AD and ASAD and AS

Tragakes 2012, chapter 9Tragakes 2012, chapter 9

Aggregate DemandAggregate Demand Aggregate Demand (AD): The total

quantity of aggregate output, or real GDP, that all buyers in an economy want to buy at different possible price levels, ceteris paribus.

The price level is measured using the GDP deflator.

The quantity of real GDP demanded is composed of C+I+G+(X-M).

The AD curve shows the relationship between real GDP demanded and the economy’s price level, ceteris paribus.

The AD curve is NOT the same as a market demand curve.

A market demand curve illustrates the total demand of all consumers for ONE particular product. The AD curve illustrates the total demand of all agents in the economy for all goods and services in the economy.

Negative slope of the AD curveNegative slope of the AD curve

1.1. Wealth EffectWealth Effect. Changes in the price . Changes in the price level affect the real value of people’s level affect the real value of people’s wealth. Wwealth. Wealth is the value of assets that ealth is the value of assets that people own (ex: houses, stocks, juwellery, people own (ex: houses, stocks, juwellery, art…). art…).

If price level ↑, real value of wealth ↓. If price level ↑, real value of wealth ↓. People then feel worse off and decrease People then feel worse off and decrease their consumption of g&s. So the their consumption of g&s. So the quantityquantity of output demanded falls (downward of output demanded falls (downward movement ALONG the AD curve).movement ALONG the AD curve).

If price level If price level ↓↓, real wealth , real wealth ↑↑. People feel . People feel better off and increase their spending on better off and increase their spending on g&s. So the g&s. So the quantityquantity of real GDP of real GDP demanded rises (upward movement demanded rises (upward movement ALONG the AD curve).ALONG the AD curve).

2.2. Interest rate effectInterest rate effect An ↑ in the PAn ↑ in the PL L means consumers and firms means consumers and firms

need more money for C and I, respectively. need more money for C and I, respectively. People then increase their borrowing.People then increase their borrowing.

The increase in borrowing (because of an The increase in borrowing (because of an increase in increase in money demandmoney demand) pushes up the ) pushes up the price of money...which is the interest rate.price of money...which is the interest rate.

As the interest gets higher it becomes too As the interest gets higher it becomes too costly to borrow and people tend to costly to borrow and people tend to decrease their expenditures financed by decrease their expenditures financed by borrowing (ex: houses, cars, luxury borrowing (ex: houses, cars, luxury vacations, renovations) and firms decrease vacations, renovations) and firms decrease their I. As a result, the quantity of real GDP their I. As a result, the quantity of real GDP demanded falls.demanded falls.

A ↓ in the PA ↓ in the PL L means consumers and firms means consumers and firms need less money for C and I, respectively. need less money for C and I, respectively. People then decrease their borrowing.People then decrease their borrowing.

The decrease in borrowing (because of a The decrease in borrowing (because of a decrease in decrease in money demandmoney demand) pushes down the ) pushes down the price of money...which is the interest rate.price of money...which is the interest rate.

As the interest gets lower it becomes cheaper As the interest gets lower it becomes cheaper to borrow and people tend to increase their to borrow and people tend to increase their expenditures financed by borrowing (ex: expenditures financed by borrowing (ex: houses, cars, luxury vacations, renovations) houses, cars, luxury vacations, renovations) and firms increase their I. As a result, the and firms increase their I. As a result, the quantity of real GDP demanded rises.quantity of real GDP demanded rises.

NOTENOTE: The interest rate effect can be : The interest rate effect can be tricky! tricky!

If changes in the price level are CAUSING If changes in the price level are CAUSING the change in the interest rate then the the change in the interest rate then the change in the interest rate is linked to a change in the interest rate is linked to a movement movement alongalong the AD curve. the AD curve.

BUT the government can change the BUT the government can change the level of the interest rate completely level of the interest rate completely separately from any changes in the price separately from any changes in the price level. In this case the change in the level. In this case the change in the interest rate will cause a interest rate will cause a SHIFTSHIFT of the of the AD curve.AD curve.

3.3. International trade effect.International trade effect. An ↑ in the PAn ↑ in the PLL means the price of means the price of

domestic goods is changing relative domestic goods is changing relative to the prices of foreign goods…to the prices of foreign goods…foreign goods could be more foreign goods could be more attractive due to this change in attractive due to this change in relative prices. Thus M ↑ and X relative prices. Thus M ↑ and X (which are relatively more (which are relatively more expensive to the foreigners buying expensive to the foreigners buying them) ↓. Domestic goods are them) ↓. Domestic goods are substituted by foreign goods.substituted by foreign goods.

