Aggregate Supply and Demand in Macroeconomics

Announcements

• Email for questions: maria.hatalis@rutgers.edu

• Today: Begin Chapter 10

• Homework 6: Chapters 8 + 10 due Tuesday, Dec. 9th at 11:59 PM

• Final Exam: December 19 - Covers Chapters 8, 10, 12, 13, 14
  Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Chapter 10: Aggregate Supply and Aggregate Demand

Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Learning Objectives

After studying this chapter, you will be able to:

• Explain what determines aggregate supply in the long run and the short run.

• Explain what determines aggregate demand.

• Explain how real GDP and the price level are determined and what causes growth, inflation, and cycles.
  Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Aggregate Supply

• Definition: Aggregate supply is the relationship between:

  • The quantity of real GDP supplied and the price level.

  • Quantity of real GDP supplied = total quantity that firms plan to produce during a given period.

• Time Frames: Distinction between:

  • Long-run aggregate supply (LAS)

  • Short-run aggregate supply (SAS)
    Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Long-Run Aggregate Supply

• Definition: Long-run aggregate supply is the relationship between the quantity of real GDP supplied and the price level when:

  • Real GDP = potential GDP.

  • Potential GDP is independent of the price level.

• Characteristics: The long-run aggregate supply curve (LAS) is vertical at potential GDP.
  Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Short-Run Aggregate Supply

• Definition: Short-run aggregate supply is the relationship between the quantity of real GDP supplied and the price level when:

  • The wage rate, the prices of other resources, and potential GDP remain constant.

• Behavior: A rise in price level (with no change in wage rate or factor prices) increases the quantity of real GDP supplied, resulting in:

  • Movement along the short-run aggregate supply curve (SAS).

• Characteristics: The short-run aggregate supply curve (SAS) is upward sloping.
  Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Changes in Aggregate Supply (Shift Factors)

• Aggregate supply changes if an influence on production plans, other than the price level, changes. Remember: changes in price cause a movement along the supply curve—never a shift.

• Influences include:

  • Changes in potential GDP (shifts both LAS & SAS)

  • Changes in wage rate & prices for factors of production (shifts only SAS curve).
    Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Changes in Potential GDP

• Effect on Curves: When potential GDP increases:

  • Both the LAS and SAS curves shift to the right.

• Reasons for Change: Potential GDP changes for the following reasons:

  1. Increase in the full-employment quantity of labor.

  2. Increase in the quantity of capital (physical or human).

  3. Advance in technology.
     Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Changes in Money Wage Rate

• Effect on SAS: A rise in the money wage rate:

  • Decreases short-run aggregate supply (SAS), causing it to shift left.[LAS ext{ does NOT change}
    y
    Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Aggregate Demand

• Definition: 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.
  Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Quantity of Real GDP Demanded

• Formula: Quantity of real GDP demanded, Y, is defined as: Y = C + I + G + X_M Where:

  • C = Consumption expenditures

  • I = Investment

  • G = Government expenditure

  • X_M = Net exports
    Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Factors Affecting Buying Plans

• Main Factors:

  • The price level (causes movement along the curve).

• Shift Factors:

  • Expectations

  • Fiscal policy & monetary policy

  • The world economy
    Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Factors that Shift Aggregate Demand

• A change in any influence on buying plans other than the price level changes aggregate demand. The main influences are:

  • Expectations

  • Fiscal policy and monetary policy

  • The world economy
    Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Expectations Impact on Aggregate Demand

• Examples of Expectations:

  • Increases in expected future income raise consumption today, thus increasing AD.

  • A rise in the expected inflation rate makes purchasing conventional today cheaper, increasing AD.

  • An increase in expected future profits boosts firm investment, leading to an increase in AD.
    Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Fiscal Policy

• Definition: Fiscal policy is the government’s attempt to influence the economy by changing:

  • Taxes (T)

  • Government spending (G)

• Effects:

  • Tax cuts (T): increase households’ disposable income leading to increased consumption (C) and aggregate demand.

  • Increases in government expenditure (G): increases a component of AD (Y = C + I + G + X - M), thus increasing aggregate demand.
    Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Monetary Policy

• Definition: Monetary policy refers to the Fed’s attempt to influence the economy by changing:

  • The interest rate.

