Topic 2 Aggregate Demand Supply and Equilibrium Agenda What are we trying to do Flow diagrams Short run Economic Equilibrium Aggregate Demand Aggregate Supply Long run Economic Equilibrium The economy is great The important question How can we tell However some smaller questions What do we even mean by economy What interactions are important What interactions are unimportant Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium What are the main components of an economy Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium An agricultural example picking oranges Assume the only item in our economy which we can purchase is an orange Who produces them Where do we buy them How are they gathered Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium The economy Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium More general term we can use instead of workers We are also consumers meaning we buy and use goods services So really what are we in one word Households we live in houses we go to the parking lot to be workers we go to the farmer s market to be consumers Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium How else can households earn income Hint farms don t own stuff in this model So farms will rent from households Machines tractors pickup truck etc Buildings grain mill etc These are called factors of production or capital Other sources of income coming up Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium Two general kinds of markets Output Market All of the markets for goods and services Firms sell households buy Factor Market All of the markets for factors of production i e labor and capital machines buildings etc Households sell firms buy Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium Now we generalize Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium What are we missing Overview Republicans and Democrats The top 1 A lot of firms own machines right Technology Wall Street Everyone else as in other countries Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium Adding these Consumers Output Market Factor Market Firms Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium But how does this help in answering the question i e We have a model but how do we use it to tell if the economy is doing well Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium First a couple of definitions Short Run Prices are not correct Input prices wages price of flour are fixed output prices price of bread can vary Consider a few weeks or months Ex Can you renegotiate your wage every day Long Run Prices are fully flexible and adjust to the correct level Consider a few months or years Ex Are wages fixed for ever Can you get fired Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium So when is an economy doing well If the total amount of goods being produced in the short run is the same as that which would ideally be produced in the long run Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium The U S economy LR equilibrium SR equilibrium Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium So what is SR equilibrium The intersection of short run Aggregate Supply and short run Aggregate Demand Short Run Aggregate Supply Short Run Aggregate Demand 1 Overview Flow Diagrams SR Equilibrium 2 Aggregate Demand 3 Aggregate Supply 4 LR Equilibrium Quantity But what exactly is aggregate demand or Aggregate Supply for that matter Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium First some assumptions About individuals 1 People are rational they maximize utility If people know what they want and how to get it they will try to get it if benefits exceed costs 2 People have unlimited wants 3 People have limited income Recall scarcity and opportunity costs Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium More assumptions Mistakes are allowed as long as at that point in time you made the best decision you could Ex You can lose money on the stock market because you thought it would go up Didn t have enough info Law of Demand All other things equal as the price for a good goes up the demand for that good goes down Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium Why do these matter Falsify Assumption Effect of Price drop on demand Maximize Utility Unlimited Wants Depends on if desire for good is satiated Limited Income None Always buy an infinite amount of goods Falsify Assumption Effect No Mistakes Unrealistic Model would not reflect reality Law of Demand Simplification Some goods do not exhibit this behavior but the majority do Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium Back to Aggregate Demand Consider the following We have four consumers A B C D and demand Price level 10 20 30 A 40 40 30 B 40 25 25 C 10 5 0 D 10 10 5 Draw the demand curve for consumer C Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium But we want to consider aggregate demand AD Recall our flow diagram Who demands goods and services AD is determined by 1 2 3 4 Overview Consumption Expenditures by Households Investment Spending by Firms Government Spending by Government Net exports by Rest of World This is exactly the total of the output market Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium Consider the previous example in the macro context Price level 10 20 30 Consumers 40 40 30 Firms 40 25 25 Government 10 5 0 Net Exports 10 10 5 What is total demand at each price level Draw the AD curve Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium Why does the demand curve slope downwards In Micro Substitution Effect If price of one good goes up consumers purchase more of a substitute good Income Effect If price of good increases I can t afford the same number of items I am poorer and therefore purchase less Overview Flow Diagrams SR Equilibrium Aggregate Demand Aggregate Supply LR Equilibrium The substitution and income effects are
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