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AggregateDemandandAggregateSupply

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Aggregate Demand and Aggregate Supply

LEARNING OBJECTIVES

1. AggregateDemand(AD)has5 LearningObjectives

2. AggregateSupply(AS)alsohas5

3. MacroeconomicEquilibriumintheAD/ASModelhas2

The Learning Objectives in this presentation

are covered in Chapter 20:

Aggregate Demand and Aggregate Supply

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Today, many economies, including the US, the UK and the Eurozone are suffering from weak GDP and high unemployment; some are still in recession.

Most economists think the cause is a lack of Aggregate Demand (low levels of spending)

The Aggregate Demand and Aggregate Supply Models help explain short-run fluctuations in Output, Prices and Employment.

Making theConnection

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Aggregate Demand (AD)

LEARNING OBJECTIVES

1. TounderstandAggregateDemand(AD)isitscomponents

2. TounderstandwhytheADCurveSlopesDownwards

3. ToidentifythedifferencebetweenaMovementAlongtheCurveandaShiftintheCurve

4. ToidentifythevariablesthatshifttheADcurve

5. TounderstandtheimpactofmacroeconomicpolicyonAD

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Components of Aggregate Demand

› AggregateDemandisthetotallevelofplannedspendingongoodsandservicesinaneconomybyhouseholds,businesses,governmentandforeignparties.AD(alsosumstoexpenditurebasedGDP)andhasfourcomponents:

› Consumption(C)

› Investment(I)

› Governmentpurchases(G)

› NetExports(NX)

› IfweletY standforAD,wecanwritethefollowing:

› Y=C+I+G+NX

LEARNING OBJECTIVE: (1) ONESee Chapter 20 for more details

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The Aggregate Demand Curve

› TheADCurveshowsthelevelofplanneddemandforrealoutputconsistentwithaparticularpricelevelrelationship

Price Level (P)

Real GDP (Y)

Y1Y2

P2

P1

AD

LEARNING OBJECTIVE: (1) ONESee Chapter 20 for more details

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Why does the AD Curve Slope Downwards?

TherearethreemainreasonsforaninverserelationshipbetweenADandthepricelevelinaneconomy(i.e.adownwardslope):

1. TheWealthEffect

› Thisaffectsconsumption

2. TheInterestRateEffect

› Thisaffectsinvestment

3. TheInternational‐tradeEffect

› Thisaffectsnetexports

Price Level (P)

Real GDP (Y)

AD

LEARNING OBJECTIVE: (1) TWOSee Chapter 20 for more details

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Why does the AD Curve Slope Downwards?

HowaChangeinthepricelevelaffectsConsumption |TheWealthEffect

› Whenpricesrisethemoneypeoplehavebuysfewergoodsandservices,sorealwealthislower,peoplefeelpoorerandCgoesdown. P⬆∴ AD⬇

HowachangeinthepricelevelaffectsInvestment |Interest‐RateEffect

› Ariseinpricesleadstoincreasedmoneydemandandrisinginterestrates.Investmentis

thusaffectednegatively. P⬆∴ AD⬇

HowachangeinthepricelevelaffectNetexports| International‐TradeEffect

› Whenpricesrise,exportsbecomemoreexpensiveandsoforeigndemandforthemfalls,

atthesametimeimportsbecomecheaper,thusnetexportsdecline.P⬆∴ AD⬇

LEARNING OBJECTIVE: (1) TWOSee Chapter 20 for more details

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Aggregate Demand Curve

› ChangesinP causemovements up ordownagivenADCurve

› AnincreaseinP reducesthequantityofGoodsandServicesdemandedbecause:

› Thewealtheffect

(C)falls

› Theinterest‐rate

effect(I)falls

› TheInternational‐Trade

effect(NX)falls

Price Level (P)

Real GDP (Y)

Y1Y2

P2

P1

AD

Y3

P3

A rise in the P from P1 to P2 causes a contraction in AD (moves up)

A fall in P from P1 to P3 causes an expansion in AD (moves down)

LEARNING OBJECTIVE: (1) TWOSee Chapter 20 for more details

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Shifts of the AD Curve Vs. Movements Along it

› AnimportantpointtonoteisthattheADCurve– holdingeverythingelseconstant – tellsustherelationshipbetween

› thePriceLeveland thequantity ofrealGDPdemandedinaneconomy

› OnlyachangeinthepricelevelwillcauseamovementalonganexistingADcurve.

