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Condensed version of 4 chapters. Aggregate Supply, Aggregate Demand, Classical, Keynesian

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GDP 2007 to 2010

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OK One more time.. Component parts of GDP? C + I + G + (X-M) = GDP Long-Run Aggregate Supply Curve (LRAS) A vertical line representing the real output of goods and services after full adjustment has occurred It represents the real GDP of the economy under conditions of full employment; the economy is on its production possibilities curve

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The Production Possibilities and the Economys Long-Run Aggregate Supply Curve

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Output Growth and the Long-Run Aggregate Supply Curve (cont'd) LRAS is vertical Input prices fully adjust to changes in output prices Suppliers have no incentive to increase output Unemployment is at the natural rate Determined by endowments and technology (or existing resources) Growth is shown by outward shifts of either the production possibilities curve or the LRAS curve caused by Growth of population and the labor-force participation rate Capital accumulation Improvements in technology

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What is AD and why slope downward? AD = C + I + G + (X-M)

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Think: Why does AD slope downward? Real domestic output, GDP AD Price level Vertical axis represents Price level for ALL final goods And services The aggregate price level Is measured by either GDP Deflator or CPI The horizontal axis represents the real quantity of all G&S purchased as measured by the level of REAL GDP

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Figure 10-4 The Aggregate Demand Curve As the price level rises, real GDP declines

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There are 3 Reasons that cause the Aggregate Demand Curve to be downward sloping. Real Balance Effect (Wealth effect) Interest Rate Effect International Trade Effect

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Real Balance Effect 1) Wealth effect= as price level falls, the real wealth people hold increases and they can consumer more. 2) Real Balance Effect (or wealth effect) Higher price level means less consumption spending.

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Real Balance Effect The change in the purchasing power of dollar- Relates to assets that result from a change in the price level

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Interest Rate Effect Inverse relationship between price level and quantity demanded of GDP . Price level falls (bundle of goods costs less) rest of money into savings, more money available for borrowing interest rate down. Think of money as stationary demand drives up price of money.

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Factors That Change Aggregate Demand & Consumption/Interest Rates Interest Rate C AD Interest Rate C AD

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Interest Rate continued Now if bundle of goods increases want to purchase interest sensitive good, cost to borrow is up. An increase in money demand will drive up the price paid for its use use of money = interest rate As price level rises, houses and firms require more money to handle transactions

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International Trade Effect ( Open Economy Effect) FYI: An open economy is global, a closed economy is domestic. The Open Economy Effect Higher price levels result in foreigners desiring to buy fewer American- made goods while Americans desire more foreign-made goods (i.e., net exports fall). Decrease in price level leads domestic goods to be cheaper- Means foreigners want to purchase more and exports increase. When Demand for exports decreases, this is an unfavorable balance of trade (imports exceed exports)

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Reminder about PL Definition below: Price level is the weighted average of the prices of al final goods and services produced in an economy. PL is measured by CPI (most common) GDP deflator (govt prefers because it yields a lower figure) Price Level Stability = steadiness of the PL from one period to the next. (low annual rate of inflation = price stability Can take your $20 dollars and know what you can buy.

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Changes in AD Change in PL will change amount of aggregate spending which changes amount of real GDP PL Change in one of determinants of AD (C+I+G+X-M) which directly affects real GDP. (consumption GDP Change in any of the component parts of AD (C + I + G + Net Exports) GDP A B PL is made up of CPI or GDP deflator PL

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Difference between Quantity of AD and Change of AD QAD = movement up or down as result of price level changing (ONLY) Change in AD = Change in any of the component parts of AD (C + I + G + Net Exports)

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DETERMINANTS OF AGGREGATE DEMAND Change in Consumer Spending Consumer Wealth Consumer Expectations (expect higher prices) Interest rate ( interest sensitive durables) Taxes

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Changes in Investment Spending Real Interest Rates ( rates high- not much I taking place) Expected Future Sales ( health of economy- confidence is big) Business Taxes ( higher taxes less profit)

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Factors That Change Aggregate Demand & Investment/ Business Taxes Business taxes I AD Business taxes I AD

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Government Spending This will be discussed further, but anytime government spends, it has an affect on GDP. Infrastructure Health Care Supplies for military Education Etc.

