Transcript CHAPTER 10- Real GDP and PL in Long Run

Aggregate Supply –
Aggregate Demand
GDP 2007 to 2010
What is Aggregate Demand?

A schedule or curve showing amounts of
real output that buyers collectively desire
to purchase at each possible price level.
Think: Why does AD slope downward?
Why does AD slope downward?
Vertical axis represents
Price level for ALL final goods
And services
Price
level
The aggregate price level
Is measured by either
GDP
Deflator or CPI
The horizontal axis represents
the real quantity of all G&S
purchased as measured by the
level of REAL GDP
Inverse Relationship
AD
Real domestic output,
GDP
Vertical and Horizontal Axis
Horizontal axis = GDP
Vertical axis = GDP deflator (includes C+I+G)
or CPI…. Government uses the deflator* so it
get a lower number.
*A broader measure of price level… includes airplanes, dentist
Visits, pizzas, new shopping centers, etc.
ASSUMPTION for Aggregate demand IS:
If Price level is decreasing, so are
incomes.
Economy moves down its AD curve
Moves to lower price level
*remember circular flow model- (when consumers pay lower
prices for goods and services – Less nominal income flows to
resource suppliers .
There are 3 Reasons that cause the
Aggregate
Demand Curve to be downward
sloping.
Real Balance Effect (Wealth effect)
Interest Rate Effect
International Trade Effect
Real Balance Effect

1)
Price level falls- causes purchasing
power to rise… translates into more
money to spend or monetary wealth
improves.
Real Balance Effect (or Wealth
Effect) – Higher price level means less
consumption spending.
Real Balance Effect
Higher price level reduces real value of purchasing
power of public’s accumulated savings
The change
in the
purchasing
power of
dollarRelates to
assets that
result from
a change in
the price
level
Interest Rate Effect



Inverse relationship between price level
and quantity demanded of GDP –
because households and businesses
adjust to interest rates for those
interest-sensitive purchases.
Price level falls (bundle of goods costs
less) rest of money into savings, more
money available for borrowing interest
rate down.
Think of money as stationary… demand
drives up price of money.
Interest Rate continued
Now if bundle of goods increases… want to
purchase interest sensitive good, cost to borrow
is up.
 An increase in money demand will drive up the
price paid for its use
… use of money = interest rate
 As price level rises, houses and firms
require more money to handle
transactions…

International Trade Effect (Open
Economy Effect)
FYI: An open economy is global, a closed economy
is domestic.
The Open Economy Effect

Higher price levels result in foreigners’ desiring to buy
fewer American-made goods while Americans desire
more foreign-made goods (i.e., net exports fall).

Equivalent to a reduction in the amount of real goods
and services purchased in the U.S.
When Demand for exports decreases, this is an
unfavorable balance of trade (imports
exceed exports)
Effect on AD
Wealth
Why an Increase in Price
Level Reduces Quantity of
Real GDP Demanded
Why a Decrease in Price
Level Raises Quantity of
Real GDP Demanded
When P falls, consumers are
When P rises, consumers are
wealthier in real terms. This
poorer in real terms. This
primarily increases the
primarily decreases the demand
demand for consumption
for consumption goods.
goods.
When P rises, individuals save
less, which increases the
equilibrium interest rate. Higher
Interest Rate
interest rates reduce the
quantity demanded of
investment goods.
When P falls, individuals can
afford to save more, which
decreases the equilibrium
interest rate. Lower interest
rates increase the quantity
demanded of investment
goods.
When P rises in the United
States, all else equal, goods
International and services produced
Trade
elsewhere are less expensive.
Imports rise and exports fall so
that net exports fall.
When P falls in the United
States, all else equal, goods
and services produced
elsewhere are more
expensive. Imports fall and
exports rise so net exports fall.
Movement on the Curve
These 3 cause movement on the curve:
Wealth Effect (or Real Balance Effect)
Interest Rate Effect
International Trade Effect
Difference between D and AD
If price of one item falls- quantity demanded
tends to rise. (bread goes down, we buy
more.) This is Law of Demand
If price level falls (any parts of C + I + G)
consumers pay lower prices. But less
nominal income flows to suppliers. This is
Aggregate Demand
Difference between Quantity of AD and
Change of AD
QAD = movement up or down as result of
price level changing (ONLY)
Change in AD =
Change in any of the component parts of
AD (C + I + G + Net Exports)
Shifts of Aggregate Demand
Curve shifts right or left according to
stimuli.
These shifts come from any or all
components of GDP (C, I, G, X-M)
DETERMINANTS OF AGGREGATE DEMAND
Change in Consumer Spending
•Consumer Wealth (people’s
houses fell in value)
•Consumer Expectations
(expect higher prices)
• Interest rate (interest
sensitive durables)
• Taxes
Think in aggregate terms
Changes in Investment Spending

