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.