AD, LRAS, SRAS

Aggregate demand ( )

The AD curve is downward sloping. This means that when . Three explanations of the slope:

1. Wealth effect: when real wealth

  1. Interest rate effect: when investment (I)

  2. Exchange rate effect: when U.S. dollar-denominated asset)

rate Net exports

households hold more money, lend less money

( interest rate nominal exchange rate

want to hold more ) real exchange

Movement along the curve (when ):

The purchasing power of money goes up The real interest rate goes down
The real exchange rate goes down

With an increase in either , we have an increase in

Factors that shift the curve:

Anything that changes C, I, G, or NX

along the curve.

  1. Change in consumption (examples: increase in consumer confidence, increase in disposable income)

  2. Change in planned investment (examples: increase in expected future profit, decrease in real interest rate due to monetary policy changes)

  3. Change in NX (examples: increase in foreign income, decrease in real exchange rate)

  4. Change of fiscal policy (change in government expenditure or taxes)

    Short Run Aggregate Supply ( )

In the short run, the aggregate supply curve (SRAS) is upward sloping. This means that when .

Three explanations of the slope:

  1. Sticky wages: firms set nominal wages, which are fixed in the short run. If

    , then real wages production becomes more profitable, so

  2. Sticky prices: firms set their prices based on expected economic conditions. Because it is costly to update menus and catalogs, these prices are fixed in the short run. If , then the firm's prices are set too low increasing sales firms increase production

  3. Misperceptions theory: changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output. suppliers mistakenly believe their relative price has risen suppliers produce more

Factors that shift SRAS:

  1. Cost of production changes: (1) nominal factor price changes: nominal wage changes, nominal resource/input price changes (e.g. oil); (2) exogenous production shock: e.g. bad weather destroy crops

  2. Expected price level raise price today

3. Potential GDP changes: change in quantity of factor of production (e.g. less labor in the economy, destruction of physical capital), change in productivity/technology (e.g. introduction of automation/AI)

Long Run Aggregate Supply (LRAS)

In the long run, the aggregate supply curve (LRAS) is vertical. Recall: an econo- my's production of goods and services (real GDP) depends on its suppliers of labor, capital, natural resources, human capital, and productivity (L, K, N, H, A).

Factors that shift LRAS curve

Anything that affects labor , capital , natural resources , natural resources , or productivity

Self-correcting mechanism

Self-correcting mechanism: changes in the wages & expectations of prices return the economy to the natural level of output in the long run without government in- tervention.

Assume economy initially at its long-run eq, but there is suddenly a decline in con- sumer confidence.

In the short run ( )
curve shifts down, thus, , , .

Back to long run ( )

As workers and firms observe that, they start to adjust. , , shifts right.

Thus, , , . The and shift back to natural level, but does not