Economics Chapter 10 Aggregate Demand and Aggregate Supply

Economics

Chapter 10

Aggregate Demand and Aggregate Supply

AS - AD model

Examine the changes in price level and real GDP with

AD: Aggregate demand (總需求 )

AS: Aggregate supply (總供應 )

Aggregate demand (AD)

Factors affecting the demand of local computers:

Household income Demand ( Private consumption [ C ] )

Companies computers renewal Demand ( Investment [ I ] )

Government e-service Demand ( Gov’t expenditure [ G ] )

Economic growth overseas Demand ( Export [ NX ] )

Price of foreign computer Demand ( Import [ NX ] )


The quantity of domestic output (i.e. goods and services)

demanded at different price level.

Aggregate demand (AD)In a closed economy No foreign trade AD = C + I + G

Private consumption expenditure (C) Investment expenditure (I) Government expenditure (G)

Remarks: GDP

Investment = Private investment + Public investment Government expenditure = Gov’t / Public expenditure

Aggregate demand Investment = Private investment Government expenditure = Public investment + Gov’t / Public expenditure


In an open economy

Net export = Export – Import

( NX = X – M )

AD = C + I + G + NX

Aggregate demand curve

AD curve shows the quantity of domestic

output demanded at different price level.

Relationship bet.

Aggregate output (Y), i.e. real GDP

Price level (P), i.e. GDP deflator

Aggregate demand curve

The downward sloping AD curve

P Y

P Y

Price level

Aggregate

output0AD

Y1

P1

Y2

P2

Price level

Aggregate

output0AD

Y2

P2

Y1

P1

Reasons for downward sloping AD curve

Change in “Price level” will lead to :

1. Wealth effect

2. Interest rate effect

3. Exchange rate effect

* These effects show the movement along AD

curve.

Reasons for downward sloping AD curve1. Wealth effect

Wealth = Money + Financial asset (e.g. bonds)

Take “money” for explanation Price level Purchasing power of money Real wealth

Holder of money is richer Buy more goods and services

Quantity of output demanded

Price level

Aggregate

output0AD

Y2

P2

Y1

P1

Reasons for downward sloping AD curve1. Wealth effect

Wealth = Money + Financial asset (e.g. bonds)

Take “financial asset” for explanation Price level Value of bond Real value of assets

Holder of financial asset is poorer Buy less goods and services


Price level

Aggregate

output0AD

Y1

P1

Y2

P2


1. Wealth effect

Increase in price level

Price level Wealth

Consumption


Decrease in price level

Price level Wealth

Consumption


Reasons for downward sloping AD curve2. Interest rate effect

Money market related

Take “money” for explanation Price level Purchasing power of money

Real money supply ( buying∵ same goods needs less money)

Interest rate Present Consumption & Investment


Price level

Aggregate

output0AD

Y2

P2

Y1

P1

Interest rate (%)

Md

0

Quantity of money

Ms2

r1

Ms1

r2

Reasons for downward sloping AD curve2. Interest rate effect

Money market related

Take “money” for explanation Price level Purchasing power of money

Real money supply ( buying∵ same goods needs more money)

Interest rate Present Consumption & Investment


Interest rate (%)

Md

0

Quantity of money

Ms1

r2

Ms2

r1

Price level

Aggregate

output0AD

Y1

P1

Y2

P2


2. Interest rate effect


Price level Real money supply

Real interest rate Consumption & Investment



Price level Real money supply

Real interest rate Consumption & Investment


Reasons for downward sloping AD curve3. Exchange rate effect

Real exchange rate related i.e. price of domestic goods in terms of foreign goods

Real exchange rate = Nominal exchange rate x

Take “local goods” for explanation Price level of local goods

Local goods can exchange for more foreign goods

Real exchange rate

Less demand of local goods from foreigners

Net export


Reasons for downward sloping AD curve2. Exchange rate effect

Real exchange rate related i.e. price of domestic goods in terms of foreign goods

Real exchange rate = Nominal exchange rate x

Take “local goods” for explanation Price level of local goods

Local goods can exchange for fewer foreign goods

Real exchange rate

More demand of local goods from foreigners

Net export



3. Exchange rate effect


Price level Real exchange rate

Net export



Price level Real exchange rate

Net exports



Conclusion Change of price level Change of quantity of output demand

Movement along the AD curve

Opposite direction

Price level

1. Wealth effect- Wealth - purchasing power


2. Interest effect- real interest rate - consumption - Investment

3. Exchange rate effect- Real exchange rate - net export

Changes in AD caused by other factors

Change in other factors (not “price level”):

1. Consumption (C)

2. Investment (I)

3. Government expenditure (G)

4. Net exports (NX)

* These effects show the shifting of AD curve.

