econ 100.1 - aggregate demand and supply

3 key facts about economic fluctuations

1. economic fluctuations are irregular and unpredictable (business cycle: correspond to the changes in business conditions): real GDP decreases significantly = recession → businesses are doing bad bc sales are declining & real GDP grows rapidly = business is doing good → economic expansion bc profits are high

2. most macroeconomic quantities fluctuate together: real gdp is used to monitor short run changes in the economy bc its the most comprehensive measure of economic activity
* note: most of the time when the gdp declines, its not bc of a problem but bc ppl are expanding (spend on new factories, houses, inventories, etc.)

3. as output falls, unemployment rises: when firms choose to produce less → they need less workers → they fire people now

classical dichotomy

separation of real and nominal variables

- real: measure in qty or relative prices
- nominal: measured in terms of money

changes in money supply affect nominal variables, not real

however, this best describes the long run, not the short run bc money supply changes could affect real gdp and employment in the short run

aggregate demand and supply

focuses on real gdp instead of nominal gdp (economys output of goods and services and the avg lvl of prices)

aggregate: talking abt all goods and services in all markets

aggregate demand

qty of goods and services that people want to buy at each lvl

it is downwards sloping bc lower prices increase the qty of goods and services demanded (ceteris paribus)

3 effects that cause AD to slope downwards

Y = C + I + G + NX
- assuming G is fixed by policy, each component contributes to AD

1. wealth effect: C is affected by price lvl: low prices → higher real value of money → larger purchasing power → ppl demand more goods and services
> consumers become wealthier, stimulating the demand for consumption

2. interest rate effect: I (investment) is affected by the interest rate: low prices → less bills held → invest in bonds or saving acct → higher supply of loanable funds → lower interest rates → more borrowing and investment
> interest rates fall, stimulating the demand for investment goods

3. exchange rate effect: NX is affected by the exchange rate: lower prices → interest rates of the ph decreases → ph investors want to invest abroad → exchange pesos for foreign currency → supply for pesos increases → peso depreciates → domestic goods become cheaper than foreign goods → exports increase → increase demand by foreigners
> currency depreciates, stimulating the demand for net exports

4 factors that shift the AD

- any change in C, I, G, & NX

1. changes in consumption: if ppl wanna spend or save more
> stock boom or crash: boom → ppl get richer → increase in spending → qty demanded increases → AD shifts to the right
> preferences: consumption or saving trade off: ppl wanna save more → consumption reduces → qty demanded decreases → price lvl is lower → ad shifts to the left
> tax hikes or cuts: higher taxes → less disposable income → lower consumption

2. investments: when businesses are more optimistic in the economy (stable economy), then they will be incentivized to invest
> expectations: firm buys new eq if they expect the economy to be better → AD shifts to the right
> monetary policy: increase in money supply → lowers interest rate in the short run → ppl are incentivized to borrow and invest → AD shifts to the right
> investment tax credit or tax incentives: no tax for buying eq → incentivizes ppl to invest → AD shifts to the right

3. gov spending: higher gov spending bc infrastructure → AD shifts to the right

4. net exports: if vietnam has a recession, it stops importing goods from the philippines → ph exports decreases → shifts AD to the left
> booms or recessions in countries that buy our exports
> investors think yen is depreciating → they want to move to the ph economy → peso appreciates → goods are more expensive compared to jp goods → AD shifts to the left

effects of a shift in AD

• Event: Stock market crash
1. Affects C, AD curve
2. C falls → AD shifts left
3. SR equilibrium at B. P & Y lower →
unemployment higher
4. Over time, PE falls, SRAS shifts right, until LR equilibrium at C. Y and unemployment back at initial levels.
> if bumagsak ng demand, there will be lower prices → ppl think mababa yung presyo forever → expected price goes down & input cost also decreases → firms supply curve will shift to the right bc if general prices go down (including raw mats), the firm can produce more goods, causing the supply curve to shift to the right

aggregate supply

LRAS: vertical
> bc it doesnt depend on the prices, it depends on the supply of labor, capital, natural rss, tech

