Ch. 11 Aggregate Demand/Aggregate Supply

Keynes' Law and the Macroeconomics of Demand says that

"demand creates its own supply".

Says Law and the Macroeconomics of Supply says that

"supply creates its own demand".

Potential GDP is sometimes also called

full employment GDP

As GDP increases, some firms and industries will start running into

limits.

Also refer to the vertical line at Potential GDP as the

long run aggregate supply curve

The Neoclassical Perspective focuses on the macro-economy in the

long run, where aggregate supply plays a crucial role.

Say's Law applies more accurately in the

long run.

Says Law is Neoclassical theory. Primarily applies in the

long run.

The economy could still experience a situation of some firms earning profits while other firms suffer

losses.

When an economy is operating at its potential GDP

machines and factories are running at capacity, and the unemployment rate is relatively low - at the natural rate of unemployment.

Vertical axis shows

price level - measures average price of all goods and services produced in the economy.

AS slopes

up and from the left to the right. as the price level for output rises firms have an incentive to produce more to earn higher profits.

The short run aggregate supply curve slopes __________, showing a __________ relationship between __________, a measure of output, and __________.

upward positive real GDP price level

Economists who discussed the views of national income approach to measuring GDP were known as:

"classical" economists, who generally subscribe to the Say's Law view on the importance of supply for determining the size of the macroeconomy - which are known as neoclassical economists.

Far left - level of output in economy is far below potential GDP.

(amount of real GDP an economy can produce by fully employing its existing levels of labor, physical capital, and technology in the context of its existing market and legal institutions.

An AS curve shows how producers as a group will respond to an increase in

AD

What are two ways inflationary pressures may rise?

AD continues to shift to the right when economy is already at or near potential GDP and full employment - pushing equilibrium into AS curve's steep portion. Occur due to rise in input prices that affect many or most firms across the economy - an important input to production like oil or labor - causes AS curve to shift back to the left.

during the long run - economic growth due to productivity increases over time will be represented by a gradual shift to the right of

AS vertical line representing potential GDP will gradually shift to the right over time.

A decrease in taxes paid by firms reduces operating costs and causes the

AS curve to increase

A higher minimum wage increases labor costs for the firm and

AS decreases

The Aggregate Supply Curve and Potential GDP

ASC - total quantity of output - real GDP - that firms produce and sell at each price level. Potential GDP - level of production of goods and services that the economy is capable of its workforce is fully employed and its capital stock is fully utilized.

The foreign price effect is the idea that the inflation causes a decline in net exports, which leads to lower levels of

GDP

The price level in the AD/AS model is what we call the

GDP deflator in the macro perspective.

What is the Intermediate Zone?

If the AD curve crosses this portion of the SRAS curve at an equilibrium point, then we might expect unemployment and inflation to move in opposing directions.

One reason that the aggregate demand curve is downward sloping is the "foreign price effect". What best describes the foreign price effect?

Inflation makes goods produced domestically more expensive relative to foreign produced goods causes net exports to decrease.

Keynes' Law and Say's Law in the AD/AS model - consider the SRAS curve's three zones:

Keynesian Zone Neoclassical Zone Intermediate Zone

What is the Neoclassical Zone?

SRAS curve which is near-vertical portion on the right-hand side. shifts of AD to the right or the left have little effect on the level of output or employment. only way to increase the size of the real GDP is for AS to shift to the right. Shifts in AD will create pressures to change the price level.

Which is a valid interpretation of Say's Law?

a given value of supply creates an equal value of demand somewhere in the economy.

To build and accurate macro model, we need a model that shows what determines

aggregate demand or aggregate supply for the economy, and how the total demand and total supply interact at the macro level. This is called the AD/AS model - explains AD/AS and the equilibrium between them.

What is the Aggregate Demand Curve?

amount of total spending on domestic goods and services in an economy. includes all four components of demand.

What is the Interest Rate Effect?

as prices for outputs rise, same purchases will take more money or credit to accomplish.

