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ECO 102PRINCIPLES OF MACROECONOMICS

LECTURE 5:AGGREGATE DEMAND AND SHORT-RUN AGGREGATE SUPPLY

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THE PRICE LEVEL AND AGGREGATEEXPENDITURE

An increase in the price level (P) shifts the AE curve downward

A decrease in the price level (P) shifts the AE curve upward

This shift of the AE curve is due to the effect of changes in Pon consumption (C) and net exports (NX)

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WEALTH AND THE CONSUMPTIONFUNCTION

Households save some of their disposable income in order to spend it later at some point

For instance, households might save (and accumulate wealth) now in order to be able to finance their consumption expenditures when they retire

Therefore, an unexpected rise in wealth would shift the consumption curve up (and the saving curve down) That is, less will be needed to be saved for retirement

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CHANGES IN P AND THE CONSUMPTIONFUNCTION

Changes in P affect C through their impact on real wealth

An increase in P lowers real wealth Reduces the real value of money

Bondholders’ perception of their wealth also decreases

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SHIFTS OF THE CONSUMPTION ANDSAVING FUNCTIONS

C

SYD

YD

C (P1)

S (P1)

An increase in P from P1 to P2 decreases real wealth, thus causing the S curve to shift up and the C curve to shift down.

YD0 At each level of YD households will need to save more for retirement.

S (P2)

C (P2)

YD1

45°

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THE EFFECT OF AN INCREASE IN P ON THEAE CURVE

C

AE

Y

Y

C (P1)

AE (P1)

An increase in P from P1 to P2decreases real wealth, thus causing savings to increase and autonomous consumption to decrease.

The decrease in autonomous consumption causes the AE curve to shift down by ∆C.

AE (P2)

C (P2)

Y2 Y1

∆Y = αAE ∆C

ΔC

ΔC

•AE < Y

At P1, the real value of the quantity demanded of goods and services is Y1.

At P2, the real value of the quantity demanded of goods and services is Y2.

45°

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THE IMPACT OF A CHANGE IN P ON NETEXPORTS

An increase in P makes domestic goods relatively more expensive than foreign good

Therefore, NX decreases as P increases Exports decrease

Imports increase

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THE EFFECT OF AN INCREASE IN P ONEQUILIBRIUM INCOME

AE

Y

AE(P1)

Y1

P2 > P1

45°

AE(P2)

∆AE

Y2

∆Y = αAE ∆AE

At P1, the real value of the quantity demanded of goods and services is Y1.

At P2, the real value of the quantity demanded of goods and services is Y2.

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THE AGGREGATE DEMAND CURVE

The price level and equilibrium income are negatively related to each other As P increases, Y decreases (and vice versa)

This relationship between P and Y is expressed by the aggregate demand curve (AD) At any P level, the corresponding Y represents the real

value of the quantity demanded of goods and services For any given P level, the AD curve shows the level of Y for

which AE = Y

A change in P causes the AE curve to shift But the AD curve doesn’t shift It represents a movement along the AD curve

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THE GRAPHICAL DERIVATION OF THEAGGREGATE DEMAND CURVE

AE

PY

Y

AE(P1)

AD

When P = P1, Y = AE at Y1. Therefore, the point A’ = (Y1, P1) is one point on the AD curve.

Y1As P increases to P2, the AE curve shifts down and Y = AE at Y2 now. Therefore, the point B’ = (Y2, P2) is another point on the AD curve.

AE(P2)

Y2

Y1

P1

Y2

P2

A

A’

B

B’

45°

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THE SLOPE OF THE AD CURVE

The slope of the AD curve depends on:

The sensitivity of C to a change in P (and thus on the impact of a change in P on real wealth)

The sensitivity of NX to a change in P

Therefore, the greater the sensitivity of AE to a change in P, the flatter the AD curve That is, the greater the impact of a change in P on the level

of Y at which Y = AE, the flatter the AD curve

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POINTS OFF THE AGGREGATE DEMANDCURVE

AE

PY

Y

AE(P1)

AD

Consider a point above the AD curve, say point C’ = (Y1, P2). The corresponding point on the AE diagram is point C where Y > AE.

Y1 Consider now a point below the AD curve, say point D’ = (Y2, P1). The corresponding point on the AE diagram is point D where Y < AE.

