Macro Project 2 Important Final Assignment $ Any Takers?

Handout MACRO #19P

Aggregate Supply and Aggregate Demand

Good Things in a Bigger Package

Aggregate Demand

Aggregate demand is the total quantity demanded of real GDP at all price levels. The aggregate demand curve (AD) looks just like a market demand curve, sloping downward to the right, showing an inverse relationship between the price level and the quantity demanded of real GDP. Remember, real GDP = Consumption [C] + Investment [I] + Government [G] + (Exports – Imports) [NX].

The AD curve slopes downward showing the inverse relationship between price level and quantity demanded of real GDP for three reasons:

1) The real balance effect —when the price level falls, the purchasing power of consumers increases and they can buy more goods and services with the same amount of money. C will increase. When the price level rises, the purchasing power of consumers decreases and they can buy fewer goods and services with the same amount of money. C will decrease.

2) The interest rate effect —when the price level falls, consumers can save more without reducing the goods and services they purchase. When consumers save more, interest rates go down.

Simplistically, there is a supply and demand for loanable funds in an economy. The supply of loanable funds comes from savers and the demand for loanable funds comes from borrowers for investment (I). The equilibrium price of loanable funds is the interest rate—savers receive interest and borrowers pay interest.

When interest rates go down, the quantity demanded of real GDP by consumers and businesses goes up because the cost of borrowing is cheaper and they can buy more goods and services. C & I will increase. When interest rates go up, the quantity demanded of real GDP by consumers and businesses goes down because the cost of borrowing is higher and they can buy fewer goods and services. C & I will decrease.

3) The international trade effect —when the price level in the U.S. economy drops, U.S. goods are relatively cheaper than goods in other countries, ceteris paribus. Consumers in other countries will buy more U.S. goods and fewer foreign goods than before, so exports will increase and thus NX will increase. U.S. consumers will also buy more U.S. goods and fewer foreign goods than before, so imports will decrease and thus NX will increase.

When the price level in the U.S. economy rises, U.S. goods are relatively more expensive than goods in other countries, ceteris paribus. Consumers in other countries will buy fewer U.S. goods and more foreign goods than before, so exports will decrease and thus NX will decrease. U.S. consumers will also buy fewer U.S. goods and more foreign goods than before, so imports will increase and thus NX will decrease.

Factors Influencing Aggregate Demand

As with market demand, there are various factors or determinants that can change aggregate demand. These factors work through the components C, I, G and NX. Some factors can influence more than one component.

1) Consumption Factors

a) Wealth—changes in wealth will change consumption. If wealth, which is simply the value of all monetary and non-monetary assets, increases then consumption will increase. When consumption increases, aggregate demand increases. The AD curve shifts outward to the right. A decrease in wealth will decrease consumption and thus aggregate demand. The AD curve will shift inward to the left.

b) Expectations of future prices and income—just like with the market demand curve, if individuals expect future prices to be higher, they will buy more now. Consumption will increase and thus aggregate demand will increase. The AD curve will shift outward to the right. If individuals expect future prices to be lower, they will wait to buy and consume less now. Consumption will decrease and thus aggregate demand will decrease. The AD curve will shift inward to the left.

If individuals expect their future income to be higher, they will increase consumption, which will in turn increase aggregate demand. The AD curve will shift outward to the right. If individuals expect their future income to be lower, they will decrease consumption, which will in turn increase aggregate demand. The AD curve will shift inward to the left.

c) Interest rate—if the interest rate falls, individuals will increase consumption, especially on consumer durables like cars and appliances. Aggregate demand will then increase and the AD curve will shift outward to the right. If the interest rate rises, individuals will decrease consumption and aggregate demand will also decrease. The AD curve will shift inward to the left.

d) Income Taxes—when income taxes go down, consumers’ disposable income goes up and consumption will increase as will aggregate demand. The AD curve will shift outward to the right. When income taxes go up, consumers’ disposable income goes down and consumption will decrease. Aggregate demand will also decrease and the AD curve will shift inward to the left.

