Economics - Macro - Aggregate Supply and Aggregate Demand

Start 10:00 am

Aggregate Supply and Aggregate Demand

Aggregate supply = amount of goods and service produced by an economy.  A function of the price level.

In short run, higher prices = higher output.

Long run aggregate supply is vertical, short run slopes up

Adjustment to definitions of short run and long run:

• Short run - period over which wages are fixed

Key factor that drives workers' wage demands is expectations about future inflation

• Higher inflation means workers want higher wages and decreases their short term supply
• Higher wages increases marginal costs of productions, employers produce less at each price level

LRAS represents supply of goods/services when workers' expectations = actual inflation

• Change in actual inflation doesn't shift short run agg supply - you move along the line to a temporary disequilibrium
• In the long run, expected inflation must = actual inflation = production at full employment GDP
• As workers' expectations match actual, SRAS shifts to return to equilibrium

Determinants of LRAS

• Not affected by price level
• It is the potential real output of the economy
• Fully determined by the quantity of labor, capital, and technology of the economy
• To shift LRAS:
• Full-employment Q of labor changes
• Amount of capital in economy changes
• Technology improves productivity of K, L or both

To shift SRAS

• Same things that shift LRAS, to start (when LRAS shifts, SRAS comes too)
• e.g. in expansion of technology, everything moves to the right
• If wage rates or prices increase, SRAS will shift left, decreasing SR aggregate supply
• Wage rates are impacted by employment levels and inflation expectations

Aggregate demand: relation between price level and real Q of final goods and services demanded.

Components of aggregate demand

• Consumption
• Investment
• Government spend
• Net exports

Aggregate demand is down sloping - at higher prices, all should decrease

• Wealth effect - when prices go up real wealth decreases, so there is less spend
• Substitution effect - increase in interest rates increases the cost of current consumption

To shift aggregate demand - lots of things can shift agg demand

• Expectations about incomes, inflation, profits
• Inflation - you expect higher future prices - buy now (increase demand)
• Higher incomes - you expect more money to come, so buy now
• Increased profits = businesses invest more
• Fiscal/monetary
• Increase in G spending
• Lowering taxes or increasing transfer pmts might increase discretionary income
• Increase in money supply = decrease in interest rates
• State of world economy
• Influence through net exports
• Foreign incomes up = higher demand for US products, X increases
• Exchange rate increase = your goods are more expensive, and you import more, so X decreases

Macroeconomic equilibrium

• If prices temporarily too high, this is a recessionary gap
• If prices temporarily too low, this is an inflationary gap
• Difference between real GDP and full-employment GDP is called recessionary gap or output gap
• Changes in SRAS are driven by changes in aggregate demand
• Say demand increases
• Intersection of SAS and AD now out to the right and higher
• Real wages are lower bc wages in SAS are fixed and prices now higher
• Firms try to produce more, leading to even more demand for wages
• SRAS contracts in response (it is more expensive to provide each good)
• Decrease in demand does the opposite - wages go up, demand for wage increases goes down, this in turn increases SRAS

Classical, Keynesian, and Monetarist Schools

• Classical - shifts in AD and LRAS primarily driven by technology over time
• Adjustments in wages/LRAS should be fairly quick
• Strong tendency toward economic equilibrium
• Taxes were the impediment to equilibrium
• Depression did not support this view - long term unemployment, business cycles very severe
• Keynes - wages are 'downward sticky'
• This reduces ability of economy to increase SAS
• New Keynesians - prices and other productive inputs also downward sticky
• Policy prescription: 
• Increase agg demand through monetary policy (increase money supply) 
• Fiscal policy (increase gov spend, decrease tax, or both)
• Monetarists
• To keep demand growing/stable, central bank should steadily and predictably increase supply of money
• Recessions are caused by inappropriate decreases in money supply
• Money wage rates are downward sticky (similar to keynes)
• Similar to classical though in they want low taxes, minimize disruption of taxes

End

11:00 AM

1 hour