Aggregate Demand and Aggregate Supply Model: Shifts and Long-Run Equilibrium

Foundations of the Aggregate Demand and Aggregate Supply Model

• Review of Aggregate Demand (AD) Derivation: The aggregate demand model is derived based on three primary economic effects:

  • Real Balances Effect: Changes in the price level affect the purchasing power of money, influencing consumer spending.

  • Interest Rate Effect: Changes in the price level impact interest rates, which subsequently affect investment and consumption.

  • Foreign Trade Effect: Changes in the domestic price level relative to foreign prices affect net exports.

• The Short-Run Aggregate Supply (SRAS) Model: The SRAS curve is derived from profit incentives.

  • Core Assumption: In the short run, output prices (the price of goods sold) change while input prices (wages and raw materials) are assumed to remain stable, constant, or sticky.

  • Behavioral Mechanism: If output prices increase and input prices do not, firms perceive a higher profit margin and are incentivized to produce more output.

  • Result: There is a positive relationship between the price level and the quantity of real GDP produced in the short run.

• The Long-Run Aggregate Supply (LRAS) Curve: Unlike the short-run curve, the LRAS is represented as a vertical line.

  • Full Capacity/Full Employment: The vertical line represents a fixed level of real GDP where the economy uses all available resources. This state is known as full employment.

  • Long-Run Resource Constraints: In the long run, firms cannot increase production simply by raising prices because all resources are already employed. Attempting to produce beyond full capacity (e.g., asking workers to work more than their standard weekly hours, such as a $48$-hour week) requires paying higher wages.

  • Wage-Price Spiral: If businesses pay higher wages to increase output, they must raise prices to cover those costs. If all prices and wages rise together, there is no real incentive for additional labor or production, maintaining the vertical nature of the curve.

Economic Equilibrium and Output Gaps

• Long-Run Equilibrium: This occurs at the point where the Aggregate Demand ($AD$) curve, the Short-Run Aggregate Supply ($SRAS$) curve, and the Long-Run Aggregate Supply ($LRAS$) curve all intersect. This is the ideal target state for the economy.

• Short-Run Equilibrium: An economy is in short-run equilibrium where $AD$ and $SRAS$ intersect, regardless of whether they meet the $LRAS$ curve.

• Recessionary Gap:

  • Definition: Occurs when the intersection of $AD$ and $SRAS$ lies to the left of the $LRAS$ curve.

  • Calculation: The difference between Full Employment Real GDP ($GDP_{FE}$) and Short-Run Equilibrium Real GDP ($GDP_{SR}$).

  • Remediation: To move toward full employment, the economy requires:

    • The $AD$ curve to shift to the right (with $SRAS$ constant).

    • The $SRAS$ curve to shift to the right (with $AD$ constant).

    • Both $AD$ and $SRAS$ shifting to the right simultaneously.

• Expansionary (Inflationary) Gap:

  • Definition: Occurs when the intersection of $AD$ and $SRAS$ lies to the right of the $LRAS$ curve.

  • Context: The economy is overexpanded and producing beyond its sustainable capacity.

  • Remediation: To return to full employment, the economy requires:

    • The $AD$ curve to shift to the left.

    • The $SRAS$ curve to shift to the left.

    • Both curves shifting to the left simultaneously.

Determinants of Aggregate Demand (AD) Shifts

• Economic Growth Requirements (Page 566, Chapter 28): Achieving higher potential production (created by supply factor improvements) requires a corresponding reaction on the demand side. Households, businesses, and the government must expand their purchases of goods and services to provide a market for the new output.

• Fiscal Policy and Household Spending:

  • Taxes: Income taxes are a primary form of fiscal policy. A cut in income taxes increases disposable income, shifting the $AD$ curve to the right. Conversely, a tax increase shifts the $AD$ curve to the left.

  • Consumer Wealth and Expectations: Increases in consumer wealth or more money available to spend (disposable income) shift $AD$ to the right.

