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MACROECONOMICS

Aggregate Demand and Aggregate


Supply
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Aggregate Demand (AD)
Factors That Can Change AD
Short-Run Aggregate Supply (SRAS)
Short-Run Equilibrium
Long-Run Aggregate Supply (LRAS)
and Long-Run Equilibrium
Three States of an Economy

In This Lecture..
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AD-AS Framework
The AD-AS framework has three parts:
1- Aggregate Demand (AD)
2- Short-Run Aggregate Supply (SRAS)
3- Long Run Aggregate Supply (LRAS)

We start with a discussion of AD.
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1- Aggregate Demand (AD)
Aggregate Demand (AD)- The quantity
demanded of all goods and services (Real
GDP) at different price levels, ceteris
paribus.
Aggregate Demand (AD) Curve - A curve
that shows the quantity demanded of all
goods and services (Real GDP) at different
price levels, ceteris paribus.
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The Aggregate Demand Curve (AD)
The aggregated
demand curve (AD) is
downward-sloping,
specifying an inverse
relationship between
the price level and the
quantity demanded of
Real GDP.
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Why Does AD Curve Slope
Downward?
Because of three (3)
effects:
Real Balance Effect
Interest Rate Effect
International Trade
Effect
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Real Balance Effect
The change in
the purchasing
power of dollar-
denominated
assets that results
from a change in
the price level
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Interest Rate Effect
Changes in
household
and business
buying as the
interest rate
changes.
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International Trade Effect
The change in
foreign sector
spending as
the price level
changes

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Change in Quantity Demanded
A change in the quantity
demanded of Real GDP
is the result of a change
in the price level.
A change in the quantity
demanded of Real GDP
is graphically
represented as a
movement from one
point, A, on AD1 to
another point, B, on
AD1.
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A change in AD is
graphically
represented as a
shift in the AD
curve from AD1 to
AD2
Change in Aggregate Demand
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Change in Aggregate Demand
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Factors that Change AD
We said change in consumption (C),
investment (I), government expenditure
(G), and net export (NX) shifts AD.
But the question is what changes C, I, G,
and NX?
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Change in G will
be discussed in
later chapter.
Factors That Change Consumption (C)
1. Wealth
2. Expectations about future prices and
income
3. Interest rate, and
4. Income taxes

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Factors That Change Aggregate
Demand & Consumption/Wealth
Wealth - The value of all assets owned, both
monetary and non- monetary
Wealth C AD
Wealth C AD
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Factors That Change Aggregate
Demand & Consumption/Prices
Expect higher future prices C AD
Expect lower future prices C AD
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Factors That Change Aggregate
Demand & Consumption/Income
Expect lower future income C AD
Expect higher future income C D
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Factors That Change Aggregate Demand &
Consumption/Interest Rates
Interest Rate C AD
Interest Rate C AD
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Factors That Change Aggregate Demand &
Consumption/Income Taxes
Income taxes C AD
Income taxes C AD
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Factors That Change Investment (I)
1. Interest rate
2. Expectations about future sales, and
3. Business taxes

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Factors That Change Aggregate
Demand & Investment/ Interest Rates
Interest rates I AD
Interest rates I AD
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Factors That Change Aggregate
Demand & Investment/ Future Sales
Optimistic about future sales I AD
Pessimistic about future sales I AD
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Factors That Change Aggregate Demand &
Investment/ Business Taxes
Business taxes I AD
Business taxes I AD
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Factors That Change Net Export (NX)
1. Foreign real national income, and
2. Exchange rate

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Factors That Change Aggregate Demand &
Net Exports/ Foreign Real National Income
Foreign real national income EX NX AD
Foreign real national income EX NX AD
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Factors That Change Aggregate Demand & Net
Exports/ Exchange Rate
US $ appreciates EX and IM NX AD
US $ depreciates EX and IM NX AD
Appreciation
An increase in the value of
one currency relative to
other currencies.
Depreciation
A decrease in the value of
one currency relative to
other currencies.
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Summary of Factors That Change AD
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Self-Test
1. Explain the real balance effect.
Real balance effect: a rise (fall) in the price
level causes purchasing power to fall
(rise), which decreases (increases) a
persons monetary wealth. As people
become less (more) wealthy, the quantity
demanded of Real GDP falls (rises).



