AD and AS

1. AD and AS

2. 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.

3. The AD Curve: Negatively sloped.

4. 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)

5. 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).

6. Interest rate effect • An ↑ in the PL means consumers and firms need more money for C and I, respectively. People then increase their borrowing. • The increase in borrowing (because of an increase in money demand) pushes up the price of money...which is the interest rate. • 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.

7. 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.

8. 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.

9. 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.

10. 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).

11. Shifts in the AD curve • 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.

12. Factors causing a change in C • 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 expensiveand C increases. • Personal income taxes. If the gov decides to ↑ taxes paid by households, then their disposable income decreases and C spending drops.

13. 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.

14. Factors causing a change in I • 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.

15. 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 • 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: • 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.

16. Factors causing a change in X-M • 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.

17. 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.

18. 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.

19. Shifts in the SRAS curve • 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

20. Factors that influence firms’ production costs • 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.

21. 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.

22. Supply shocks • Events that have a sudden and strong impact on SRAS. • 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.

23. Long-Run Aggregate Supply • 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

24. 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.

25. Movements along the AS curves • 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.

26. Shifts in the LRAS curve • An economy can achieve some limited growth (a shift of the LRAS curve) through: • Increases in efficiency. • Reductions in the NRU. • The economy can continue to grow by increasing its production possibilities, that is: • 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.

27. 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.

28. 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.