Understanding the Economy

Framework

• The economy viewed as composed of:

  • Aggregate Demand (AD): Represents the buying side.

  • Short-Run Aggregate Supply (SRAS): Represents the selling side.

  • Long-Run Aggregate Supply (LRAS): Incorporates long-term economic factors.

Aggregate Demand

Definition

• Aggregate Demand (AD): Shows the quantity demanded of all goods and services at different price levels, ceteris paribus.

• The AD Curve illustrates this relationship under the assumption of constant conditions.

Downward-Sloping AD Curve

• Reasons for Downward Slope:

  • Real Balance Effect: Changes in purchasing power from price level alterations.

  • Interest Rate Effect: Variations in household and business spending influenced by interest rate changes.

  • International Trade Effect: Impact of price level changes on foreign spending.

Changes in Aggregate Demand

• Change in Quantity Demanded vs. Change in Aggregate Demand:

  • Change in quantity demanded: Movement along the AD curve due to price level changes.

  • Change in AD: Results in a shift of the entire AD curve:

    • Increase in AD: Rightward shift.

    • Decrease in AD: Leftward shift.

Factors Affecting Aggregate Demand

• Components of AD:

  • Changes in Consumption (C), Investment (I), Government Spending (G), and Net Exports (NX) affect AD's position:

  • Increase in any component leads to a rightward shift; a decrease leads to a leftward shift.

Specific Factors Driving Changes in AD

1. Consumption (C)

   • Influenced by wealth, expectations of future prices/income, interest rates, and income taxes.

2. Investment (I)

   • Determined by interest rates, expectations of future sales, and business taxes.

3. Net Exports (NX)

   • Affected by foreign real national income and exchange rates.

Short-Run Aggregate Supply

Definition

• Short-Run Aggregate Supply (SRAS): Shows the quantity supplied of all goods and services at different price levels, ceteris paribus.

Upward-Sloping SRAS Curve

• Reasons for Upward Slope:

  • Sticky Wages: Wages do not adjust immediately to market conditions.

  • Worker Misperceptions: Short-term misinterpretations of information.

Changes in Short-Run Aggregate Supply

• Change in Quantity Supplied vs. Change in SRAS:

  • Quantity changes occur along the SRAS curve; a shift in the curve represents a change in supply conditions.

• Factors Causing SRAS Shift:

  • Wage rates, prices of non-labor inputs, productivity, and supply shocks.

Short-Run Equilibrium in the Economy

• The intersection of the AD and SRAS curves identifies the short-run equilibrium.

• Equilibrium Factors:

  • Determines the price level, real GDP, and unemployment rates.

Changes and New Equilibrium

• Shifts in AD or SRAS affect:

  • Price levels

  • Real GDP

  • Unemployment

• Steps to find new equilibrium involve assessing changes, shifting curves, and identifying new intersection points.

Long-Run Aggregate Supply

Definition

• Natural Real GDP: Output at the natural unemployment rate; when the economy is in long-run equilibrium.

• Long-Run Aggregate Supply Curve (LRAS): A vertical representation indicating output when all prices and wages have adjusted fully.

Long-Run Equilibrium States

• Two equilibrium states:

  • Short-run equilibrium: Current intersection of AD and SRAS.

  • Long-run equilibrium: Intersection with LRAS.

Key Questions to Consider During Assessments

• Changes in investment levels, expectations about future conditions, and external factors affect shifts across the AD and SRAS curves and determine real GDP outcome.

Chapter Summary

• The chapter covered:

  • The downward slope of the aggregate demand curve.

  • Factors causing shifts in aggregate demand and short-run aggregate supply.

  • Differences in the slopes of supply curves.

  • Identification of long-run equilibrium in the AD-AS model.