of input prices o Any type of price stickiness leads to a positively sloped aggregate supply curve in the short run • Shifts in the aggregate supply: when the long-run aggregate supply curve shifts, it signals a permanent change (all long-run shifts leads to short-run shifts) o Input or resources: When firms’ production costs fall, firms produce more output at any given price level, which means that short-run aggregate supply increases ▪ Could change due to union bargaining, inflation, o Higher expected future prices leads to lower quantity of aggregate supply o Supply shocks: events that change a firm’s production costs ▪ If they are temporary, they only impact the short-run aggregate curve ▪ Can be positive or negative (higher input and production costs) ▪ Can include a price change in an important production factor o The price level increases or decreases > the SRAS curve will remain unchanged o Right SRAS shifts: ▪ Input prices decrease > the SRAS curve will shift right ▪ unemployment falls, price level falls > SRAS shifts to the right. ▪ Firms and workers expect the price level to fall > the SRAS curve will shift right ▪ Wages fall o Left SRAS shifts: ▪ The number of workers in the labor force increases > the SRAS curve will shift right ▪ New policies cause an increase in the cost of meeting government regulations > the SRAS will shift left Equilibrium • Equilibrium: the point where opposing forces of supply and demand are balanced • Prices naturally adjust to scooch the economy closer to equilibrium • Long-run equilibrium requires long-run and short-run aggregate supply to equal aggregate demand • If the price level is too high, producers are producing more than consumers desire at current prices. Therefore, prices naturally begin to fall to eliminate a potential surplus of goods and services. • As prices fall, the quantity of aggregate demand increases and the economy moves toward a new equilibrium at P*. • LRAS = SRAS = AD • Y = C + I + G + NX where Y is aggregate supply/real GDP produced • A change in equilibrium: o Begin with the model in long-run equilibrium. o Determine which curve(s) are affected by the change(s), and identify the direction(s) of the change(s). o Shift the curve(s) in the appropriate direction(s). o Determine the new short-run and/or long-run equilibrium points. o Compare the new equilibrium point(s) with the starting point. Results of Shifts • Results of long-run aggregate shifts: o technological progress leads to more output and a lower price level, which drops from 100 to 95 but doesn’t impact employment, just worker productivity o Right shifts in long-run aggregate supply: new resources or favorable institutions • Results of shifts in the short-run aggregate supply o Negative supply shocks shift it left, new equilibrium is left, higher price level, and lower level of output o Short-run disruptions in aggregate supply do not alter the long-run equilibrium o economic downturn brings higher unemployment and lower real GDP. • Results of shifts in aggregate demand o consumers start spending more > increased aggregate demand o Expectations o short-run equilibrium is associated with higher prices (P = 105) and higher real GDP (Y1) o Demand changes have no real affect in the long run because price level (a nominal variable) is the only thing affected o After all prices have adjusted, the price level does not affect the quantity of output Bonus: • Variables: o aggregate output (Y) o the price level (P) o the unemployment rate (u). • Impacts on unemployment: o Increased by: negative supply shock (raised prices), US dollar gaining value o Decreased by: increasing real estate values, more exports, high income expectations • GDP is mostly consumption then investments then net exports • Money illusion, menu costs, and sticky prices explain why the SRAS is sloped rather than vertical • Given that there is always some inflation, an increase in the price level is observed as a temporary increase in the inflation rate. • When the price level falls, household real wealth will increase and consumption spending will rise. Therefore, the quantity of aggregate demand will increase • If the price level falls, people will save more and the interest rate will fall. Firms, therefore, will increase investment spending • Since real output rose, and unemployment and the price level fell, there was an increase in short-run aggregate supply. • Increases in aggregate demand and short-run aggregate supply are necessary for the economy to experience long-run economic growth. • an increase in aggregate demand in the short run o price level and output increase o unemployment decreases • Graph of all the lines o A: Full-employment output o B: Aggregate demand o C: Long-run aggregate supply o D: Short-run aggregate supply o E: Equilibrium price level o F: Output when unemployment is below the natural rate o G: Output when unemployment is above the natural rate o H: Price level where producers are producing more than buyers desire o I: Price level where buyers desire more than producers are willing to supply