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Net Export Spending National Income Abroad- (when foreign nations do well, their incomes are higher- can buy more U.S. goods and services. U.S. exports rise) Exchange Rates- Price of one nations currency in terms of another. Dollar vs Euro Our currency appreciates if it takes more foreign $ to buy it.. (depreciates if it takes more of ours to buy theirs.) $1.00 to $1.25 Euro. Depreciation of nations currency makes foreign goods more expensive (but attracts foreigners to buy our goods.) Our exports rise. *this is why the Fed has not worried about our low dollar valuation.

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Long-Run Equilibrium and the Price Level For the economy as a whole, long-run equilibrium occurs at the price level where the aggregate demand curve (AD) crosses the long-run aggregate supply curve (LRAS).

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Long-Run Equilibrium and the Price Level For the economy as a whole, long-run equilibrium occurs at the price level where the aggregate demand curve (AD) crosses the long-run aggregate supply curve (LRAS).

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Aggregate Supply Short Run In short run input prices and output prices are fixed (referred to as immediate SR) Regular SR = SRAS input prices fixed but output can vary. * Example: wages/contracts fixed and little adjustment can occur until either laid off or contract renewal. Long Run Long run supply curve is vertical. Full employment and capacity has been reached *wages and prices are flexible and the profit level will adjust to give firms the right profit level and firm has no incentive to produce beyond Qf.

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SRAS Period where adjustment occurs.

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AD and SRAS

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LRAS = long-run aggregate supply (a period when nominal wages and other resource prices respond to price-level changes) LRAS is a vertical line reflecting that LR Aggregate Supply is not affected by changes in PL. The LRAS is labeled as the natural level of real GDP The natural level of real GDP is defined as the level of real GDP that arises when the economy is fully employing all of its available input resources ( We are in agreement that it hovers around 5%)

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Equilibrium States of the Economy During the time an economy moves from one equilibrium to another, it is said to be in disequilibrium.

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Real Rate Of Interest Money Supply D1 D2D2 Can a Change in Money Supply Change AD? Probably but it is a chain of events. MS changes, then Interest Rates, then chance in consumption and investment. Then Change in AD

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Long Run Aggregate Supply Price level Real domestic output, GDP Q P LRAS LR Long-run Aggregate Supply QfQf Full-Employment

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LRAS G oods & S ervices (real GDP) P rice level P 100 Y F SRAS 1 AD 1 Unanticipated Increase in Aggregate Demand In response to an unanticipated increase in AD for goods & services (shift from AD 1 to AD 2 ), prices will rise to P 105 and output will temporarily exceed full-employment capacity (increases to Y 2 ). P 105 Y 2 AD 2 Short-run effects of an unanticipated increase in AD

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LRAS 1 G oods & S ervices (real GDP) P rice level Y F AD P 1 SRAS 1 Y F1 SRAS 2 Y F2 LRAS 2 Y F2 Here we illustrate the impact of economic growth due to capital formation or a technological advancement, for example. Both LRAS and SRAS increase (to LRAS 2 and SRAS 2 ); the full employment output of the economy expands from Y F1 to Y F2. P 2 Growth in Aggregate Supply A sustainable, higher level of real output and real income is the result. ***If the money supply is held constant, a new long-run equilibrium will emerge at a larger output rate (Y F2 ) and lower price level (P 2 ).

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LRAS G oods & S ervices (real GDP) P rice level AD Y F P 100 SRAS 1 (P r 1 ) A P 110 Y 2 The higher resource prices shift the SRAS curve to the left; in the short-run, the price level rises to P 110 and output falls to Y 2. What happens in the long-run depends on whether the reduction in the supply of resources is temporary or permanent. Effects of Adverse Supply Shock If temporary, resource prices fall in the future, permitting the economy to return to its original equilibrium (A). If permanent, the productive potential of the economy will shrink (LRAS shifts to the left) and (B) will become the long-run equilibrium. SRAS 2 (P r 2 ) B

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Price Level Real Domestic Output, GDP Q P AS AD 1 INCREASES IN AD: DEMAND-PULL INFLATION P2P2 P1P1 AD 2 QfQf Q1Q1 Q2Q2

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Price Level Real Domestic Output, GDP Q P AS 1 AD 1 DECREASES IN AS: COST-PUSH INFLATION P2P2 QfQf Q1Q1 a b AS 2 P1P1

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Non-governmental actions that shift AS Shift AS left: Raw materials cost rise Wages rise faster than productivity Worker productivity decreases Obsolescence Wars Natural disasters

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Fiscal Policy Governmental actions that shift AD Shift AD right: Govt spending increases Taxes decreases Money Supply increases Shift AD left: G decreases T increases MS decreases

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