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Self-Test
2. Explain what happens to the AD curve if the
dollar appreciates relative to other currencies.
If the dollar appreciates, it takes more foreign
currency to buy a dollar and fewer dollars to buy
foreign currency. This makes U.S. goods
(denominated in dollars) more expensive for
foreigners and foreign goods cheaper for
Americans. In turn, foreigners buy fewer U.S.
exports, and Americans buy more foreign imports.
As exports fall and imports rise, net exports fall. If
net exports fall, total expenditures fall, ceteris
paribus. As total expenditures fall, the AD curve shifts
to the left.


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Self-Test
3. Explain what happens to the AD curve if
personal income taxes decline.
If personal income taxes decline,
disposable incomes rise. As disposable
incomes rise, consumption rises. As
consumption rises, total expenditures rise,
ceteris paribus. As total expenditures rise, the
AD curve shifts to the right.


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2- Short-Run Aggregate Supply Curve
(SRAS)
Aggregate Supply - The quantity supplied of
all goods and services (Real GDP) at different
price levels, ceteris paribus.
Short-Run Aggregate Supply Curve (SRAS) - A
curve that shows the quantity supplied of all
goods and services (Real GDP) at different
price levels, ceteris paribus.

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Short-Run Aggregate Supply Curve
The short-run
aggregate supply curve
(SRAS) is upward-
sloping, specifying a
direct relationship
between the price level
and the quantity
supplied of Real GDP.
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Why Does the SRAS Aggregate Supply
Curve Slope Upward?
Two possible explanations:
Sticky wages, and
Worker misconceptions

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Sticky (Inflexible)Wages, the Real Wage
Rate, and SRAS
Wages are locked in for a few years due to
labor contracts or perhaps because of social
conventions or perceived notions of fairness.
While firms pay nominal wages, they often
decide how many workers to hire based on real
wages.

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Sticky Wages and the Real Wage Rate - Workers
The Real wage = Nominal wage / Price level.
Price level Real wage , ceteris paribus
Price level Real wage , ceteris paribus
As real wage more individuals are willing to
work, and current workers are willing to work
more at higher real wages than at lower real
wages and vice versa.
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Real wage Quantity supplied of labor
Real wage Quantity supplied of labor
Sticky Wages and the Real Wage Rate - Firms
Firms will employ more workers the cheaper it is to hire
them.
Real wage Quantity of labor demanded
Real wage Quantity of labor demanded
Thus, if wages are sticky, an increase in the price level
(which pushes real wages down) will result in a increase in
output.
This is what an upward-sloping SRAS curve represents:
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As the price level rises, the quantity supplied of goods
and services rises. The opposite occurs if price levels fall.
Worker Misconceptions
This is another explanation for upward sloping SRAC
curve.
If workers misperceive real wage changes, then a fall in
the price level will bring about a decline in output,
ceteris paribus, which is illustrative of an upward-
sloping SRAS curve.
In response to (the misperceived) falling real wage,
workers may reduce the quantity of labor they are
willing to supply.
With fewer workers (resources), firms will end up
producing less. See p. 168 of the text for an example.

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Changes in SRASShift in SRAS
Shifts in the SRAS curve may be caused by
changes in:
Wage rates
Prices of non-labor inputs
Productivity
Supply shocks:
Adverse (such as major cutback in supply of
oil from Middle East to US)
Beneficial (such as major oil discovery in US)

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Changes in SRASShift in SRAS
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Changes in SRASA Summary
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Self-Test
1. If wage rates decline, explain what
happens to the short-run aggregate supply
(SRAS) curve.
As wage rates decline, the cost per unit of
production falls. In the short run (assuming
prices are constant), profit per unit rises.
Higher profit causes producers to produce
more units of their goods and services. In
short, the SRAS curve shifts to the right.


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Self-Test
2. Give an example of an increase in labor
productivity.
Last year, 10 workers produced 100 units
of good X in 1 hour. This year, 10 workers
produced 120 units of good X in 1 hour.