› Whenanyvariable,otherthanprice,changesandaffectsthewillingnessoffirms,householdsandgovernmenttospend,thentheADwillshift.

LEARNING OBJECTIVE: (1) THREESee Chapter 20 for more details

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Why might the AD Curve Shift?

AnyeventthatchangesC,I,G,orNX – exceptachangeinP – willcauseashifttheADCurve.

Price Level (P)

Real GDP (Y)

Y1 Y2

P1

AD1 AD2

LEARNING OBJECTIVE: (1) THREESee Chapter 20 for more details

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Variables that Shift the AD Curve

ThevariablesthatcausetheADcurvetoshiftfallintofourcategories:

Changesin…

1. Businessandhouseholdexpectations

2. Householdwealth

3. Foreignvariables

4. GovernmentandCentralBankmacroeconomicpolicies

LEARNING OBJECTIVE: (1) FOURSee Chapter 20 for more details

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Variables that Shift the AD Curve (1)

1. Changesintheexpectationsofbusinessesandhouseholds

› Household/businessoptimismorconfidenceaboutfutureincome/profitabilityhasa

powerfulaffectontheirspending andisaffectedbyexpectationsaboutthefuture

growthoftheeconomyandinflation.

2. Changesinhouseholdwealth

› Wealthisthevalueofassetsowned.Thusachangeinhouseorsharepricesinfluences

wealthandinturnalsoaffectsconsumerconfidence.

3. Changesinforeignvariables

› Achangeinthevalueoftheexchangerateandforeignincomeaffectsthedemandfor

exportsandtheNXcomponentofAD.

LEARNING OBJECTIVE: (1) FOURSee Chapter 20 for more details

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4. ChangesinGovernmentandCentralBankPolicies

› Fiscalpolicy|Referstochangesingovernmentspending,welfarebenefitsand

taxationandtheamountthegovernmentborrows.

› Changesinfederalincometax,corporatetaxes,governmentpurchasesandtransferpayments,allaffectAD.

› Monetarypolicy|Theactionsthecentralbanktakestomanagethemoneysupplyandinterestratestopursuemacroeconomicpolicyobjectives.

› Changesintheinterestrateaffecttheincentivesofhouseholdsandbusinessesto

borrowandsave.

› Theavailabilityofcreditfrombankswillalsoaffectborrowingtofinanceconsumptionorinvestment.

Variables that Shift the AD Curve (2)LEARNING OBJECTIVE: (1) FIVESee Chapter 20 for more details

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Shifts in the AD Curve to the Right (Summary)

VariablesthatShifttheADCurvetotheright:

Price Level (P)

Real GDP (Y)

AD1 AD2

Anincreasein…

Governmentpurchases

Households’expectationsoftheirfutureincomes

Firm’sexpectationsofthefutureprofitabilityofinvestmentspending

shiftstheADCurveright because…

Thesearecomponentsofaggregatedemand

Consumptionspendingincreases

Investmentspendingincreases.

LEARNING OBJECTIVE: (1) FIVESee Chapter 20 for more details

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Shifts in the AD Curve to the Left (Summary)

VariablesthatShifttheADCurvetotheleft:

Price Level (P)

Real GDP (Y)

AD2 AD1

Anincreasein…

Interestrates

Taxes

ThegrowthrateofdomesticGDPrelativetothatofforeignGDP

Theexchangerate(valueofdomesticcurrency)relativetoforeigncurrencies.

