Transcript AD and AS - uwcmaastricht-econ

AD and AS
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AGGREGATE DEMAND (AD): The quantity of
real GDP demanded (total quantity of G&S that all
buyers in an economy want to buy) at different price
levels.
The price level is measured using the GDP deflator.
The quantity of real GDP demanded is composed of
C+I+G+(X-M)
The AD curve is NOT the same as a market demand
curve.
A market demand curve illustrates the total demand of
all consumers for ONE particular product. The AD
curves illustrates the total demand of all agents in the
economy for all goods and services in the economy.
The AD Curve: Negatively sloped.
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Real Wealth Effect. Real wealth is the amount of
money in the bank, bonds, stocks and other assets
people own (ex: art) measured in terms of what they
will buy.
People save and hold money, bonds and stocks. One
reason is to build up funds for future spending (ex:
college fund or retirement savings).
If price level ↑, real wealth ↓. People then feel worse
off and decrease their consumption of g&s. So the
quantity of real GDP demanded falls (downward
movement ALONG the AD curve)
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If price level ↓, real wealth ↑. People feel better
off and increase their spending on g&s. So the
quantity of real GDP demanded rises (upward
movement ALONG the AD curve).
2. Interest rate effect
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An ↑ in the PL means consumers and firms need
more money for C and I, respectively. People then
increase their borrowing.
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The increase in borrowing (because of an increase in
money demand) pushes up the price of money...which is
the interest rate.
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As the interest gets higher it becomes too costly to
borrow and people tend to decrease their
expenditures financed by borrowing (ex: houses, cars,
luxury vacations, renovations) and firms decrease
their I. As a result, the quantity of real GDP
demanded falls.
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A ↓ in the PL means consumers and firms need less
money for C and I, respectively. People then decrease
their borrowing.
The decrease in borrowing (because of a decrease in
money demand) pushes down the price of money...which
is the interest rate.
As the interest gets lower it becomes cheaper to borrow
and people tend to increase their expenditures financed
by borrowing (ex: houses, cars, luxury vacations,
renovations) and firms increase their I. As a result, the
quantity of real GDP demanded rises.
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NOTE: The interest rate effect can be tricky!
If changes in the price level are CAUSING the
change in the interest rate then the change in the
interest rate is linked to a movement along the
AD curve.
BUT the government can change the level of
the interest rate completely separately from any
changes in the price level. In this case the
change in the interest rate will cause a SHIFT
of the AD curve.
3. International trade effect.
 An ↑ in the PL means the price of domestic
goods is changing relative to the prices of
foreign goods…foreign goods could be more
attractive due to this change in relative prices.
Thus M ↑ and X (which are relatively more
expensive to the foreigners buying them) ↓.
Domestic goods are substituted by foreign
goods.
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A ↓ in the PL means the price of domestic
goods is changing relative to the prices of
foreign goods…foreign goods could be less
attractive due to this change in relative prices.
Thus M ↓ and X (which are relatively cheaper to
the foreigners buying them) ↑. Foreign made
goods are substituted by domestic goods (by
both domestic and foreign consumers).
Shifts in the AD curve
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Rightward shift of AD means that for any
particular PL, a larger amount of real GDP is
demanded.
Leftward shift of AD means that for any
particular PL, a smaller amount of real GDP is
demanded.
Since AD = C + I + G + (X-M), anything that
causes a change in any of the components of
AD, will cause AD to shift.
Factors causing a change in C
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Wealth. An ↑ in wealth (ex: value of homes) makes people feel
wealthier, so they increase C expenditures.
Expectations about future income and the economy.
Expectations of increasing incomes in the future or optimistic
expectations about the economy will increase spending by
consumers because they know they will have more money.
Interest rates. Some consumer spending is financed by
borrowing and thus sensitive to interest rate changes. If i ↓,
borrowing becomes less expensive and C increases.
Personal income taxes. If the gov decides to ↑ taxes paid by
households, then their disposable income decreases and C
spending drops.
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Household indebtedness. Indebtedness is how much
money people owe from taking out loans in the past
(ex: mortgages, credit cards). If cons are able to lower
their debt payments more money can be spent on C
and AD will rise and shift right.
Attitudes towards spending. In different periods of
time, households may become more comfortable with
spending more. After a war or a major national calamity
they may become more cautious and decide to spend
less.
Factors causing a change in I
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Expectations about future sales. Higher profit
expectations will lead to higher I and thus ↑ AD. It will
shift right. Lower profit expectations will lower I and
thus ↓ AD. It will then shift left.
Changes in business taxes. If the gov ↓ taxes on
profits of businesses (fiscal policy), firms’ after-tax
profits increase, which ↑ I, as firms have more money
to spend. An ↑ in taxes will ↓ I, as firms will have less
money to spend.
Legal/institutional changes. Sometimes the legal and
institutional environment in which firms operate has an
impact on I spending. Ex: access to credit, property
rights.
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Changes in interest rates. An ↑ in interest rates
makes borrowing more expensive and I tends to fall. A
↓ in interest rates makes borrowing less expensive, so
firms tends to increase their I.
Factors causing a change in G
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Changes in political priorities. The gov may decide
to ↑ or ↓ its expenditures in response to changes in its
priorities.
Efforts to influence AD through Fiscal policy:
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Expansionary FP: ↓ taxes and/or ↑ gov expenditures = more
overall spending, AD shifts right.
Contractionary FP: ↑ taxes and/or ↓ gov expenditures = less
overall spending, AD shifts left.
