Lecture 14 - Short-Run Aggregate Demand and Supply Concepts

Aggregate Demand and Supply in the Short Run

• Short Run Equilibrium:

  • Defined as the intersection of the aggregate demand (AD) curve and the short run aggregate supply (SRAS) curve.

  • This intersection determines the equilibrium price level and output.

  • At prices other than the equilibrium, either surplus or shortage occurs.

• Graphical Representation:

  • Price Level (Y-axis) vs. Real GDP (X-axis).

  • Short run equilibrium is at the intersection point of the AD and SRAS curves.

  • Surplus occurs when the price is above equilibrium leading to a decrease in price, while a shortage occurs below equilibrium leading to an increase in price.

Positive Demand Shock

• Initial Equilibrium:

  • Let the fixed nominal wages be denoted as $w$, with equilibrium price and output being $p<em>0$ and $y</em>0$, respectively.

  • The real wage is given by $\frac{w}{p_0}$.

• Positive Demand Shock:

  • Such shocks shift the AD curve right due to increased spending, increasing both price level and output.

  • New equilibrium moves to $p<em>1, y</em>1$ after the shock, indicating higher prices and output.

  • The shift creates a shortage at the previous price level, prompting price adjustments upward.

Contractionary Monetary Policy

• Initial Equilibrium:

  • Starts with initial equilibrium at $p<em>0, y</em>0$.

• Effects of Contractionary Monetary Policy:

  • Reduction in money supply (to $m'$) shifts the LM curve back to the left, resulting in a new equilibrium at $y_0'$ with decreased output at the same price level as equilibrium.

  • This causes prices to decrease eventually leading to a new equilibrium at $p<em>1, y</em>1$.

The Phillips Curve

• Inflation-Unemployment Trade-off:

  • Traditionally illustrated by the Phillips Curve, which depicts an inverse relationship between inflation and unemployment rates in the short run.

  • An increase in AD causes inflation and a decrease in unemployment, while a decrease in AD causes inflation to drop and unemployment to rise.

Historical Context: 1960s to 1970s

• 1960s: Stable Phillips curve relationship between inflation and unemployment.

• 1970s Stagflation:

  • Characterized by high inflation and high unemployment, caused by negative supply shocks (e.g., oil price increases, productivity slowdowns).

  • Break in stable inverse relationship, leading to higher inflation at higher unemployment levels.

Causes of Inflation

• Demand-Pull Inflation:

  • Caused by an increase in AD.

  • Results in higher output and lower unemployment.

• Cost-Push Inflation:

  • Resulting from a leftward shift in the aggregate supply curve due to increased production costs.

  • Causes inflation to rise while output and employment decrease.

Key Takeaways

• Factors Influencing AD/Supply:

  • Changes in consumption, investment, government spending, or net exports affect AD.

  • Changes in input costs or productivity lead to shifts in aggregate supply.

• Understanding shifts in AD and AS can help predict economic scenarios related to inflation, unemployment, and output levels.

• Prepare for various exam scenarios by analyzing potential economic events and their impacts on AD and AS.