Aggregate Supply and Demand

Short-run vs. long-run

Short-run vs. long-run

In macroeconomics, the long-run refers to a period of time sufficient for all prices to adjust. The short-run refers to the period of time in which some prices have adjusted, but not all.

Aggregate demand

Total demand for all final goods/services in an economy. The AD curve illustrates the quantity of goods/services that households, firms, gov’t, and customers abroad want to buy at each price level. C, I, G, NX all work together to create the AD curve.

Wealth effect

When the price level falls: The assets of consumers have more purchasing power, so they buy more stuff. An increase in consumer spending increases the overall quantity of goods/services demanded. Real wealth increases when the price level falls.

Conversely, an increase in the price level (inflation): Reduces the real value of money, making consumers poorer. This reduces consumer spending and the overall quantity of goods/services demanded.

Aggregate supply

Total supply of final goods/services in an economy. The AS curve illustrates the quantity of goods/services that firms choose to produce and sell at each price level. (upward sloping in the short-run, vertical in the long-run)

Interest rate effect

A lower price level: Reduces the interest rate. Encourages greater spending on investment goods. And thereby increases the quantity of goods/services demanded.

Conversely, a higher price level: Raises the interest rate. Discourages investment spending. And decreases the quantity of goods/services demanded.

Biggest reason why the AD curve slopes downward.

Exchange-rate effect

When a decrease in the US price level causes a decrease in interest rates: The real value of the dollar declines in foreign exchange markets. This depreciation stimulates US NX and thereby increases the quantity of goods/services demanded.

Conversely, when the US price level rises and causes interest rates to rise: The real value of the dollar increases. This appreciation reduces US NX and the quantity of goods/services demanded.

AD shifters

Consumption, investment, gov’t spending and net exports all create the AD curve. Changes in C, I, G, and NX will shift the AD curve.

AS shifters

Short-run: Anything that affects the production of a lot of goods/services shifts SRAS. Primary shifter of SRAS: changes in input or resource prices.

Long-run: Any change in the economy that alters the natural level of output shifts the LRAS. Because output depends on labor, capital, natural resources, and technological knowledge, these 4 sources are the primary shifters of the LRAS curve.

AD and AS curves at equilibrium (short-run)

Long-run equilibrium

Causes of economic fluctuations

Understand how shifts in AD and SRAS impact equilibrium in the long-run.

4 steps for analyzing macro fluctuations:

1) Decide whether the event shifts AD or AS (or both)

2) Decide the direction of the shift(s): Recall: IRDL

3) Use the AD/AS curve to determine the impact on output and the price level in the short-run.

4) Use the curves to analyze how the economy moves from its new short-run equilibrium to its new long-run equilibrium.

Monetary policy

The supply of money set by the Fed

Fiscal policy

Levels of gov’t spending and taxation set by the president and Congress.

Theory of liquidity preference

MS is fixed by the Fed. MD depends on the opportunity cost of holding money and also on the price level and real output. Increase in the interest rate: raises the cost of holding money, and reduces the quantity of money demanded.

When you hold wealth as cash in your wallet (liquid), rather than as an interest-bearing bond or in an interest-bearing bank account, you lose the interest you could have earned.

If interest rate is above equilibrium vs. below equilibrium in the money market…

Impact of price level on the money market

A higher price level raises money demand. A higher money demand leads to a higher interest rate. A higher interest rate reduces the quantity of goods/services demanded.

Conversely, a lower price level lowers the money demand. This leads to a lower interest rate. A lower interest rate increases the quantity of goods/services demanded.

Impact of changes in the money supply on AD

When the money supply is increased, it lowers the interest rate and increases the quantity of goods/services demanded for any given price level, shifting the AD curve to the right.

Conversely, when the money supply is decreased, it raises the interest rate and decreases the quantity of goods/services demanded for any given price level, shifting the AD curve to the left.

How fiscal policy impacts AD

When policymakers change the money supply or the level of taxes, they shift the AD curve indirectly by influencing the spending decisions of firms or households.

By contrast, when the gov’t alters its own purchases of goods/services, it shifts the AD curve directly.

Multiplier effect

Additional shifts in AD that result when expansionary fiscal policy increases income and consumer spending. Multiplier effect depends on the marginal propensity to consume (MPC).

Multiplier = 1/(1-MPC)

Crowding out can reduce the impact of the multiplier.

Keynesian thoughts

Gov’t has a role to play in the short-run. Keynesians believe the gov’t should actively stimulate AD when needed.

Case against stabilization policies

1) Lags: Fiscal and monetary policy both take time to have an impact…and…

2) By the time the policy takes effect, the issue may be over or it may have changed.