SRAS: horizontal

AD and LRAS

- used to depict long run growth and inflations

- over time, technological progress shifts AS to the right

- over time, higher money supply shifts AD to the right

shifters of LRAS

1. changes in labor: immigration/emigration, higher structural unemployment

2. changes in capital: physical or human capital

3. changes in natural rss: discovery of a new mineral or oil deposit in west ph sea

4. changes in technology: inventions and freer trade

why does SRAS curve upwards

Because it is in the short run, as price level increases, firms want to sell more because it is more profitable.

sticky wages theory

- nominal wages dont automatically adjust in the short run

- prices are lower than expected, cant fire workers, affects profitability of firms, induces lower production

- ex: a year ago, a firm expected the price lvl today will be 100, so they pay their employees $20/hr. but in reality, the price lvl is 95. so bc price is below expectation, the firm gets -5% for each unit of the product it sells. bc the labor is stuck at $20/hr, production is less profitable → higher less workers → reduce qty supplied. but over time, the labor contract will expire and the firm can negotiate with the workers for a lower wage

sticky prices theory

menu costs: if prices decrease, those who dont adjust their menus will see lower sales and production'

- a decrease in price lvl reduces the qty of goods and services supplied in the short run

misperceptions theory

changes in overall price can temporarily mislead suppliers abt whats happening in the individual markets where they sell their outputs

ex: with lower prices of rice, farmers assume lower rewards to price production (thinking theyre the only ones affected) so they lower rice production in the short run. in reality tho, it may be possible that all the goods and services have lowered, not just the price of rice

shifters of SRAS

same shifters as LRAS (labor, capital, natural rss, tech) plus:

expected price lvl: when expected prices rice → wages increase → costs increase → firms produce smaller qty of goods and services → SRAS shifts to the right
*same vice versa, if expected prices fall, SRAS will shift to the right

price relationship

- price increase → consumption goes down

- price increase → interest rate increases
> u need more money to buy the same qty

exchange rate effects

price increases → interest rates increases → peso appreciates → net imports increases → net exports decrease

> price goes up, interest rate increases, e appreciates (demand for peso increases → value becomes stronger → peso appreciates), net imports goes up & net exports decrease
> "stronger peso" 1 peso can be exchanged for more USD

steps to analyze an economic fluctuation

1. determine if the event shifts AD or AS

2. determine if it shifts to the right or left

3. use AD-AS diagram to see how it changes Y (qty) and P (price) in the short run

4. use AD-AS diagram to see how economy moves from the new SR equilbrium to new LR equilibrium

- in the short run, shifts in AD causes fluctuations in the economys output of goods and services
- in the long run, shifts in AD affect the overall price lvl but not output
- bc policy makers influence ad, they can potentially mitigate the severity of economic fluctuations

analyze an economic fluctuation:

effect of pessimism in the economy (ex: scandal, stock market crash, outbreak of war or conflict)

left shift of AD bc ppl have less money to buy goods

short run equilibrium: lower prices short run AS will shift to the right bc theyll produce less since theres less demand (lower qty output, leading in a recession)

long run equilibrium: ppl will expect prices in the future to be lower. and output will rise back to the natural rate
> so the economy corrected itself even without policy → bale equilibrium point is on the same output as when it first began, just on a lower price
> in the long run, theres lower prices (nominal) and zero changes in output (real)
> policy makers could also increase AD in a recession (by gov spending or stimulus bill); if theyre quick enough, the move from A-B-A and recession can be abated quicker

analyze an economic fluctuation:

what if bad weather destroys crops, driving up food costs, or a war interrupts the shipping of crude oil

AS will shift to the left → less qty and higher prices → recession bc the output is lower than the demand

short run equilibrium: ppl will expect higher prices → AS will shift even more to the left → stagnation (lower output) + inflation (rising prices) = stagflation