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Self-Test
3. Discuss the details of the worker misperceptions
explanation for the upward-sloping SRAS curve.
Workers initially misperceive the change in their
real wage due to a change in the price level. For
example, suppose the nominal wage is $30 and the
price level is 1.50; it follows that the real wage is
$20. Now suppose the nominal wage falls to $25
and the price level falls to 1.10.The real wage is
now $22.72. But suppose workers misperceive the
decline in the price level and mistakenly believe it
has fallen to 1.40. They will now perceive their real
wage as $17.85 ($25/1.40).
(continued)


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Self-Test (Continued)
In other words, they will misperceive their real
wage as falling when it has actually increased.
How will workers react if they believe their real
wage has fallen? They will cut back on the
quantity supplied of labor, which will end up
reducing output (or Real GDP). This process is
consistent with an upward-sloping SRAS curve:
A decline in the price level leads to a reduction in
output.


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Short-run Equilibrium
At P
1
, the quantity supplied of
Real GDP is greater than the
quantity demanded. As a result,
the price level falls and firms
decrease output.
At P
2
, the quantity demanded
of Real GDP is greater than the
quantity supplied. As a result,
the price level rises and firms
increase output.
Short-run equilibrium occurs at
point E, where the quantity
demanded of Real GDP equals the
(short-run) quantity supplied.
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Changes in Short-Run Equilibrium in the Economy
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How a
Factor
Affects
the Price
Level
and Real
GDP in
the Short
Run.
An Important Exhibit
Much of our discussion up to this point has
been about the economy in the short run.
Specifically, it has been about changes in the
price level (P) and Real GDP (Q) in the short
run.
The following exhibit tells us that changes in AD
and SRAS will change the price level and Real
GDP in the short run, and
then we see what factors will actually change
AD and what factors will change SRAS.

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A Summary Exhibit of AD and SRAS
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Natural Real GDP & Natural Unemployment
Natural Real GDP is the Real GDP that is
produced at the natural unemployment* rate.
Or, it is the Real GDP which is produced
when the economy is in long-run equilibrium.

* Unemployment caused by frictional and structural
factors in the economy.

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3- Long-Run Aggregate Supply Curve
(LRAS )
The LRAS curve is a
vertical line at the level of
Natural Real GDP.
It represents the level of
Real GDP the economy
produces when wages and
prices have adjusted to their
(final) equilibrium levels and
there are no misperceptions
on the part of workers.
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Short-Run Equilibrium
The condition that exists in the economy when
the quantity demanded of Real GDP equals the
(short-run) quantity supplied of Real GDP. See
slide 54.
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Graphically, short-run equilibrium occurs at
the intersection of the AD and SRAS curves.
Long-run Equilibrium
The condition that exists in the economy when
wages and prices have adjusted to their (final)
equilibrium levels and workers do not have
any relevant misperceptions. See slide 54.
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Graphically, long-run equilibrium occurs at
the intersection of the AD and LRAS curves.
Equilibrium States of the Economy
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Disequilibrium
When the economy is in neither short-run
equilibrium nor long-run equilibrium, it is said
to be in disequilibrium.

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Disequilibrium is the state of the economy as it
moves from one short-run equilibrium to another
or from short-run equilibrium to long-rune equilibrium.
In disequilibrium, quantity supplied of Real GDP and
quantity demanded of Real GDP are not equal.
Self-Test
1. What is the difference between short-run
equilibrium and long-run equilibrium?
In both short-run and long-run equilibrium, the
quantity supplied of Real GDP equals the quantity
demanded of Real GDP.
Also, in long-run equilibrium, quantity supplied and
demanded of Real GDP equal Natural Real GDP.
But, in short-run equilibrium, quantity supplied and
demanded of Real GDP are either more than or less
than Natural Real GDP. See Graphs on slide #54.


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Self-Test
2. Diagrammatically represent an economy that is
in neither short-run equilibrium nor long-run
equilibrium.
The diagram should show the price level in the
economy at P
1
and Real GDP at Q
1
but the
intersection of the AD curve and the SRAS curve at
some point other than (P
1
, Q
1
).
In addition, the LRAS curve should not be at Q
1
or
at the intersection of the AD and SRAS curves.

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Wall Street Journal
The Wall Street Journal is a is a rich source
of information which provides real life
examples of micro- and macro economic
activities. Check todays issue to see the
most current news.
http://www.wsj.com
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