Change in AD caused by other factors

Increase in AD At any price level, the

quantity of output demanded will rise.

AD curve shifts rightward

Decrease in AD At any price level, the

quantity of output demanded will fall.

AD curve shifts leftward

Price level

Aggregate output

0

AD2AD1

Price level

Aggregate output

0

AD1AD2

Shifting of AD curve caused by Consumption

Private consumption AD *Disposable income

Income tax rate Tax allowance

Economic prospects (growth) More able to earn higher salary Expected more future income

Interest rate More current consumption Less saving

Desire to spend Saving rate

Price level

Aggregate output

0

AD2AD1

Shifting of AD curve caused by Investment

Investment expenditure AD *Interest rate

Lower cost to make loan for investment Economic prospects (growth)

More willing to invest Profit tax

Increase firms’ net profit Higher incentive to invest more

Price level

Aggregate output

0

AD2AD1

Shifting of AD curve caused by Government Exp.

Government expenditure AD Government expenditure

*Infrastructure, e.g. highways and new airport runway Medical services, e.g. medical coupons for elderly Education, e.g. small class teaching Cultural, e.g. Art Festival

Price level

Aggregate output

0

AD2AD1

Shifting of AD curve caused by Net Export

Net export AD Income of foreign countries

Demand of domestic goods Domestic export

Exchange rate of domestic currency Price of domestic goods in terms

of foreign currency Remarks:

Change in exchange rate lead to price change Not price change lead to change in exchange rate

Conclusion: Aggregate demand

Price level Quantity of output demand Consumption Investment Net exports

Other factors Change in AD Consumption Investment Government expenditure Net exports

Aggregate supply

The quantity of output supplied (or the real national income) at different price levels.

It shows the relationship between the output supplied and the price level.

Two classifications of aggregate supply Long run aggregate supply ( LAS or LRAS ) Short run aggregate supply ( SAS or SRAS )

Assumptions in macroeconomic

Similarity in short run and long run Production resources Technology Productivity

Differences Market prices

Short run: can’t fully adjust to clear the market. Long run: fully adjust to clear the market.

Price level Short run: misconception about price level Long run: correct all mistakes after gathering all information


Short run Long run

Price

Can’t adjust freely

to clear the

market.

Can adjust freely.

Misconceptions about price level Yes No

Production resources and

technologyConstant Constant


Explanation to the differences If there is an economic recession, employers cut the wages of the

workers Short run:

Workers refuses a pay cut. Employers can’t find workers Employment level Aggregate supply

Long run: Workers know reason (i.e. recession) of the cutting of wages Workers finally agree to a pay cut. Employers can hire worker to full employment Aggregate supply increases to the full employment level.

Long Run Aggregate Supply

1. Potential output The output of an economy at full employment

i. Labour Labour supply Potential output Productivity Potential output

ii. Capital More advanced equipment Potential output Capital accumulation Potential output

Long Run Aggregate Supply

1. Potential output The output of an economy at full employment

iii. Natural resources Richer natural resources Potential output E.g. fertile soil more crops

iv. Technology Advanced technology higher productivity Potential output e.g. Internet help speed up international trading

Long Run Aggregate Supply2. Aggregate output in long run = Potential output

Price can be adjusted freely to reach equilibrium Labour market is at equilibrium wage

No surplus labour No labour shortage i.e. Full employment

The economy can achieve potential output. Example:

Equilibrium wage = W* Qs of labour = Qd of labour = 500 Assume that average productivity of labour =10 units Then, Potential output = 500 x 10 = 5000 units

Long-run Aggregate Supply (LAS)3. LAS curve Relationship between

the price level (P) the potential output (YF) which is determined

by Labour Capital Natural resources Technology

Market price can be adjusted to achieve full employment

At each price level, the economy reaches potential output.

