NATIONAL INCOME AND PRICE DETERMINATION

Shifters of Aggregate Demand

Change in Consumer Spending

Change in Investment SpendingChange in Government Spending

Net EXport Spending

AD = C + I + G + X

Shifters of Aggregate SupplyAS = I + R + A + P

Change in Resource PricesChange in Actions of the GovernmentChange in Productivity (Investment) 2

Change in Inflationary Expectations

BA

D

A

D

B

A

A

C A major increase in productivity.A

Answer and identify shifter: C.I.G.X or I.R.A.P

3

Putting AD and AS together to get Equilibrium Price Level and Output

4

How does this cartoon relate to Aggregate Demand?

5

• Macroeconomic equilibrium occurs at the intersection of aggregate demand and short-run aggregate supply.

**Handout

It can also happen that this

occurs at the long-run equilibrium point, but not necessarily.A

ggre

gate

Pric

e Le

vel

Aggregate Output

LRASSRAS

AD

• As we have learned a Demand Shock can effect equilibrium: (demand shocks are shifts in the AD curve and Supply shocks are shifts in the SRAS)

Shocks

• Demand shock causes Ag. Price Level and Ag. Output to move in the same direction

• Supply Shock causes them to move in opposite directions

Shocks cont.

• Demand shocks have short-run effects on Ag. Output because the economy is self-correcting in the long run

• In a recessionary gap, an eventual fall in nominal wages moves the economy to long-run equilibrium (wages are sticky—slow to move-- in the SR)

• In an inflationary gap, an eventual rise in nominal wages moves the economy to long run equilibrium

To sum it up…Shocks cause a shift in the Aggregate Demandor Supply and can also lead to

Recessionary Gaps orInflationary Gaps or

Stagflation Stagflation is inflation and falling output

and is caused by a negative supply shock

What’s it look like?

Price Level

14

AS

Inflationary Gap

GDPR

LRAS

QY

AD1

PL1

Q1

Output is high and unemployment is less than NRU

Actual GDP above potential

GDP

Price Level

15

AD

AS

Example: Assume the government increases spending. What happens to PL and Output?

GDPR

LRAS

QY

AD1

PLe

PL1

Q1

PL and Q will Increase

Price Level

16

AD

GDPRQY

PL1

Q1

LRAS AS1

Recessionary Gap

Output low and unemployment is more than NRU

Actual GDP below potential

GDP

Price Level

17

AD

AS

GDPRQY

PLe

PL1

Q1

LRAS AS1

StagflationStagnate Economy

+ Inflation

Example: Assume the price of oil increases drastically. What happens to PL and Output?

What about the long run?

Baby Steps

Price Level

19

AD

AS

Assume the government increases spending. What happens to PL and Output?

GDPR

LRAS

QY

AD1

PLe

PL1

Q1

PL and Q will Increase

Price Level

20

AD

AS

Now, what will happen in the LONG RUN?

GDPRQY

AD1

PLe

PL1

Q1

LRAS

Inflation means workers seek higher wages and production costs increase

AS1

PL2

Back to full employment with higher price level

Price Level

21

AD

AS

Assume consumers increase spending. What happens to PL and Output?

GDPR

LRAS

QY

AD1

PLe

PL1

Q1

Price Level

22

AD

AS

Now, what will happen in the LONG RUN?

GDPRQY

AD1

PLe

PL1

Q1

LRAS

Inflation means workers seek higher wages and production costs increase

AS1

PL2

Back to full employment with higher price level

Supply shocks and demand shocks can cause recessions

Long Term Equilibrium

• To summarize how an economy responds to recessions/inflation we focus on Output Gap which is the % difference between actual aggregate output and potential output. Actual Aggregate Output-Potential Output x 100

Potential Output

In the Long Run the economy is self-correcting but many times Governments are not willing to wait that long which brings about Macroeconomic Policy