Real Interest Rates (rates high- not much I
taking place)

Expected Future Sales (health of economy-
confidence is big)

Business Taxes (higher taxes less profit)
Government Spending
This will be discussed further, but anytime
government spends, it has an affect on
GDP.
Infrastructure –
Health Care
Supplies for military
Education
Etc.
Net Export Spending
National Income Abroad-(when foreign
nations do well, their incomes are higher- can buy
more U.S. goods and services. – U.S. exports rise)
Exchange Rates- Price of one nation’s currency
in terms of another. Dollar vs Euro
Our currency appreciates if it takes more foreign $
to buy it.. (depreciates if it takes more of ours to buy
theirs.) $1.00 to $1.25 Euro.
Depreciation of nation’s currency makes foreign
goods more expensive (but attracts foreigners to buy
our goods.) Our exports rise. *this is why the Fed
has not worried about our low dollar valuation.
Factors That Change Aggregate Demand &
Consumption/Interest Rates
Interest Rate ↑ → C↓ → AD↓
Interest Rate ↓ → C ↑ → AD↑
Factors That Change Aggregate Demand &
Investment/ Interest Rates
Interest rates ↑ → I↓ → AD↓
Interest rates ↓ → I ↑ → AD↑
Factors That Change Aggregate Demand &
Investment/ Business Taxes
Business taxes↓ → I↑ → AD↑
Business taxes↑ → I↓ → AD↓
Long-Run Equilibrium and the Price
Level
For the economy as a whole, long-run
equilibrium occurs at the price level where
the aggregate demand curve (AD) crosses
the long-run aggregate supply curve
(LRAS).
Figure 10-5 Long-Run
Economywide Equilibrium
OK… One more time…..
Component parts of GDP?
C + I + G + (X-M) = GDP
Long-Run Aggregate Supply Curve (LRAS)

A vertical line representing the real output of goods and
services after full adjustment has occurred

It represents the real GDP of the economy under
conditions of full employment; the economy is on its
production possibilities curve
The Production Possibilities and the
Economy’s Long-Run Aggregate Supply
Curve
Output Growth and the Long-Run
Aggregate Supply Curve (cont'd)

LRAS is vertical

Input prices fully adjust to changes in output
prices

Suppliers have no incentive to increase output

Unemployment is at the natural rate

Determined by endowments and technology
(or existing resources)
Output Growth and the Long-Run
Aggregate Supply Curve (cont'd)

Growth is shown by outward shifts of
either the production possibilities curve or
the LRAS curve caused by

Growth of population and the labor-force
participation rate

Capital accumulation

Improvements in technology
What does Long Run Equilibrium
Mean?





Economy is a full employment
Any additional production would be
difficult to achieve.
Economy operating at natural rate of
unemployment (anyone wanting job=have
it.)
Equate the LRAS curve with bowed line on
PPC.
To extend either would be to discover new
resources – R&D
Full Employment
The condition that
exists when the
unemployment rate
is equal to the
natural
unemployment rate.
 Full productive
capacity has been
 Reached.

Image Cylinder= Economy…
Businesses, factories, economy
not working at full capacity
Full Employment
AD
AS
LRAS
SRAS (short run aggregate supply)

Period where adjustment occurs.

