Chapter 12 – Aggregate Demand and Aggregate Supply (Part 1)
• Derive the aggregate demand curve from the income-expenditure model.
• Derive the short-run & long-run aggregate supply curves.
• Discuss the short-run equilibrium vs. the long-run equilibrium.
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• Introduce the concept of output gap.
• Discuss the (natural) adjustment mechanism.
MGEA06 Week 6 (Recorded Lecture) Iris Au 1
Aggregate Demand (AD)
• An economy’s aggregate demand shows the relationship between the aggregate price level and the quantity of aggregate output demanded by all sectors in the economy (households, firms, the government, and the foreign sector).
• Holding all else constant, there is an inverse relationship between the aggregate price level (P) and the quantity of aggregate output demanded.
Why Is the Aggregate Demand Curve Downward Sloping?
• The national income identity (Chapter 7): GDP = Y = C + I + G + X – IM
• With the exception of government spending (G), most of the components of GDP are largely from the private sectors.
To derive the AD curve, we need to understand how does a change in P
affect C, I, X, and IM.
• An obvious but WRONG answer: If P , demand for goods and services .
• In macroeconomics, we look at the demand for ALL goods and services.
If all prices, including input prices such as labour and capital, increase, then dollar incomes also increase.
If both incomes and prices increase at the same rate, there is no change in real income (real income = Dollar income) there should be no change in
aggregate demand because purchasing power does not change.
MGEA06 Week 6 (Recorded Lecture) Iris Au 2
• A downward sloping AD curve can be explained by 2 effects: 1) the wealth effect of a change in aggregate price level.
2) the interest rate effect of a change in aggregate price level.
The Wealth Effect of an Aggregate Price Level Change
• Holding all else constant, a rise in aggregate price lowers the real value of
existing assets real value of wealth .
• When P , wealth (autonomous) C (Chapters 10 & 11) AD .
The Interest Rate Effect of an Aggregate Price Level Change
• Holding all else constant, interest rate rises when aggregate price increases
because the purchasing power of our (existing) money holdings falls.
In order to purchase the same amount of goods and services, we need to
hold more money than before.
To increase their money holdings, people will withdraw from their savings
or increase their borrowings interest rate . (Chapter 10)
• When interest rate , cost of borrowing investment . (Chs 10 & 11)
• When interest rate , current consumption become more expensive
consumption . (Chapter 10)
• An open economy also experiences (net) capital inflows when interest rate
domestic currency appreciates X & IM NX (some people called
it the international trade effect). (Chapter 18)
• In conclusion, C , I & NX when aggregate price AD .
MGEA06 Week 6 (Recorded Lecture) Iris Au 3
The Aggregate Demand Curve and the Income-Expenditure Model
• In the income-expenditure model, the aggregate price level is assumed to be fixed. (Chapter 11)
• To derive the AD curve from the income-expenditure model, we need to take the effect of a price change on planned aggregate expenditure into account: Along an AEPlanned line, we hold the aggregate price level fixed.
The AEPlanned will shift when there is a change in aggregate price level, P.
Graphical Derivation of the AD Curve
Y = AEPlanned AEPlanned(P0)
Suppose P to P1:
P0 A Y*,0
MGEA06 Week 6 (Recorded Lecture)
Mathematical Derivation of the AD Curve
• The AD summarizes the relationship between the aggregate price level and the quantity of aggregate output demanded by households, firms, the government, and the foreign sector.
• The AD curve shows the combination of Y and P such that Y = AEPlanned(P).
• To derive the AD curve:
Equate AEPlanned(P) to Y (i.e., set AEPlanned(P) = Y).
Solve for P as a function of Y or Y as a function of P.
• Derivation of AD:
Suppose the planned expenditure function is given as follows: AEPlanned(P) = AE0 – P + MPC × Y, where > 0
Income-expenditure model’s equilibrium: Y = AEPlanned(P) Y = AE0 – P + MPC × Y
Note: AE0 = [AC + AI + G + X0 – IM0 – MPC × T0 + MPC × TR0 – d × i] (based on the assumptions made about the behaviours of households, firms,
government and the foreign sector in Chapter 11)
MGEA06 Week 6 (Recorded Lecture) Iris Au 5
Shifts in the Aggregate Demand Curve
• The AD equation in generic form: Y = ( 1 ) AE0 − ( ) P
where AE0 = AC + AI + G + X0 – IM0 – MPC×T0 + MPC×TR0 – d×i
• Factors that affect AEPlanned other than Y and P will shift the AD curve, i.e., changes in AE0 will shift the AD curve.
