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Aggregate Supply and Demand Model

Introduction to Economics and Modeling

  • Nature of Economics: Economics combines science (modeling) with art (selecting relevant models).

  • Key Idea: Economic materials vary over time, necessitating models to distinguish constant factors from fluctuating ones.

  • Keynes Quote: "Good economists are scarce because the gift for using vigilant observation to choose good models is rare."

Economic Models

  • Purpose of Economic Models: Simplified representations focusing on important aspects for understanding economics.

  • Ceteris Paribus: Assumes all other factors remain unchanged, similar to controlled experiments.

Decision-Making in Economics

  • Three Keys Model:

    1. Choose actions where additional benefits outweigh additional opportunity costs.

    2. Analyze only additional benefits and costs.

    3. Include all costs, such as implicit costs and externalities.

Supply and Demand Framework

  • Price and Quantity Dynamics: Changes in price and quantity are results of economic events, not causes.

  • Comparative Statics: Analyze changes starting from an equilibrium situation and comparing outcomes after changes.

Circular Flow Model

  • Components: Includes consumers, businesses, government, and the rest of the world (ROW).

  • Equations:

    • Aggregate income equation: C + I + G + (X - IM) = Y

Aggregate Supply and Aggregate Demand

  • Core Concepts: Explains how economies reach potential GDP and the implications for full employment and price stability.

  • Shocks: Business cycles arise from shifts in aggregate supply or demand, leading to unemployment or inflation.

Long-Run and Short-Run Aggregate Supply

Potential GDP

  • Definition: Full-employment output, represented as a vertical line in long-run aggregate supply (LAS) showing no change regardless of price level.

  • Production Possibilities Frontier: Areas inside indicate unused resources; as inputs change, LAS and the PPF shift.

Time Horizons in Economics

  • Long Run: All prices adjust; economy operates at potential GDP.

  • Short Run: Some prices fixed; supply plans influenced by expectations on future demand.

Short-Run Aggregate Supply (SAS)

  • Concept: Aggregate supply made by businesses based on existing inputs and expectations about future demand.

  • Law of Short-Run Aggregate Supply: As the price level rises, quantity supplied of real GDP increases; represented by upward sloping SAS.

  • Impact of Input Prices: Rising prices shift SAS left; falling prices shift SAS right.

Supply Shocks

  • Negative Supply Shocks: Increase costs or decrease inputs, moving the SAS curve leftward.

  • Positive Supply Shocks: Improve productivity, moving SAS rightward.

Demand Factors in the Economy

Aggregate Demand (AD)

  • Components: Aggregate demand consists of consumption (C), investment (I), government spending (G), and net exports (X - IM).

  • Law of Aggregate Demand: Inverse relation; as price level rises, quantity demanded decreases.

Demand Shocks

  • Characteristics: Changes in expectations, interest rates, and government policy can shift the AD curve.

  • Negative and Positive Demand Shocks: Affect the economy's demand posture, shifting AD left or right respectively.

Long-Run Macroeconomic Equilibrium

  • Equilibrium Definition: Where aggregate demand equals aggregate supply at potential GDP.

  • Performance Target: LAS indicates where policymakers strive to position the economy.

Economic Growth and Shocks

  • Impacts of Shocks: Economic shocks lead to either recessionary gaps or inflationary gaps, affecting real GDP and unemployment inversely.

  • Framework for Analysis: Use the AS/AD model to assess responses to demand and supply shocks, leading to adjustments towards equilibrium.