Shift in the AD curve to the right means that at least one of the

components of demand has increased so that a greater amount of total spending would occur at every price level. the opposite happens when AD curve shifts left.

Two other key inputs that may shift SRAS curve are

cost of labor, or wages, and the cost of imported goods that we use for other products.

What are the two types of unemployment in the AD/AS model?

cyclical long run

AD slope

down, which means that increases in the price level of outputs lead to a lower quantity of total spending.

What is the bottom line of National Income Approach to measuring GDP?

every sale represents income to some, and so, SAY'S law argues, a given value of supply must create and equivalent value of demand somewhere in the economy.

During the short run - GDP

falls and rises in every economy.

how can government macro policy choices shift AD?

government spending being one component of AD will cause AD to shift right.

If demand was all that mattered at the macro level, then the government could make the economy as large as it wanted just by pumping up total demand through a large increase in the

government spending component or by legislating large tax cuts to push up the consumption component.

What are the two broad categories that could cause AD curves to shift:

how changes by consumers and firms affect AD how government macro policy choices can shift AD

AD/AS model shows cyclical unemployment by

how close the economy is to the potential for full GDP employment level. low unemployment occurs when its close to potential GDP. high unemployment occurs when its to the left of potential GDP.

what is productivity?

how much can be produced with a given quantity of labor. -output per worker or GDP per capita -over time, productivity grows so that the same quantity of labor can produce more output.

What are the two most important factors that can lead to shifts in the AS curve?

how productivity growth shifts the AS curve - most important in the long run. how changes in input prices shift the AS curve

What is the Foreign Price Effect?

if prices rise in the US while remaining fixed in other countries, then goods in the US will be relatively more expensive compared to goods in the rest of the world.

How changes in input prices shift the AS curve

increases in the price of such inputs will cause the SRAS curve to shift left - a higher price for inputs will discourage production b/c it will reduce the possibilities for earning profits.

An increase in productivity causes by the Internet

increases the AS curve

Each time a good or service is produced and sold,

it generates income that is earned for someone that supply inputs along the chain of production.

In the short run, if demand is too low (or too high),

it is possible for producers to supply less GDP (or more GDP) than potential.

Say's Law that supply creates its own demand does seem a good approximation for the

long run. Over the periods of some years or decades, as the productive power of an economy to supply goods and services increases, total demand in the economy grows at roughly the same pace. Over shorter time horizons of a few months or even years, recessions or even depressions occur in which firms, as a group, seem to face a lack of demand for their products.

With increased productivity, workers can produce

more GDP. thus, full employment corresponds to a higher level of potential GDP.

Is inflationary pressure much to worry about in the Keynesian Zone?

no. the price level does not vary much in this zone.

What is the Keynesian Zone?

portion of the SRAS curve on the far left which is relatively flat. equilibrium of real GDP is far below potential GDP. the economy is in recession. cyclical unemployment is high.

In the long run, producers are limited to producing at

potential GDP. For this reason, we may refer to what we have been calling the AS curve as the short run aggregate supply curve

Keynes argued that the Great Depression were not caused by a drop in the ability of the economy to supply goods as measured by labor, physical capital, or technology. He argued the economy often produced less than its full

potential. not b/c it was technically impossible to produce more w/the existing workers and machines, but b/c a lack of demand in the economy as a whole led to inadequate incentives for firms to produce.

AD is determined by a number of factors, but one of them is the

price level - index number such as the GDP deflator that measures the average price of the things we buy.

Rise in input prices ends up with higher

price level for outputs.

What is the Wealth Effect?

price level increases, buying power of savings will diminish, eaten away by inflation - a rise in the price level reduces people's wealth, consumption spending will fall as the price level rises.

Firms determine profits, in turn, by the price of the outputs they sell and by the

prices of the inputs, like labor or raw materials, that they need to buy.

Economies do face genuine limits to how much they can

produce. limits determined by the quantity of labor, physical capital, technology, and the institutional market structures that bring these factors of production together.

Shifts in Aggregate Supply - when the AS curve shifts to the right, then at every price level,

producers supply a greater quantity of real GDP.

