Eco 200 – Principles of Macroeconomics

1. Eco 200 – Principles of Macroeconomics Chapter 9: Macroeconomic Equilibrium (AD/AS)

2. Aggregate demand and supply • Aggregate demand – a relationship between the price level and the equilibrium quantity of real GDP demanded. • Aggregate supply – a relationship between the price level and the equilibrium quantity of real GDP supplied.

3. Macroeconomic equilibrium

4. Demand-pull inflation • Demand-pull inflation is caused by an increase in AD

5. Business cycle expansion • As AD rises, output rises, and unemployment falls

6. Business cycle contraction • As AD falls, output falls and unemployment rises

7. Cost-push inflation • Cost-push inflation is caused by a reduction in AS.

8. Stagflation • Rising prices and falling output

9. Aggregate demand • Aggregate demand (AD) consists of spending on GDP by: • consumers (C) • firms (I) • the government (G), and • the foreign sector (X) • Anything that increases C, I, G, or X at a given price level results in an increase in AD.

10. Factors affecting Consumption • Income • Wealth • Expected future income and wealth • Demographics • Taxes

11. Factors affecting Investment • Interest rate • Technology • Cost of capital goods • Capacity utilization

12. Government spending • Determined by government authorities

13. Factors affecting net exports • Foreign and domestic income • Foreign and domestic price levels • Exchange rates • Government policy (tariffs, trade restrictions, etc.)

14. Aggregate expenditures • AE = C+I+G+X • AE is affected by any factor that changes C, I, G, or X.

15. Aggregate demand • Note that AD curve is not the same as the demand curve for a particular good • negative slope is NOT the result of income and substitution effects • Why is it downward sloping? • Wealth effect • Interest rate • International trade effect

16. Wealth effect • As the price level rises: • the real value of dollar-denominated assets decline (real wealth declines) • this decline in wealth results in a reduction in consumption spending • This effect is also called the real-balance effect (or Pigou effect)

17. Interest-rate effect • As the price level rises: • Individuals must hold more money to pay for transactions • To acquire more money, households sell bonds, and other financial assets. • As more bonds are sold, the price of bonds declines • A decline in bond prices results in a higher rate of return (interest rate) on bonds and other financial assets • A higher interest rate results in a reduction in investment and consumption spending

18. International trade effect • As the domestic price level rises: • Imports become relatively cheaper, • Exports become relatively more expensive • Exports decline, imports rise, and net exports decline

19. Combined price-level effects • As the price level rises, AE falls due to the combined wealth, interest-rate, and international trade effects

20. Nonprice determinants of AD • Anything that changes C, I, G, or X at a given price level will cause the AD curve to shift • Effects of: • Expectations (consumer and investor confidence) • Foreign income and price levels • Government policy

21. Aggregate supply • Price-level effects • Assumption: Resource prices adjust more slowly than output prices • As price level rises, production becomes more profitable and the quantity of output supplied rises.

22. Aggregate supply

23. Short-run Aggregate Supply

24. Long-run Aggregate Supply Resource and output prices are assumed to be flexible in the long run. Output = potential real GDP.

25. Changes in Short-Run AS • Resource prices • Technology • Expectations

26. Changes in Long-Run AS • Changes in the quantity and/or quality of resources • Technology

27. Macroeconomic equilibrium

28. Short-run effect of an increase in AD

29. Long-run adjustment process