Macroeconomics: Aggregate Supply and Demand

Aggregate Supply

Quantity Supplied and Supply

• The quantity of real GDP supplied is the total quantity that firms plan to produce during a given period.
• Aggregate supply is the relationship between the quantity of real GDP supplied and the price level.
• Two time frames are distinguished based on the labor market:
  • Long-run aggregate supply
  • Short-run aggregate supply

Long-Run Aggregate Supply

• Long-run aggregate supply is the relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP.
• Potential GDP is independent of the price level.
• The long-run aggregate supply curve (LAS) is vertical at potential GDP.

Short-Run Aggregate Supply

• Short-run aggregate supply is the relationship between the quantity of real GDP supplied and the price level when the money wage rate, the prices of other resources, and potential GDP remain constant.
• A rise in the price level, with no change in the money wage rate and other factor prices, increases the quantity of real GDP supplied.
• The short-run aggregate supply curve (SAS) is upward sloping.

LAS Curve

• In the long run, the quantity of real GDP supplied is potential GDP.
• As the price level rises and the money wage rate changes by the same percentage, the quantity of real GDP supplied remains at potential GDP.

SAS Curve

• In the short run, the quantity of real GDP supplied increases if the price level rises.
• The SAS curve slopes upward.
• A rise in the price level with no change in the money wage rate induces firms to increase production.

SAS and LAS Intersection

• With a given money wage rate, the SAS curve intersects the LAS curve at potential GDP.
• If the price level falls below 110, the quantity of real GDP supplied decreases along the SAS curve.
• If the price level rises above 110, the quantity of real GDP supplied increases along the SAS curve, and real GDP exceeds potential GDP.

Changes in Aggregate Supply

• Aggregate supply changes if an influence on production plans other than the price level changes.
• These influences include:
  • Changes in potential GDP
  • Changes in money wage rate (and other factor prices)

Changes in Potential GDP

• When potential GDP increases, both the LAS and SAS curves shift rightward.
• Potential GDP changes for three reasons:
  • An increase in the full-employment quantity of labor
  • An increase in the quantity of capital (physical or human)
  • An advance in technology

Effect of Increase in Potential GDP

• The LAS curve shifts rightward, and the SAS curve shifts along with the LAS curve.

Changes in the Money Wage Rate

• Short-run aggregate supply decreases, and the SAS curve shifts leftward.
• Long-run aggregate supply does not change.

Aggregate Demand

Quantity of Real GDP Demanded

• The quantity of real GDP demanded, Y, is the total amount of final goods and services produced that people, businesses, governments, and foreigners plan to buy.
• This quantity is the sum of consumption expenditures C, investment I, government expenditure G, and net exports.
• Y = C + I + G + (Exports - Imports)

Factors Influencing Buying Plans

• Buying plans depend on many factors, including:
  • The price level
  • Expectations
  • Fiscal policy and monetary policy
  • The world economy

Aggregate Demand Curve

• Aggregate demand is the relationship between the quantity of real GDP demanded and the price level.
• The aggregate demand curve (AD) plots the quantity of real GDP demanded against the price level.

Slope of the AD Curve

• The AD curve slopes downward for two reasons:
  • Wealth effect
  • Substitution effects

Wealth Effect

• A rise in the price level decreases the quantity of real wealth (money, stocks, etc.).
• To restore their real wealth, people increase saving and decrease spending, decreasing the quantity of real GDP demanded.
• A fall in the price level increases the quantity of real wealth, increasing the quantity of real GDP demanded.

Substitution Effects

• Intertemporal substitution effect:
  • A rise in the price level decreases the real value of money and raises the interest rate.
  • When the interest rate rises, people borrow and spend less, so the quantity of real GDP demanded decreases.
  • A fall in the price level increases the real value of money and lowers the interest rate.
  • When the interest rate falls, people borrow and spend more, so the quantity of real GDP demanded increases.
• International substitution effect:
  • A rise in the price level increases the price of domestic goods relative to foreign goods.
  • Imports increase and exports decrease, which decreases the quantity of real GDP demanded.
  • A fall in the price level increases the quantity of real GDP demanded.

