Aggregate Supply and Aggregate Demand

Study Session 5

Exam Focus

The title says it all, but you should spend some quality time here getting the details down. This is the model of equilibrium output and price level for the overall economy and it is used repeatedly for analysis in the topic reviews that follow. Learn it well; no breaks here. Learn the differences between the classical, Keynesian, and monetarist views of economic equilibrium and growth too.

LOS 23.a: Explain the factors that influence real GDP and iong-run and short-run aggregate supply, explain movement along the long-run and short-run aggregate supply curves (LAS and SAS), and discuss the reasons for change;: rc potential GDP ana aggregate supply.

Aggregate supply refers to the amount of goods and services produced by an economv. Aggregate supply is a function of the price level. Just as in goods markets, higher prices-bring about a greater amount of supply in the short run. Figure 1 illustrates a short run aggregate supply (SAS) curve and a long run aggregate supply (LAS) curve. The overall price level in the economy is on the vertical axis and the real level of output of goods and services (real GDP) is on the horizontal axis.

Figure 1: Aggregate Supply in the Long Run and Short Run

Price Level

Long-run aggregate supply (LAS)

Long-run aggregate supply (LAS)

Keynesian Long Run Aggregate Supply
Real Output

First we will address the questions of why the LAS curve is a vertical line and why the SAS curve is upward sloping. Then we will discuss the factors that cause the curves to shift over time.

Recall that in our discussion of microeconomic principles we defined the short run as that period of time for which the quantities of some productive inputs were fixed and the long run as a period of time over which all factors of production, including plant size, could be adjusted. The short run and long run in our aggregate supply and demand model are defined differently. While a bit of a simplification, you can generally take the short run in the aggregate demand and supply model to be that period over which workers' wage demands are constant. We say that the short-run aggregate supply curve is constructed holding the money wage (not the real wage) constant.

A key factor that drives workers' wage demands in this model is their expectations about future rates of inflation. An increase in workers' expectations about future inflation increases their wage demands, and this decreases short-run aggregate supplv. Higher real wage costs (monev wages up at each price level) increase the marginal costs of production, and employers will produce less at each price level when wages are higher.

Long-run aggregate supplv represents the supplv of goods and services at each price level when workers' inflation expectations are just equal to actual inflation. Therefore, an increase in the actual rate of inflation that does not change workers' inflation expectations does nor shift the short-run aggregate supply curve (SAS). A change in actual inflation, holding workers' money wage demands constant, leads to movement along the SAS curve to a temporary disequilibrium situation, either above or below full employment GDP (LRAS).

We assume that in the long run, expected inflation must equal actual inflation, and this leads to economic production at full-employment GDP, that is, with no cyclical unemployment. As workers' inflation expectations adjust and equal actual inflation, the SAS curve shifts in a way that returns us to equilibrium at full employment real GDP. It will be very helpful to keep this relation in mind, as in this model any deviation from long-run equilibrium (full-employment GDP) results from differences between actual inflation and workers' expectations about inflation that cause workers' real wage demands to be higher or lower than the long-run equilibrium real wage rate.

LAS is not affected by the price level. LAS is the potential (full-employment) real output of the economy. The potential output of an economy will primarily depend on three factors. Potential output is positively related to:

1. The quantity of labor in the economy.

2. The quantity of capital (productive resources) in the economy.

3. The technology that the economy possesses.

The quantity of labor available at any point in time can vary as unemployment varies. As employees change jobs, businesses expand or fail, and employees decide to enter or leave the work force, the number of people employed and their hours worked will fluctuate. The level of real GDP on the LAS curve is the economy's level of production when the economy is operating at full employment. Full employment does not mean zero unemployment. There will always be some unemployment as workers search for the best available job, employers search for the best available employee, and changes in the economy leave workers from industries with decreasing employment without the necessary skills to work in expanding industries. There is a natural rate of unemployment corresponding to the level of real GDP along the LAS curve. That level of output is referred to as full-employment GDP. As we will see, the economy can operate at less than full employment GDP during a recession when cyclical unemployment is high, and (temporarily) at above full-employment GDP during periods of rapid economic growth.

Over time, the LAS curve may shift as the full-employment quantity of labor changes, as the amount of available capital in the economy changes, ot as technology improves the productivity of capital, labor, or both.

