Chapter 13 Aggregate Demand and Aggregate Supply Analysis In the short run real GDP fluctuates around the long run upward trend because of the business cycle Fluctuations in GDP lead to fluctuations in employment Aggregate Demand Aggregate demand and aggregate supply model a model that explains short run fluctuations in real GDP and the price level Aggregate demand curve AD a curve that shows the relationship between the price level and the quantity of real GDP demanded by households firms and the government Short run aggregate supply curve SRAS a curve that shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms The aggregate demand curve is downward sloping because a fall in price level increases the quantity of real GDP demanded The wealth effect o As total household wealth rises consumption rises o When price levels rise the real value of household wealth declines consumption declines reducing the demand for goods and services o When price levels fall the real value of household wealth rises consumption rises increasing the demand for goods and services The interest rate effect o Higher price level increases the interest rate reduces investment spending reduces the quantity of goods and services demanded o Lower price levels decrease the interest rate increases investment spending increasing the quantity of goods and services demanded The international trade effect o Price levels in the US rise relative to price levels in other countries US exports will become more expensive foreign imports will become less expensive net exports will fall reducing quantity of goods demanded o Lower price level in the US relative to other countries net exports rise increasing the quantity of goods and services demanded Movement along curve o If the price level changes but other variables that affect the willingness of households firms government to spend are unchanged the economy will move up or down a stationary aggregate demand curve Shifts of the aggregate demand curve o If any other variable other than the price level changes the demand curve will shift o Variable that shift Changes in government policies Monetary policy the actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives Fiscal policy changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives Changes in the expectations of households and firms If households firms become more optimistic about their future incomes they are likely to increase their current consumption shifting curve to the right If households firms become more pessimistic about their future incomes demand curve will shift to the left Changes in foreign variables If firms and households in other countries buy fewer US goods or if firms and households in the US buy more foreign goods next exports will fall aggregate demand curve will shift to the left Net exports will fall if the exchange rate between the dollar and foreign currencies rises because the price in foreign currency of US products sold in other countries will rise and the dollar price of foreign products sold in the US will fall A change in net exports that results from a change in the price level in the US will result in a movement along the aggregate demand curve Aggregate Supply The effect of changes in the price level on the quantity of goods and services that firms are willing able to supply In the long run the level of real GDP is determined by the number of workers the capital stock In the long run changes in the price level do not affect the level of real GDP o Level of real GDP in the long run is called potential full employment GDP Long run aggregate supply curve LRAS a curve that shows the relationship in the long run between the price level and the quantity of real GDP supplied o Vertical curve SRAS curve is upward sloping o Over the short run as price level increases the quantity of goods and services firms are willing to supply will increase o As prices of final goods and services rise prices of inputs rise more slowly wages of workers price of natural resources o Higher price level leads to higher profits and increases the willingness o firms to supply more goods and services o A firm that is slow to raise its prices when the price level is increasing may find its sales increasing therefore will increase production o Some firms and workers fail to accurately predict changes in the price level o Contracts make some wages and prices sticky When prices or wages do not respond quickly to changes in demand or supply o Firms are often slow to adjust wages Wages of many union workers remain fixed by contract for several years If firms are slow to adjust wages a rise in the price level will increase the profitability of hiring more workers and producing more output A fall in the price level will decrease the profitability of hiring more workers and producing more output o Menu costs make some prices sticky Firms base their prices today partly on what they expect future prices to be Menu costs the costs to firms of changing prices Unexpected increase in the price level firm swill want to increase the prices they charge Low prices firms will find sales increasing increase output Shifts of the Short Run Aggregate Supply curve vs Movements along it o If price levels changes but other variables are unchanged the economy will move up or down a stationary aggregate supply curve o Variables that shift the short run aggregate supply curve Increases in labor force and in capital stock Technological change Expected changes in the future price level If workers and firms expect the price level to increase by a certain percentage the SRAS curve will shift by an equivalent amount Adjustments of workers and firms to errors in past expectations about the price level If workers and firms across the economy are adjusting to the price level being higher than expected SRAS curve will shift to the left If they are adjusting to the price level being lower than expected the SRAS curve will shift to the right Unexpected changes in the price of an important natural resource Supply shock an unexpected event that causes the short run aggregate supply curve to shift Macroeconomic Equilibrium in the Long Run and the Short Run The economy has not been experiencing any inflation The price level is currently 100 and workers and firms expect it to remain at 100 in the