Supply 7 Aggregate Demand (AD) Factors That Can Change AD Short-Run Aggregate Supply (SRAS) Short-Run Equilibrium Long-Run Aggregate Supply (LRAS) and Long-Run Equilibrium Three States of an Economy
In This Lecture.. 2 AD-AS Framework The AD-AS framework has three parts: 1- Aggregate Demand (AD) 2- Short-Run Aggregate Supply (SRAS) 3- Long Run Aggregate Supply (LRAS)
We start with a discussion of AD. 3 1- Aggregate Demand (AD) Aggregate Demand (AD)- The quantity demanded of all goods and services (Real GDP) at different price levels, ceteris paribus. Aggregate Demand (AD) Curve - A curve that shows the quantity demanded of all goods and services (Real GDP) at different price levels, ceteris paribus. 4 The Aggregate Demand Curve (AD) The aggregated demand curve (AD) is downward-sloping, specifying an inverse relationship between the price level and the quantity demanded of Real GDP. 5 Why Does AD Curve Slope Downward? Because of three (3) effects: Real Balance Effect Interest Rate Effect International Trade Effect 6 Real Balance Effect The change in the purchasing power of dollar- denominated assets that results from a change in the price level 7 Interest Rate Effect Changes in household and business buying as the interest rate changes. 8 International Trade Effect The change in foreign sector spending as the price level changes
9 Change in Quantity Demanded A change in the quantity demanded of Real GDP is the result of a change in the price level. A change in the quantity demanded of Real GDP is graphically represented as a movement from one point, A, on AD1 to another point, B, on AD1. 10 A change in AD is graphically represented as a shift in the AD curve from AD1 to AD2 Change in Aggregate Demand 11 Change in Aggregate Demand 12 Factors that Change AD We said change in consumption (C), investment (I), government expenditure (G), and net export (NX) shifts AD. But the question is what changes C, I, G, and NX? 13 Change in G will be discussed in later chapter. Factors That Change Consumption (C) 1. Wealth 2. Expectations about future prices and income 3. Interest rate, and 4. Income taxes
14 Factors That Change Aggregate Demand & Consumption/Wealth Wealth - The value of all assets owned, both monetary and non- monetary Wealth C AD Wealth C AD 15 Factors That Change Aggregate Demand & Consumption/Prices Expect higher future prices C AD Expect lower future prices C AD 16 Factors That Change Aggregate Demand & Consumption/Income Expect lower future income C AD Expect higher future income C D 17 Factors That Change Aggregate Demand & Consumption/Interest Rates Interest Rate C AD Interest Rate C AD 18 Factors That Change Aggregate Demand & Consumption/Income Taxes Income taxes C AD Income taxes C AD 19 Factors That Change Investment (I) 1. Interest rate 2. Expectations about future sales, and 3. Business taxes
20 Factors That Change Aggregate Demand & Investment/ Interest Rates Interest rates I AD Interest rates I AD 21 Factors That Change Aggregate Demand & Investment/ Future Sales Optimistic about future sales I AD Pessimistic about future sales I AD 22 Factors That Change Aggregate Demand & Investment/ Business Taxes Business taxes I AD Business taxes I AD 23 Factors That Change Net Export (NX) 1. Foreign real national income, and 2. Exchange rate
24 Factors That Change Aggregate Demand & Net Exports/ Foreign Real National Income Foreign real national income EX NX AD Foreign real national income EX NX AD 25 Factors That Change Aggregate Demand & Net Exports/ Exchange Rate US $ appreciates EX and IM NX AD US $ depreciates EX and IM NX AD Appreciation An increase in the value of one currency relative to other currencies. Depreciation A decrease in the value of one currency relative to other currencies. 26 Summary of Factors That Change AD 27 Self-Test 1. Explain the real balance effect. Real balance effect: a rise (fall) in the price level causes purchasing power to fall (rise), which decreases (increases) a persons monetary wealth. As people become less (more) wealthy, the quantity demanded of Real GDP falls (rises).