shiftstheADCurveleft because…

raisesthecostofborrowing,reducingconsumptionandinvestment

theycauseconsumptionandinvestmenttofall

Exportswillfall,reducingnetexports

Importswillriseandexportswillfall,reducingnetexports

LEARNING OBJECTIVE: (1) FIVESee Chapter 20 for more details

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Theimmediatecausehasbeenadeclineinaggregatedemand.Dueto:

› Afallinconsumerdemand,resultingfromhigh unemploymentratesandasqueezeonrealwages(frozenorevenreduced);

› Inflationandtaxrises;

› Thegovernment’sausterityprogrammeiscurtailingfiscalexpenditure;

› ExportgrowthhasbeenconstrainedbyaslowingdownintheglobaleconomyandespeciallyintheEurozone(theUK’smaintradingpartner);

› Investmentisbeingheldbackbypessimisticbusinesssentimentanddifficultiesinraisingfinance.

| Source: The Sloman Economics News site: http://pearsonblog.campaignserver.co.uk/?tag=aggregate-demand

LEARNING OBJECTIVE: (1) FIVESee Chapter 20 for more details

The UK economy shrank by a further 0.7% in Q2 of 2012, meaning that was the longest “double dip” recession in over 50 years.

Making theConnection

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Situations to Consider…

Explainhow and why eachofthefollowingfactorswillinfluencecurrent(short‐run)aggregatedemandintheUAE:

1. Businessesbecomemoreoptimisticaboutthefuture

2. TheUAECentralBanklowersinterestrates

3. TheUAEGovernmentincreasesspendingoninfrastructure

4. InflationriseswithintheUAE(becarefulwiththisone!)

5. LowerrealincomeinAsia(akeyexportmarketfortheUAE)

6. Thereisapricecollapseintherealestatesector

7. UAEstockmarketsfallsharply.

LEARNING OBJECTIVE: (1) TWO to FIVE

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Aggregate Supply (AS)

LEARNING OBJECTIVES

1. TounderstandthedeterminantsofLong‐RunAggregateSupply(LRAS)

2. ToidentifythevariablesthatshifttheLRASCurve

3. TounderstandthedeterminantsofShort‐RunAggregateSupply(SRAS)

4. TounderstandwhytheSRAScurveslopesupwards

5. ToidentifythevariablesthatshifttheSRAScurve

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Long Run Aggregate Supply

› LRAS

› LRASislocatedatpotentialGDP– itrepresentsalevelofrealnationaloutputintheeconomy

› PotentialGDPisassumedtobeindependentofthepricelevel(moneyisneutral).

› LRASisdeterminedbytheproductiveresourcesavailabletomeetdemandandbytheproductivityofthefactorinputs(labour,landandcapital).

› LRAScurve

› AcurvethatshowstherelationshipinthelongrunbetweenthepricelevelandthequantityofrealGDPsupplied.

LEARNING OBJECTIVE: (2) ONESee Chapter 20 for more details

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TheLong‐RunAggregateSupplyCurve(LRAS)

Changesinthepriceleveldonotaffect

thelevelofAS inthelongrun.

Therefore,theLRAS,isaverticallineat

thepotentiallevelofrealGDP.

Anincreaseinthequantityand

productivityoffactorsofproduction

oranadvanceintechnologycausesan

increaseintheproductivepotentialof

theeconomy.

i.e.anoutwardshiftintheLRAScurve.

The LRAS Curve

Price level (P)GDP deflator, 2000 = 100

Real GDP (Y)Trillions of 2000 $ dollars

12.0

120

LRAS2007

11.7

130

110

12.3

LRAS2008 LRAS2009

LEARNING OBJECTIVE: (2) TWOSee Chapter 20 for more details

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Short-Run Aggregate Supply

› Measuresthe volumeofgoodsandservices producedwithintheeconomyatagivenpricelevel,itrepresentstheabilityofaneconomytodelivergoodsandservicestomeetdemand.

› SRASisdeterminedbythesupplysideperformanceoftheeconomy,theproductivecapacityoftheeconomyandthecostsofproductionineachsector.

› ThereisapositiverelationshipbetweenASandthegeneralpricelevel.