A A ↓↓ in the P in the PLL means the price of means the price of domestic goods is changing relative domestic goods is changing relative to the prices of foreign goods…to the prices of foreign goods…foreign goods could be less attractive foreign goods could be less attractive due to this change in relative prices. due to this change in relative prices. Thus M Thus M ↓↓ and X (which are relatively and X (which are relatively cheaper to the foreigners buying cheaper to the foreigners buying them) them) ↑↑. Foreign made goods are . Foreign made goods are substituted by domestic goods (by substituted by domestic goods (by both domestic and foreign both domestic and foreign consumers).consumers).

Shifts in the AD curveShifts in the AD curve Rightward shift of AD means that for Rightward shift of AD means that for

any particular any particular PPLL, a larger amount of , a larger amount of real GDP is demanded.real GDP is demanded.

Leftward shift of AD means that for Leftward shift of AD means that for any particular any particular PPLL, a smaller amount , a smaller amount of real GDP is demanded.of real GDP is demanded.

Since AD = C + I + G + (X-M), Since AD = C + I + G + (X-M), anything that causes a change in any anything that causes a change in any of the components of AD, will cause of the components of AD, will cause AD to shift.AD to shift.

AD2ADAD1

Real GDP

Price level

Shifts in the AD curve

Factors causing a change in CFactors causing a change in C Changes in WealthChanges in Wealth. An . An ↑ ↑ in wealth (ex: value of in wealth (ex: value of

homes) makes people feel wealthier, so they homes) makes people feel wealthier, so they increase C expenditures.increase C expenditures.

Changes in consumer confidenceChanges in consumer confidence Consumer Consumer confidence is a measure of how optimistic confidence is a measure of how optimistic consumers are about their future income and the consumers are about their future income and the economy. Expectations of increasing incomes in economy. Expectations of increasing incomes in the future or optimistic expectations about the the future or optimistic expectations about the economy will increase spending by consumers economy will increase spending by consumers because they know they will have more money.because they know they will have more money.

Changes in Interest ratesChanges in Interest rates. Some consumer . Some consumer spending is financed by borrowing and thus spending is financed by borrowing and thus sensitive to interest rate changes. If sensitive to interest rate changes. If ii ↓, ↓, borrowing borrowing becomes less expensivebecomes less expensive and C increases.and C increases.

Changes in personal income taxesChanges in personal income taxes. If the gov . If the gov increases increases personal income taxespersonal income taxes (taxes paid (taxes paid by households on their incomes), then their by households on their incomes), then their disposable incomedisposable income (income left over after (income left over after personal income taxes have been paid) falls and personal income taxes have been paid) falls and C spending drops. C spending drops.

Changes in the level of household Changes in the level of household indebtednessindebtedness. Indebtedness is how much . Indebtedness is how much money people owe from taking out loans in the money people owe from taking out loans in the past (ex: mortgages, credit cards). past (ex: mortgages, credit cards). If cons are If cons are able to lower their debt payments more money able to lower their debt payments more money can be spent on C and AD will rise and shift right.can be spent on C and AD will rise and shift right.

Factors causing a change in IFactors causing a change in I Changes in business confidenceChanges in business confidence. . Business Business

confidence refers to how optimistic firms are confidence refers to how optimistic firms are about their future sales and economic activity. about their future sales and economic activity. Optimism about the future leads to higher I and Optimism about the future leads to higher I and thus ↑ AD, which will shift right. Pessimism will thus ↑ AD, which will shift right. Pessimism will lower I and thus ↓ AD, which will then shift left.lower I and thus ↓ AD, which will then shift left.

Changes in business taxesChanges in business taxes. If the gov ↓ taxes . If the gov ↓ taxes on profits of businesses (fiscal policy), firms’ on profits of businesses (fiscal policy), firms’ after-tax profits increase, which ↑ I, as firms have after-tax profits increase, which ↑ I, as firms have more money to spend. An ↑ in taxes will ↓ I, as more money to spend. An ↑ in taxes will ↓ I, as firms will have less money to spend.firms will have less money to spend.

Legal/institutional changesLegal/institutional changes. Sometimes the . Sometimes the legal and institutional environment in which firms legal and institutional environment in which firms operate has an impact on I spending. Ex: access operate has an impact on I spending. Ex: access to credit, property rights.to credit, property rights.

Changes in interest rates.Changes in interest rates. An An ↑↑ in interest rates in interest rates makes borrowing more expensive and I tends to makes borrowing more expensive and I tends to fall. A ↓ in interest rates makes borrowing less fall. A ↓ in interest rates makes borrowing less expensive, so firms tends to increase their I.expensive, so firms tends to increase their I.