28 Self-Test 2. Explain what happens to the AD curve if the dollar appreciates relative to other currencies. If the dollar appreciates, it takes more foreign currency to buy a dollar and fewer dollars to buy foreign currency. This makes U.S. goods (denominated in dollars) more expensive for foreigners and foreign goods cheaper for Americans. In turn, foreigners buy fewer U.S. exports, and Americans buy more foreign imports. As exports fall and imports rise, net exports fall. If net exports fall, total expenditures fall, ceteris paribus. As total expenditures fall, the AD curve shifts to the left.
29 Self-Test 3. Explain what happens to the AD curve if personal income taxes decline. If personal income taxes decline, disposable incomes rise. As disposable incomes rise, consumption rises. As consumption rises, total expenditures rise, ceteris paribus. As total expenditures rise, the AD curve shifts to the right.
30 2- Short-Run Aggregate Supply Curve (SRAS) Aggregate Supply - The quantity supplied of all goods and services (Real GDP) at different price levels, ceteris paribus. Short-Run Aggregate Supply Curve (SRAS) - A curve that shows the quantity supplied of all goods and services (Real GDP) at different price levels, ceteris paribus.
31 Short-Run Aggregate Supply Curve The short-run aggregate supply curve (SRAS) is upward- sloping, specifying a direct relationship between the price level and the quantity supplied of Real GDP. 32 Why Does the SRAS Aggregate Supply Curve Slope Upward? Two possible explanations: Sticky wages, and Worker misconceptions
33 Sticky (Inflexible)Wages, the Real Wage Rate, and SRAS Wages are locked in for a few years due to labor contracts or perhaps because of social conventions or perceived notions of fairness. While firms pay nominal wages, they often decide how many workers to hire based on real wages.
34 Sticky Wages and the Real Wage Rate - Workers The Real wage = Nominal wage / Price level. Price level Real wage , ceteris paribus Price level Real wage , ceteris paribus As real wage more individuals are willing to work, and current workers are willing to work more at higher real wages than at lower real wages and vice versa. 35 Real wage Quantity supplied of labor Real wage Quantity supplied of labor Sticky Wages and the Real Wage Rate - Firms Firms will employ more workers the cheaper it is to hire them. Real wage Quantity of labor demanded Real wage Quantity of labor demanded Thus, if wages are sticky, an increase in the price level (which pushes real wages down) will result in a increase in output. This is what an upward-sloping SRAS curve represents: 36 As the price level rises, the quantity supplied of goods and services rises. The opposite occurs if price levels fall. Worker Misconceptions This is another explanation for upward sloping SRAC curve. If workers misperceive real wage changes, then a fall in the price level will bring about a decline in output, ceteris paribus, which is illustrative of an upward- sloping SRAS curve. In response to (the misperceived) falling real wage, workers may reduce the quantity of labor they are willing to supply. With fewer workers (resources), firms will end up producing less. See p. 168 of the text for an example.
37 Changes in SRASShift in SRAS Shifts in the SRAS curve may be caused by changes in: Wage rates Prices of non-labor inputs Productivity Supply shocks: Adverse (such as major cutback in supply of oil from Middle East to US) Beneficial (such as major oil discovery in US)
38 Changes in SRASShift in SRAS 39 Changes in SRASA Summary 40 Self-Test 1. If wage rates decline, explain what happens to the short-run aggregate supply (SRAS) curve. As wage rates decline, the cost per unit of production falls. In the short run (assuming prices are constant), profit per unit rises. Higher profit causes producers to produce more units of their goods and services. In short, the SRAS curve shifts to the right.
41 Self-Test 2. Give an example of an increase in labor productivity. Last year, 10 workers produced 100 units of good X in 1 hour. This year, 10 workers produced 120 units of good X in 1 hour.
