Basic Macroeconomic Markets Economies do not always perform at full employment levels, nor do economies constantly run smoothly.

At times real gross domestic product (GDP), which is the gross domestic product in constant dollars, falls noticeable or steeply as it did in the Great Depression. Due to this fall in real GDP, recessions, which are periods lasting over 2 consecutive quarters or 6 months registering a fall in output, and major unemployment, which is the portion of the labour force that does not have job, occurs affecting the natural rate of unemployment. When real GDP grows too fast, inflation occurs. Inflation is the state of having too much money chasing too few goods in an economy. Changes in the growth in real GDP or movements of GDP away from potential output, where it grows too fast or too slow demonstrates economic fluctuations also termed business cycles. Business Cycles and Economic Fluctuations This cycle shows the short terms up and downs in the economy. Business cycles envelope aggregate behaviour, which is the economic behaviour of all business and households together and so aggregate output is the total amount of goods produced in an economy in a given period. In a regular business cycle there is a trend that envelope the following actions that affect output growth that is, measured in GDP. (Figure 1.1) Peak A peak is the date at which the recession starts and output stats to decline. Recession Two or more consecutive quarters of a fall in output and employment. Trough This is the date at which the recession ends and output starts to rise again.

Depression A long and deep recession. Boom - The period in the business cycle from a trough up to a peak during which output and employment grow.

Aggregate Demand and Supply Aggregate demand and supply is a model developed to understand how output prices are determined in both the short term and long term. The price index is the measure of the amount by which prices change over time. General Price indices cover a wide range of prices and include the GDP deflator and other methods and so the price level is the average level of prices in the economy, as measured by a price index. Aggregate Demand This is the total demand for final goods and services in an economy at a given time and and its price level showing the amount of goods and services in the economy that will be purchased at all possible price levels. Therefore the aggregate demand curve is a graphical tool that is used to plot the total demand for GDP as a function of price level. For each price level it is asked that the total quantity demanded will be for the total all goods and services in the economy. (See Figure 2) The Slope of the Aggregate Demand Curve In considering the supply of money, it is the total amount of currency (cash and coin) in an economy. Purchasing power is the ability to use money to buy goods and services. As the price level or the average level of prices in the economy changes so does the purchasing power of and households or firms.

The change in purchasing power affects aggregate demand in the following ways: As price level falls, the purchasing power of money will increase, and the money owned by firms and households can purchase more goods and services. When price level falls, increasing the purchasing power of money, people find that they are wealthier, and due to this increased wealth more money is spent on goods and services. This means the quantity demanded for goods and services will increase as price level falls and result in the aggregate demand curve having a downward slope. The increase in spending that happens when the price level falls is known as the wealth effect: this is one reason why the slope is downward. Lower prices leads to higher levels of wealth. Higher levels of wealth increase spending on total goods and services. The downward slope is also an influence of the interest rate effect. The interest rate effect is with a given a supply of money in the economy, a lower price level will mean a lower interest level, and as interest level falls, the demand for investment goods in the economy will increase. Another cause of the downward slope is international trade. This happens where in an economy; a lower price level will mean that domestic goods become cheaper in relation to foreign goods so the demand for domestic goods will increase. The wealth effect, the interest rate effect and the effects from foreign trade all reinforce each other and lead to the downward sloping aggregate demand curve. As price level rises, the real value of money decreases. The purchasing power of household and firms decreases as money owned cannot purchase more goods and services. This reduces wealth and thus reduces the total demand for goods and services. This means as price level rises, total demand for goods and services in the economy decreases.

Shift in Aggregate Demand Curve Many factors can shift the aggregate demand curve. At any price level, an increase in aggregate demand means that total demand in the economy for goods and services contained in GDP has increased. This causes a shift in the aggregate demand curve to the right. Any factor that decrease the aggregate demand will cause a shift in the aggregate demand curve to the left and means the demand for total goods and services contained in real GDP has decreased. Factors that shift the aggregate demand curve include: (See Figure 3) Changes in the supply of money Changes in taxes Changes in government spending Changes in international trade

Decreases in taxes, increases in government spending and increase in the supply of money all shift the aggregate demand curve to the right, which means there is an increase in the total demand for goods and services in the economy contained in GDP. Increases in taxes, decreases in government spending, and decreases in the supply of money shift the curve to the left, which means the demand for the total supply of goods and services in the economy has decreased.

