Aggregate Supply and Demand: Econ102

Introduction to Aggregate Demand and Aggregate Supply

• Macroeconomics focus: Econ102

Outline

• Introduction and definitions of aggregate supply and demand
• Discussion of aggregate supply in the long-run
• Examination of aggregate demand
• Review of goods market, loanable funds market and real balances market
• Combining AS and AD to explain economic fluctuations

Introduction and definitions

• Aggregate supply (AS) and aggregate demand (AD) models helps explain movements in prices and output
• Models also help determine the impacts of policies and assist in understanding debates in macroeconomics

AD Curve

• Represents the aggregate spending (Y) levels for price (P) in the economy
• Depicts equilibrium in the goods and money markets
• Has a downward sloping curve
• Shifts right due to expansionary fiscal policy, expansionary monetary policy, and exogenous changes that raise aggregate spending

AS Curve

• Represents the relationship between the output (Y) supplied and the general price level (P) in the economy
• Shifts to the right with technological progress and/or an increase in available productive resources
• Full-employment level of output or potential output (Yf) defines the quantity of output produced when all resources are fully employed

Time horizons

• Macroeconomics include: short-run, medium-run, long-run and very long run

Short-run

• The economy has excess productive capacity with unemployment

Medium-run

• Transition period between the short-run and long-run

Long-run

• The economy operates at full capacity but is constrained by a factor, usually capital, indicated by Y = Yf

Very long run

• The economy operates at full capacity, without constraints on output, all inputs can vary

Aggregate supply

• Relates to the short-run, wages, and other prices do not respond to economic condition changes
• Certain markets possess sticky prices, leading to sustained shortages and surpluses, such as unemployment
• Wage and price stickiness prevents achieving the natural employment level and potential output
• Prices and wages are flexible in the long-run
• Markets adjust towards achieving full-employment and potential output over time
• Potential output is the sustainable highest output level, given resources

Quantity of capital fixed

• Generally, fixed in the long-run
• The economy adjusts so the labor market equilibrium satisfies the quantity of labor needed, based on current production function
• No unemployment in the economy

AS curve

• In the short run, it is flat, the price level does not affect output
• In the long run, it is vertical as potential output is achieved, not depending on the price level

AS-AD model

• Initial condition in the short-run
• Impact of demand increase on graphs in the short run

Long-run

• Effect of potential output increase in the long-run

Medium-run

• Effect of potential output increase in the medium-run on graphs

Aggregate Supply

• The AS curve follows the assumption of the "classical school of economics"

The classical theory of employment

• Rests on two principles in the long-run
• Underspending is unlikely
• If underspending occurs, wage-price flexibility in free markets prevents recessions by increasing output and decreasing wages and prices
• Based on Say's law, supply creates its own demand
• Underspending is unlikely because production generates income to purchase what was produced

Total production

• Determined by two things quantity of inputs or factors of production and ability to turn inputs into output as represented by the production function
• Key factors of production are capital (K) and labor (L)
• Capital: set of tools workers use Labor: total hours worked by those employed

Long-run assumptions

• Both capital and labor are fixed
• Results in approximately fixed output in the macroeconomics makes use of production functions that exhibit constant returns to scale

Macroeconomics

• Common practice to make use of production functions that exhibit constant returns to scale
• when both capital and labor are increased by a certain factor (z), output will also be increased by that factor

Example of output schedule.

• Given levels of labor, capital

Production function follows

• Constant returns to scale
• Exogeneity of K and L in the long-run is assumed because of full employment
• In the long-run, values of utilized capital and labor are approximately stable

Stability in markets

• By stability markets ensure equality of supply and demand in an economy
• Short-run models cannot ensure equality, economic fluctuations are persistent in the short-run

Predictions of model

• Aggregate production is the only endogenous variable
• Capital, labor, and Technology have a positive relationship with production (Y)
• Production function implies that no other variable affects Y
• Government spending, money supply, interest rates, and taxation do not affect Y
• Aggregate demand will show how these factors affect Y

Aggregate Demand

• Focuses on aggregate expenditure

Closed economy

• Only three components: Consumption (С), Investment (I), and Government purchases (G)
• Has no trade involved with other countries
• National income accounts identity
• Households and firms consume output, use output for investment and Governments purchase output for public purposes

Goods market: consumption

• Households receive labor and ownership income, pay taxes, and allocate disposable income to consumption and saving
• If consumption depends on disposable income, a mathematical model can be created
• Disposable income is net taxes
• We call this math formulation as the consumption function.

Marginal propensity to consume (MPC)

• The amount by which consumption changes when disposable income increases by one dollar
• 0 < MPC < 1
• If MPC = 0.8, households spend 80 cents for every 1 peso of income

Consumption: linear

• Intercept 40 is considered autonomous consumption
• It represents all other exogenous variables, such as asset prices, consumer optimism, and interest rates

Goods market: investment

• Business fixed investment adds to capital stock or replaces existing capital
• Residential investment includes construction of new houses.
• Inventory investment refers to buffer stocks for firms
• Generally, investment depends on real interest rates that reflect the true cost of borrowing funds.