AE(P2)

Y2

Y1

P1

Y2

P2

A

A’

B

B’

C’

C

D’

D

Y > AE

Y < AE

45°

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SHIFT OF THE AGGREGATEDEMAND CURVE

AE

PY

Y

AE’(P1)

AD

If P = P1, then initially Y = AE at point A where Y = Y1 . The corresponding point on the AD curve is point A’ = (Y1, P1).

Y1

The point on the AD diagram corresponding to point B on the AE curve is point B’ = (Y2, P1).

AE(P1)

Y2

Y1

P1

Y2

A

A’

B

B’

AD’

An increase in AE shifts the AE curve up. At P1, now Y = AE at point B where Y = Y2.

∆AE

∆Y = αAE ∆AE

The AD curve has thus shifted to the right to AD’.

AE = AE + [c(1 – t) – m] Y

45°

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THE SHORT-RUN AGGREGATE SUPPLYCURVE

Short-run AS curve (SRAS) shows the real value of the output firms are willing to produce at each P level

The construction of the SRAS requires the assumption that the level of technology, the stock of capital, and the prices of factors of production remain constant

A change in technology or in factor-prices will, therefore, cause the SRAS to shift

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THE SLOPE OF THE SRAS CURVE

In the general case, the slope of the SRAS curve is assumed to be positive

That is, firms will supply a greater quantity of goods and services only if P rises

Firms require a higher P to increase output due to the law of diminishing returns The law of diminishing returns implies increasing marginal

costs

The SRAS curves becomes steeper as Y (real GDP) increases and approaches the level of full-employment output

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THE SRAS CURVE

P

YYfe

SRAS

SRAS curve becomes steeper as Y increases and approaches Yfe.

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THE SRAS CURVE (CONT’D)

P

YYfe

SRAS

Keynesian Model

General Model

Classical Model

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THE EFFECT OF AN INCREASE IN INPUT-PRICES

P

Y

SRAS

An increase in input-prices increases costs of production and causes the SRAS to shift up.An upward shift of the SRAS curve represents a decrease in aggregate supply.

SRAS’

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THE EFFECT OF A TECHNOLOGICALIMPROVEMENT

P

Y

SRAS

Technological improvement decreases costs of production and causes the SRAS to shift down.A downward shift of the SRAS curve represents an increase in aggregate supply.

SRAS’

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MACROECONOMIC EQUILIBRIUM

P

Y

SRASMacroeconomic equilibrium is determined by the intersection of the AD and the SRAS curves.

AD

Y*

P* At any other price level the economy would not be in equilibrium. At P1, for instance, there is an excess demand and P will increase.

P1

YDYS

Excess Demand

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MACROECONOMIC EQUILIBRIUM (CONT’D)

Y

P

AD

P1

Y1 Y

AE

45°

AE(P1)

Y1

A A’

SRAS

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GENERAL CASE: THE IMPACT OF ANAGGREGATE DEMAND SHOCK

Y

P

AD

P1

Y1 Y

AE

45°

AE(P1)

Y1

A

A’

SRAS

An increase in AE will cause the AE curve to shift up by ΔAEand the AD curve to shift to the right by αAE ΔAE.

AE’(P1)

Y1’

αAE ΔAE

AD’

Y1’

B

CP2

Y2 Y2

AE’(P2)

ΔAE

B’

C’

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KEYNESIAN CASE: THE IMPACT OF ANAGGREGATE DEMAND SHOCK

Y

P

AD

P1

Y1 Y

AE

45°

AE(P1)

Y1

A

A’SRAS

An increase in AE will cause the AE curve to shift up by ΔAEand the AD curve to shift to the right by αAE ΔAE.

AE’(P1)

Y2

αAE ΔAE

AD’

Y2

BΔAE

B’

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CLASSICAL CASE: THE IMPACT OF ANAGGREGATE DEMAND SHOCK

Y

P

AD

P1

Y1 Y

AE

45°

AE(P1)

Y1

A A’

SRAS

An increase in AE will cause the AE curve to shift up by ΔAEand the AD curve to shift to the right by αAE ΔAE.

AE’(P1)

Y1’

αAE ΔAE

AD’

Y1’

B

CP2

ΔAE

B’

= C’= AE’(P2)

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GENERAL CASE: THE IMPACT OF ANAGGREGATE SUPPLY SHOCK

Y

P

AD

P1

Y1 Y

AE

45°

AE(P1)

Y1

A

A’SRAS

An increase in input-prices will cause the SRAS curve to shift up and the AE curve to shift down due to the increase in P.

BP2

Y2 Y2

AE(P2)

B’

SRAS’