2) Investment Factors

a) Interest rate—if the interest rate falls, businesses will increase investment because the costs of investment projects are lower. Aggregate demand will then increase and the AD curve will shift outward to the right. If the interest rate rises, fewer investment projects will be undertaken and both investment and aggregate demand will decrease. The AD curve will shift inward to the left.

b) Expectations of future sales—if businesses expect future sales to be higher, they will gear up now to produce more. More investment projects will be undertaken and investment will increase. Aggregate demand will increase and the AD curve will shift outward to the right. If businesses expect future sales to be lower, they hold off on investment and thus aggregate demand will decrease. The AD curve will shift inward to the left.

c) Business Taxes—when business taxes go down, business profits go up and investment will increase as will aggregate demand. The AD curve will shift outward to the right. When business taxes go up, profitability goes down and investment will decrease. Aggregate demand will also decrease and the AD curve will shift inward to the left.

3) Net Exports Factors

a) Foreign real national income—if income rises in other countries, foreigners will buy more U.S. goods and services. Exports will increase, so net exports will increase and so will aggregate demand. The AD curve will shift outward to the right. If income falls in other countries, foreigners cut back on purchases of U.S. goods and services. Exports will decrease, so net exports will decrease and so will aggregate demand. The AD curve will shift inward to the left.

b) Exchange rate—if the exchange rate of U.S. currency for other countries’ currency falls or depreciates, requiring less foreign currency for each $1, U.S. goods become relatively cheaper than before. Foreigners can buy more U.S. goods and services with the same amount of foreign currency. Conversely, foreign goods are now more expensive to Americans, as it will take more dollars to buy the same priced good. Exports will increase while imports will decrease. Net exports will rise, and thus aggregate demand increases. The AD curve will shift outward to the right.

If the exchange rate of U.S. currency for other countries’ currency rises or appreciates, requiring more foreign currency for each $1, U.S. goods become relatively more expensive than before. Foreigners can buy fewer U.S. goods and services with the same amount of foreign currency. Conversely, foreign goods are now less expensive to Americans, as it will take fewer dollars to buy the same priced good. Exports will decrease while imports will increase. Net exports will fall, and thus aggregate demand decreases. The AD curve will shift inward to the left.

Aggregate Supply

Aggregate supply is the total quantity supplied of real GDP at all price levels. Aggregate supply includes both short-run aggregate supply and long-run aggregate supply. The short run is a period of indeterminate length where supply cannot fully adjust to changes, due to some fixed factors such as technology or capital stock. The long run is a length of time where all necessary adjustments can be made in response to changes in the economy. The economy has two supply curves—an aggregate short-run supply curve and an aggregate long-run supply curve.

The aggregate short-run supply curve (SRAS) looks just like a market supply curve, sloping upward to the right, showing a positive relationship between the price level and the quantity supplied of real GDP. Costs of the factors of production are the primary determinant of supply, with labor costs being the largest component of costs for producers in the aggregate. Therefore, changes in wage rates will have a major effect on supply in the economy, but the effects are different depending on whether the change was in nominal (money) wage rates or real wage rates.

Nominal wages are real wage rates expressed at the current price level (in other words, in current dollars). The real wage rate is the equilibrium wage set by supply and demand in the labor market, at the base year price level (in other words, with inflation removed). You can calculate the real wage rate by dividing real wages by the price level. So a drop in the price level causes real wages to increase and an increase in the price level will cause real wages to fall, ceteris paribus.

When the price level changes and the money wage rate and other resource prices remain constant, real GDP departs from potential GDP and there is a movement along the SRAS curve. The SRAS curve slopes upward showing the positive relationship between price level and quantity supplied of real GDP. This slope reflects that a higher price level combined with a fixed money wage rate, lowers the real wage rate, The lower real wage rate in turn increases the quantity of labor firms employ which increases the real GDP that firms produce.

Producers increase output or real GDP in the short run for three main reasons:

1) Sticky Wages —due to inflexibility in wages from long-term contracts and other factors, when the price level falls, firms might still be locked into a nominal wage rate. That would mean that their real wages have risen and they will cut back output and hire fewer workers. With sticky wages, a drop in the price level will result in a decrease in the quantity supplied of real GDP. An increase in the price level will cause an increase in real GDP supplied because real wages will fall when nominal wages are inflexible.

