Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Economics 202Principles Of MacroeconomicsProfessor Yamin AhmadLecture 9• Aggregate Supply• Aggregate Demand• Macroeconomic EquilibriumProfessor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesBig Concepts• Determination of “Aggregate Supply”Short Run vs. Long Run• Aggregate Demand• Equilibrium in the EconomyProfessor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesProduction and Prices• What forces bring persistent and rapid expansion of real GDP?• What causes inflation?• Why do we have business cycles?• How do policy actions by the government and the Federal Reserve affect output and prices?Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesAggregate Supply Fundamentals• The aggregate quantity of goods and services supplied depends on three factors:– The quantity of labor (L )– The quantity of capital (K )– The state of technology (Z )• The aggregate production function shows how quantity of real GDP supplied, Y, depends on labor, capital, and technology.Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesAggregate Supply• The aggregate production function is written as the equation:Y = F(L, K, Z ).• In words: the quantity of real GDP supplied depends on (is a function of) the quantity of labor employed, the quantity of capital, and the state of technology.• The larger is L, K, or Z, the greater is Y.Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesAggregate Supply• At any given time, the quantity of capital and the state of technology are fixed but the quantity of labor can vary.• The higher the real wage rate, the smaller is the quantity of labor demanded and the greater is the quantity of labor supplied.• The wage rate that makes the quantity of labor demanded equal to the quantity supplied is the equilibrium wage rate and at that wage the level of employment is the natural rate of unemployment.Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesAggregate SupplyWe distinguish two time frames associated with different states of the labor market: Long-run aggregate supply Short-run aggregate supplyProfessor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesLong-Run Aggregate Supply• The macroeconomic long run is a time frame that is sufficiently long for all adjustments to be made so that real GDP equals potential GDP and there is full employment.• The long-run aggregate supply curve (LRAS or LAS) is the relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP.Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesAggregate Supply• Figure 1 shows an LAS curve with potential GDP of $10 trillion.• The LAS curve is vertical because potential GDP is independent of the price level.• Along the LAS curve all prices and wage rates vary by the same percentage so that relative prices and the real wage rate remain constant.Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesShort-Run Aggregate Supply• The macroeconomic short run is a period during which real GDP has fallen below or risen above potential GDP.• At the same time, the unemployment rate has risen above or fallen below the natural unemployment rate.• The short-run aggregate supply curve (SAS) is the relationship between the quantity of real GDP supplied and the price level in the short run when the nominal wage rate, the prices of other resources, and potential GDP remain constant.Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesTheories of Short-Run Aggregate SupplyThe aggregate supply curve is upward sloping. Theories which attempt to explain these include:• Sticky-Wage Theory• Imperfect Information/Worker Misperception Theory• Sticky-Price Theory• Summary of Different ModelsProfessor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesThe Sticky-Wage model• Assumes that firms and workers negotiate contracts and fix the nominal wage before they know what the price level will turn out to be. • The nominal wage they set is the product of a target real wage and the expected price level:eWω PeWPωPPTarget real wageProfessor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesThe Sticky-Wage modelIf it turns out thateWPωPPePPePPePPthenUnemployment and output are at their natural rates.Real wage is less than its target, so firms hire more workers and output rises above its natural rate.Real wage exceeds its target, so firms hire fewer workers and output falls below its natural rate.Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesProfessor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesThe Sticky-Wage model• Implies that the real wage should be counter-cyclical, should move in the opposite direction as output during business cycles:– In booms, when P typically rises, real wage should fall. – In recessions, when P typically falls, real wage should rise. • This prediction does not come true in the real world:Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesThe cyclical behavior of the real wagePercentage change in real wagePercentage change in real GDP-5-4-3-2-1012345-3 -2 -1 0 1 2 3 4 5 6 7 8197419791991197220042001199819651984198019821990Professor Yamin Ahmad, Principles of