In the short run, firms will respond to changes in the prices of goods and services. The kev to understanding movements along the SAS curvc is to understand that we are allowing the prices of final goods and services to vary, while holding the wage rate and the price of other productive resources constant in the short run. When goods and services prices rise (fall), businesses have an incentive to expand (reduce] production, and real GDP will increase (decrease) above (below) the full-cmplovment level shown bv the LAS curve. This is why we show real GDP as an upward sloping function of the price level along the SAS curve. Again, in the macroeconomic short run, we are holding the monev wage rare, other resource prices, and potential GDP (LAS) constant.

Next we turn our attention to the factors that will shift the SAS curve. Our list begins with those factors that also shift the LAS curve. The SAS and LAS curves will both shift when the full-emplovment quantity of labor changes, the amount of available capital in the economy changes, or as technology improves the productivity capital, labor, or both.

In Figure 2, we illustrate the effects on LAS and SAS that would result from an increase in full-employment GDP, due to an increase in labor, capital, or an advance in technology. Long-run aggregate supply increases to LAS? and short-run aggregate supply increases to SAS9.

Figure 2: An Increase in Potential GDP

There are some factors that will shift SAS, but not affect LAS. We held the money wage rate and other resource prices constant in constructing the SAS curve. If the wage rate or prices of other productive inputs increase, the SAS curve will shift to the left, a decrease

Price Level

Price Level


Real Output (GDP)

in short-run aggregate supply. When businesses observe a rise in resource prices, they will decrease their output as the profit maximizing level of output declines.

Two important factors influence the change in money wage rates. One is unemployment; when unemployment rises, it puts downward pressure on the money wage rate as there is an excess supply of labor at the current rate. Conversely, if the economy is temporarily operating above full-employment levels, there will be upward pressure on the money wage rate. The second factor that can influence the money wage rate is inflation expectations. An expected increase in inflation will lead to increases in the money wage rate and an expected decrease in inflation will slow the increase of money wages.

LOS 23.b: Explain the components of and the factors that affect real GDP demanded, describe the aggregate demand curve and why it slopes downward, and explain the factors that can change aggregate demand.

W e turn our attention now to the aggregate demand curve. The aggregate demand

curve shows the relation between the price level and the real quantity ol final goods and services (real GDP) demanded. The components ol" aggregate demand are:

• Net exports (X), which is exports minus imports, aggregate demand = C + 1 + G + X


The aggregate demand curve is downward sloping (a good thing for a demand curve!) because at higher price levels, consumption, business investment, and exports will all likely decrease. There are two effects here to consider. First, when the price level rises, individuals' real wealth decreases. Since they have less accumulated wealth in real terms, individuals will spend less. This is referred to as the "wealth effect.'" Second, when the price level increases, interest rates will rise. An increase in interest rates decreases business investment (I) as well as consumption (C) as consumers delay or forego purchases of consumer durables such as cars, appliances and home repairs. This is a substitution effect, as consumers substitute consumption later for consumption now because the cost of consuming goods now instead of later (the interest rate) has increased. This is referred to as "intertemporal substitution," substitution between time periods.

So changes in the price level cause changes in (the quantity of) aggregate demand. What factors will shift the aggregare demand curve? Among the man}' things that can affect aggregate demand there are three primary factors:

• Expectations about future incomes, inflation, and profits.

• Fiscal and monetary policy.

An increase in expected inflation will increase aggregate demand as consumers accelerate purchases to avoid higher prices in the future. An expectation of higher incomes in the future also will cause consumers to increase purchases in anticipation of these higher incomes. An increase in expected profits will lead businesses to increase their investment in plant and equipment.

Fiscal policy refers to government policy with regard to spending, taxes, and transfer payments. An increase in spending increases the government component (G) of aggregate demand. A decrease in taxes or an increase in transfer payments (e.g. social security benefits or unemployment compensation) will increase the amount that consumers have to spend (their disposable income) and increase aggregate demand through an increase in consumption (C).

Monetary policy refers to the central bank's decisions to increase or decrease the money supply. An increase in the money supply will tend to decrease interest rates and increase consumption and investment spending, increasing aggregate demand. We will look at both monetary and fiscal policy effects more closely in subsequent topic reviews.

The state of the world economy will influence a country's aggregate demand through the net exports (X) component. If foreign incomes increase, foreign demand for the country s exports will increase, increasing X. It the country's foreign exchange rate increases (foreign currency buys fewer domestic currency units), its goods are relatively more expensive to foreigners, and exports will decrease. At the same time, imports will be relatively cheaper and the quantity of imported goods demanded will increase. Both effects will tend to decrease net exports (exports minus imports, X) and consequently decrease aggregate demand. A decrease in a country's exchange rate (currency depreciation) will have the opposite effect, increasing exports, decreasing imports, and increasing net exports and aggregate demand.