AS curve shifts to the left, then at every price level,

producers supply lower quantity of real GDP.

Firms make decisions about what quantity to supply based on the

profits they expect to earn.

Aggregate Supply curve describes how suppliers will

react to a higher price level for final outputs of goods/services, while holding the prices of inputs like labor and energy constant.

Horizontal axis shows

real GDP - level GDP adjusted for inflation.

As the price levels rise,

real GDP rise as well. b/c price level on the vertical axis represents prices for final goods or outputs bought (GDP deflator) - not the price level for intermediate goods/services that are inputs to production.

If supply always creates enough demand and the macro level, it is hard to understand why periods of

recession and high unemployment should ever occur.

This type of movement will bring a nasty set of effects:

reduced GDP or recession, higher unemployment b/c the economy is now further away from potential GDP, and inflationary higher price level.

A higher level productivity shift AS curve to the

right. firms can produce a greater quantity of output at every price level.

A decline in the price of a key input like oil will shift the SRAS to the

right. providing an incentive for more to be produced at every given price level for outputs.

If equilibrium occurs in the steep range of the AS, then the economy is close or at potential GDP and will be experiencing

rising price level or inflationary pressures, but will have low unemployment rate.

the tradeoffs and connections between the three goals of macro may be different in the

short run and the long run.

Keynes' Law seems to apply fairly well in the

short run of a few months to a few years, when many firms experience either a drop in demand for their output during a recession or so much demand that they have trouble producing enough during and economic boom.

What is Cyclical Unemployment?

short run variations which are caused by the business cycle as the economy expands and contracts.

The Keynesian Perspective focuses on the macro-economy in the

short run, where AD plays a crucial role.

Keynes' Law applies more accurately in the

short run.

Keynes' Law is Keynesian theory. Primarily applies in the

short run.

Inflation fluctuates in the

short run. higher typically during or just after economic booms: wartime. lower during recessions (deflation): Great Depression.

A recession is a situation in which the economy as a whole, is

shrinking in size, business failures outnumber the remaining success stories, and many firms end up suffering losses and laying off workers.

The pattern of shift to the left in SRAS leads to a

stagnant economy - high unemployment and high inflation.

Combining Supply and Demand in Macro - we need to take into account both

supply and demand.

When equilibrium is fairly far from where the AS curve becomes nearly vertical (or at least steep), this implies

that the economy is not close to potential GDP. Unemployment will be high, but stable price level.

If businesses anticipate a recession,

the AS curve decreases as firms cut production levels

The negative slope of the AD curve indicates that higher price levels are associated with lower levels of spending.

the foreign price effect is one reason for this.

The potential GDP line shows

the maximum that the economy can produce with full employment of workers and physical capital.

A decrease in the personal income tax rate paid by households has no impact on aggregate supply;

this would impact aggregate demand.

Macroeconomists divide into two groups:

those who argue that supply is the most important - while demand tags along. those who argue demand is the most important - while supply tags along.

The level of GDP in the economy was not primarily determined by the potential of what the economy could supply, but rather by the amount of

total demand.

Aggregate Supply

total quantity of output (real GDP) firms will produce and sell.

Aggregate Supply Curve

total quantity of output (real GDP) that firms will produce and sell at each price level.

Aggregate Demand Curve

total spending on domestic goods and services at each price level

Aggregate Demand

total spending on domestic goods and services.

What is the long run unemployment in the AD/AS diagram?

unemployment rate hovers around 5% when the economy is healthy.

AS curve's slope changes from nearly flat at its far left to nearly

vertical at its far right.

At the far right, the AS curve becomes nearly

vertical. at this quantity, higher prices for outputs cannot encourage additional output.

how do changes by consumers and firms affect AD?

when consumers feel more confident about the future of the economy, they tend to consume more and vice versa. economists associate a rise in confidence w/higher consumption and investment demand, it will lead to an outward shift in the AD curve, and a move of the equilibrium to a higher quantity of output and a higher price level.