Aggregate Demand and Aggregate Supply

Aggregate Demand and Aggregate Supply

Outline

• Introduction to key four markets in any economy:

• Aggregate Demand (AD) • Short-run Aggregate Supply (SRAS) • Long-run Aggregate Supply (LRAS)

The four key markets are:

Goods and services market

Resources market

Loanable funds market

Foreign exchange market

Goods & Services Market

Firms supply goods & services to the market in exchange for sales revenue.

Households, investors, governments, and foreigners (net exports) demand these goods & services.

Resource Market

Firms demand resources for their productive activities.

Households supply labor and other resources in exchange for income.

Loanable Funds Market

Borrowers demand funds (e.g. firms demand capital for their operations)

Lenders supply funds (Households supply their savings)

Foreign Exchange Market

Households and firms demand foreign currency (in order to buy things abroad)

Foreigners supply foreign currencies in exchange for dollars (so they can buy domestic goods and services).

Circular Flow Diagram (Without Gov & Foreign Exchange)

The Circular Flow Diagram

In this course, we will be examining three of these four markets in details!

We start by the Goods & Services Market

Aggregate Demand

• The total demand for final goods and services in an economy

• The AD curve indicates the various quantities of domestically produced goods & services that buyers are willing to buy at different price levels.

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Aggregate Demand (AD) – Cont’d

• Think of AD as the spending side of the economy. • When people spend more on goods and services, AD increases.

• Not only households spend on goods & services, business and the government spend too.

• Thus

𝑨𝑫 = 𝑪 + 𝑰 + 𝑮 + 𝑵𝑿

Aggregate Demand (AD) – Cont’d

This figure depicts the aggregate demand curve. The downsloping aggregate demand curve, AD, indicates an inverse (or negative) relationship between the price level and the amount of real output purchased.

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Why AD Is Downward Sloping?

Real-balances/ wealth Effect: Other things being constant, lower prices make people richer in real terms (increase the purchasing power of money), so they increase their consumption.

Interest rate effect: lower prices reduce the demand for money and therefore reduces interest rates, which stimulates additional purchases.

International Effect (foreign purchases effect): Other things being constant, lower prices make domestic goods cheaper relative to foreign goods, which increases exports.

Aggregate demand is a schedule or curve that shows the various amounts of real domestic output that domestic and foreign buyers desire to purchase at each possible price level. The aggregate demand curve shows an inverse relationship between price level and real domestic output.

(The explanation of the inverse relationship is not the same as for demand for a single product, which centered on substitution and income effects. Substitution effect doesn’t apply within the scope of domestically produced goods, since there is no substitute for “everything.” Income effect also doesn’t apply in the aggregate case, since income now varies with aggregate output.)

The explanation of the inverse relationship between price level and real output in aggregate demand are explained by the following three effects.

Real balances effect: When price level falls, the purchasing power of existing financial balances rises, which can increase spending.

Interest rate effect: A decline in price level means lower interest rates that can increase levels of certain types of spending.

Foreign purchases effect: When price level falls, other things being equal, U.S. prices will fall relative to foreign prices, which will tend to increase spending on U.S. exports and also decrease import spending in favor of U.S. products that compete with imports (similar to the substitution effect).

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You need to distinguish between shifts in the AD curve and movements along the curve.

Shifts occur due to factors that lead people to demand more of the goods or services at a certain price.

Movements occur due to factors that change the overall price level.

Factors that cause movement along AD

The same factors that result from price changes. For example:

a) Real-balances effect

b) Interest rate effect c) International trade effect

These factors result in change in the QUANTITY of goods & services demanded.

Factors that cause shifts in the AD

1. Change in consumer spending:

Changes in real wealth

Changes in real interest rates

Change in expectations (income, inflation)

2. Change in Investment spending:

Interest rates

Expected returns

3. Changes in government spending

4. Changes in net exports

Change in foreign income

Changes in exchange rates

1. Consumer wealth is the difference between household assets (homes and stocks and bonds) and liabilities (loans and credit cards). The value of the assets can change and the consumer will react by spending more as asset values increase and spending less as asset values decrease.

Households can borrow in order to spend more which increases AD and if the household reduces spending in order to pay off household debt, AD decreases.

Expectations of future higher incomes or higher prices will increase current household spending and AD; expectations of lower household spending or lower prices will decrease AD.