42 Self-Test 3. Discuss the details of the worker misperceptions explanation for the upward-sloping SRAS curve. Workers initially misperceive the change in their real wage due to a change in the price level. For example, suppose the nominal wage is $30 and the price level is 1.50; it follows that the real wage is $20. Now suppose the nominal wage falls to $25 and the price level falls to 1.10.The real wage is now $22.72. But suppose workers misperceive the decline in the price level and mistakenly believe it has fallen to 1.40. They will now perceive their real wage as $17.85 ($25/1.40). (continued)
43 Self-Test (Continued) In other words, they will misperceive their real wage as falling when it has actually increased. How will workers react if they believe their real wage has fallen? They will cut back on the quantity supplied of labor, which will end up reducing output (or Real GDP). This process is consistent with an upward-sloping SRAS curve: A decline in the price level leads to a reduction in output.
44 Short-run Equilibrium At P 1 , the quantity supplied of Real GDP is greater than the quantity demanded. As a result, the price level falls and firms decrease output. At P 2 , the quantity demanded of Real GDP is greater than the quantity supplied. As a result, the price level rises and firms increase output. Short-run equilibrium occurs at point E, where the quantity demanded of Real GDP equals the (short-run) quantity supplied. 45 Changes in Short-Run Equilibrium in the Economy 46 47 How a Factor Affects the Price Level and Real GDP in the Short Run. An Important Exhibit Much of our discussion up to this point has been about the economy in the short run. Specifically, it has been about changes in the price level (P) and Real GDP (Q) in the short run. The following exhibit tells us that changes in AD and SRAS will change the price level and Real GDP in the short run, and then we see what factors will actually change AD and what factors will change SRAS.
48 A Summary Exhibit of AD and SRAS 49 Natural Real GDP & Natural Unemployment Natural Real GDP is the Real GDP that is produced at the natural unemployment* rate. Or, it is the Real GDP which is produced when the economy is in long-run equilibrium.
* Unemployment caused by frictional and structural factors in the economy.
50 3- Long-Run Aggregate Supply Curve (LRAS ) The LRAS curve is a vertical line at the level of Natural Real GDP. It represents the level of Real GDP the economy produces when wages and prices have adjusted to their (final) equilibrium levels and there are no misperceptions on the part of workers. 51 Short-Run Equilibrium The condition that exists in the economy when the quantity demanded of Real GDP equals the (short-run) quantity supplied of Real GDP. See slide 54. 52 Graphically, short-run equilibrium occurs at the intersection of the AD and SRAS curves. Long-run Equilibrium The condition that exists in the economy when wages and prices have adjusted to their (final) equilibrium levels and workers do not have any relevant misperceptions. See slide 54. 53 Graphically, long-run equilibrium occurs at the intersection of the AD and LRAS curves. Equilibrium States of the Economy 54 Disequilibrium When the economy is in neither short-run equilibrium nor long-run equilibrium, it is said to be in disequilibrium.
55 Disequilibrium is the state of the economy as it moves from one short-run equilibrium to another or from short-run equilibrium to long-rune equilibrium. In disequilibrium, quantity supplied of Real GDP and quantity demanded of Real GDP are not equal. Self-Test 1. What is the difference between short-run equilibrium and long-run equilibrium? In both short-run and long-run equilibrium, the quantity supplied of Real GDP equals the quantity demanded of Real GDP. Also, in long-run equilibrium, quantity supplied and demanded of Real GDP equal Natural Real GDP. But, in short-run equilibrium, quantity supplied and demanded of Real GDP are either more than or less than Natural Real GDP. See Graphs on slide #54.
56 Self-Test 2. Diagrammatically represent an economy that is in neither short-run equilibrium nor long-run equilibrium. The diagram should show the price level in the economy at P 1 and Real GDP at Q 1 but the intersection of the AD curve and the SRAS curve at some point other than (P 1 , Q 1 ). In addition, the LRAS curve should not be at Q 1 or at the intersection of the AD and SRAS curves.
57 Wall Street Journal The Wall Street Journal is a is a rich source of information which provides real life examples of micro- and macro economic activities. Check todays issue to see the most current news. http://www.wsj.com 58