Economics BASIS 8 Unit 7 : Aggregate Supply & Demand and Macroeconomic Equilibrium

7A : Aggregate Demand

Definition

Aggregate Demand is the sum of all spending on final goods

• The AD curve is a graphical representation of the relationship between the aggregate price level and quantity of aggregate output, or real GDP, demanded by households, businesses, government, and the world at each possible price level

Demand in the macroeconomy comes from four general sources:

• Consumption

• Investment

• Gov. Spending

• Net Exports

Determinants

Can be remembered by the formula for GDP, Y = C + I + G + NX
Sudden Changes in Consumption

• Changes in consumer confidence and expected price changes

• Changes in income

Sudden Changes in Investment

• Changes in producer confidence and expected price changes

• Changes in interest rates

Sudden Changes in Gov. Purchases

• Changes in gov. spending

• Changes in tax rates

Sudden Changes in Net Exports

• Changes in income of trading partners

• Changes of exchange rates

7B : Aggregate Supply

Definition and Shape

The aggregate supply curves show the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy.

• The short-run aggregate supply curve is upward-sloping

• The long-run aggregate supply curve is vertical

Determinants - SRAS

Does it change the per-unit profit of the producer? If so, it’s SRAS

Changes in Input Prices/Availability (Resources)

• Commodities — the price of raw materials or commodities, such as metals, oil, agriculture, cotton, and livestock.

• Nominal Wages — changes in labor cost can affect production costs

Changes in Expected Price Levels

Changes in Business Confidence

Changes in Gov. Policies

Changes in Tech Advancements

Changes in Natural Events/Productivity

Determinants - LRAS

The determinants for long-run aggregate supply are the same as those that shift the production possibilities curve.

Quantity and Quality of an economy’s factors of production, or resources

• Land (or natural resource) availability — changes in the availability or quality of natural resources

• Capital Stock — increased investment in capital goods like machinery and infrastructure expands the production capacity

• Labor — changes in the size and quality of the labor force, such as population growth, immigration, and education levels.

• Entrepreneurship — the level of entrepreneurial activity can drive innovation and economic growth

Technological Advancements — improvements in technology lead to increased productivity and potential output

Gov. Policies — regulation/deregulation can influence the incentives for businesses to invest and produce

• Anything that shifts the LRAS curve will also shift the SRAS curve in the same direction

7C : Macroeconomic Equilibrium

Business Cycle review

A business cycle is a diagram illustrating short-run fluctuations in Real GDP over time, relative to what the economy is capable of doing when productive resources are being fully employed

• Economic Growth is typically marked by periods of recession followed by periods of expansion

Business Cycles are deviations of GDP away from the long run trend. (“Real GDP is increasing over time, but it’s a bumpy road along the way with lots of ups and downs.”

Short-run Equilibrium

The short-run macroeconomic equilibrium is the point at which Aggregate Demand and Short-run Aggregate Supply intersect.

• Short-run equilibrium aggregate output (Y*) and short-run equilibrium price level (PL*) can change for 3 reasons:

  • AD changes

  • SRAS changes

  • Both AD and SRAS change

Demand Shocks

A demand shock is an unexpected change that shifts aggregate demand (AD).

• A negative demand shock leads to a lower aggregate price level, lower aggregate output, and increased unemployment.

  • AD moves to the left

• A positive demand shock leads to a higher aggregate price level, higher aggregate output, and decreased unemployment.

  • AD moves to the right

Supply Shocks

A supply shock is an unexpected change that shifts short-run aggregate supply (SRAS).

• A negative supply shock leads to lower output, a higher aggregate price level, and increased unemployment.

  • SRAS moves to the left

• A positive supply shock leads to higher aggregate output, a lower aggregate price level, and decreased unemployment

  • SRAS moves to the right

Long-run Equilibrium

The long-run macroeconomic equilibrium occurs where the short-run macro equilibrium is on the long-run aggregate supply curve.

• Long-run full employment output is the max amt. of goods and services an economy can produce while using all avail. resources efficiently

• The unemployment rate at this pt. is the natural rate of unemployment.

• A contractionary gap (recessionary gap) occurs when an economy’s output is lower than it’s potential

  • Short-run equilibrium is to the left of the LRAS curve, unemployment > natural rate, decrease in input cost, increase in SRAS to correct gap

• An expansionary gap (inflationary gap) is when an economy’s actual output is higher than it’s potential output. This means that the economy is operating above it’s potential. This level of production is NOT sustainable in the long-run!

  • Short-run equilibrium is to the right of the LRAS curve, unemployment < natural rate, increase in input cost, decrease in SRAS to correct gap