AD - AS

• Aggregate Demand


  A curve that shows the quantity of goods and services that households, firms, and the government want to buy at each price level

  
• Aggregate Supply


  A curve that shows the quantity of goods and services that firms choose to produce and sell at each price level

  
• Aggregate Demand and Aggregate Supply Model

  • Determines the equilibrium price level and the equilibrium level of output (real GDP)

  
• Aggregate Demand


  1. AD = C + I + G + NX

  2. Where: C = Consumption, I = Investment, G = Government Expenditure, NX = Net Export
• Increase in price level

  Reduces the quantity of goods and services demanded due to: the wealth effect (C falls), the interest-rate effect (I falls), the exchange-rate effect (NX falls)
• Shift in Aggregate Demand


  Any event that changes C, I, G, or NX (except a change in price level) will shift the AD curve
• Factors that shift Aggregate Demand


  • Stock market boom (C rises)
  • Government cuts taxes (C rises)
  • Firms become pessimistic about future business conditions (I falls)
  • Investment tax credit (I rises)
  • Increase in money supply (I rises)
  • Recession in Europe (NX falls)
  • Increase in exchange rate of ringgit (NX falls)
• Short-Run Aggregate Supply (SRAS)

  Relationship between the price level and the quantity of goods and services supplied at a given period of time

  
• Increase in price level

  Causes an increase in the quantity of goods and services supplied
• Long-Run Aggregate Supply (LRAS)

  Vertical at the natural rate of output, as the quantity supplied does not depend on the overall price level

  
• Natural rate of output (YN)

  The amount of output the economy produces when unemployment is at its natural rate
• Shift in LRAS


  Any event that changes the determinants of YN will shift LRAS
• Factors that shift LRAS

  • Immigration increases labor
  • Investment in physical or human capital increases
• Potential output


  The maximum sustainable output an economy can produce at full employment
• Full-employment output


  The level of output produced when all available resources are fully employed
• LRAS


  Long-run aggregate supply
• YN


  Natural rate of output
• Why the LRAS Curve Might Shift

  1. Any event that changes any of the determinants of YN will shift LRAS

  2. Example: Immigration increases Labor, causing YN to rise
• A firm increases advertising

  Demand curve shifts right
• LRAS Curve Might Shift

  • Any change in natural rate of output
  • Changes in labor
  • Changes in capital
  • Changes in natural resources
  • Changes in technological knowledge
• LRAS Shifts Arising from Changes in (i) Labor


  1. The Baby Boom generation retires: L falls, LRAS shifts left

  2. New govt policies reduce the natural rate of unemployment: the % of the labor force normally employed rises, LRAS shifts right
• LRAS Shifts Arising from Changes in (ii) Physical or Human Capital

  1. Investment (K) in factories or equipment: K rises, LRAS shifts right

  2. More people get college degrees: Human capital rises, LRAS shifts right

  3. Earthquakes or hurricanes destroy factories: K falls, LRAS shifts left
• LRAS Shifts Arising from Changes in (iii) Natural Resources

  1. A change in weather patterns makes farming more difficult: LRAS shifts left

  2. Discovery of new mineral deposits: LRAS shifts right

  3. Reduction in supply of imported oil or other resources: LRAS shifts left
• LRAS Shifts Arising from Changes in (iv) Technology

  1. Technological advances allow more output to be produced from a given bundle of inputs: LRAS shifts right

  2. The invention of the computer has allowed us to produce more goods and services from any given level of resources, shifting the long-run aggregate-supply curve to the right
• Will opening up international trade shift LRAS to right?
• SRAS


  Short-run aggregate supply
• Increase in overall level of prices in economy


  Tends to raise the quantity of goods and services supplied
• Decrease in level of prices

  Tends to reduce quantity of goods and services supplied
• Sticky-wage theory


  • Nominal wages are slow to adjust to changing economic conditions
  • Long-term contracts: workers and firms
  • Slowly changing social norms
  • Notions of fairness influence wage setting
  • Nominal wages are based on expected prices and don't respond immediately when actual price level is different from expected
• Sticky-wage theory


  • Suppose a firm has agreed in advance to pay workers an hourly wage of RM20 based on the expectation that the price level will be 100. If the price level is actually 95, the firm receives 5% less for its output than it expected and its labor costs are fixed at RM20 per hour. Production is now less profitable, so the firm hires fewer workers and reduces the quantity of output supplied.
• Sticky-price theory


  • The prices of some goods and services are slow to respond to changing economic conditions, often due to menu costs
  • If the price level falls unexpectedly, and a firm does not change the price of its product quickly, its relative price will rise and this will lead to a loss in sales
  • When sales decline, firms will produce a lower quantity of goods and services
  • If prices don't adjust instantly to changing conditions, an unexpected fall in the price level leaves some firms with higher-than-prices, which depress sales and cause firms to lower the quantity of goods and services supplied
• Why SRAS Curve Might Shift

  1. Events that shift the long-run aggregate-supply curve will shift the short-run aggregate-supply curve as well

  2. Expectations of the price level will affect the position of the short-run AS curve even though it has no effect on the long-run AS curve

  3. A higher expected price level decreases the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the left and vice versa
• Macroeconomic equilibrium


  • Long-run equilibrium is found where the aggregate-demand curve intersects with the long-run aggregate-supply curve
  • Output is at its natural rate
  • Perceptions, wages, and prices have all adjusted so that the short-run aggregate-supply curve intersects at this point as well

  
• The Effect of a Shift in AD

  Wave of pessimism - Aggregate demand shifts left

  Short-run: Output falls, Price level falls

  Long-run: Short-run aggregate supply curve shifts right, Output returns to natural rate, Price level falls
• The Effect of a Shift in AS

  Firms - increase in production costs

  Aggregate supply curve - shifts left

  Short-run - stagflation: Output falls, Price level rises