› RisingpricesareasignalforbusinessestoexpandproductiontomeetahigherlevelofAD,whenpricesarefallingproductionmaycontract.

LEARNING OBJECTIVE: (2) THREESee Chapter 20 for more details

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Short-run Aggregate Supply Curve

TheShort‐runAggregateSupplyCurve(SRAS)

› Showstherelationshipinthe

shortrunbetweenthe

pricelevelandthequantity

ofrealGDPsuppliedbyfirms.

Price level (P)

Real GDP (Y)Y1

P2

P1

SRAS

Y2

LEARNING OBJECTIVE: (2) FOURSee Chapter 20 for more details

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Why does the SRAS Curve Slope Upwards?

Factorsforwhyashort‐runaggregatesupplycurveslopesupwardinclude:

› Contractsmakesomewagesandprices“sticky.”

» Assomeproductioncostsareunchangedanincreaseinthepriceofthegoodsoldwill

givethefirmthechancetoincreaseprofitsbyincreasingitsprice.

› Firmsareoftenslowtoadjustwages

› Menucostsmakesomepricessticky

» Assomefirmshavelowerpricesthanothers,thuswhenpricelevelisincreasingthis

firmmightfinditssalesincreasingandthusadjustathigherproductionlevels.The

oppositealsoholds.

LEARNING OBJECTIVE: (2) FOURSee Chapter 20 for more details

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Movements along the SRAS Curve

ShiftsoftheSRASCurvevs.MovementsAlongtheCurve

Itisimportanttorememberthedifferencebetween:

› ashiftinacurveandamovementalongacurve.

› ChangesinaggregatedemandcauseeitheracontractionorexpansionalongtheSRAScurve,e.g.anincreaseindemandshouldleadtoanexpansionofaggregatesupplyintheeconomy.

LEARNING OBJECTIVE: (2) FOURSee Chapter 20 for more details

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AmovementalongtheSRASCurve

Ariseinthepricelevelwill cause

anexpansionofaggregatesupply

intheeconomy

Producersarerespondingto

higherprices(drivenupby

increaseddemand)

RealGDPwillincreasefromY1

toY2

A Movement Along the SRAS Curve

Price level (P)

Real GDP (Y)Y1

P2

P1

SRAS

Y2

1a

1b

1c

AD1

AD2

LEARNING OBJECTIVE: (2) FOURSee Chapter 20 for more details

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Variables that Shift the SRAS Curve

VariablesThatShifttheShort‐RunAggregateSupplyCurve

1. ChangesinthesizeandqualityoftheLaborForce

2. Changesinthesizeandqualityofthecapitalstockthroughinvestment

3. Technologicalchange

4. Changesinexpectationsaboutprices(inflation)

5. AdjustmentsofworkersandfirmstoerrorsinpastexpectationsaboutthePriceLevel

6. UnexpectedChangesinthepriceofanimportantnaturalresource

7. Supplyshock|Anunexpectedeventthatcausestheshort‐runaggregatesupplycurvetoshift.

LEARNING OBJECTIVE: (2) FIVESee Chapter 20 for more details

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Shifts in the SRAS

ShiftsintheSRASCurvecanresultfromexpectedchangesinpricelevels

Iffirmsandworkersexpectthat

thepricelevelwillbe3percent

higherin2013thanin2012…

…theSRAS curvewillshifttothe

lefttoreflectfirmandworker

expectationsofrisingcosts.

11

12

Price level (P)GDP deflator, 2000 = 100

Real GDP (Y)Trillions of 2000 $ dollars

10.0

103

100

SRAS2013 SRAS2012

11

12

LEARNING OBJECTIVE: (2) FIVESee Chapter 20 for more details

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Shifts in the AS Curve to the Right (Summary)

VariablesthatShifttheShort‐runASCurve(SRAS)totheright:

Price Level (P)

Real GDP (Y)