  • Household Borrowing: Taking loans from banks or finance companies is influenced by interest rates.

• Monetary Policy and Investment Spending:

  • Expansionary Monetary Policy: The Federal Reserve (monetary authority) increases the money supply to decrease interest rates. Lower interest rates make it easier/cheaper for businesses to borrow for capital equipment, shifting $AD$ to the right.

  • Contractionary Monetary Policy: The Federal Reserve increases interest rates to deter household and business spending, shifting $AD$ to the left.

• Business Taxes and Expected Returns:

  • Corporate Income Taxes: Higher corporate taxes shift $AD$ to the left.

  • Proprietors\' Income: Since proprietors report business income on personal tax returns, changes in individual tax rates directly impact business spending in this sector.

• Government Spending and Budgetary Impacts:

  • Budget Deficit: Occurs when the government spends more than it collects in taxes. This injects more money into the household and business sectors, shifting $AD$ to the right.

  • Budget Surplus: Occurs when the government collects more in taxes than it spends. This removes money from the economy, shifting $AD$ to the left.

Determinants of Short-Run Aggregate Supply (SRAS) Shifts

• Supply Factors (Page 566):

  • Increases in the quantity and quality of natural resources (land).

  • Increases in the quantity and quality of human resources (labor).

  • Increases in the supply of capital goods.

  • Increases in technology.

• Input Prices (Page 656, Figure 32.6):

  • Domestic Resource Prices: Shifts depend on the cost of rent, wages, and interest (the price of capital).

  • If rent, wages, or capital costs fall, the $SRAS$ curve shifts to the right.

  • If rent, wages, or capital costs rise, the $SRAS$ curve shifts to the left.

• Productivity: Driven by two main sources:

  • Human Capital: A smarter, more educated workforce is a more productive workforce.

  • Technology: Better technology allows for greater output from the same inputs.

• Government Regulations and Taxes:

  • Regulations: Generally, increased government regulations shift the $SRAS$ curve to the left.

  • Deregulation: Reducing regulatory burdens shifts the $SRAS$ curve to the right.

Complex Dynamics: Simultaneous Shifts and LRAS Changes

• Rule 1: Supply and Demand move in the same direction:

  • If $AD$ and $SRAS$ both shift in the same direction (e.g., both shift right), the real GDP equilibrium moves in that same direction (increases).

  • The aggregate price level remains indeterminate.

• Rule 2: Supply and Demand move in opposite directions:

  • If $AD$ and $SRAS$ move in opposite directions, the price level moves in the same direction as the $AD$ curve.

  • The equilibrium level of real GDP remains indeterminate.

• Shifts in the Long-Run Aggregate Supply (LRAS) Curve: These are considered extraneous and driven by major structural changes.

  • Leftward Shift: Caused by natural disasters that destroy resources (land, labor, or capital structure).

  • Rightward Shift: Caused by a significant, permanent increase in all resources, primarily driven by a massive increase in capital structure and technology that requires more employment and land use.

Questions & Discussion

• Logistics Question: A student named Jordan mentioned late-night studying and general life updates.

• Dialogue:

  • Speaker: "Hi, Jordan… Is he there right now? Can I see?"

  • Jordan: Mentioned it was $12:30$ in the morning and they had a test at $2:00$ AM. They expressed annoyance about staying up for summer classes.

  • Speaker: Asked about Georgetown, track, and the heat.

  • Jordan: Mentioned it was over $100$ degrees for a solid two weeks and they were in shock as they weren't used to those levels.

Administrative Notes

• Upcoming Test: The fourth test is scheduled for Monday (not tomorrow). Zoom invites will be sent out on Sunday.

• Next Class: Friday's lecture will begin the unit on Money.

• Final Exam Schedule: The fifth test (final exam) is scheduled for Friday, the 24th.

• Study Materials: Students are advised to check Brightspace content for outlines and additional supplemental readings posted earlier this week.