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Aggregate Supply and Demand

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Stephanie Schmidt

on 23 May 2018

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Transcript of Aggregate Supply and Demand

Aggregate Supply and Demand
Increase in aggregate demand
Decrease in Aggregate Demand
Warm- Up
What is demand? What does the demand curve look like?

IRDL the Turtle
Aggregate Supply
the relationship between economy-wide production and the aggregate price level.
The Short- Run Aggregate Supply Curve
C = Consumers' expenditures on goods and services
I = Investment spending by companies on capital goods
G = Government expenditures on publicly provided goods and services
X = Exports of goods and services
M = Imports of goods and services.
Aggregate Demand
The aggregate demand curve shows, at various price levels, the quantity of goods and services produced domestically that consumers, businesses, governments and foreigners (net exports) are willing to purchase.
Warm- Up
Complete "Factors that Shift Aggregate Demand" handout
Take out your HW
The curve slopes downward to the right, indicating that as price levels decrease (increase), more (less) goods and services are demanded.
What Increases Aggregate Demand?
Households and firms have high expectations for the future growth
The government increases spending, or reduces taxes
The Federal Reserve lowers interest rates
More exports
What Decreases Aggregate Demand?
Households and firms have low expectations for the future growth
The government reduces spending, or increases taxes
The Federal Reserve increases interest rates
More imports or less exports
Assume the Fed sets short term interest rates
Assume a rise in the price level will be met by a rise in interest rates
Any increase in interest rates will raise the cost of borrowing:
- Consumption spending will fall
- Investment will fall
- International competitiveness will decrease - exports fall, imports rise
Therefore – a rise in the price level leads to lower levels of aggregate demand

Why does AD slope down from left to right?
The AD Curve
Price level is on the y- axis
Real GDP or Real National Income is on the x- axis
Aggregate Demand (AD) = C + I + G + (X-M)

Spending on:

Social Welfare
Foreign Aid
Law and Order

Goods and services bought from abroad
represents an outflow of funds from the US
reduces AD

Goods and services sold abroad
represents a flow of funds into the US
raises AD

Aggregate means
"the sum of".

It refers to a whole formed by combining several separate elements.
Read your example. Explain whether the situation would increase or decreases aggregate demand. Draw an aggregate demand curve to explain your answer.
Why does the short- run aggregate supply curve slope upward to the right?
Rising prices are usually signals for businesses to expand production to meet a higher level of aggregate demand.
If the price of a unit of output is rising faster than the cost of producing that unit of output, that unit of output will be produced.
This is exactly what economists believe happens in the short run. And this gives us an upward sloping SRAS curve.
shows total planned output when prices in the economy can change, but other factors are fixed
there is a positive slope to the SRAS curve
Short run aggregate supply (SRAS)
shows total planned output when prices and everything else can change (variable)
it is a measure of a country’s potential output
Long run aggregate supply (LRAS)
Long- Run Aggregate Supply Curve
What Changes Short- Run Aggregate Supply?

Input Costs
Government Policy on Taxes
If input costs such as wages increase, then SAS will decrease because the producers will decrease supply.
As technology continues to improve, SRAS will increase.
If business or corporate taxes are lowered, then SRAS will increase.
If investments were to increase, SRAS will increase.
Increase in Short- Run Aggregate Supply
Decrease in Short- Run Aggregate Supply
Long- Run Aggregate Supply vs. Short Run Aggregate Supply
in the long run every factor of production can change (variable)
in the short run, at least one factor cannot change (fixed)
Long- Run Aggregate Supply
In the long run, the ability of an economy to produce goods and services to meet demand is based on the state of production technology and the availability and quality of factor inputs.
What Changes Long Run Aggregate Supply?
Improvements in productivity cause the LRAS curve to increase
Increase in Long- Run Aggregate Supply
Decrease in Long- Run Aggregate Supply
Supply and Demand: Micro. vs. Macro.
The macroeconomic model for Aggregate Demand and Aggregate Supply differs from the microeconomic model in the fact that the AD/AS model represents all goods and not just one single good.

It takes into account the price level of all goods as well as the overall aggregate output of the economy.
The Long Run and Short Run in Economics
Short- run: some factors are fixed (ie. paying rent, your workers' wages)

Long- run: every factor is variable (can change)
Many economists believe that, given enough time, the economy will adjust back to this level of output.
In the long-run, there is exactly one quantity that will be supplied.
Why is the LRAS Curve Vertical?

Some input prices are “sticky.”
This just means that they don’t rise or fall very quickly in response to a change in demand for them.
What explains this?
An increase, or outward shift, in SRAS means that producers are willing to produce more aggregate output at any price level.

Increase Right
Decrease Left
A decrease in short-run aggregate supply means that the SRAS curve shifts to the left. A leftward shift implies that the quantity of aggregate output supplied falls at any aggregate price level.
Shifts in SRAS
1. Changes in Commodity Prices

A commodity is a standardized input bought and sold in bulk quantities.
Examples: oil, copper, steel
These commodities are production inputs for final products, so higher commodity prices make it more costly for firms economy-wide to produce.
This would shift SRAS to the left.

2. Changes in Nominal Wages
A very important input to production is labor and the current price of labor is the nominal wage.
Gradually these nominal wages change due to changes in the labor markets.
If the nominal wage were to increase, the SRAS will shift to the left.
3. Change in Productivity

Suppose workers at a factory are provided with better tools so that they can increase output with the same amount of effort.
If this is happening across the economy, the same amount of labor can produce more goods and services and SRAS shifts to the right.

The economy from year to year fluctuates around the level of potential output Yp. Some years the economy is weak and real GDP lies below Yp. Other years the economy is extremely strong and real GDP lies above Yp.
In the AD/AS model, the economy is always operating along the SRAS supply curve, but only sometimes does this coincide with the intersection of SRAS with LRAS.
This model predicts however that, in the long run, the economy will adjust to where SRAS intersects LRAS at Yp.
From the Short Run to the Long Run
Scenario 1: The economy is weak and in a recession
In this scenario, current real GDP Y1 < Yp
A weak labor market has falling demand for labor.
There are many unemployed workers.
Employers find that they can get workers to accept lower wages.
Eventually nominal wages fall and SRAS shifts to the right until current output is equal to Yp.
So what is expected to happen?
Scenario 2: The economy is booming
In this scenario, current real GDP Y2 > Y
So what is expected to happen?
A strong labor market has rising demand for labor.
There are very few workers that are unemployed.
Employers are scrambling to find scarce employees.
Eventually nominal wages rise and SRAS shifts to the left until current output is equal to Yp.
Long run aggregate supply is NOT the same as the short run
In the short run, certain factors are fixed

1. Increase in human capital
2. Increase in physical capital
3. Increase in technology
So what increases productivity?
Warm- Up:
Why are wages sticky in the short run?
LRAS touches the horizontal axis at the economy’s potential output
we label this Yp
What is Potential GDP?
it's theoretical
what our GDP would be if we were perfectly efficient and using all of our resources
But why does potential GDP matter?
How do we use it?
Monetary policymakers use the difference between actual and potential GDP—the output gap—to determine whether the economy needs more or less monetary stimulus.
Full transcript