SRAS1 SRAS2

Anincreasein…

Thelabourforceorthecapitalstock

Productivity

shiftstheSRASCurveright because…

Moreoutputcanbeproducedateverypricelevel

Costofproducingoutputwillfall

LEARNING OBJECTIVE: (2) FIVESee Chapter 20 for more details

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Shifts in the AS Curve to the Left (Summary)

VariablesthatShifttheShort‐runASCurve(SRAS)totheleft:

Anincreasein…

Theexpectedfuturepricelevel

Workersandfirmsadjustingtohavingpreviouslyunderestimatedthepricelevel

Theexpectedpriceofanimportantnaturalresource

shiftstheSRASCurveleft because…

Workersandfirmsincreasewagesandprices

Workersandfirmsincreasewagesandprices

Costofproducingoutputrises.

Price Level (P)

Real GDP (Y)

SRAS2 SRAS1

LEARNING OBJECTIVE: (2) FIVESee Chapter 20 for more details

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Macroeconomic Equilibrium – AD/AS Model

LEARNING OBJECTIVES

1. LearnhowtousetheAD/ASmodeltoillustratethedifferencebetweenShort‐runandLong‐runmacroeconomicequilibrium

2. LearnhowtousetheDynamicAD/ASmodeltoanalysemacroeconomicconditions

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Long-run Macroeconomic Equilibrium

Long‐RunMacroeconomicEquilibrium

Price level (P)GDP deflator, 2000 = 100

Real GDP (Y)Trillions of 2000 dollars$10.0

100

ADSRAS

LRAS

LEARNING OBJECTIVE: (3) ONESee Chapter 20 for more details

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Long and Short Run Macroeconomic Equilibrium

Recessions,Expansions,and SupplyShocks

Becausethefullanalysisoftheaggregatedemandandaggregatesupplymodelcanbecomplicated,webeginwithasimplifiedcase,usingtwoassumptions:

› Theeconomyhasnotbeenexperiencinganyinflation

› Thepriceleveliscurrently100,andworkersandfirmsexpectittoremainat100in

thefuture.

› Theeconomyisnotexperiencinganylong‐rungrowth

› PotentialrealGDPis$10.0trillionandwillremainatthatlevelinthefuture.

LEARNING OBJECTIVE: (3) ONESee Chapter 20 for more details

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Recession |TheShort‐RunandLong‐RunEffectsofadecrease inAD

1. AdeclineininvestmentshiftsAD

totheleft,causingarecession.

2. Asfirmsandworkersadjustto

thepricelevelbeinglowerthan

theyhadexpected,costswillfall

andcauseSRAStoshifttotheright.

3. EquilibriummovesfrompointB

backtopotentialGDPatpointC,

withalowerpricelevel.

Modelling a Recession

Price level (P)GDP deflator, 2000 = 100

Real GDP (Y)Trillions of 2000 $ dollars

10

100

AD1 SRAS1LRASAD2 SRAS2

9.8

98

96

11

12

13

11 12

13

A

B

C

LEARNING OBJECTIVE: (3) ONESee Chapter 20 for more details

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Expansion |TheShort‐RunandLong‐RunEffectsofaincrease inAD

1. AnincreaseininvestmentshiftsAD

to theright,causinganinflationary

expansion.

2. Asfirmsandworkersadjustto

thepricelevelbeinghigherthan

theyhadexpected,costswillrise

andcauseSRAStoshifttotheleft.

3. EquilibriummovesfrompointB

backtopotentialGDPatpointC,

withahigherpricelevel.

Modelling an Expansion

Price level (P)GDP deflator, 2000 = 100

Real GDP (Y)Trillions of 2000 $ dollars

10

106

AD2 SRAS2LRASAD1 SRAS1

10.3

103100

11

12

13

11 12

13

A

C

B

LEARNING OBJECTIVE: (3) ONESee Chapter 20 for more details

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Supply Shocks

› Asupplyshockisanyunexpectedeventaffectingcostsandpricesindifferentcountries.

› E.g.Ariseintheworldpriceofcrudeoilornaturalgas,foodstuffsorotherimportant

commodities

› AnASshockiseitheraninflationshockorashocktoacountry’spotentialnationaloutput.