Direct relationship

As the output increases that puts upward
pressure on price.

Movement on the curve denotes the
relationship between price level and real
output.
SRAS………….Shift
Shift in the curve denotes determinates
that affect more or less real output
production at various price levels.
 Determinants:
Change in input prices (steel, plastic, wool
change in resource availability )

Change in productivity (+ = Shift right; - =
Shift left) (more for less is the object)
Change in legal environment (contracts,
taxes, subsidies)
AD and SRAS
LRAS = long-run aggregate supply
LRAS is a vertical line reflecting that LR
Aggregate Supply is not affected by changes
in PL.
The LRAS is labeled as the natural level of real
GDP
The natural level of real GDP is defined as
the level of real GDP that arises when the
economy is fully employing all of its
available input resources ( We are in
agreement that it hovers around 5%)
Long Run Aggregate Supply
Price level
P
LRASLR
Long-run
Aggregate
Supply
Full-Employment
Qf
Real domestic output, GDP
Q
Real
Rate
Of
Interest
D1
Money Supply
Can a Change in Money Supply Change AD?
Probably… but it is a chain of events.
MS changes, then Interest Rates, then change in
consumption
Equilibrium States of the Economy
During the time an economy moves from one
equilibrium to another, it is said to be in disequilibrium.
Unanticipated Increase
in Aggregate Demand
Price
level
LRAS
SRAS1
Short-run effects of an
unanticipated increase in AD
P105
P100
AD1
YF Y2

AD2
Goods & Services
(real GDP)
In response to an unanticipated increase in AD for
goods & services (shift from AD1 to AD2), prices will
rise to P105 and output will temporarily exceed fullemployment capacity (increases to Y2).
Growth in Aggregate
Supply
LRAS2
Price
level
LRAS1
SRAS1
SRAS2
P1
P2
AD
YFF1


Goods & Services
(real GDP)
YF2
YF2
Here we illustrate the impact of economic growth due to
capital formation or a technological advancement, for
example.
Both LRAS and SRAS increase (to LRAS2 and SRAS2); the
full employment output of the economy expands from YF1
to YF2.

A sustainable, higher level of real output and real income is the
result. ***If the money supply is held constant, a new long-run
equilibrium will emerge at a larger output rate (YF2) and lower
price level (P2).
Effects of Adverse Supply Shock
Price
LRAS
level
SRAS2 (Pr2)
SRAS1 (Pr1)
P110
P100
B
A
AD
YF
Goods & Services
(real GDP)
Y2

The higher resource prices shift the SRAS curve to the left; in
the short-run, the price level rises to P110 and output falls to
Y
2.
What
happens in the long-run depends on whether the
reduction in the supply of resources is temporary or
permanent.

If temporary, resource prices fall in the future, permitting the economy
to return to its original equilibrium (A).


If permanent, the productive potential of the economy
will shrink (LRAS shifts to the left) and (B) will become
the long-run equilibrium.
INCREASES IN AD:
DEMAND-PULL INFLATION
Price Level
P
AD1
AD2
AS
P2
P1
Qf
Q 1 Q2
Real Domestic Output, GDP
Q
DECREASES IN AS:
COST-PUSH INFLATION
AS2
Price Level
P
P2
P1
AS1
b
a
AD1
Q1 Qf
Real Domestic Output, GDP
Q
Long run growth
Capital
goods
PPC shifts out and
LRAS shifts right.
P
AD2
AD1
P1
P2 AS1
LRAS1 LRAS2
x
AS2
Consumer
goods
Yf1
Yf2 Y
Non-governmental actions that shift AS
 Shift AS left:

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




Raw materials cost rise
Wages rise faster than productivity
Worker productivity decreases
Obsolescence
Wars
Natural disasters
Fiscal Policy


Governmental actions that shift AD
Shift AD right:




Govt spending increases
Taxes decreases
Money Supply increases
Shift AD left:



G decreases
T increases
MS decreases