1 −MPC 1 −MPC
Factors that cause AD shifting to the right Consumer confidence
Business confidence
Size of the existing stock of physical capital is low Government spending
Households become more optimistic
Firms become more optimistic
Households feel that they become richer
Incentive to invest increases
MGEA06 Week 6 (Recorded Lecture)
Factors that cause AD shifting to the right (Lump-sum) Taxes
(Lump-sum) Transfer Money supply
A demand shift between foreign goods and domestic goods that favours domestic goods Trade policies such as import tariffs, import quotas.
Conclusion:
YD = Y – T + TR
YD = Y – T + TR
Agents have more money holdings than they want
Foreign demand for domestic goods increases
Domestic demand for foreign goods falls
Import tariffs makes foreign goods become more expensive
• When AE0 , AD shifts to the right. When AE0 , AD shifts to the left. MGEA06 Week 6 (Recorded Lecture) Iris Au 7
Aggregate Supply (AS)
• The aggregate supply (AS) curve represents the quantity of output that producers are willing to supply at each aggregate price level.
• There are two types of aggregate supply:
1) The short-run aggregate supply (SRAS). 2) The long-run aggregate supply (LRAS).
The Short-Run Aggregate Supply Curve (The SRAS Curve)
Assumptions:
• Prices and wages are sticky in the short run.
• Holding all else constant, producers are willing to supply more goods and
services in the short run when the aggregate price increases.
• The SRAS curve takes the following form:
SRAS: P = (𝑎 + 𝑏𝑌) ( ̅ ), where a = constant, b > 0, W > 0,W = wages
The short-run aggregate supply (SRAS) curve is upward sloping. P SRAS
MGEA06 Week 6 (Recorded Lecture) Iris Au
Shifts of the Short-Run Aggregate Supply Curve
• Factors that affect producers’ willingness to supply other than Y & P will shift the SRAS curve.
• Producers’ willingness to supply is determined by their per-unit profit: Per-unit profit = Per-unit output price – Per-unit production cost.
Factors that cause SRAS shifting to the right
Commodity prices
Nominal wages, W,
Productivity
Per-unit production cost
Per-unit profit
Per-unit production cost
Per-unit profit
Per-unit production cost
Per-unit profit
Conclusion: Any factor that increases per-unit profit other than output price
will shift the SRAS curve to the right.
MGEA06 Week 6 (Recorded Lecture) Iris Au 9
The Long-Run Aggregate Supply Curve (The LRAS Curve)
Assumptions:
• In macroeconomics, prices and wages are flexible in the long run.
• The long-run level of output is determined by the aggregate production
function. (Chapter 9)
YP = YFE = A × F(K, L, H)
where YP = potential output
YFE = full-employment level of output
• Therefore, change in the aggregate price level DOES NOT affect the quantity of aggregate supplied in the long run.
The long-run aggregate supply curve is vertical.
MGEA06 Week 6 (Recorded Lecture) Iris Au
From the Short Run to the Long Run
Short-Run Equilibrium vs. Long-Run Equilibrium
• The short-run equilibrium refers to the situation in which the aggregate
demand equals to the aggregate supply in the short run.
SR equilibrium: AD intersects SRAS.
• The long-run equilibrium refers to the situation in which the short-run
equilibrium is on the LRAS curve. In the long run, Y must equal to YFE. LR equilibrium: AD, SRAS and LRAS intersect at the same point.
Output Gap
• It is possible for the short-run level of output (Y* = YSR) to be different than
the long-run level of output (YFE).
• If this is the case, the economy has an output gap.
If YSR > YFE, then the economy is said to be in an inflationary gap. If YSR < YFE, then the economy is said to be in a recessionary gap.
MGEA06 Week 6 (Recorded Lecture)
The (Natural) Adjustment Mechanism from the Short Run to the Long Run:
• If YSR ≠ YFE, then nominal wages adjust to ensure that YSR = YFE in the long
• When the economy is in a recessionary gap (YSR < YFE), there will be pressure
for nominal wages to fall because the (current) level of unemployment is high.
• When the economy is in an inflationary gap (YSR > YFE), there will be pressure for wages to rise because it is very difficult for firms to hire workers given the
current state of the economy.
Example: The economy is in a recessionary gap.
P LRAS SRAS0
MGEA06 Week 6 (Recorded Lecture)
Iris Au 12
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