Lecture 13: AD & AS Econ 102 w/ Dr. Adam Stevenson Aggregate Demand & Aggregate Supply Now: the model of SR fluctuations Build the model Relate it to long run (full resource-utilization) How does this model imply fluctuations? Straight off: when we discuss aggregate S & D, do your best to remove micro (Ch. 3 & 4) S & D from your mind The micro model explains relative prices It explains how one price changes holding all other prices constant Aggregate S & D explains how all prices change together: changes in the price level Aggregate Demand Aggregate Demand: the relationship between the aggregate price level (P) and aggregate production (rGDP), as demanded by households, firms, government, and the rest of the world GDP = C + I + G + NX A negative (downward-sloping) relationship Why? Again, NOT because of the law of demand Two main reasons, both of which hinge on a ceteris paribus assumption: When drawing AD, we hold constant the quantity of money (actual bills and currency) constant Aggregate Demand Aggregate demand slopes downwards because of: The wealth effect If an individual holds a certain quantity of money ($1,000) and the price level rises, that money can buy fewer goods and services: consumption falls When the economy has a fixed money supply, the same holds The interest rate effect Higher prices ? more money to buy same consumption bundle. More demand for money Demand for funds rises ? higher interest rate High r ? less demand for investment (I) Aggregate Demand From Income-Expenditure to AD In the Income-Expenditure (Keynesian Cross) model, we explained equilibrium total production. One assumption there: prices are constant. Therefore, as prices change, we must shift the AEplanned curve, and get a new rGDP. From this, can get the AD curve! Recall: AEplanned = C + Iplanned Write C = C(P) (?consumption is (partly) a function of price?), where (as from the wealth effect) as P?, C(P)? ? AEplanned = C(P) + Iplanned A fall in P, from P1 to P2 (P1 > P2) rGDP Planned AE rGDP Agg P AD shifters Changes in the quantity of money (monetary policy) Changes in fiscal policy ? government spending and taxing. GDP = C(P, Yd) + I + G Changes in capital stock ? as with forces of inventory accumulation, as K (or HH durable goods) stocks rise, there is less desire to spend/invest more. Changes in wealth ? wealthier individuals spend more Changes in expectations ? life cycle and permanent income, as before. Firms invest based on such expectations, as well = A(P) + MPC*(Y - T) + I + G Aggregate Supply Aggregate Supply: the relationship between the aggregate price level (P) and aggregate production (rGDP) that firms are willing to supply For AS, we will distinguish between the long run and the short run Short run characteristic: Sticky nominal wages Long run characteristics Perfectly flexible wages Full/natural levels of production ? production equals potential output Short Run AS Sticky nominal wages Come from formal contracts & ?informal contracts? ? social norms and expectations that firms will not cut wages. SRAS is the firm response to changes in the price level, given sticky wages Profit per unit = Price per unit ? cost per unit When firms can?t change their price (in ?perfect competition?), when Agg P falls, profits fall. Produce less! When firms can change their price (in ?imperfect competition?), when D?, can increase P and production stuck SRAS SRAS shifters Broad theme: anything that shifts profitability! Changes in commodity prices ? changes in the cost of inputs (used in production/not final goods) Changes in nominal wages ? another cost of production Changes in productivity ? by definition, ability to produce more with the same resources or, the ability to produce the same amount with fewer resources. A cost reduction The AD-AS model Put AD and SRAS together to determine short run macroeconomic equilibrium Why an equilibrium? If SR quantity supplied > aggregate quantity demanded, not all production is consumed, and Agg P falls to sell it off If SR quantity supplied < aggregate quantity demanded, all producers can raise prices, ensure sales of all G & S The AD-AS model Long Run AS Why is AD-SRAS a model of SR ?fluctuations?? We need one more component: the long run Perfectly flexible wages ? there is ?enough time? to negotiate changes in every wage contract (or to hire new workers) Produce at the level of potential output. The output level that comes from employing all resources at their natural rates (Ch. 8). Also call this full employment level of production Production is fixed by resource stock, and prices will fully adjust to any change in the LR. Graph it! LRAS Interpretational note p. 335: ?a fall in either [P or rGDP in the SR graph] is a fall compared to the long-run trend? In the graphs that follow, we should think of an decrease in P as a decrease in the rate of inflation Think of an increase in rGDP as an increase in the growth rate Think of the LRAS graph as representing that baseline growth rate (from the Ch. 9 model) Then the LRAS graph will essentially not shift (by definition) in this class A tiny sidenote in the text (which all graph labels ignore), but VERY important in understanding the arguments! When SR equilibrium = LR equilibrium Movement from SR ? LR Suppose some shock to AD: a positive shift (say, a wealth increase ? the 1990s tech boom) What happens to SR equilibrium, what happens to LR equilibrium? rGDP growth ?, agg price level ? Now hard to find workers, so firms must offer higher nominal wages. An input cost increase! SRAS will shift inwards, increasing inflation, reducing rGDP growth. If SR equil rGDP ? LR equil rGDP, go back to item #2 When SR equilibrium ? LR equilibrium Thurs: Countercyclical policy and fiscal policy Discussion section questions: Ch. 12: 8, 10, 11, 13 Ch. 13: 4, 6, 12
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