Aggregate Demand and Supply AD • What is AD? Determinants of AD • Change in Consumer Spending – – – – Consumer Wealth Consumer Expectatitons Household Borrowing Taxes • Change in Investment Spending – Interest Rates – Expected Returns • • • • Expected future business conditions Technology Degree of excess capacity Business taxes • Change in government spending • Change in net export spending – National Income Abroad – Exchange Rates Aggregate Supply • What is AS? • 1st : Immediate Short run: • 2nd : Short Run: • 3rd : Long Run: AS-Immediate Short Run AS- Short Run AS- Long Run Changes in Aggregate Supply • Change in Input Prices – Domestic Resource prices – Prices of imported resources • Change in productivity • Change in Legal-Institutional Enviroment – Business Taxes and subsidies – Government Regulations • Factors that change LRAS: An increase (decrease) in the supply of resources. An improvement (deterioration) in technology and productivity. Institutional changes that increase (reduce) the efficiency of resource use. Factors that change SRAS: A decrease (increase) in resource prices — that is, production costs. A reduction (increase) in the expected rate of inflation. Favorable (unfavorable) supply shocks, such as good (bad) weather or a reduction (increase) in the world price of a key imported resource. Questions for Thought: 1. Indicate how each of the following would influence U.S. aggregate supply in the short run: (a) An increase in real wage rates. (b) A severe freeze that destroys half the orange crop in Florida. (c) An increase in the expected rate of inflation in the future. (d) An increase in the world price of oil, a key import. (e) Abundant rainfall during the growing season of agricultural states. Equilibrium • Changes in equilibrium? – Demand pull and Cost Push Unanticipated Changes in Aggregate Demand • In the short-run, output will deviate from full employment capacity as prices in the goods & services market deviate from the price level that people expected. Impact of unanticipated increases in AD: Initially, the strong demand and higher price level in the goods & services market will temporarily improve profit margins. Output will increase, the rate of unemployment will drop below the natural rate, and output will temporarily exceed the economy's long-run potential. With time, however, contracts will be modified and resource prices will rise and return to their competitive relation with product prices. Once this happens, output will recede to the economy's long-run potential. Unanticipated Increase in Aggregate Demand Price level LRAS SRAS1 Short-run effects of an unanticipated increase in AD P105 P 100 AD1 YF Y2 AD2 Goods & Services (real GDP) In response to an unanticipated increase in AD for goods & services (shift from AD1 to AD2), prices will rise to P105 and output will temporarily exceed full-employment capacity (increases to Y2). Unanticipated Increase in Aggregate Demand Price level LRAS SRAS2 SRAS1 P110 Long-run effects of an unanticipated increase in AD P105 P100 AD1 YF Y2 AD2 Goods & Services (real GDP) With the passage of time, prices in resource markets, including the labor market, will rise due to the strong demand. As a result, higher costs reduce aggregate supply to SRAS2. In the long-run, a new equilibrium at a higher price level (P110) and an output consistent with the economy’s sustainable potential will occur. Thus, the increase in demand will expand output only temporarily. Unanticipated Changes in Aggregate Demand • Impact of unanticipated reductions in AD: Weak demand and lower prices in the goods & services market will reduce profit margins. Many firms will incur losses. Firms will reduce output, the rate of unemployment will rise above the natural rate, and output will temporarily fall short of the economy's long-run potential. With time, long-term contracts will be modified. Eventually, lower resource prices and a lower real interest rate will direct the economy back to longrun equilibrium, but this may be a lengthy and painful process. Unanticipated Reduction in Aggregate Demand Price level LRAS SRAS1 Short-run effects of an unanticipated reduction in AD P 100 P95 AD AD2 1 YF Y2 Goods & Services (real GDP) The short-run impact of an unanticipated reduction in AD (shift from AD1 to AD2) will be a decline in output (decreases to Y2), and a lower price level (P95). Temporarily, profit margins decline, output falls, and unemployment rises below its natural rate. Unanticipated Reduction in Aggregate Demand Price level LRAS SRAS1 SRAS2 P100 Long-run effects of an unanticipated reduction in AD P95 P90 AD2 Y2 YF AD1 Goods & Services (real GDP) In the long-run, weak demand and excess supply in the resource market will lead to lower wage rates and resource prices resulting in an expansion