Macroeconomic Equilibrium ADAS Aggregate demand supply n n

Macroeconomic Equilibrium (AD/AS)

Aggregate demand supply n n 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.

Macroeconomic equilibrium

Demand-pull inflation n Demand-pull inflation is caused by an increase in AD

Business cycle expansion n As AD rises, output rises, and unemployment falls

Business cycle contraction n As AD falls, output falls and unemployment rises

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

Stagflation n Rising prices and falling output

Aggregate demand n Aggregate demand (AD) consists of spending on GDP by: n n n 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.

Factors affecting Consumption n n Income Wealth Expected future income and wealth Demographics Taxes

Factors affecting Investment n n Interest rate Technology Cost of capital goods Capacity utilization

Government spending n Determined by government authorities

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

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

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

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

Interest-rate effect n As the price level rises: n n n Individuals must hold more money to pay for transactions To acquire 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

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

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

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

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

Aggregate supply

Short-run Aggregate Supply

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

Changes in Short-Run AS n n n Resource prices Technology Expectations

Changes in Long-Run AS n n Changes in the quantity and/or quality of resources Technology

Macroeconomic equilibrium

Short-run effect of an increase in AD

Long-run adjustment process