LOS 2.3.c: Differentiate between short-run and long-run macroeconomic equilibrium, and explain how economic growth, inflation, and changes in aggregate demand and supply influence the macroeconomic equilibrium.

Now we examine macroeconomic equilibrium in the short run and in the long run.

In Figure 3, we illustrate long-run equilibrium at the intersection of the LAS curve and the aggregate demand curve. Just as we saw that price was the variable that led us to equilibrium in the goods market in microeconomics, here changes in the price level of final goods and services can move the economy to long-run macroeconomic equilibrium. In Figure 3, equilibrium is at a price level of 110. If we are at a short-run disequilibrium with the price level at 115, there is excess supply; the quantity of real goods and services supplied exceeds the (aggregate) demand for real goods and services. This is sometimes termed a recessionary gap, and there will be downward pressure on prices. Businesses will see a build-up of inventories and will decrease both production and prices in response. This will result in a decrease in the price level, which will move the economy toward long-run equilibrium at a price level of 110. If the price level were 105, there would be excess demand for real goods and services. This is sometimes referred to as an inflationary gap. Businesses will experience unintended decreases in inventories and respond by increasing output and prices. As the price level increases, the economy moves along the aggregate demand curve toward long-run equilibrium.

Figure 3: Long-Run Equilibrium Real Output

Price Level (Index)

Price Level (Index)

\\ c will now extend this analysis to include shifts in short-run aggregate suppK that are part ol the process of moving toward the long-run equilibrium output and price level. Recall that in constructing the SAS curve we held inonev wages and other resource prices constant. If the economy is in short-run equilibrium, but at a level ol output above or below full-emplovment GDP, it is in long-run disequilibrium. In Figure 4, we illustrate two situations where the economv is in short-run equilibrium but not in long-run equilibrium. In panel (a), short-run equilibrium real GDP, GDPj, is less than full employment GDP (along the LAS curve) and we would interpret this as a recession or "below full-employment equilibrium." This difference between real GDP and full-employment GDP is called a recessionary gap or output gap. As we will detail, this brings downward pressure on money wages and resource prices that will decrease the equilibrium price level from P, to P*.

The opposite situation, ''above full-employment equilibrium," is illustrated in panel (b), where the short-run equilibrium real GDP, GDP,, is above the full-employment level. This would be the situation in an economic expansion where aggregate demand has grown faster than LAS. The result will be upward pressure on prices that will result in inflation as the general price level increases from P( to PL

Figure 4: Long-Run Disequilibrium

(a) Below full employment (b) Above full employment

We have essentially described the phases of a business cycle here as deviations of short-run equilibrium real GDP below full-employment GDP (recession) and above full-employment GDP (expansion leading to inflationary pressure). How does this happen? Changes in aggregate demand can drive these business cycles.

Consider the short-run and long-run adjustment to an increase in aggregate demand illustrated in Figure 5- From an initial state of long-run equilibrium at the intersection of AD0 with LAS, assume that aggregate demand increases to ADp The new short-run equilibrium will be at over-full employment with real GDP, GDPp above full-employment GDP, GDP*. The increase in the price level (from PQ to Psf^) at the new equilibrium level means that workers' real wages have decreased (we are holding money wages constant in the short run). At the same time, the increase in demand will cause businesses to attempt to increase production, which will require hiring more workers. These two factors both lead to increased money wage demands. As these demands are met, we get a shift in the SAS curve from SAS() to SASp which will restore long-run macroeconomic equilibrium at full-cmplovment real GDP and at a new price level of Pj Note thai an increase in the money wage and other resource prices means that business will be willing to supplv less real goods and services ai each price level i prices ol final goods and services). It is the increase in resource prices that causes SAS to decrease.

In Figure 6. we illustrate how a decrease in aggregate demand from AD() ro AD] will lead to a new short-run equilibrium with the price level at PSR and real GDP at GDPj. GDI^ is less than full-employment GDP (a recession). The resulting excess supply of labor (workers seeking jobs) will put downward pressure on money wage rates and other resource prices. This will lead to a shifr in SAS to SAS, (an increase in supply), restoring long-run equilibrium at full-employment GDP along the LAS curve and at a new, lower price level of P| Remember, a decrease in wages and other input prices increases short-run aggregate supply.

Figure 6: Adjustment to a Decrease in Aggregate Demand

Price Level LAS SAS,

Price Level LAS SAS,


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