Aggregate Demand and Aggregate Supply

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

Reminder: The components that make up AE are the same components that make up AD. • A. Why the AD curve Slopes Downward (**see Table 31-1 p. 711) • Wealth Interest Rate Exchange Rate • B. Why the AD curve might shift (**see Table 31-1 p. 711) • same as changes in AE • Changes in C I G Xn

Activity 16 and Intro Review Worksheets • Activ 16 1. What is the relationship between PL and RGDP? inverse (negative) – just like “Law of Demand” 2. How is downward sloping AD different from D curve for a single product? AD shows average P level and Q for all goods ; No substitution or income effects -- explain…..?

Explain how each of following explain why AD is downward sloping A. Interest rate effect: • as P level decreases, people hold less money : put more into banks, bonds etc.. = greater supply of loanable funds = lower interest rates = greater amt. of investment by firms and households (new housing) ….= increase AD

B. Wealth Effect (real balances) : As P level decreases, dollars held can now buy more (=wealth) …leads to…. …increase in Consumption…= increase in AD C. Exchange Rate effect (Foreign Purchases) : As P level decreases, IR decrease….seek higher returns in foreign markets = increase S of US dollars in Foreign Exchange Market = …..(don’t need to know for now) depreciation of dollar = ….(*don’t think inflation) US goods are cheaper = Increase Exports = Xn increases …= increase AD

Activ 16 part B • Increase • Decrease • Increase • Increase • Decrease • Decrease • No change in AD – increase in AS • Decrease

Intro. Review • 1. Draw and Label Y = Price Level X = RGDP (real output) 2. • C decreases • Movement up • Decrease • Show..

3. • IR increase • Investment decreases • Movement up • Decrease • Show.. 4. a. Appreciates b. Xn decreases c. Movement d. Decrease e. show… 5. AD is downward sloping

Intro Review • Developing Long Run AD/AS • Draw and Label • See last two slides of ppt.

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

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

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

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:

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?

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

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

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

Aggregate Demand and Aggregate Supply