Changes in technologyChanges in technology. Improvements in . Improvements in technology stimulate investment spending, so AD technology stimulate investment spending, so AD ↑ ↑ and shifts right.and shifts right.

Level of corporate indebtednessLevel of corporate indebtedness. If firms have . If firms have high levels of debt, they will be less inclined to high levels of debt, they will be less inclined to make investments and AD curve will shift left. make investments and AD curve will shift left.

Factors causing a change in GFactors causing a change in G Changes in political prioritiesChanges in political priorities. . The gov may The gov may

decide to decide to ↑↑ or ↓ its expenditures (provision of or ↓ its expenditures (provision of merit and public goods, subsidies and pensions, merit and public goods, subsidies and pensions, salaries to gov employees) in response to salaries to gov employees) in response to changes in its priorities. changes in its priorities. ↑G: AD shifts right.↑G: AD shifts right.

Deliberate efforts to influence AD Deliberate efforts to influence AD . The gov . The gov can use G as part of a deliberate attempt to can use G as part of a deliberate attempt to influence AD. Same effects as above.influence AD. Same effects as above.

Factors causing a change in X-MFactors causing a change in X-M Changes in national income abroadChanges in national income abroad. . If If

national income in foreign countries is rising they national income in foreign countries is rising they will buy more goods and services from us, so our will buy more goods and services from us, so our AD will ↑ and shift right. If national income in AD will ↑ and shift right. If national income in foreign countries is falling they will buy less foreign countries is falling they will buy less goods from us, so our AD will ↓ and shift left.goods from us, so our AD will ↓ and shift left.

Changes in exchange ratesChanges in exchange rates. . If the exchange rate (the price you pay using your own If the exchange rate (the price you pay using your own

currency to buy another currency) goes up then it takes currency to buy another currency) goes up then it takes more of your currency to buy foreign goods, M will ↓ but more of your currency to buy foreign goods, M will ↓ but X ↑ as it is easier for foreigners to buy our currency. So X ↑ as it is easier for foreigners to buy our currency. So (X-M)↑, and AD shifts right. (X-M)↑, and AD shifts right.

If the exchange rate (price of foreign currency) goes If the exchange rate (price of foreign currency) goes down it takes less domestic currency to buy foreign down it takes less domestic currency to buy foreign goods. M↑ and X↓ as it costs more in terms of foreign goods. M↑ and X↓ as it costs more in terms of foreign currency to buy our goods. (X-M)↓ and AD shifts left.currency to buy our goods. (X-M)↓ and AD shifts left.

Shifts in the AD and national incomeShifts in the AD and national income

Income is not included among the factors that can Income is not included among the factors that can shift the AD curve, as changes in national income shift the AD curve, as changes in national income cannot initiate any AD curve shifts. Remember that cannot initiate any AD curve shifts. Remember that national income is measured on the horizontal axis, national income is measured on the horizontal axis, and it is not possible for any variable measured on and it is not possible for any variable measured on either of the two axes to cause a shift of a curve.either of the two axes to cause a shift of a curve.

Important: do not confuseImportant: do not confuse The The wealth effect wealth effect resulting from a change in the price resulting from a change in the price

level (causing a movement along AD) with level (causing a movement along AD) with changes in changes in wealthwealth, that cause shifts in the AD curve. , that cause shifts in the AD curve.

The interest rate effect that results from a change in the The interest rate effect that results from a change in the price level (producing a movement along the AD curve) price level (producing a movement along the AD curve) and changes in interest rates that occur without any and changes in interest rates that occur without any change in the price level, causing shifts of the AD curve.change in the price level, causing shifts of the AD curve.

Aggregate Supply (AS)Aggregate Supply (AS)Short run and long run in macroeconomics.Short run and long run in macroeconomics. Short runShort run: the period of time when prices of : the period of time when prices of

resources, in particular wages, are roughly constant or resources, in particular wages, are roughly constant or inflexible (they do not change much in response to inflexible (they do not change much in response to supply and demand).supply and demand).

Long runLong run: the period of time when the prices of all : the period of time when the prices of all resources, including wages, are flexible and change in resources, including wages, are flexible and change in response to changes in the price level.response to changes in the price level.

The price of labour is often rigid because:The price of labour is often rigid because: Labour contracts fix wages for a period of timeLabour contracts fix wages for a period of time Minimum wage legislationMinimum wage legislation Resistance from workers and labour unions to wage cutsResistance from workers and labour unions to wage cuts Negative effects on worker morale, causing firms to avoid Negative effects on worker morale, causing firms to avoid

themthem

AS is the total quantity of G&S produced in an AS is the total quantity of G&S produced in an economy (real GDP) over a particular time period economy (real GDP) over a particular time period at different price levels. at different price levels.