Aggregate Supply This is the measure of the volume of goods and services produced within the economy at a given overall price level. There is a positive relationship between aggregate supply and the general price level. The aggregate supply curve depicts the relationship between the levels of prices and real GDP. Rising prices are a signal for businesses to expand production to meet a higher level of aggregate demand. An increase in demand should lead to an expansion of aggregate supply in the economy. This can be shown both in the long run or short run. (See Figure 4) Short Run Aggregate Supply Curve In the short run prices are sticky and output is determined primarily by demand. Aggregate supply is determined by the supply side performance of the economy. It reflects the productive capacity of the economy and the costs of production in each sector. The movement of the aggregate supply curve to the right shows an increase in aggregate supply at each price level and the movement of an aggregate supply curve to the left shows a decrease in aggregate supply at each price level. Long Run Aggregate Supply Curve This is measure when the economy is at full employment; this is also called the classical aggregate supply curve. The full level of employment depends solely on supply factors such as capital and labour and the state of the technology. These fundamental factors that determine output in the long run, that is when the economy operates at the full employment.

The level of full employment output does not depend on the level of prices in the economy; due to this the supply curve can be plotted as a vertical line. Shifts in Aggregate Supply Curve Shifts in the AS curve can be caused by the following factors: (See Figure 5)

Changes in size & quality of the labour force available for production Changes in size & quality of capital stock through investment Technological progress and the impact of innovation Changes in factor productivity of both labour and capital Changes in unit wage costs (wage costs per unit of output) Changes in producer taxes and subsidies Changes in inflation expectations - a rise in inflation expectations is likely to boost wage levels and cause AS to shift inwards

Therefore the difference between aggregate demand and aggregate supply is that aggregate demand shows the total demand for final goods and services in the economy contained in GDP at a given price level, while aggregate supply is the volume of goods and services produced within and economy at the overall price level. Equilibrium and the Illustration of Output and Inflation Short Run equilibrium is determined by the intersection of the aggregate demand curve with the short run aggregate supply curve. While inflation and actual output are determined by the intersection of the short run aggregate supply curve with the aggregate demand curve. (See Figure 6)

Long Run equilibrium occurs when current output exceeds potential, the resulting expansionary gap exerts upward pressure on inflation, shifting the short-run aggregate supply curve upward, a process that continues until output returns to potential; at this point inflation stops changing. (See Figure 7) If current output is lower than potential output, the resulting recessionary gap places downward pressure on inflation, causing the short-run aggregate supply curve to shift downward, and once again the process continues until current output returns to potential. (See Figure 8)

This shows that the manner in which the short-run aggregate supply curve shifts in response to output gaps reinforces the conclusion that the long run aggregate supply curve is vertical.

In long-run equilibrium, current output equals potential output and current inflation is steady and equal to target inflation, which equals expected inflation

The Impact of Inflation Shocks on Output and Inflation An inflation shock shifts the short-run aggregate supply curve (such as an oil price increase) A positive shock moves it to a higher level, and the result is higher inflation and lower output, a situation called stagflation. A positive inflation shock shifts the short-run aggregate supply curve upward, moving short run equilibrium from point 1 to point 2. Inflation rises and output falls.

Appendices

Figure 1: The Business Cycle

Figure 2: Aggregate Demand Curve

Figure 3: Aggregate Demand Curve Shifts

Figure 4: Aggregate Supply Curve

Figure 5: Aggregate Supply Curve Shifts

Figure 6: Short Run equilibrium and how it determines inflation and output.

Key: SRAS Short run aggregate supply ADC Aggregate Demand Curve

Figure 7: Long run equilibrium and effects on output and inflation

Key: LRAS Long run aggregate supply SRAS Short run aggregate supply ADS Aggregate demand curve

Figure 8: Recession Gap due to low output

Key: LRAS Long run aggregate supply SRAS Short run aggregate supply ADS Aggregate demand supply

Sources: 1. http://free-books-online.org/management/money-banking/equilibrium-and-the-determinationof-output-and-inflation/ 2. http://tutor2u.net/revision_notes_economics.asp 3. Macroeconomics Principles and Tools, Second Edition 1998 Prentice Hall Inc, New Jersey by A. Osullivan and S Shreffin, 4. Macroeconomics fourth edition study guide mark rush and Michael parkin. 1998 addisonwesley publishing company Inc