Lecture Outline – Aggregate Demand and Supply A. Introduction1. This model incorporates many of the concepts that we learned in ear-lier chapters.2. Many of the parts in this model are expressed in terms of a growth rates.B. Dynamic Aggregate Demand (AD) Curve1. What does the AD curve tell us?a. Shows spending growth within the economy.b. Households, firms, the government, and net exportsc. C+I+G+NX2. What is the relationship between the AD curve and the quantity equa-tion?a. Spending growth = M+Vb. M+V=P+Y. P=inflation rate, Y=GDP growth3. Graph the AD curve. What is on the x-axis? The y-axis?a. Inflation rate(Pi) on the Y axis.b. Read GDP growth rate on the X axis.c. AD curve represents a given level of spending growth. Ex. 5% is equal to growth in money supply +growth rate of velocity.d. AD curve is downward slopinge. What happens to the AD curve if spending growth in-creases? If spending growth decreases?1. Each point on the AD curve sums up to the spending growth rate. (X and Y must add to the total which hits the x axis)2. How does an increase in or an increase in affect spending growth? The AD curve?a. AD curve is shifted out to the right of the initial ag-gregate demand curve. If there is no change in growth rate of GDP but spending growth has in-crease, spending is being driven by higher inflation If spending growth slows, AD shifts left.1b. Change in spending growth rate is caused by any change in monetary growth ratec. Increase in M of V shifts AD to the right3. How does a decrease in or a decrease in affect spending growth? The AD curve?a. If they decrease monetary growth rate or Velocity, AD shifts to the left.C. The Solow Growth Curve (SGC)1. Long run Aggregate supply curve2. Models the economies potential growth rate in the long run under the assumption that prices are flexible.3. Economic growth ultimately depends on increases in the stock of real factors of production and/or technological progress (i.e. increases in productivity). From Chapter 25, what role do institutions play in drivingeconomic growth?a. A positive shock causes the growth rate to shiftb. Any kind of change to the long run aggregate supply curve=positive real shockc. Anything that causes us to increase real productive capac-ity1. Ex. positive technological shock, decrease in price of im-portant resource, positive weather changes(for Agricul-tural societies) or a reduction in regulations/taxes2. Negative shock: long run growth rate decreases. Falls from 3% . Caused by extra regulations, extra taxes etc...4. What do we mean when we say that the economy has a “potential growth rate?” What do we mean when we use the term “Solow growth rate?” 5. When deriving the SGC, we assume prices are flexible and that money is neutral. a. If the FED decides to increase monetary growth rate, AD curve will be shifted to the right. This affects the economy be-cause inflation will increase. At new equilbrium the growth rate 2stays the same but the inflation rate shifts up proportionally withthe monetary supply( inthe long run) (Use the Equation).b. If fed slows the money supply, there will be a reduction in the inflation rate(disinflation) and no effect on the economy’s potential growth rate.c. Graph the SGC. What is on the x-axis? The y-axis?1. Growth curve is a vertical line located at the economy’s potential growth rate2. Y axis: inflation3. X axis: Real GDP growth rated. What is the relationship between the position of the SGC and the Solow growth rate?1. SGC is located at the Solow growth rate2. US has been about 3% (Average growth rate = 3.4%3. Actual growth rate represents short run fluctuations with the growth ratee. Explain why your graph of the SGC embodies price flexibility and monetary neutrality.1. Long enough period time that prices are flexible. Full em-ployment, and existing factors of production and technol-ogy available to us.2. Does not depend on the price level. To produce goods andservices you need resources and technology.3. Because its verticle: shows that ability to produce goods and services upon inflation. Depends on factors of produc-tion and tecbnology.D. Real Business Cycle (RBC) Model 1. In this model, how are the equilibrium inflation rate and the equilibriumgrowth rate determined?a.2. What is a real shock or productivity shock? Will a real shock shift AD orSGC?a. What is a positive real shock? Give an example of a positive real shock. How will a positive real shock affect the economy’s growth 3rate and inflation rate? How will a positive real shock affect the spending growth rate?1. A positive economic is going to increase the growth rate and lower the inflation rateb. What is a negative real shock? Give an example of a negative real shock. How will a negative real shock affect the economy’s growth rate and inflation rate? How will a negative real shock affect the spending growth rate?1. oil crisis from early 1970s. Shift to the left in the LRAS curve.2. Result will be a higher expected inflation rate.3. Do real shocks cause temporary or permanent changes in the growth rate and the inflation rate? Explain.4. How can real shocks be used to explain the business cycle?5. Use the RBC model to explain how a change in rainfall – a real shock – has affected India’s growth rate. a. Which is more sensitive to the change in rainfall, the growth rate of agricultural output or the growth rate of real GDP? Explain.b. Have shocks to rainfall become more or less important in India since 1980? Explain.c. Are shocks to rainfall more or less economically important in India or the US? Explain.6. Use the RBC model to explain how an oil shock – a real shock – can af-fect an economy.7. List some factors that shift the SGC.E. AD Shocks and the Short-Run Aggregate Supply (SRAS) Curve 1. Draw the SRAS curve on a graph. What is on the x-axis? The y-axis? a. Sticky prices are in the short run: prices are not fully flexi-ble like in the long run. Wages can be sticky because of con-tracts(they don’t change very much) If inflation goes up, your wage does not adjust for this.b. Wages set by contracts take into account expected infla-tion. IF actual inflation exceed expected, firms profit. Firms prof-4its will rise because their prices are rising faster than their costs.Quantity will increase in prices rise. (supply and demand logic)c. If actual inflation rate is less than what is expected, firms profits will fall because prices are rising at a slower rate