Zara Mahmood Nov 12 2013 EC102 Lecture 13 Aggregate Expenditure Aggregate Demand AD Curve Shows relationship between the price level and the quantity of real GDP demanded by households firms and the government Change in aggregate expenditure For every output what price level is consistent with that For every price level what output is consistent with that Aggregate expenditure is a point on an aggregate demand curve Increase Expenditure Movement along the aggregate demand curve in Aggregate Decrease in Aggregate Expenditure Movement along the aggregate demand curve Increase in AE Y Price level goes down Decrease in AE Y Price level goes up Why does the AE Demand Curve Slope Down Why does it have a negative slope Along the AE demand curve o Everything is being held constant except for the P and Y Y C I G NX 3 basic causes Wealth Effect o Impact on C o Consumption Function C Y T Y T e r Wealth Price Level o C goes up when goes up down when goes up o P then purchasing power of household wealth then C then AE Interest Rate Effect Zara Mahmood Nov 12 2013 EC102 o P then r then C I NX then AE o Interest rate increases More incentive to save Borrowing is more expensive o Investment Function I r Y q r then I r then I International Trade Effect Real Exchange rate e PDOM x E PFOR Where E nominal exchange rate E will change if PDOM changes PDOM relative to PFOR then e then NX then AE Shifts vs Moving Along the Aggregate Demand Curve Change in aggregate demand entire curve will shift o Increase shift right Higher AE at every P level o Decrease shift left Lower AE at every P level Price level changes move up or down on demand curve Any other variable changes aggregate demand curve shifts What Could Shift the AD Curve Government Policies o Monetary policy policies which affect r r then C I NX then AD shifts left r then C I NX then AD shifts right Monetary Policy is only handled by the Federal Reserve Central Banks o Fiscal Policy policies which affect G and or T G then AD shifts right G then AD shifts left T then C and I then AD shifts left T then C and I then AD shifts right Zara Mahmood Nov 12 2013 EC102 Congress President etc handle fiscal policy Changes in Expectations of Household or Firms C Y T Y T e r Wealth Price Level o People get scared o Make decisions based on what might happen Y T e then C Y T e then C Ye then I then AD shifts right Ye then I then AD shifts left Changes in Foreign Variables o Outside economies changing impact US NX E then e then NX then AD shifts left YDOM Macroeconomic Equilibrium The Long Run The Short Run o Inflationary Gap Transition to the long run Shifts AD slope to the right o Recessionary Gay Transition to the long run SRAS and AD curve intersect at point in LRAS curve Equilibrium occurs at a point along the LRAS economy is at potential real GDP o Only natural rate of unemployment Zara Mahmood Nov 12 2013 EC102 Aggregate Supply Curve AS Curve Shows the relationship between the price level and the quantity of output that all firms in the economy are ready willing and able to supply Long Run Aggregate Supply vertical line o Economy s capacity to produce o Total amount of goods and services that can be potentially produced Capital stock Office buildings Machinery and equipment Factories Labor Technology Number of workers NOT THE PRICE LEVEL same capacity to produce o The level of unemployment associated with long run aggregate supply is the natural rate of unemployment Economy grows LRAS shifts right Short Run Aggregate Supply upward sloping o As P increases Y decreases o What they are willing and able to produce o Associated with the price level Fixed price level sticky horizontal line Why does the SRAS Curve Slope Up Contracts make some wages and prices sticky Firms are often slow to adjust wages Menu costs make some prices sticky What Causes the SRAS Curve to Shift Increases in the labor force and capital stock Technological change Expected changes in the future price level Adjustments of workers and firms to errors in past expectations about the price level Unexpected changes in the price of an important natural resource Zara Mahmood Nov 12 2013 EC102 Zara Mahmood Nov 12 2013 EC102 A DYNAMIC AGGREGATE DEMAND AND AGGREGATE SUPPLY MODEL Difficulty of the model arises from the two assumptions The economy does not experience continuing inflation The economy does not experience long run growth o Dropping these assumptions will create more accurate model Dynamic economy potential real GDP that grows over time and inflation that continues every year Potential real GDP increases continually o Shifting LRAS curve right Aggregate demand curve shifts right SRAS shifts right o Expect when workers and firms expect high rates of inflation What Is the Usual Cause of Inflation Zara Mahmood Nov 12 2013 EC102 The most common cause of inflation is total spending increasing faster than total production Increase in full employment real GDP causes LRAS shift right o AD shifts right If AD shifts right more than LRAS then price level rises Recession The Short Run Effect of a Decline in Aggregate Demand Rising interest rates cause firms to reduce spending on factories and equipment o Decline in investment shifts AD curve left New Short run macroeconomic equilibrium o GDP is below potential level Economy will be in recession Adjustment Back to Potential GDP in the Long Run Recession will eventually end because forces push economy back to potential GDP in long run o Initial decline in prices Workers willing to work for less money Firms willing to accept lower prices SRAS will shift to the right can take several years Back to long run equilibrium o Called automatic mechanism Without any government intervention Expansion The Short Run Effect of an Increase in Aggregate Demand Firms become optimistic about future profitability of new investment o Increase in investment will shift the AD curve to the right o Real GDP rises and price level rises Adjustment Back to Potential GDP in the Long Run Economy will be above potential real GDP Automatic mechanism brings the economy back from short run equilibrium beyond potential GDP o Workers and firms begin to adjust price level being higher than expected Workers push for higher wages Firms will charge higher prices SRAS curve will shift to the left not instant Back to long run equilibrium