AS and AD

By Daniel Gentry and Retchee Joseph

Aggregate Supply and Aggregate Demand

Aggregate Demand


Aggregate Demand is the relationship between the aggregate price level and the quantity of output. The factors that affect AD are household consumption, government spending, investment, and net exports. It is important to note that AD is the same in both the short run and the long run. Aggregate Demand represents how a change in a certain price level will change expenditures on all services and goods in an economy. The AD curve is downward sloping due to the interest rate effect, the international effect, and the wealth effect.

Shift Factors of Aggregate Demand



Aggregate Demand can increase or decrease depending on several things. In effect, these things will cause shifts up or down in the AD curve. These include:

  • Exchange Rates: When a country's exchange rate increases, then net exports will decrease and aggregate expenditure will go down at all prices. This means that AD will decrease.
  • Distribution of Income: This is directly related to wages and profits. When worker's real wages increase, then people will have more money on their hands because their overall income has increased. When this happens they tend to consume more causing the consumption expenditures to increase.
  • Expectations: Consumers tend to have certain expectations about the future of the economy and will adjust their spending accordingly. If they would expect the economy to not do so well in the future, saving would increase thus decrease overall expenditures. Rising price levels will cause aggregate demand to increase. If consumers foresee the price level to rise in the near future, they might just go out and buy that good now, increasing the consumption expenditures in AD. Many different expectations have the capacity to increase or decrease aggregate demand and it is not always clear as to how this will happen.
  • Foreign Income: This relates U.S. economic output with the income of its trading partners in the world. When foreign income rises, U.S. exports will increase causing aggregate demand to increase.
  • Monetary and Fiscal Policies: The government has some ability to impact AD. They can spend money or increase taxes in order to influence how consumers spend or save. An expansionary fiscal policy causes AD to increase, while a contractionary monetary policy causes AD to decrease.
  • wealth effect: If real household wealth increases (decreases), then aggregate demand will increase (decrease).
  • Changes In Expectations: If businesses and households are more optimistic about the future of the economy, they are more likely to buy large items and make new investments; this will increase aggregate demand.
  • Inflation Expectation Changes: If consumers expect inflation to go up in the future, they will tend to buy now causing aggregate demand to increase. If consumers' expectations shift so that they expect prices to decline in the future, t aggregate demand will decline and the aggregate demand curve will shift up and to the left.
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Aggregate Supply and Demand

the purpose of the aggregate supply-aggregate demand model is to explain how real GDP and the price level are determined. the quantity of real GDP supplied is the total amount of final goods and services that firms in the united states plan to produce and it depends on the quantity of

  • labor employed
  • capital, human capital, and the state of technology
  • land and natural resources
  • entrepreneurial talent

Aggregate supply


Aggregate supply is the relationship between the quantity of real GDP supplied and the price level when all other influences on production plans remain the same. the aggregate supply curve slopes upward because a movement along the AS curve brings a change in the real wage rate.if the price level rises, the real wage rate falls, and if the price level falls, the real wage rate rises..

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Aggregate Demand

Ad is the sum of the four components of domestic spending( C, I, G, (X-M), if any of these components increases, holding the price level constant, AD increases, which increases the real GDP which shift the Ad Curve to the right. I any of those components decreases, then the curve will shift to the left.
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LRAS and SRAS


Short run aggregate supply shows total planned output when prices can change but the prices and productivity of factor inputs e.g. wage rates and the state of technology are held constant.

Long run aggregate supply shows total planned output when both prices and average wage rates can change – it is a measure of a country’s potential output and the concept is linked to the production possibility frontier.
In the long run, the LRAS curve is assumed to be vertical (i.e. it does not change when the general price level changes).
In the short run, the SRAS curve is assumed to be upward sloping (i.e. it is responsive to a change in aggregate demand reflected in a change in the general price level).
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Shifts in Short Run Aggregate Supply (SRAS)

Shifts in the position of the short run aggregate supply curve in the price level / output space are caused by changes in the conditions of supply for different sectors of the economy:

  • Employment costs e.g. wages, employment taxes. Unit labor costs are also affected by the level of labor productivity
  • Costs of other inputs e.g. commodity prices, raw materials. The exchange rate can affect the prices of key imported products
  • Impact of government e.g. environmental taxes such as carbon duties & business regulations which affect the costs of production

Recessionary Gap

a recessionary gap exists when the economy is operating below Qf and the economy is likely experiencing a high unemployment rate.

macroeconomic equilibrium

when the quantity of real output demanded is equal to the quantity of real output supplied.
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Recessionary gap

a recessionary gap exists when the economy is operating below Qf and the economy is likely experiencing a high unemployment rate. one of the most common causes of a recession is falling AD as it lowers real GDP and increases the unemployment rate.
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inflationary gap

an inflationary gap exist when the economy is operating above GDPf. because production is higher than GDPf, a rising price level is the greatest danger to the economy.
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inlfation

a falling in the price level or a severe decrease in AD is called deflation. stagflation is a situation when both inflation and unemployment rises at the same time. This cannot occur with an aggregate demand shift. If AD increases, then inflation rises but unemployment falls (because output rises). If AD falls, then inflation falls but unemployment rises.

Summary

  • increase in AD causes an increase in real GDP, decrease in unemployment and increases price level.
  • decrease in AD causes decrease in real GDP, increase in unemployment and decrease price level.
  • increase in SRAS causes increase in real GDP, decrease unemployment and decrease price level.
  • decrease in SRAS causes decrease in real GDP, increase unemployment and increase price level.
Macro 3.3- Long Run Aggregate Supply, Recession, and Inflation (LRAS)
http://www.youtube.com/watch?v=em5Wqg1IVp
Macro 3.1 AD, AS, and LRAS (Additional Version)

the Phillips curve

the inverse relationship between inflation and the unemployment rate has come to be known as the Phillips curve and in the short run is downward sloping.

supply shock and the Phillips curve

when the sras shifts to the left, we get stagflation because inflation and unemployment rates ar both rising. supply shock shifts the Phillips curve inward when sras shifts to the right, and outward when sras shifts to the left.
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http://www.youtube.com/watch?v=zatnIhwmu1

Review Questions

1. Which is the best way to describe the AS curve in the long run?

(A) Always vertical in the long run.

(B) Always upward sloping because it follows the Law of supply.

(C) Always Horizontal.

(D) Always downward sloping.

(E) Without more information we cannot predict how it looks in the long run.


2. Stagflation most likely results from

(A) increasing AD with constant SRAS.

(B) decreasing SRAS with constant AD.

(C) deceasing AD with constant SRAS.

(D) a decrease in both AD and SRAS.
(E) an increase in both AD and SRAS.

3. Equilibrium real GDP is far below unemployemnt, and the government lowers household taxes. Which is the likely result?

(A) Unemployment falls with little inflation.

(B) Unemployment rises with little inflation.

(C) Unemployment falls with rampant inflation.

(D) Unemployment rises with rampant inflation.

(E) No change occurs in unemployment or inflation