Econ 104 1st Edition Lecture 21 Outline of Last Lecture II Net Exports as a Component of AD III Exchange Rate IV LRAS and SRAS Outline of Current Lecture I Wealth Effect II Interest Rate Effect III NX effect IV LRAS V SRAS Current Lecture I II III IV V Aggregate Demand a AD C I G NX i Is the level of real GDP purchased by households C business I government G and foreigners NX The Wealth Effect a Wealth Assets Liabilities b As the price level rises real value of wealth falls i C falls move up along AD The interest Rate Effect a As the price level rises we need more money to buy goods and services i Households more cash and borrow more 1 The increase in demand for loans increases the real interest rate on loans ceteris paribus The NX effect a As the price level rises faster in the US compared to the ROW i X down and M up results in a NX down LRAS Long Run Aggregate Supply These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute a Identifies output at potential where Y Y Bar and U U bar unemployment at full employment i Potential Output is determined by the 1 Number of workers 2 Capital stock 3 Available technology b LRAS is vertical changes in the price level do not affect the level of real GDP in the LR i As the price level rises LRAS remains unchanged at Y Ybar c Shifts in LRAS i A change in potential output 1 Change in resource base a A change in number of workers b A change in the size of the capital stock 2 Technological change innovation VI VII VIII SRAS a Short run aggregate supply b SRAS shows the relationship in the Short Run between the price level and the quantity of real GDP supplied by firms c When prices rise in the SR firms produce more output because input prices are sticky or fixed Why are input prices sticky or fixed a It is difficult to predict future inflation when negotiating wages and prices of inputs i Wages and prices of inputs are often set by contracts for one year or more ii Menu costs 1 The costs of firms of changing prices 2 EXAMPLE you own a coffee shop a Suppose AD is increasing in US economy i This increases the price of lattes mochas espressos etc b Input costs are very slow to adjust i Profits and revenues increase ii You have an incentive to increase output iii Profits revenues costs b A rising price level leads to a larger quantity of goods and services supplied in the short run Shifts in SRAS a An unexpected change in the price of an important natural resources IX X i For example an increase in the price of oil supply shock leads to an increase in the costs of production and there will be less produced at every price b Increase in the labor force and the capital stock SRAS shift right i Firms can supply more at every price c Technological Change i Increase productivity SRAS shifts right d An increase in the expected future price level SRAS shifts left i Workers will ask for a higher wage and firms will increase output prices e Workers and firms adjust to errors in past expectations about the price level i If prices are higher than expected SRAS shifts left ii If prices are lower than expected SRAS shifts right Example 1 of a SRAS shift a An increase in AD and the automatic adjustment of prices and real output i As AD shortage output starts to rise prices will go up Short run equilibrium will change b Short run adjustments i An increase in G or decrease iin r 1 Ad shifts right and there is an AD shortage ii Firms step up production to try and meet the increase in AD expansion 1 Output prices shortage relative to input prices Change in profits is greater than 0 iii As output and prices increase the economy moves to where the AD SRAS c From SR to LR i Workers and firms will adjust to the price level being higher than expected 1 Workers will ask for higher wages firms will increase their prices 2 As a result SRAS shifts left until Y Y bar at the new equilibrium AD SRAS LRAS Example 2 of a SRAS shift a A decrease in AD and the automatic adjustment of prices and output i A policy intervention 1 Decrease AD a Surplus b Prices fall c Output falls 2 SR equilibrium a Workers accept lower wages b Firms lower output prices ii Short Run Adjustment 1 A decrease in G or an increase in R a AD shifts left surplus 2 Firms cut production and lay off workers recession a Inventories build up and firms are forced to cut their prices Output prices fall surplus relative to input prices sticky fixed i Change in profits is negative 3 As output and prices fall the economy moves from to where AD SRAS iii From SR to LR 1 Workers and firms will adjust to the price level being lower than expected a Workers will be willing to accept lower wages firms will accept lower prices b As a result SRAS shifts right until Y Y bar at the new LR equilibrium where AD SRAS LRAS