  • Adjusting the quantity of money.

• Effects:

  • An increase in the quantity of money allows people to buy more, leading to increased AD.

  • A cut in interest rates encourages expenditure (spending), thus increasing AD.
    Copyright © 2023 Pearson Education, Inc. All Rights Reserved

The World Economy's Influence on Aggregate Demand

• Ways it Influences:

  1. A fall in the foreign exchange rate lowers the price of domestic goods relative to foreign goods, increasing exports (X), decreasing imports (M), and increasing aggregate demand.

  2. An increase in foreign income increases demand for U.S. exports (X), thus increasing aggregate demand.
     Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Changes in Aggregate Demand

• AD Curve Shifts:

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

  • When aggregate demand decreases, the AD curve shifts leftward.
    Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Short-Run Macroeconomic Equilibrium

• Definition: Occurs when:

  • Quantity of real GDP demanded = quantity of real GDP supplied.

  • It is the intersection point of the AD curve & SAS curve.
    Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Long-Run Macroeconomic Equilibrium

• Definition: Occurs when:

  • Real GDP = potential GDP (the economy is on its LAS curve).

• Long-run equilibrium is where the AD, SAS, and LAS curves intersect.
  Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Example 1: Adjustment to Long-Run Equilibrium

• Scenario: Economy is at below-full employment equilibrium (AD/SAS equilibrium left of LAS curve).

• Long-Term Adjustment: Money wage falls until SAS shifts right and intersects the long-run equilibrium point where LAS, SAS, & AD intersect.
  Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Example 2: Above-Full Employment Equilibrium

• Scenario: Economy is at above-full employment equilibrium (AD/SAS equilibrium right of LAS curve).

• Long-Term Adjustment: Money wage rate rises until SAS shifts left and intersects the LAS curve.
  Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Economic Growth

• Drivers of Growth:

  • Growth in quantity of labor.

  • Capital accumulation.

  • Advances in technology.

• Result: Potential GDP increases and LAS curve shifts right.
  Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Inflation

• Scenario: If the quantity of money grows faster than potential GDP,

  • Aggregate demand increases more than long-run aggregate supply, shifting the AD curve rightward more than the right shift of the LAS curve.
    Copyright © 2023 Pearson Education, Inc. All Rights Reserved

The Business Cycle

• Definition: The business cycle occurs due to fluctuations in aggregate demand and short-run aggregate supply, while the money wage does not adjust rapidly enough to maintain real GDP at potential GDP.

• Types of Equilibrium:

  • Above full-employment equilibrium: real GDP > potential GDP.

  • Full-employment equilibrium: real GDP = potential GDP.

  • Below full-employment equilibrium: potential GDP > real GDP.
    Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Inflationary and Recessionary Gaps

• Inflationary Gap: The amount by which real GDP exceeds potential GDP.

  • Previously referred to as a positive output gap.

• Recessionary Gap: The amount by which real GDP is less than potential GDP.
  Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Effects of Changes in Aggregate Demand

• Scenario: An increase in aggregate demand shifts the AD curve right.

  • Firms increase production and the price level rises in the short run.
    Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Short-Run Equilibrium and Inflationary Gaps

• At short-run equilibrium: an inflationary gap exists when real GDP is temporarily greater than potential GDP.

• Subsequently, the money wage rate begins to rise, shifting the SAS curve leftward, with price levels also continuing to rise until real GDP equals potential GDP.
  Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Effects of Aggregate Supply Changes

• Scenario: A rise in the price of oil leads to a leftward shift in the SAS curve.

  • Result: Real GDP decreases and the price level rises, leading to stagflation (high prices and GDP below potential GDP).
    Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Summary of Equilibrium Conditions

• Short-run equilibrium occurs where the AD curve intersects the SAS curve.
  Copyright © 2023 Pearson Education, Inc. All Rights Reserved

Additional Key Concepts

• Economic growth is demonstrated by a potential GDP increase as the long-run aggregate supply curve shifts rightward.

• Shifts of the aggregate demand curve due to fiscal or monetary policy are significant in macroeconomic stability and growth.
  Copyright © 2023 Pearson Education, Inc. All Rights Reserved