Aggregate Demand and Aggregate Supply

1. Aggregate Demand and Aggregate Supply • ***(p. 701-706 is all review for you, but you should skim it) • “Classical Dichotomy”, “Monetary Neutrality” p. 705 – skip for now • Aggregate Demand • shows VARIOUS amounts of goods and services that the entire economy desires to purchase • different from Micro D curve (individual choices for one good) ; • will NOT be able to apply income (normal/inferior) or substitution (substitute/compliment)effects**** c. Inverse relationship : lower P level = larger real GDP ; higher the P level = smaller real GDP

2. A. Why the AD curve Slopes Downward (**see Table 31-1 p. 711) • B. Why the AD curve might shift (**see Table 31-1 p. 711)

3. II. Aggregate Supply • How do we know that aggregate supply is upward sloping in the short run and vertical in the long run? B. First, recall from microeconomics that output is a function of the inputs to production i. Supplies of labor, capital, natural resources, and available technology –(these are not affected by the price level) ii. The only way to increase output in the long run is to increase the levels of capital and labor. iii. This is called increasing the capital stock--the result of investment--and increasing the labor force--the result of more people working

4. iv. Therefore, in the long run, the aggregate supply curve is affected only by the levels of capital and labor and not by the price level. Thus, the long run aggregate supply is vertical with respect to the price level. • ***see example on bottom of pg. 712 to 713

5. Why LRAS will Shift • Think of what would shift PPF out? • pg. 713-714 • LABOR • CAPITAL • NATURAL RESOURCES • TECHNOLOGICAL KNOWLEDGE

6. Stated another way…… 1. LRAS is vertical and represents full employment and full output (natural rate of unemployment)Real GDP is maximized. 2. Any changes in AD will affect only the price level. 3. In the long run, prices and wages are flexible. 4. This menas that if products don’t sell and employees become unemployed, the market will self correct in the following ways:

7. firms lower prices to sell off inventory • workers take lower wages, leading to re-employment • The economy self corrects; P and W change but it is nominal (not real) and these changes offset eachother and purchasing power remains the same. • = Classical view • ………………………………but how long do we wait for self correcting?

8. Short Run = nominal wages don’t respond to P change • Long Run = nominal wages fully respond to previous P change

9. Event increases (C, I, G, or Xn) = shift AD right • Evaluate = P increase, GDP increase (output is beyond full employment levels • = Inflationary Gap • Nominal Wages don’t respond in short run = so Real Wages decrease • As “Long Run” nears, Nominal Wages begin to respond and increase • All input P have increased and now W increase = Shift Short Run AS left • Result= higher P but back at Yf and increase in Nominal W are offset by increase in P level Yf

10. Event decreases (C, I, G, or Xn) = shift AD left • Evaluate= P decrease, GDP decrease (below full employment levels) • = Recessionary Gap • Nominal Wages don’t respond in short run, so = Real Wages increase • With lower Prices and output and Nominal wages “stuck” = decrease profits • As the Long Run nears, Nominal W begin to decrease • All input P have decreased and now W decrease = shift Short Run AS right • Result = lower P level but back at Yf, and decrease in Nominal W are offset by lower P levels Yf