LAS curve is vertical at potential output.

LASPrice level

Aggregate output

0YF

P3

P2

P1

Long-run Aggregate Supply (LAS)

Why is LAS curve vertical?

Suppose the real GDP = Potential output and you have a shop in this economy.

If the gov’t double the money supply:1. According to the QTM in long-run, %MS = %P Price level will be doubled

2. Inflation ( Price level) Purchasing power Market price of products will be doubled so as to offset the reduction of purchasing power i.e. you will sell your goods at a doubled price in order to gain the same purchasing power

3. Wages to workers will be doubled then. ∵Workers have less purchasing power under inflation. They will ask for higher wages to offset the decrease in purchasing power. If no wages increases, they will quit and your shop will close down.

Result of your shop:

Revenue : Ms Price level Market price Revenue (double)

Cost : Price level Purchasing power Wage Cost (double)

Output : Same amount of workers to sell same amount of goods (potential output)

No change in real price / real wage / Qd of labour / Qs of labour /

level of full employment / Aggregate supply

Long-run Aggregate Supply (LAS)

Why is LAS curve vertical?

Conclusion In long-run, all prices are fully flexible. Change in price level will not change the relative price because

All money prices change in the same proportion Product prices Cost of production factors, e.g. wage rate

Change in price level will not affect the production decision of the firms and workers ∵ they know there’s no change in relative price

Therefore, output will not be affected by the price level. LAS curve is vertical.

Long-run equilibrium

1. Long-run equilibrium price level and aggregate output Long-run equilibrium refers to

Quantity of output demanded = Quantity of output supplied = Potential output Price level at which AD curve cuts LAS curve

If price level in above P1

Quantity of output demanded < Quantity of output supplied Market price will be adjusted freely Price level will fall until P1

Price level

Aggregate output

0AD

LAS

YF

P1

Price level

Aggregate output

0AD

LAS

YF

P1

P

Long-run equilibrium

2. Aggregate demand only affects the price level LAS curve is vertical AD does not affect aggregate output

Shift of AD curve affects the price level only

Increase in aggregate demand: AD curve shifts rightward from AD1 to AD2

Price level increases from P1 to P2

Aggregate output remains unchanged at YF

Decrease in aggregate demand: AD curve shifts leftward from AD1 to AD3

Price level decreases from P1 to P3

Aggregate output remains unchanged at YF

Price level

Aggregate output

0AD1

LAS

YF

P1AD2

P2

Price level

Aggregate output

0

AD1

LAS

YF

P1

AD3

P3

Shift of the LAS curve

In AS-AD model, Potential output is constant at YF

LAS curve is vertical

Factors leading to the change in YF:

Increase in YF ( LAS1 LAS2 ),

[ LAS curve shifts rightward] Increase in population labour supply * Economic growth * over time by

Capital accumulation * Technology advancement *

Price level

Aggregate output0

LAS1

Y1

LAS2

Y2

Shift of the LAS curve

Factors leading to the change in YF:

Decrease in YF ( LAS1 LAS3 )

[LAS curve shifts leftward] War / Mass emigration labour supply * Major incidents

911 horror attack Financial crisis in 1998 / Financial tsunami in 2008

Price level

Aggregate output

0

LAS1

Y1

LAS3

Y3

Economic growth

LAS curve shifts rightward ( LAS1 LAS2 )

Increase in YF

Labour supply ( population ∵ ) Productivity ( capital accumulation and higher technology level)∵

Assume AD does not change Price level

Price level

Aggregate output

0

LAS1

Y1

LAS2

Y2

AD

P1

P2

Economic growth

AD curve shifts rightward ( AD1 AD2 )

Increase in population Consumption

Continual economic development Higher AD

Change in price level is determinedby the extent of the rightward shifting of AD curve and LAS curve

Price level

Aggregate output

0

LAS1

Y1

LAS2

Y2

AD1

P1

AD2Aggregate output

Aggregate output

Price level

Price level remains unchanged

Price level

Price level

Aging problem = Negative economic growth?Hong Kong Low birth rate Forecasted 26% of population aged 65 or above Labour supply YF

