Chapter 13: The Aggregate Demand-Aggregate Supply Model

When the LRAS curve shifts to the right

this shift also indicates a change in the economy's full-employment output level from Y* to Y**

Menu Costs

the costs of changing prices Because of this expense, firms do not adjust their output price when the price level changes

Supply shocks

unexpected events that affect aggregate supply, sometimes only temporarily

Shifts in Investment

- General expectation about the future - Interest rate - Changes in the quantity of money in the economy

Shifts in International Trade

- Income of individuals in other countries - Exchange rates

Long-Run Aggregate Supply

- LRAS - The long-run output of an economy depends on resources, technology, and institutions. - It is not affected by the price level. - In the long-run, the economy moves toward full-employment output (Y*).

Business cycle

- Most evident in real GDP growth and Unemployment rate - Business cycle theory typically focuses on time horizons of five years or less

The Long-Run Aggregate Supply Curve

- The LRAS curve is vertical at Y* because in the long run the price level does not affect the quantity of aggregate supply. - Y* is full-employment output, where the unemployment rate (u) is equal to the natural rate (u*)

The Aggregate Demand Curve

- The aggregate demand curve shows the negative relationship between the quantity demanded of real GDP and the economy's price level (P). - The negative slope of the aggregate demand curve means that increases in the price level lead to decreases in the quantity of aggregate demand. - when the price level falls, the quantity of aggregate demand rises.

How Changes in Input Prices Shift the Short-Run Aggregate Supply Curve

- The short-run aggregate supply curve shifts to the right (from SRAS1 to SRAS2) when resource prices fall. - This could occur when negotiations lead to lower wages or when there is a positive supply shock. The curve shifts to the left (from SRAS1 to SRAS3) when resource prices rise. - This happens when workers negotiate higher wages or when negative supply shocks increase resource prices.

The Wealth Effect

- The wealth effect is the change in the quantity of aggregate demand that results from wealth changes due to price-level changes - A rise in price all over the economy reduces real wealth in the economy, and then the quantity of aggregate demand falls - If price fall, real wealth increases, and then the quantity of aggregate demand also increases

Input Prices

- Wage is set for a period of time - Interest rates for your loans are normally fixed - Economists say that these inputs prices are sticky, because the stick at a certain level and take time to change.

There is a Negative relationship between quantity of aggregate demand and the price level because of the following:

- Wealth Effect - Interest rate effect - International trade effect

Wealth

- Wealth is the net value of one's accumulated assets - Your wealth is the total net value of everything you own, including the money in your wallet and in your bank accounts

Shifts in Consumption

- When National wealth increases, the consumption component of aggregate demand increases - When wealth falls, consumption declines - Changes expectation about the future - Changes in taxes

Shifts in Aggregate Demand

- When people demand more goods and services at all levels, aggregate demand increases and the AD curve shifts to the right. - When people have fewer foods and services at all price level, aggregate demand decreases and the AD curve shifts to the left.

To determine how the economy moves from one long-run equilibrium to another:

1. Begin with the model in long equilibrium 2. Determine which curve(s) are affected by the direction(s) of the change(s) 3. Shift the curve(s) in appropriate direction(s) 4. Determine the new short-run and/or long-run equilibrium points 5. Compare the new equilibrium point(s) with the starting point

What are the four major groups that constitute the four pieces of aggregate demand?

1. Consumption (C) 2. Investment (I) 3. Government spending (G) 4. Net exports (NX) AD = C+ I+G +NX

In macroeconomics, there are two major paths of study

1. One direction explores long-run growth and development 2. The second direction examines short-run fluctuation, or business cycles

Aggregate Demand

AD = C+ I+G +NX - Aggregate demand is the sum of spending in the economy. - When people spend on goods and services, aggregate demand increases

What is aggregate supply (AS)?

Aggregate supply is the total supply of final goods and services in an economy.

Equilibrium in the Aggregate Demand-Aggregate Supply Model:

Forces in the economy naturally move it toward equilibrium at point A, where aggregate supply is equal to aggregate demand, P = P*, Y = Y*, and u = u*.

Short-Run Aggregate Supply

In the short run there is positive relationship between the price level and quantity of aggregate supply. There are 3 reasons for this relationship: 1. inflexible input costs 2.Menu costs 3.money illusion.

Shifts in Government Spending

Influenced by Policy These changes may be made in response to economic conditions.

A technological advance moves an economy from what?

LRAS 1 - LRAS 2

New technology shifts long-run aggregate supply how?

New technology shifts long-run aggregate supply positively from LRAS1 to LRAS2 because the economy can now produce more at any price level.

Aggregate

The word "aggregate" means total

What is aggregate demand (AD)?

Total demand for final goods and services in the economy

Slope of the AD Curve

When the price level rises, the quantity of aggregate demand falls. This negative relationship is due to three different effects, (1) the wealth effect implies a lower quantity of consumption (C) demand because real wealth falls at higher price levels; (2) the interest rate effect implies a lower quantity of investment (I) demand due to higher interest rates; (3) the international trade effect implies a lower quantity of net export (NX) demand due to relatively higher domestic prices. Each effect focuses on a different component of aggregate demand

Shifts in Short-Run Aggregate Supply

Whenever the long-run AS curve shifts, it takes the short-run AS curve with it. Factors that shift only the short-run AS curve - Changes in prices - Changes in Expectation of price - Supply shocks

Long-run equilibrium

a situation in which the AD and AS curves intersect at potential output Y*

interest rate effect

effect occurring when a change in the price level leads to a change in interest rates and therefore in the quantity of aggregate demand

What is the international trade effect?

effect occurring when a change in the price level leads to a change in the quantity of net exports demanded

LRAS 1 can also shift to the left LRAS 3

hift would occur with a permeant decline in the economy's resources or with the adoption of inefficient institutions If political instability leads to overthrow the government of a nation

Long run

is a period of time sufficient for all prices to adjusted. The long run doesn't arrive after a set period of time; it arrives when all prices have adjusted

Negative supply shocks

lead to higher input prices and higher production costs

Money Illusion

occurs when people interpret nominal changes in wages or prices as real changes Workers are very reluctant to accept pay decreases, even if the pay decrease is nominal.

Short Run

only some prices can change, in macroeconomics, the short run is the period of time in which some prices have not yet adjusted.

During expansion

real GDP growth expands and the unemployment rate falls

During recessions

real GDP slows and the unemployment rate rises

Consider just the AD curve. Suppose consumption (C) broadly increases across the entire economy. This will cause

the AD curve to shift outward

With the AD-AS graph, what variable is on the vertical axis?

the price level

How Does the Aggregate Demand-Aggregate Supply Model Help Us Understand the Economy?

• In the market economy, output is determined by exchanges between buyers and sellers • We bring aggregate demand and aggregate supply together and then consider how changes in the economy affect real GDP, unemployment, and the price level.