Factors causing a change in X-M
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Changes in real GDP abroad. If GDP in foreign
countries is rising they buy more of all goods including
goods they buy from us, so our AD will ↑ and shift
right. If GDP in foreign countries is falling they buy
less of all goods including goods they buy from us, so
our AD will ↓ and shift left.
Changes in exchange rates. If the exchange rate (the
price you pay using your own currency to buy another
currency) goes up then it takes more of your currency
to buy foreign goods, M will ↓ but X ↑ as it is easier for
foreigners to buy our currency. So (X-M)↑, and AD
shifts right. If the exchange rate (price of foreign
currency) goes down it takes less domestic currency to
buy foreign goods. M↑ and X↓ as it costs more in terms
of foreign currency to buy our goods. (X-M)↓ and AD
shifts left.
Aggregate Supply (AS)
Short run and long run in macroeconomics.
 Short run: the period of time during which the
nominal prices of resources, in particular wages, do not
change in response to changes in the price level. That is,
resource prices are constant.
 Long run: the period of time in which the nominal
prices of all resources, including wages, change in
response to changes in the price level.
 In the short run, wages are constant, whereas in the
long run wages change in response to changes in PL.
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AS is the total quantity of G&S produced in an
economy at different price levels.
The short run AS (SRAS) curve shows the relationship
between the price level and the quantity of real GDP
produced by firms when resource prices (wages) do not
change.
SRAS curve is upward sloping because of firm
profitability. As PL ↑, with nominal wages constant,
firms’ profits increase. As production becomes more
profitable, firms increase the quantity of output they
produce. As PL ↓, firm profitability falls and output
decreases.
Shifts in the SRAS curve
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A number of factors other than the PL can cause
shifts of the SRAS curve.
A rightward shift of the SRAS curve means that
for any particular price level, firms produce a
larger quantity of real GDP.
A leftward shift of the SRAS curve means that
for any particular price level, firms produce a
smaller quantity of real GDP
Factors that influence firms’ production costs
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Changes in wages. Wages constitute a major portion of
firms’ costs of production. They can change as a result
of a change in minimum wage legislation or as a result
of labour union negotiations with employers. If
nominal wages ↑ (with PL constant), firms’ costs ↑ and
SRAS shifts left. If nominal wages ↓ (with PL constant),
firms’ costs ↓ and SRAS shifts right.
Changes in non-labour resource prices. Ex: changes in
the price of oil, equipment, capital goods,... They have
the same impact on SRAS as a change in wages.
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Changes in business taxes. These are taxes on firms’
profits and are treated by firms as a cost of production.
If taxes ↑ = production costs ↑ and SRAS shifts to the
left. If taxes ↓ = production costs ↓ and SRAS shifts to
the right.
Changes in subsidies offered to businesses. These are
money transferred from the gov to firms, so they have
the opposite effect to taxes.
Supply shocks
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Events that have a sudden and strong impact on SRAS.
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Negative supply shocks. A war can result in the destruction
of physical capital and disruption of the economy, which
reduces output produced and shifts the SRAS curve to the
left. Unfavourable weather conditions can decrease
agricultural output, shifting SRAS to the left. A sudden
increase in the price of a major input such as oil, increases
firms’ production costs, shifting SRAS curve to the left.
Positive supply shocks. Oil discovery or good weather
conditions lead to an increase in SRAS and a rightward shift
of the SRAS curve.
Long-Run Aggregate Supply
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In the long-run, all resource prices change so as
to match changes in the PL.
The LRAS curve is vertical at potential GDP
(YP). In the long run, a change in the price level
does not give rise to any change in the amount
of output produced.
A movement along the LRAS curve involves a
change in two sets of prices:
The price level
 The prices of resources
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An increase of 10% in PL is matched by an
increase of 10% in wages, so firms’ profits
remain constant and there is no incentive to ↑ or
↓ the output level.
Therefore, along the LRAS curve, as PL changes,
real GDP remains at potential GDP.
An important implication is that in the long run
output gaps (when actual GDP produced differs
from potential GDP) disappear and the
economy moves automatically towards FE
equilibrium. This represents the Neoclassical
view.
Movements along the AS curves
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A rise in the PL, with the prices of resources
held constant, brings an increase in the quantity
of real GDP supplied and a movement along
the SRAS curve.
A rise in the PL with equal percentage increases
in the prices of resources keeps the quantity of
real GDP supplied constant at potential GDP
and brings a movement along the LRAS curve.
Shifts in the LRAS curve
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An economy can achieve some limited growth
(a shift of the LRAS curve) through:
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Increases in efficiency.
Reductions in the NRU.
The economy can continue to grow by
increasing its production possibilities, that is:
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Increases in the quantities of the factors of
production. An increase in the quantity of labour,
the quantity of physical capital or the quantity of
land means that the economy is able to produce a
larger quantity of real GDP.
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Improvements in the quality of factors of
production. For ex: greater levels of education,
skills or health contribute to a more productive
workforce, increasing the level of output
produced.
Improvements in technology. Technological
change enables firms to produce more from any
given amount of inputs.
If the LRAS shifts, then the SRAS also shifts.
This is because at any moment in time the
economy is always producing on a SRAS
curve.
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However, a shift in the SRAS curve does not
cause the LRAS to shift.
Changes in input prices only shift the SRAS
without affecting the LRAS. An increase in wages
increases firms’ production costs, shifting SRAS to
the left, but this does not affect potential GDP. The
same happens with an increase in the price of oil.
 Certain events have only a temporary impact on AS
and these can shift the SRAS for a short while, while
leaving the LRAS unchanged. Ex: adverse wheather
conditions during one season that cause a drop in
agricultural output.
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