in short-run aggregate supply to SRAS2. In the long-run, a new equilibrium at a lower price level (P90) and an output consistent with the economy’s sustainable potential will result. This method of restoring equilibrium may be both long and painful. Impact of Changes in Aggregate Supply • Economic growth and anticipated shifts in longrun aggregate supply. Increases in LRAS will make it possible to produce and sustain a larger rate of output. Both LRAS and SRAS will shift to the right and output will increase. These changes generally take place slowly and therefore they need not disrupt long-run equilibrium. Shifts in Aggregate Supply Price Price level LRAS1 YF,1 level LRAS2 YF,2 SRAS1 Goods & Services (real GDP) SRAS2 Goods & Services (real GDP) Such factors as an increase in the stock of capital or an improvement in technology will expand the economy’s potential output and shift the LRAS to the right (note that SRAS will also shift to the right). Such factors as a reduction in resource prices, favorable weather, or a temporary decrease in the world price of an important imported resource would shift SRAS to the right (note that LRAS will remain constant). Growth in Aggregate Supply Price level LRAS1 LRAS2 SRAS1 SRAS2 P1 P2 AD YFF1 YF2 Goods & Services (real GDP) Here we illustrate the impact of economic growth due to capital formation or a technological advancement, for example. Both LRAS and SRAS increase (to LRAS2 and SRAS2); the full employment output of the economy expands from YF1 to YF2. A sustainable, higher level of real output and real income is the result. If the money supply is held constant, a new long-run equilibrium will emerge at a larger output rate (YF2) and lower price level (P2). Impact of Changes in Aggregate Supply • The impact of changes in short-run aggregate supply (SRAS): SRAS shifts to the right – output will temporarily exceed the economy's long-run potential. Since the temporarily favorable supply conditions cannot be counted on in the future, the economy’s long-term production capacity will not be altered. Recognizing that they will be unable to maintain their current high level of income, individuals will generally save a substantial portion of it for use at a future time that is not nearly so prosperous. The increased saving will reduce interest rates, which encourages investment (capital formation). Unanticipated, Temporary Increase in Aggregate Supply Price level LRAS SRAS1 SRAS2 P1 P2 AD YF Y2 Goods & Services (real GDP) Here we illustrate an unanticipated, but temporary, increase in aggregate supply, such as may result from a bumper crop caused by good weather. The increase in aggregate supply (shift to SRAS2) would lead to a lower price level (P95) and an increase in current GDP to Y2. Since the favorable supply conditions cannot be counted on in the future, the economy’s long-run aggregate supply will not increase. Growth in Aggregate Supply Loanable Funds Market Real Interest Rate S1 S2 r1 r2 D Q1 Q2 Quantity of Loanable Funds Predictably, decision makers will save a large proportion of their temporary higher real income, spreading the benefits into the future. Thus, the supply of loanable funds will increase (from S1 to S2). The real interest rate will fall to r2, encouraging expenditures on interestsensitive capital goods and consumer durables. Impact of Changes in Aggregate Supply • The impact of unanticipated reductions in short-run aggregate supply (SRAS): If an unfavorable supply shock is expected to be temporary, long-run aggregate supply will be unaffected. Households will reduce their current saving level (and dip into past savings) to maintain a current consumption level more consistent with their longerterm perceived opportunities. The reduction in saving will lead to higher real interest rates and retard current investment. Reduction in Resources: A Supply Shock Resource Market Price Level S2 S1 Pr2 P r1 D Q1 Q 2 Quantity of Resources Suppose there is an unanticipated reduction in the supply of resources, perhaps as the result of a crop failure or a sharp increase in the world price of a major imported resource, such as oil. Resource prices would rise from P1 to P2. Effects of Adverse Supply Shock Price LRAS level SRAS2 (Pr2) SRAS1 (Pr1) P110 P 100 B A AD YF Y 2 Goods & Services (real GDP) The higher resource prices shift the SRAS curve to the left; in the short-run, the price level rises to P110 and output falls to Y2. What happens in the long-run depends on whether the reduction in the supply of resources is temporary or permanent. If temporary, resource prices fall in the future, permitting the economy to return to its original equilibrium (A). If permanent, the productive potential of the economy will shrink (LRAS shifts to the left) and (B) will become the long-run equilibrium.