aggregate demand and aggregate supply 9.1-9.4

aggregate demand definition

• the quantity of total output, or real GDP, that all buyers in an economy want to buy at different possible price levels, ceteris paribus.

• = C + I + G + (X-M)

what does the AD curve show

the relationship between the aggregate output buyers want to buy (real GDP demanded) and the economy’s price level, ceteris paribus.

factors that cause a shift in the AD curve (determinants of aggregate demand)

• change in consumption

• change in investment

• change in government spending

• change in net exports

causes of change in consumption

• change in :

• real disposable income

• consumer confidence (Keynesian focus)

• expectation of future price levels

• interest rates

• wealth (e.g change in asset prices)

• level of household indebtedness → how much money people owe from borrowing in the past

causes of change in investment spending

• changes in:

• business confidence (Keynesian focus)

• interest rates

• (improvement) technology → stimulate investment spending

• corporate taxes

• level of corporate indebtedness

• legal/institutional changes

causes of changes in government spending

• change in :

• political priorities

• economic priorities → deliberate efforts to influence aggregate demand

• tax revenue

• borrowing

• business cycle (Keynsian focus)

causes of changes in next exports

• changes in:

• national income abroad → increase in national income abroad = import increases

• exchange rates → price of one country’s currency increases → exports fall as it is more expensive for consumers abroad. however imports increase as goods and services from abroad are cheaper for domestic consumers.

• trade policies / level of trade protection → changes in trade restrictions e.g quotas, import taxes (decrease in exports + imports)

aggregate supply definition

the total quantity of goods and services produced in an economy (real GDP) over a particular time period at different price levels.

Potential output / Productive capacity definition

the total amount that can be produced by an economy over a period of time with a given amount of resources = vertical section of the AS curve (AS=Yfe)

3 sections of Keynesian aggregate supply curve

• 1 -

• The economy has large spare capacity + unemployment

• real GDP is low

• increased demand for factors of production doesn’t push up factor prices

• 2 -

• real GDP + price levels increase

• the economy gets ever closer to maximum capacity firms will experience bottlenecks of resources become scarcer as there is an upward pressure on factor prices of goods and services

• 3 -

• The economy is working at maximum capacity (on PPC) = full employment level of national income = Yfe

• GDP cannot increase any further

definition of short run vs long run in macroeconomics

• short run: the period of time when prices of resources are constant despite changes in the average price level, applies especially to wages

• long run: the period of time when the prices of all resources, including wages are flexible and change along with changes in price level

why are wages of special interest for firms

• they make up the largest part of firms’ costs of production → strongly affect the quantity of output supplied by firms

• wages do not change much over a short period of time “sticky wages”

why do wages not change much over relatively short periods of time

• labour contracts fix wages for certain periods of time

• minimum wage legislations fix the lowest legally permissible wage

• workers and labour unions resist wage cuts

• wage cuts have negative effects on worker morale → causes firms to avoid them

short run aggregate supply curve

shows the relationship between the price level and the quantity of real output produced by firms when resources (especially wages) don’t change

why is the SRAS curve upward-sloping

• increase in price level means output prices have increased → with unchanged resource prices (due to being in the SR) → firms’ profits increase

• as production becomes more profitable firms increase the quantity of output produced → positive relationship between price level and quantity of real GDP

what factors cause a shift in the SRAS

• changes in wages

• changes in non-labour resource prices

• changes in indirect taxes → can increase costs of production

• changes in subsidies

• supply shocks

where can an equilibrium occur in both a keynesian and neoclassical model

• full employment output

• recessionary gap

• inflationary gap

long run aggregate supply curve (LRAS)

• shows the relationship between real GDP and the price level when resource prices change to reflect changes in the price level, ceteris paribus.

• LRAS is vertical at full employment → Long run output is independent of the price level

neoclassical beliefs

• AS determines AD

• The economy operates at long run equilibrium (full employment/natural unemployment)

why is the LRAS vertical

• resource prices change to match output price changes

• firms’ real costs of production remain constant even as the PL changes → firms’ real profits are constant → have no incentive to increase/decrease output levels

deflationary/recessionary gap on the neoclassical diagram

• real GDP < potential GDP

• unemployment > natural unemployment

• equilibrium is on the left of potential GDP

inflationary gap on the neoclassical diagram

• equilibrium is on the right of potential GDP