2) Sticky Prices —not all prices will adjust quickly. For some industries, there are costs to adjusting prices. When the price level drops, some firms will choose not to lower their prices immediately because of the cost and because they are not sure if the price level decrease is permanent or temporary. While they hold off on lowering their prices, they will not be able to sell the same level of output as before, so these firms will reduce the quantity supplied. A decrease in the price level results in a decrease in quantity supplied of real GDP, while a price level increase results in an increase in quantity supplied of real GDP.

3) Misperceptions —if producers and workers can’t tell if changes in prices and wages are real or nominal, they will not know how to react when the price level changes. Producers may see higher prices as a signal to increase output when actually the higher prices are a result of an increase in the overall price level. Producers may increase output when in reality they should keep it constant, or even decrease production. In the same way, workers can’t tell if higher wages are the result of an overall price increase or if real wages have risen. Due to the confusion, when price levels increase, output will increase, until things become clearer. When price levels fall, output will fall until producers and workers can tell which type of price change has occurred—real or nominal.

Factors Influencing Short Run Aggregate Supply

As with market supply, there are various factors or determinants that can change aggregate supply. Basically, anything that increases costs to producers will decrease supply and anything that reduces costs to producers will increase it.

1) Money Wage Rates —changes in money wage rates have a major impact on the costs of producers, and thus are a major influence on short run aggregate supply. If money wages decrease, supply will increase and the SRAS will shift outward to the right. If money wages increase, supply will decrease and the SRAS will shift inward to the left.

2) Prices of Non-labor Inputs —changes in other inputs to the production process have an impact on the costs of producers. If prices of non-labor inputs decrease, supply will increase and the SRAS will shift outward to the right. If prices of non-labor inputs increase, supply will decrease and the SRAS will shift inward to the left.

3) Supply Shocks —there can be adverse or beneficial natural or other supply shocks to the economy. Any supply shock that decreases costs will increase supply and the SRAS will shift outward to the right. Any supply shock that increases costs will decrease supply and the SRAS will shift inward to the left.

Short-run aggregate supply changes and the SRAS curve shifts when there is a change in the money wage rate or other resource prices. A rise in the money wage rate or other resource prices decreases short-run aggregate supply and shifts the SAS curve leftward.

Short Run Equilibrium

Aggregate demand and short run aggregate supply interact to establish an equilibrium price level and quantity of real GDP, just like in a market.

Any change in aggregate demand or short run aggregate supply will change the short run equilibrium, just like in the market.

Long Run Aggregate Supply

In the long run, aggregate supply is simply the level of potential GDP — real GDP produced at full employment or when the unemployment rate is at its natural level. Only frictional and structural unemployment is occurring and there is no cyclical unemployment. The long run aggregate supply (LRAS) is a vertical line at the level of GDP associated with potential GDP, also known as natural real GDP (QN). LRAS represents the output the economy produces when all adjustments have taken place and there are no more inflexibilities or misperceptions.

When the price level, the money wage rate, and other resource prices change by the same percentage, real GDP remains at potential GDP and there is a movement along the LRAS curve. In the long run, the money wage rate and other resource prices change in proportion to the price level. So moving along the LRAS curve both the price level and the money wage rate change by the same percentage.

LRAS illustrates the relationship between the quantity of real GDP supplied and the price level in the long run when real GDP equals potential GDP and shows that potential GDP does not depend on the specific price level. Potential GDP increases when the full employment quantity of labor increases, labor productivity increases, the quantity of capital increases, or technology advances. When potential GDP increases, both long-run and short-run aggregate supply increase, and the LRAS and SRAS curves both shift to the right. A decrease in potential GDP would shift both LRAS and SRAS to the left.

Changes in the price level have no effect on potential GDP so the LRAS does not shift when the price level changes. Price level changes move along the LRAS while changes in potential GDP move the whole LRAS curve.

And Then Unemployment

Changes in aggregate demand or aggregate supply also change the unemployment rate. If real GDP rises, from an increase in AD or SRAS, more workers are needed to produce the higher output. Thus the unemployment rate will drop. If there is a decrease in AD or SRAS, workers will be laid off, and the unemployment rate will rise.

ie

Equilibrium interest rate

Interest Rate (i)

S

Qe

Equilibrium quantity exchanged in the market

D

Loanable Funds

Pe

Short run equilibrium price level

Price Level

SRAS

Qe

Short run equilibrium real GDP

AD

Real GDP

Short run equilibrium

Price Level

LRAS

Potential GDP (QN)

U=UN