business economics ( eco 341) fall: 2012 semester
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Business Economics ( ECO 341) Fall: 2012 Semester. Khurrum S. Mughal. Aggregate Demand and Supply. The Two-Way Relationship Between Output and the Price Level. Aggregate Demand Curve. Price. Real. Level. GDP. Aggregate Supply Curve. AD and AS. - PowerPoint PPT PresentationTRANSCRIPT
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Business Economics (ECO 341)Fall: 2012 Semester
Khurrum S. Mughal
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Aggregate Demand and Supply
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PriceLevel
RealGDP
Aggregate Demand Curve
Aggregate Supply Curve
The Two-Way Relationship Between Output and the Price Level
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There exist a two-way relationship between price level and output
Changes in price level cause changes in
real GDP – illustrated by Aggregate Demand curve
Changes in real GDP cause changes in price level – illustrated by Aggregate Supply curve
AD and AS
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Aggregate Demand
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Define aggregate demand as the total demand for an economy’s output (production of goods and services) over a given period of time.
Demand may come from households (consumption), firms (investment), the public sector (government spending) or foreign households, firms, or governments (net exports).◦ YAD = C + I + G + NX
We assume an inverse relationship between price and aggregate demand
Aggregate Demand
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Suppose aggregate prices in the economy fell
This would cause the demand for money to decrease, causing interest rates to decline◦ Alternatively, the real money supply (M/P) rises, causing
interest rates to fall.
With lower interest rates, the opportunity cost of consumption is lower: ◦ P↓ Md↓ i↓ C↑
With lower interest rates, the direct cost of investment falls: ◦ P↓ Md↓ i↓ I↑
With lower interest rates a country’s currency will depreciate. A weaker currency makes exports cheaper and imports more expensive◦ P↓ Md↓ i↓ Exchange Rate↓ NX↑
Aggregate Demand Rises as Price Falls
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P
Y
AD
2
1
100 180
The Aggregate Demand Curve
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A variety of events can cause the price level to change, and move us along the AD curve
◦It’s important to understand what happens in the economy as we make such a move
Movements Along The AD Curve
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Movements Along The AD Curve
Opposite sequence of events will occur if the price level falls, moving us rightward along the AD curve
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(a)
Real GDP
Price Level
P3
Q3 Q1 Q2
AD
P1
P2
Price level ↑ moves us leftward along the AD curve
Price level ↓ moves us rightward along the AD curve
Effects of Key Changes on the Aggregate Demand Curve
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Anything (other than price!) that causes C, I, G, or NX to increase will shift the AD curve to the right.
C increases when…◦ There is an increase in consumer confidence, leading to
more current consumption and less current savings◦ Taxes are cut leaving consumers with more income to
spend
I increases when…◦ Business confidence rises, prompting firms to invest more
for the future.
Factors that Shift the AD Curve
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G increases when…◦ Government spending increases
NX increases when…◦ There is increased preference for domestically produced
goods.
An increase in the money supply will cause AD to shift right◦ Interest rates are lower, so C and I rise. The currency
weakens, so NX increases.
Factors that Shift the AD Curve
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Entire AD curve shifts rightward if:• a, IP, G, or NX increases• Net taxes decrease• The money supply increases
AD2
AD1
(b)
Real GDP
Price Level
Effects of Key Changes on the Aggregate Demand Curve
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Aggregate Supply
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Price Level
Real GDP ($ Trillions)
130
100
80C
AS
13.5106
A
B
Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises.
Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price level falls.
Short Run Aggregate Supply Curve
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Figure in last slide assumed that a number of important variables remained unchanged◦ Unit costs sometimes change for reasons other than a
change in output
In general, we distinguish between a movement along AS curve, and a shift of curve itself, as follows◦ When a change in real GDP causes the price level to change,
we move along AS curve When anything other than a change in real GDP causes price level
to change, AS curve itself shifts
What can cause unit costs to change at any given level of output?◦ Changes in world oil prices◦ Changes in the weather◦ Technological change◦ Nominal wage, etc.
Shifts of the AS Curve
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When a change in output causes price level to change, we move along economy’s AS curve
◦ What happens in economy as we make such a move?◦ As we move upward along AS curve, we can represent
what happens as follows
Movements Along the AS Curve
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(a)
Real GDP
Price Level
P3
Q2 Q1 Q3
P1
P2
ASReal GDP ↑ moves us rightward along the AS curve
Real GDP ↓ moves us leftward along the AS curve
Movements Along the AS Curve
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Tightness in the labor market.◦ Suppose that because of a big economic expansion, the economy is
producing at an output level Y that is greater than YP. ◦ This suggests that the economy is using more labor than it normally does.◦ To get people to work longer hours, you have to pay them more.◦ This increase in labor costs will shift the SRAS curve left, as profit per output
falls when labor costs rise.
Expectations about inflation◦ If workers expect inflation to be higher in the future, they will demand higher
wages in anticipation of this increase in the cost of living.◦ Higher wages reduce firm profit and shift SRAS left
Supply shocks to critical raw materials◦ Suppose a war broke out between the US and Iran. Oil prices would rise
dramatically◦ Since oil is such a pervasive part of nearly everything we produce,
production costs would rise significantly.◦ The SRAS curve would shift left as the return on production fell.
Short Run Aggregate Supply Curve
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Real GDP
Price Level(b)
AS1
AS2
Entire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP
Shifts of the AS Curve
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P
Y
P*
SRAS
Y*
AD
PH
PL
Surplus
Shortage
Short Run Equilibrium
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In the long run, money is neutral◦ Any changes in the money supply will be met by a
proportionate change in prices◦ Increasing the money supply will not affect the economy’s
output in the long run.
Long run output is determined entirely by an economy’s productive capacity◦ Production Function: YP = A*F(K,L,H,N)
Only changes in real variables can affect potential output.◦ Price does not have any effect on YP
In the long run, all resources are being efficiently utilized such that unemployment equals the natural rate
Long Run Aggregate Supply
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P
Y
2
1
LRAS
YP = 140
Long Run Aggregate Supply