› AdverseASshocksofbothtypesreduceoutputandincreaseinflationandcanincreasetheriskofstagflationforaneconomy.

› Stagflation |Acombinationofinflationandrecession,usuallyresultingfromasupplyshock.

LEARNING OBJECTIVE: (3) ONESee Chapter 20 for more details

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SupplyShocks |Short‐run effect

1. Anincreaseinoilpricesshiftsthe

SRAS totheleft…

2. …movingshort‐runequilibriumto

pointB,withlowerrealGDPanda

higherpricelevel.

Modelling Supply Shocks – Short-run

Price level (P)GDP deflator, 2000 = 100

Real GDP (Y)Trillions of 2000 $ dollars

10

SRAS2LRASAD SRAS1

9.7

102

100

1112

A

B

11

12

LEARNING OBJECTIVE: (3) ONESee Chapter 20 for more details

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SupplyShocks |Long‐runeffect

1. Therecessioncausedbythesupply

shockeventuallyleadstofallingwages

andprices,shiftingSRASbacktoits

originalposition.

2. EquilibriummovesfrompointB back

topotentialGDPattheoriginalprice

level.

Modelling Supply Shocks – Long-run

11

12

Price level (P)GDP deflator, 2000 = 100

Real GDP (Y)Trillions of 2000 $ dollars

10

SRAS1LRASAD SRAS2

9.7

102

100

11

12A

B

LEARNING OBJECTIVE: (3) ONESee Chapter 20 for more details

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WecancreateaDynamicAD/ASmodelbymakingthreechangestothebasicmodel.

› PotentialrealGDPincreasescontinually,shiftingthelong‐runaggregatesupplycurvetotheright.

› Duringmostyears,theaggregatedemandcurvewillbeshiftingtotheright.

› Exceptduringperiodswhenworkersandfirmsexpecthighratesofinflation,theshort‐runaggregatesupplycurvewillbeshiftingtotheright.

The Dynamic AD/AS ModelLEARNING OBJECTIVE: (3) TWOSee Chapter 20 for more details

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The Dynamic AD/AS Model

ADynamicAggregateDemandandAggregateSupply(AD/AS)Model

› Theeconomybeginsinequilibrium

atpointAwithSRAS1andAD1intersectingatapointonLRAS1

11

Price level (P)GDP deflator, 2000 = 100

Real GDP (Y)Trillions of 2000 $ dollars

10

10o11

A

AD1

SRAS1

LRAS1

LEARNING OBJECTIVE: (3) TWOSee Chapter 20 for more details

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WhatIstheUsualCauseofInflation?

› UsingDynamicAD/ASmodelto

understandinflation

› IfAD shiftstotherightmore

thanSRAS…

› …thepricelevelrises.

The Dynamic AD/AS Model

11

12

Price level (P)GDP deflator, 2000 = 100

Real GDP (Y)Trillions of 2000 $ dollars

10

10o

AD1

SRAS1

LRAS1

11

A

12B

10.5

104

AD2

LRAS2

SRAS2

LEARNING OBJECTIVE: (3) TWOSee Chapter 20 for more details

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The slow recovery from the 2008-2009 Recession:Case study of the USA.

Making theConnection

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The more rapid recovery from 2010:Case study of the USA (continued)

Making theConnection

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ACTUALREAL GDP

POTENTIAL REAL GDP

PRICE LEVEL

1974 $4.32 trillion $4.35 trillion 34.7

1975 $4.31 trillion $4.50 trillion 38.0

TheDynamicAD/ASModel

Showing the Oil Shock of 1974–1975By using a Dynamic Aggregate Demand and Aggregate Supply Graph

Putting it intoPractice

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Key Terms

» Aggregatedemandandaggregatesupplymodel

» Aggregatedemandcurve

» Fiscalpolicy

» Long‐runaggregatesupplycurve

» Menucosts

» Monetarypolicy

» Short‐runaggregatesupplycurve

» Stagflation

» Supplyshock