Lecture 17 & 18: Aggregate Demand, Aggregate Supply & the Business Cycle

Aggregate Demand: Endogenous Change

• A change of a variable already captures on the axis (P or Y). This triggers movement along the aggregate demand curve.

• The wealth effect, interest rate affect, and exchange rate effect are all endogenous changes.

Wealth Affect

Exchange Rate Effect

Note if RER increases then goods in the domestic country become more expensive relative to goods in the foreign country.

The Interest Rate Effect

Aggregate Demand: Exogenous change

• A change that affects aggregate demand/ aggregate expenditure for any level of P& Y.

• This change is external to P & Y and represented by one of the following letters AD= AE= C + I + G + NX

• Exogenous change my come in 2 forms: (1) shocks and (2) policies.

Aggregate Demand Exogenous Change: Shocks

• Wealth (stock market) —> real wealth must increase or decrease for a reason not having to do with P.

• Consumer confidence or investor confidence decrease

• P^for.- if the price of foreign goods fall, imports rise, exports fall, nx fall so aggregate demand falls.

Aggregate Demand Exogenous Change: Policies

• Government Spending- G increases or T decreases (Y^d increases, and consumption and investment increase).

• Central Bank- buying bonds

• Tariffs- if a foreign country reduces tariffs AD on all price levels rise.

Factors of Production/Supply in the longrun

• Y^LR = AF(K,N) = Y^p

  • A= technology

  • K= capital

  • N= labor

  • Above variables are slow moving and may not explain why Y^SR > Y^LR or Y^SR > Y^LR.

Keynes’ idea of production in the short-run

• Short-run production level Y^SR matches aggregate demand (at least in the very short run)

• Y^SR = Aggregate Demand (AD)

• The general framework for analysis of of SR economic fluctuations (P taken as given): Y^SR = AE= AD- C + I + G + NX

Assumptions about price for long-run and short-run:

• Long-run: prices are flexible & able to adjust to all economic conditions.

• Short run: Prices are fixed/ stuck because it takes time for firms to adjust and decide on the correct P to charge.

In what two lights can the determinants of aggregate supply be looked at under?

1) Short run

2) Long run

Aggregate Supply: Long Run levels of production

• Y^LR= AF(K,N) Notice that P is not a determinant so…

Aggregate Supply: Short run levels of production

• Determines by P (not fully flexible in the SR) and Y

SR Supply: Extreme Case 1- completely fixed price

SR Supply: Extreme Case 2- Completely flexible prices

Note this is equal to long run

SR Supply: “Sticky” prices (realistic SRAS)

NOTE: if prices were more flexible (S curve steeper); AD shock would be less severe. Because when adverse shocks occur, prices may adjust so output is NOT reduced.

Shifts and movements along aggregate supply: Endogenous change

• Shift along when there is a change already captures on the axis P & Y.

Shifts and movements along aggregate supply: Exogenous

• Shift when there is an “exogenous” change that has a temporary impact- temporary supply chocks.

• Generally, this is anything that affects the cost of firms to produce like…

1) P^oil

2) Health (pandemics)

3) “small” natural disasters

4) future expected prices (wages).

What would shift both the SRAS & LRAS?

• Exogenous change that has a permanent impact- permanent supply shocks.

• Positive version of this is an increase in technology.