A reduction in personal income taxes increases disposable income and increases spending by the household, increasing AD; an increase in taxes will decrease disposable income and decrease household spending, decreasing AD.

2. Investment spending is spending on capital goods. Increases in investment spending increases AD; decreases in investment goods decreases AD.

As real interest rates increase, the cost of borrowing increases and subsequently less will be borrowed resulting in less money spent, reducing AD. On the other hand, a decrease in real interest rates will increase borrowing and subsequently investment spending will increase AD.

If business owners and managers are optimistic about future expected returns they will spend more now increasing AD and if expected returns are less than favorable they will spend less now reducing AD.

3. Other things equal, if government spending increases, AD increases. An example would be of the government spending more on transportation projects.

If government spending decreases, AD decreases. An example of this is less military spending

4. If net export spending rises, AD rises. If net export spending declines, AD declines. As the national incomes of trading partners of the U.S. increase, they are more able to purchase U.S. produced goods and services which increases AD. If the foreign nations’ incomes decline, the opposite occurs.

If the dollar depreciates, AD increases. Depreciation of the dollar encourages U.S. exports since U.S. products become less expensive, as foreign buyers can obtain more dollars for their currency. Conversely, dollar depreciation discourages import buying in the U.S. because our dollars can’t be exchanged for as much foreign currency. AD can decrease through changes in currency exchange rates if the U.S. dollar appreciates. The currency appreciation of the dollar discourages U.S. exports because now U.S. goods are relatively more expensive than before since it takes more of the foreign currency to buy the U.S. dollar. This will also encourage more import spending since the U.S. dollar can buy more of another nation’s currency than before. Net exports will decline which reduces AD.

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Question

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

A movement along the AD curve.

B the AD curve to shift outward.

C the slope of the AD curve to get steeper.

D a decrease in the price level of the economy.

Answer: B

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Question

The price level rises and this changes the real value of consumers’ wealth. Does this cause a movement along the AD curve, or a shift to a new AD curve?

Answer. This causes a movement along the AD curve

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Aggregate Supply (AS)

• The total supply for final goods and services in an economy

• The AS curve indicates the willingness of the producers to supply goods & services at different price levels.

Aggregate Supply (AS) – Cont’d

When considering the AS, we need to distinguish between:

Short-run (SR):

A period of time during which (some) prices are fixed (prices are NOT adjustable because they are determined by prior contracts).

Long-run (LR):

A period of time, long enough, for agents to modify their behavior in response to price changes.

Aggregate supply is a schedule or curve showing the level of real domestic output available at each possible price level. The relationship is determined on the basis of whether input prices and output prices are fixed or flexible.

In the short run, input prices are fixed but output prices are variable.

In the long run, input prices and output prices can vary

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Short-Run Aggregate Supply (SRAS)

Indicates the various quantities of goods and services that firms supply in response to the changing demand conditions that alter the price level.

Upward sloping (positive relationship between the price level and the quantity of the output to be produced)

Short-Run Aggregate Supply (SRAS) – Cont’d

SRAS curve is upward sloping (has a positive slope)

Because input prices are fixed, changes in the price level affect the firm’s real profit, which affect their decision of how much output to produce.

Factors that shift the SRAS

• Temporary supply shocks

• Changes in resource prices

• Changes in expected future prices

Examples

Long-Run Aggregate Supply (LRAS)

Indicates the relationship between the price level and quantity of output after necessary sufficient time has passed so they adjust their prior commitments.

LRAS is related to the economy’s production possibilities constraint

The constraints are imposed by the economy’s resource base, and level of technology, and the efficiency of its institutional arrangements – Not related to the price level.

Long-Run Aggregate Supply (LRAS)

In the LR, the economy moves towards the full employment level of output (Y*).

Y* is NOT affected by the price level.

LRAS is independent of the overall price level.

Long-Run Aggregate Supply (LRAS) – Cont’d

Factors that shift the LRAS

• Factors that determine economic growth, e.g.:

Change in the recourses available Changes in technology

Changes in the quality of institutions

Example

Important Note

LRAS shifts cause SRAS shifts…

However, the reverse is not true!

There are many factors that cause SRAS to shift but does not influence LRAS (for example temporary supply shocks that occur only in the SR).

Short-run Equilibrium

Short-run equilibrium occurs at the price level (P*) & the output level, where AD = SRAS.

Graphically, it occurs at output level where the AD and SRAS curves intersect.

At this market clearing price (P*), the amount that buyers want to purchase is just equal to the quantity that sellers are willing to supply.