Factors That Shift Aggregate Demand

• A change in any influence on buying plans other than the price level shifts aggregate demand.
• The main influences on aggregate demand are:
  • Expectations
  • Fiscal policy and monetary policy
  • The world economy

Expectations

• Expectations about future income, future inflation, and future profits change aggregate demand.
• Increases in expected future income increase consumption today and increase aggregate demand.
• A rise in the expected inflation rate makes buying goods cheaper today and increases aggregate demand.
• An increase in expected future profits boosts firms’ investment, which increases aggregate demand.

Fiscal Policy and Monetary Policy

• Fiscal policy: the government’s attempt to influence the economy by setting and changing taxes, making transfer payments, and purchasing goods and services.
  • A tax cut or an increase in transfer payments increases households’ disposable income.
  • An increase in disposable income increases consumption expenditure and increases aggregate demand.
• Government expenditure on goods and services is one component of aggregate demand, so an increase in government expenditure increases aggregate demand.
• Monetary policy: The Fed’s attempt to influence the economy by changing the interest rate and adjusting the quantity of money.
  • An increase in the quantity of money increases buying power and increases aggregate demand.
  • A cut in interest rates increases expenditure and increases aggregate demand.

The World Economy

• The world economy influences aggregate demand in two ways:
  • A fall in the foreign exchange rate lowers the price of domestic goods and services relative to foreign goods and services, which increases exports, decreases imports, and increases aggregate demand.
  • An increase in foreign income increases the demand for U.S. exports and increases aggregate demand.

Shifts in Aggregate Demand

• When aggregate demand increases, the AD curve shifts rightward.
• When aggregate demand decreases, the AD curve shifts leftward.

Explaining Macroeconomic Trends and Fluctuations

Short-Run Macroeconomic Equilibrium

• Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the SAS curve.
• If real GDP is below equilibrium GDP, firms increase production and raise prices.
• If real GDP is above equilibrium GDP, firms decrease production and lower prices.
• These changes bring a movement along the SAS curve toward equilibrium.
• In short-run equilibrium, real GDP can be greater than or less than potential GDP.

Long-Run Macroeconomic Equilibrium

• Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP—when the economy is on its LAS curve.
• Long-run equilibrium occurs at the intersection of the AD and LAS curves.

Adjustment to Long-Run Equilibrium

• Initially, the economy is at below-full employment equilibrium.
• In the long run, the money wage falls until the SAS curve passes through the long-run equilibrium point.
• Initially, the economy is at an above-full employment equilibrium.
• In the long run, the money wage rate rises until the SAS curve passes through the long-run equilibrium point.

Economic Growth and Inflation in the AS-AD Model

• Economic growth:
  • The quantity of labor grows, capital is accumulated, and technology advances, potential GDP increases.
  • The LAS curve shifts rightward.
• Inflation:
  • If the quantity of money grows faster than potential GDP, aggregate demand increases by more than long-run aggregate supply.
  • The AD curve shifts rightward faster than the rightward shift of the LAS curve.

The Business Cycle in the AS-AD Model

• The business cycle occurs because aggregate demand and the short-run aggregate supply fluctuate, but the money wage does not change rapidly enough to keep real GDP at potential GDP.
• Above full-employment equilibrium: Real GDP exceeds potential GDP.
• Full-employment equilibrium: Real GDP equals potential GDP.
• Below full-employment equilibrium: Potential GDP exceeds real GDP.

Inflationary and Recessionary Gaps

• The amount by which real GDP exceeds potential GDP is an inflationary gap.
• The amount by which real GDP is less than potential GDP is a recessionary gap.
• Real GDP fluctuates around potential GDP in a business cycle as the economy moves from one short-run equilibrium to another.

Fluctuations in Aggregate Demand

• An increase in aggregate demand shifts the AD curve rightward.
• Firms increase production, and the price level rises in the short run.
• At the short-run equilibrium, there is an inflationary gap.
• The money wage rate begins to rise, and the SAS curve starts to shift leftward.
• The price level continues to rise, and real GDP continues to decrease until it equals potential GDP.

Fluctuations in Aggregate Supply

• A rise in the price of oil shifts the SAS curve leftward.
• Real GDP decreases, and the price level rises.
• The economy experiences stagflation, which means high prices (inflation) and GDP below potential GDP.