Chapter 8: Aggregate Demand and Supply

The aggregate demand curve

shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and government

The short run aggregate supply curve (SRAS)

shows the relationship between the price level and the quantity of real GDP supplied by firms

Why is aggregate demand curve downward sloping

1. The wealth effect

2. The interest rate effect

3. International trade effect

WII !

The Wealth Effect

• a higher price level reduces the real value of wealth, which reduces consumption

• A lower price level increases the real value of wealth, which increases consumption

Interest Rate effect

• When prices go up, people need more money to buy things, interest rates rise, and borrowing becomes more expensive—so spending falls

International trade effect

When domestic prices rise, our goods become more expensive compared to foreign goods, so exports fall and imports rise

Shifts in Aggregate demand vs Movement

• movement: changes in price level

• Shift: changes in any other variable

  • Changes in monetary and fiscal policy

  • Changes in expectations of households and firms

  • Changes in foreign variables

AD Equation

C + I + G + NX

Aggregate Supply

The total quantity of goods and that firms are able and willing to supply at various price levels

• LRAS

• SRAS

The Long Run Aggregate Supply Curve

the potential gdp (vertical line)

determinants of LRAS

1. The economy’s stock of capital

2. The number of workers

3. The available technology

4. The law

what is NOT a determinant of LRAS

in the long run prices are flexible, so changes in the price level do not affect real output

what makes the LRAS shift right

an increase in:

• labor

• Capital

• Natural resources

The SRAS curve

• upward sloping line with a positive relationship between price level and gdp

why do wages and prices of other inputs rise slower than prices of goods and services

• Contracts → Many workers have fixed wage contracts, so their pay doesn’t change immediately when prices rise.

• Firms are slow to adjust wages → Even without contracts, firms hesitate to raise wages quickly because it’s costly or may upset employees.

• Menu costs → Changing prices (like printing new menus or labels) costs money, so firms raise prices gradually instead of all at once.

shifts of SRAS vs movements

• movement: changes in price level

• Shift: any other changes

  • Changes in the labor force and in the economy’s capital stock

  • Technological change

  • Changes in the expected further price level

  • Adjustments of workers and firms to errors in past expectations

  • Unexpected change in the price of an important natural resource

When is the economy in Long Run equilibrium

when AD, SRAS, and LRAS intersect

what phase of the business cycle is the economy in when current output is below potential output

recession — unemployment is high

what phase of the business cycle is the economy in when current output is above potential output

Expansion — unemployment is low

what phase of the business cycle is the economy in when current output = potential output

neither a recession nor expansion — the economy is in equilibrium

automatically mechanism

When the economy adjusts back to long run equilibrium without government intervention

graph of current output below potential

Graph of current output above potential

Supply shock

A sudden, unexpected change in the cost or availability of key resources that shifts the short-run supply curve.

Negative supply shock

production becomes more expensive or harder → SRAS shifts left

Positive supply shock

production becomes cheaper or easier → SRAS shifts right

What does a negative supply shock represent

stagflation (high unemployment, inflation, and stagnant economy)

self adjusting long run equilibrium, after supply shock