Econ 121
Lecture 5
Chapter 12
Aggregate Demand and Aggregate Supply
Aggregate Supply (AS)
• The total supply for final goods and services in an economy
• The AS curve indicates the willingness of the producers to supply goods & services at different price levels.
Aggregate Supply (AS) – Cont’d
When considering the AS, we need to distinguish between:
Short-run (SR):
A period of time during which (some) prices are fixed (prices are NOT adjustable because they are determined by prior contracts).
Long-run (LR):
A period of time, long enough, for agents to modify their behavior in response to price changes.
Aggregate supply is a schedule or curve showing the level of real domestic output available at each possible price level. The relationship is determined on the basis of whether input prices and output prices are fixed or flexible.
In the short run, input prices are fixed but output prices are variable.
In the long run, input prices and output prices can vary
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Short-Run Aggregate Supply (SRAS)
Indicates the various quantities of goods and services that firms supply in response to the changing demand conditions that alter the price level.
Upward sloping (positive relationship between the price level and the quantity of the output to be produced)
Short-Run Aggregate Supply (SRAS) – Cont’d
SRAS curve is upward sloping (has a positive slope)
Because input prices are fixed, changes in the price level affect the firm’s real profit, which affect their decision of how much output to produce.
Factors that shift the SRAS
Temporary supply shocks
• Changes in resource prices
• Changes in expected future prices
Changes in resource prices: Wages and salaries make up about 75 percent of all business costs. Other things being equal, decreases in wages reduce per-unit production costs. So when wages fall, the aggregate supply curve shifts to the right. What will happen if the resource prices increase?
Changes in expected future prices: Sellers are motivated to sell the good at the highest price possible. If sellers expect that the price of a good will be increasing in the future, then they are likely to sell less today. The aggregate supply curve will shift to the left. What will happen if the sellers expect the prices to fall in the future?
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Examples
Increase in Aggregate supply is represented by a rightward shift- SRAS1 to SRAS2
Decrease in Aggregate Supply is represented by a leftward shift- SRAS1 to SRAS3
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Long-Run Aggregate Supply (LRAS)
Indicates the relationship between the price level and quantity of output after necessary sufficient time has passed so they adjust their prior commitments.
LRAS is related to the economy's production possibilities constraint
The constraints are imposed by the economy's resource base, and level of technology, and the efficiency of its institutional arrangements - Not related to the price level.
Long-Run Aggregate Supply (LRAS)
In the LR, the economy moves towards the full employment level of output (Y*).
Y* is NOT affected by the price level.
LRAS is independent of the overall price level.
Long-Run Aggregate Supply (LRAS) – Cont’d
Factors that shift the LRAS
• Factors that determine economic growth, e.g.:
Change in the recourses available Changes in technology
Changes in the quality of institutions
Example
Important Note
LRAS shifts cause SRAS shifts...
However, the reverse is not true!
There are many factors that cause SRAS to shift but does not influence LRAS (for example temporary supply shocks that occur only in the SR).
Short-run Equilibrium
Short-run equilibrium occurs at the price level (P*) & the output level, where AD = SRAS.
Graphically, it occurs at output level where the AD and SRAS curves intersect.
At this market clearing price (P*), the amount that buyers want to purchase is just equal to the quantity that sellers are willing to supply.
Short-run Equilibrium
Long Run Equilibrium
LR equilibrium requires two conditions:
The aggregate quantity demanded = aggregate quantity supplied at the current price level.
Price level anticipated by decision makers equals the actual price level (agents fully adjusted to any changes in prices that occurred in the past).
In the LR: AD = SRAS = LRAS.
Long run Equilibrium
What happens when output is different from LR potential?
There are two scenarios:
• Output is greater than LR potential: Price level increases by more that what was anticipated.
In the SR, profit margins are high hence output increases Economic boom (unsustainable)
• Output is less than LR potential: Price level is less than what was anticipated. In the SR, profit margins are low hence Output shrinks
Recession (unsustainable)
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Which curve does these factors affect? Do they cause a movement along the curve or a shift in the curve?
a. Due to the increase of clothes prices in the US, consumers substitute out of clothes made in the US to clothes made in Bangladesh
b. New Shale Gas Deposits are found in North Dakota
c. OPEC meets and decides to increase the world output of oil, which
results in the decline of the prices of oil in the next six months.
d. Consumers read positive news about expected future economic growth
e. New policies cause an increase in the cost of meeting government regulations.
Movement along the AD curve
LRAS/SRAS shift to the right
SRAS curve shifts to the left
AD shifts to the right
LRAS shifts to the left
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Which curve does these factors affect? Do they cause a movement along the curve or a shift in the curve?
Imports increase (NX decrease, AD shifts to the left) Price level increases (Movement along AD and AS) The Japanese Earthquake and Tsunami of 2011 (SRAS shifts to the left) The invention of airplanes (LRAS and SRAS shift to the right) World War II (Multiple explanations (i) Government spending increases and AD shifts to the right (ii) Income of foreign countries go down hence net exports of domestic economy fall, shifting the AD to the left
(iii) Destruction of resources can cause SRAS to shift to the left.)
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Impact of Exogenous Shocks
How the economy adjusts
• To analyze the effect of any shock to the economy, we study its impact on output, unemployment, and the price level.
• For an effective analysis, follow these steps:
Begin with the model at the LR equilibrium
Determine the curves that are affected by the shocks and identify the direction of each shift
Shift the curves in the appropriate directions
Determine the new SR/ LR equilibrium points
Compare the new equilibrium with the starting point.
Discuss the Impact of the following shocks on the US economy
World War II (discuss the impact on the Japanese economy and the US economy)
Strong economic growth in China that increases income in China (Hint: China is the second big trading partner with the US)
The housing market bust in 2008-09
The 2007 oil price shock.