Aggregate Demand and Aggregate Supply Flashcards
Macroeconomists divide time horizons into 3 basic categories:
- The “Very Long Run”: where all variables, including capital and technology can change.
- The “Long Run”: where most variables can change, except for capital and technology.
- The “Short Run”: where some variables can change (such as employment and product prices) but not wages, capital, or technology.
The Very Long Run:
- This is envisioned as taking several years to play out.
- This is where growth theory takes centre stage.
The Long Run:
- In the long run, although capital and technology do not change, all other variables (including, importantly, prices and wages) can change.
- As we’ll see, when all prices and wages are free to change, the economy runs quite well by itself. There is very little role for macroeconomic policy.
- But:“In the long run,we are all dead.”J.M. Keynes
The Short Run:
- In the short run, importantly, wages do not adjust fully to any changes in the economy.
- However, prices of goods (i.e.,the price level) can adjust.
- Monetary and fiscal policy can play major roles.
- This is the realm of “Keynesian macroeconomics”.
The Aggregate Demand and Aggregate Supply Model:
The main analytical framework for understanding macroeconomics in the long run and the short run is the AD‐AS model.
It has 3 key ingredients
- The “aggregate demand” (AD) curve.
- The “long run aggregate supply” (LRAS) curve.
- The “short-runaggregate supply” (SRAS) curve.
The AD Curve:
This shows the relationship between the price level (on the vertical axis) and the quantity of real GDP demanded by households, firms and the government (on the horizontal axis), holding everything else constant.
Why does the aggregate demand curve slope downwards?
The wealth effect:
- As the price level increases, the real value of wealth decreases. People feel less wealthy, and cut back on consumption, which is a component of AD.
The interest‐rate effect:
- As prices rise, the real value of the money supply in financial markets shrinks. This increases interest rates, which increases the cost of investment, and reduces investment, which is a component of AD.
The international‐trade effect:
- As our prices rise, our exports become less competitive internationally, and our imports increase, reducing NX, which is a component of AD.
The variables that shift the aggregate demand curve:
- Changes in government policies.
- Examples: taxes; government purchases, monetary policy.
- Changes in the expectations of households and firms.
- Changes in foreign variables.
- Examples: exchange rates; relative income levels between countries.
Long‐run aggregate supply (LRAS) curve:
A curve that shows the relationship in the long run between the price level and the quantity of real GDP supplied.
- The long‐run aggregate supply curve shows that, in the long run, changes in the price level do not affect the level of real GDP supplied. (Intuitively, why would a firm produce more, or less, simply because the general price level is increasing? The firm would simply raise its own price, not change the quantity it supplies.)
- The long‐run aggregate supply curve is a vertical line at potential GDP.
Shifts in the long‐run aggregate supply curve:
The LRAS curve shifts because potential GDP increases over time.
Increases in potential GDP (or economic growth) are due to:
- An increase in resources.
- An increase in machinery and equipment (capital).
- Technological improvements.
The short‐run aggregate supply (SRAS) curve:
The SRAS is upward sloping, showing that, in the short run, firms will produce more in response to higher prices.
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The prices of inputs tend to rise more slowly than the prices of final products.
- Contracts make some wages and prices ‘sticky’.
- Nominal wages are often slow to adjust.
- Thus, as P rises, real wages W/P fall, and so real production costs fall.
- Hence, firms produce more.
Variables that shift the SRAS curve:
- Expected changes in the future price level.
- Changes in factor prices, including nominal wages.
Variables that shift both the short‐run and the long‐run aggregate supply curves
- Increases in the labour force and/or in the capital stock and/or in resources.
- Technological change.
Changing Wages and the short-run aggregate supply curve:
- An increase in nominal wages W will raise real wages W/P and cause the SRAS to shift to the left.
- A decrease in nominal wages W will reduce real wages W/P and cause the SRAS to shift to the right.
In long‐run equilibrium…
- the aggregate demand curve
- the short‐run aggregate supply curve
- the long‐run aggregate supply curve
all intersect at the same point.
Recession:
- The short‐run effect of a decline in aggregate demand.
- AD curve shifts left, and real GDP declines.
- Adjustment back to potential GDP in the long run.
- Automatic adjustment mechanism: SRAS curve shifts right (which may take several years).
Expansion:
- The short‐run effect of an increase in aggregate demand.
- AD curve shifts right, and real GDP and the price level rise.
- Adjustment back to potential GDP in the long run.
- Automatic adjustment mechanism: SRAS curve shifts left (which may take a year or more)
A dynamic aggregate demand and aggregate supply model:
A dynamic aggregate demand and aggregate supply model can be created by making three changes to the basic model:
- Potential GDP increases continually, shifting the LRAS curve to the right.
- During most years the AD curve shifts to the right.
- The SRAS curve shifts to the right.