Investment project

• Needs to be profitable, returns must be greater than its cost
• If interest rates rise, fewer projects are profitable and capital goods demand decreases
• Wannabe homeowners also discouraged at high mortgage rates which reflect the cost of owning a home.
• Inventories also impact sales of goods
• Inventories reflect a certain opportunity cost in selling tomorrow rather than today
• Inventories reflect a certain opportunity cost in selling tomorrow rather than today, with higher interest rates making inventories costly

Spending and rate relationship

• Investment spending is inversely related to the real interest rate
• The intercept on the investment demand represents other factors (business optimism, technological progress)
• These factors cause investment demand curve to shift

Goods market: government purchases

• Build infrastructure for development
• It also pays for government employees' services and other services (healthcare and education)
• Transfers represent another expenditure form, not part of domestic Production G
• Taxes combine to get net taxes (T = Tx - Tr) Budget: balanced, surplus, deficit, decisions
• Balanced Budget is when government spending equals net taxes.
• Budget surplus is when net tax revenues are greater than spending.

Budget Surplus details

• T > G, T - G > 0 is also called public saving
• Budget deficit is when net tax revenues are less than spending (T < G)
• Macro models show that these variables are exogenous, mostly decided through politics
• With a deficit, the government finances through debt or loans from institutions

Equilibrium in the goods and services market

• In these economics, supply and demand for the economy's output are equal
• Total production equals the sum of consumption, investment, and government purchases
• The adjusting factor to this equilibrium is the real interest rate, as all variables are fixed with the only changing investment variable, the financial market determines the rate.

Market for loanable funds

• Rewrites national accounting identity
• Output after consumers and the givernment demand calls for national savings
• Identity is the output savings and investment
• The first term is private savings and the second is public with inflows to financial markets (savings) must equal outflows (investment)
• Fixed output requires factors to fix net tax and govenment spending with national savings as well
• In market the capital comes as the goods and the rate comes as the price

Savings and interest

• Savings is the supply of loanable funds
• Households lend savings to investors via banks which will lend out
• Investors also demand quantity funds to depend on the demand rate
• Savings rates adjust according to savings and investments

Low investors

• If the rate is too low, investors aim to loan more
• High rate limits firm demand
• Expansionary fiscal policy increases government, lower savings with lowered tax

Fixed levels

• In the long run, government creates crowding-out effect through an increase in govermment with balanced amount of investment
• Two rate factors of shifting the investment capital
• Businesses will tend to acquire more capital in order to pioneer tech industries and growth
• Gov'ts may provide tax incentives to pioneer industries in order to help them grow and attract more capital
• These practices are common in developing economies.

Market for real balances

• Incorporates the monetary sector demanding/supplying money
• Money aids daily goods and services and value
• No current self value, but valuable based on its goods for purchase.
• Barter is where you exchange goods and services
• Poses problems eg "Double coincidence of wants"
• Shows that it is difficult when bartering to find exactly what it is you want.

Function of balance of payments

• Include media exchange and transfers, and also universal acceptance and measure.
• Real economy depends on national income, supplies, and demand for output with the rate.
• Transfers can change the product over a good

Notes to take

• Transactions ie service cost
• Rate is the price. and product is depending on price
• The purchasing power supply is determined by money

Theories behind balance of payments

• Transactions amount to nominal change measured for good
• If GDP gets higher the rate is a messure of real debt

Money Theory

• Assumes velocities on nominal money supply, therefore rearranging the equation means setting to debt.
• The banks determine the amount of GDP spent through the rate Inflation determines the increase

Money Example

• Formulated in the balance sheet
• In which money equals debt as a means, there is a proportional amount for income or wealth.

Pricing demand

• Inveserly effect product. price
• Fixed supply means the the economy supply must fail

The Short and Long terms

• Changes to shifts in the aggregate demand curve
• AS vertical shows prices affect the horizontal curve
• Any changes will affect the output
• Media reflects between shift between short runs and long runs

Balance is good

• Both short and long show shift to the right.

Short run economy

• the AD curve causes quantity price to increase on the long term

Economic Flucuation

• Short time and supply over cause prices to increase
• A good shift demands the increase increase with prices that that short supply from the bank through contracts to return increased prizes

Supply side economy

• Shocks due to production are called adverse by price levels
• The long-run economic state can benefit though tech and tax

Curves of the AD relation

• Adverse can increase the cost and the rate

Supply state

• Where as shift over time lowers
• The GDP deficits in prices are high.
• High production means higher employment rate

Rate over term

• Shift rate increases over products
• The real market shifts to more real products

Supply Economics

• Where economic growth by lowering taxes and fees

Curve points

• In the state means higher curve

Real markets

• The market increases output from tax revenues

Summary

• The AS and AD model is an important tool in understanding fluctuations
• In the long-run fixed inputs and technology to a fixed level of product
• Given marginal propensity to consume disposable
• The interest debt affects demand
• In the run horizontal curves affect debts
• Economic depends on debts

Further

• The AD and CD are focused to debts
• Introduce variables that have effects.
• The bank looks at the economy and sets rates to affect debt.