The short run AS (SRAS) curve shows the The short run AS (SRAS) curve shows the relationship between the price level and the relationship between the price level and the quantity of real output (real GDP) produced by quantity of real output (real GDP) produced by firms when resource prices (wages) do not firms when resource prices (wages) do not change.change.

SRAS curve is upward sloping because of firm SRAS curve is upward sloping because of firm profitability. As Pprofitability. As PLL ↑, ↑, with resource prices with resource prices constant, firms’ profits increase. As production constant, firms’ profits increase. As production becomes more profitable, firms increase the becomes more profitable, firms increase the quantity of output they produce. As Pquantity of output they produce. As PLL ↓, firm ↓, firm profitability falls and output decreases.profitability falls and output decreases.

Shifts in the SRAS curveShifts in the SRAS curve A number of factors other than the PA number of factors other than the PLL can cause can cause

shifts of the SRAS curve.shifts of the SRAS curve. A rightward shift of the SRAS curve means that A rightward shift of the SRAS curve means that

for any particular price level, firms produce a for any particular price level, firms produce a larger quantity of real GDP.larger quantity of real GDP.

A leftward shift of the SRAS curve means that for A leftward shift of the SRAS curve means that for any particular price level, firms produce a smaller any particular price level, firms produce a smaller quantity of real GDP.quantity of real GDP.

Factors include: changes in firms’ costs of Factors include: changes in firms’ costs of production, changes in taxes and subsidies and production, changes in taxes and subsidies and ‘supply shocks’.‘supply shocks’.

Price level

Real GDP

SRAS3 SRAS1 SRAS2

Factors that influence firms’ costs Factors that influence firms’ costs of productionof production

Changes in wagesChanges in wages. Wages constitute a major . Wages constitute a major portion of firms’ costs of production. They can portion of firms’ costs of production. They can change as a result of a change in minimum wage change as a result of a change in minimum wage legislation or as a result of labour union legislation or as a result of labour union negotiations with employers. If wages negotiations with employers. If wages ↑ ↑ (with P(with PLL constant), firms’ costs constant), firms’ costs ↑ ↑ and SRAS shifts left. If and SRAS shifts left. If wages ↓ (with Pwages ↓ (with PLL constant), firms’ costs ↓ and constant), firms’ costs ↓ and SRAS shifts right.SRAS shifts right.

Changes in non-labour resource pricesChanges in non-labour resource prices. Ex: . Ex: changes in the price of oil, equipment, capital changes in the price of oil, equipment, capital goods,... They have the same impact on SRAS as goods,... They have the same impact on SRAS as a change in wages.a change in wages.

Changes in business taxesChanges in business taxes. These are taxes on . These are taxes on firms’ profits and are treated by firms as a cost of firms’ profits and are treated by firms as a cost of production. If taxes production. If taxes ↑ ↑ = production costs = production costs ↑ ↑ and and SRAS shifts to the left. If taxes SRAS shifts to the left. If taxes ↓ ↓ = production = production costs costs ↓ ↓ and SRAS shifts to the right.and SRAS shifts to the right.

Changes in subsidies offered to businessesChanges in subsidies offered to businesses. These . These are money transferred from the gov to firms, so are money transferred from the gov to firms, so they have the opposite effect to taxes.they have the opposite effect to taxes.

Supply shocksSupply shocks. These are events that have a . These are events that have a sudden and strong impact on SRAS:sudden and strong impact on SRAS:

Negative supply shocksNegative supply shocks. A war can result in the . A war can result in the

destruction of physical capital and disruption of the destruction of physical capital and disruption of the economy, which reduces output produced and shifts economy, which reduces output produced and shifts the SRAS curve to the left. Unfavourable weather the SRAS curve to the left. Unfavourable weather conditions can decrease agricultural output, shifting conditions can decrease agricultural output, shifting SRAS to the left. A sudden increase in the price of a SRAS to the left. A sudden increase in the price of a major input such as oil, increases firms’ production major input such as oil, increases firms’ production costs, shifting SRAS curve to the left.costs, shifting SRAS curve to the left.

Positive supply shocksPositive supply shocks. Oil discovery or good weather . Oil discovery or good weather conditions lead to an increase in SRAS and a conditions lead to an increase in SRAS and a rightward shift of the SRAS curve.rightward shift of the SRAS curve.