Short-run Equilibrium

Long Run Equilibrium

LR equilibrium requires two conditions:

The aggregate quantity demanded = aggregate quantity supplied at the current price level.

Price level anticipated by decision makers equals the actual price level (agents fully adjusted to any changes in prices that occurred in the past).

In the LR: AD = SRAS = LRAS.

Long run Equilibrium

What happens when output is different from LR potential?

There are two scenarios:

• Output is greater than LR potential: Price level increases by more that what was anticipated.

In the SR, profit margins are high hence output increases Economic boom (unsustainable)

• Output is less than LR potential: Price level is less than what was anticipated. In the SR, profit margins are low hence Output shrinks

Recession (unsustainable)

Which curve does these factors affect? Do they cause a movement along the curve or a shift in the curve?

a. Due to the increase of clothes prices in the US, consumers substitute out of clothes made in the US to clothes made in Bangladesh

b. New Shale Gas Deposits are found in North Dakota

c. OPEC meets and decides to increase the world output of oil, which

results in the decline of the prices of oil in the next six months.

d. Consumers read positive news about expected future economic growth

e. New policies cause an increase in the cost of meeting government regulations.

Movement along the AD curve

LRAS/SRAS shift to the right

SRAS curve shifts to the left

AD shifts to the right

LRAS shifts to the left

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Which curve does these factors affect? Do they cause a movement along the curve or a shift in the curve?

Imports increase Price level increases The Japanese Earthquake and Tsunami of 2011 Introducing smart phones to the cell phones market

Introduction of computers The invention of airplanes World War II

Impact of Exogenous Shocks

How the economy adjusts

• To analyze the effect of any shock to the economy, we study its impact on output, unemployment, and the price level.

• For an effective analysis, follow these steps:

Begin with the model at the LR equilibrium

Determine the curves that are affected by the shocks and identify the direction of each shift

Shift the curves in the appropriate directions

Determine the new SR/ LR equilibrium points

Compare the new equilibrium with the starting point.

Discuss the Impact of the following shocks on the US economy

World War II (discuss the impact on the Japanese economy and the US economy)

Strong economic growth in China that increases income in China (Hint: China is the second big trading partner with the US)

The housing market bust in 2008-09

The 2007 oil price shock.

Resource Market

Demand for Resources: Business firms demand resources (labor and capital) because they contribute to the production of goods the firm expects to sell at a profit.

The demand curve for resources slopes down and to the right.

Supply of Resources:

Households supply resources in exchange for income.

Higher prices increase the incentive to supply resources; thus, the supply curve slopes up and to the right.

Equilibrium in the Labor Market

Loanable Funds Market

The interest rate coordinates the actions of borrowers and lenders.

From the borrower’s viewpoint, interest is the cost paid for earlier availability.

From the lender’s viewpoint, interest is a premium received for waiting, for delaying possible current expenditures into the future.

The Money and Real Interest Rates

The money interest rate is the nominal price of loanable funds. The real interest rate is the real price of loanable funds.

The difference between the money rate and real interest rate is the inflationary premium.

This premium reflects the expected decline in the purchasing power of the dollar during the period the loan is outstanding.

i = r + inflation

Inflation & Interest Rate

Foreign Exchange Market

When Americans buy from foreigners or make investments abroad, they demand foreign currency in the foreign exchange market.

When Americans sell products and assets (including bonds) to foreigners, they generate a supply of foreign currency (in exchange for dollars) in the foreign exchange market.

The exchange rate will bring the quantity of foreign exchange demanded into equality with the quantity supplied.

Foreign Exchange Market

Appreciation & Depreciation

Appreciation: Increase in the value of the domestic currency relative to foreign currencies

Depreciation: Reduction in the value of the domestic currency relative to foreign currencies

Capital Flows and Trade Flows

When equilibrium is present in the foreign exchange market, the following relation exists:

Imports + Capital Outflows=Exports + Capital Inflows

This relation can be written as:

Imports – Exports= Capital Inflows – Capital Outflows

Trade Balance = Net Capital Flows

Capital Flows and Trade Flows

◦ When imports exceed exports, a trade deficit occurs. ◦ If, instead, exports exceed imports, a trade surplus is present.

When the exchange rate is determined by market forces, trade deficits will be closely linked with a net inflow of capital.

Conversely, trade surpluses will be closely linked with a net outflow of capital.


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