Argument: YF will increase because of Advancement in technology Capital accumulation Import of foreign labour

Question: Is it possible that the long-run aggregate supply (LAS) curve is not vertical in shape? Explain. (5)

No. (1)

In the long run, an economy’s total output is determined by its productive capacity, which depends on the quantity and/or quality of its factors of production. It is independent of the price level. The output level will remain at the full-employment level, no matter how the price level changes. (2)

The full-employment output level is also called the potential output level or the natural rate of output level because this is the production level at which the economy’s resources are fully employed and unemployment is at its natural rate. The LAS curve is vertical at the full-employment level of output or the natural rate of output. (2)

Question: Suppose a new kind of natural resources is discovered for the production of computer.

a. How will the long-run aggregate supply be affected? (2)

b. Assume there is no change in AD, how will the long-run equilibrium be changed? Explain with an aid of a diagram. (4)

c. What is the possible reason for the change in the long-run equilibrium? Give any one. (3)


a. How will the long-run aggregate supply be affect? (2)

Answer: Discovery of a new kind of natural resources for production

helps increase the productive capacity. (1)

Assume that the resources are fully employed, the long-run aggregate supply will be increased to a higher potential output level. (1)


b. Assume there is no change in AD, how will the long-run equilibrium be changed? Explain with an aid of a diagram. (3)

Answer: As the long-run aggregate supply increases, the LAS curve

shifts rightward from LAS1 to LAS2, (1) where aggregate output level will be increased to a new potential output level, YF. (1)

Price level will drops from P1 to P2. (1) Correct diagram (2)

Question: Suppose a new kind of natural resources is discovered for the production of computer.What is the possible reason for the change in the long-run equilibrium? Give any one. (3)

Answer: Increase in long-run aggregate supply will lead to a fall in

price level, which lead to an increase in real wealth. As people are richer, they will increase their private consumption. Therefore the equilibrium aggregate output will increase because of this wealth effect.

or Increase in long-run aggregate supply will lead to a fall in

price level, which lead to an increase in real money supply and hence lower the interest rate. Since there is lower cost in loan making, investment will be increased. Therefore the equilibrium aggregate output will increase because of this interest rate effect.

Short-run Aggregate Supply (SAS)

SAS curve Relationship between

the price level (P) the quantity of output supplied (or real national income)

in the short run Upward sloping Positive relationship

P Y P Y

SAS

Price level

Aggregate output

0Y1

P3

P2

P1

Y2Y3


Why is SAS curve sloping upward?

1. Sticky-price theory

2. Sticky-wage theory

3. Misperceptions theory

a. Misperceptions of firms

b. Misperceptions of workers


1. Sticky-price theory

In the short-run, price are not fully adjusted because there is cost of price changing insufficient information

Economic recession Demand of good Price level

Firms may not lower the price of goods

Cost of price adjustment

Therefore, firms will produce less.

(Below full-employment level)

Conclusion: P Y

SASPrice level

Aggregate output

0 Y1 = YF

P2

P1

Y2


2. Sticky-wage theory

In the short-run, wages are not fully flexible Long term contracts and pressure from labour unions Therefore, impossible for instant wage cut.


Decrease in price level means increase in real wage

Real wage Production cost

To lower the production cost Fire workers Reduce the output

Therefore, firms will produce less. (Below full-employment level)

Conclusion: P Y


3. Misperception theory

Misperception of change in price level:

Monetary price level vs. Relative price level


General price level = Money prices of all goods The truth is

all money prices change by the same proportion i.e. Relative prices remain unchanged if people realize no change in relative prices, then production decision

will be unchanged also. However, in reality, due to imperfect competition,

people make decision by studying money prices



a. Misperceptions of firms

Economic boom Demand of good Price level Firms notice that money prices rise Mistakenly believe it to be a rise in the relative prices Increase production Hire more workers (beyond full employment level)

Economic recession Demand of good Price level Firms notice that money prices fall Mistakenly believe it to be a reducton in the relative prices Decrease production Cut workers (below full employment level)

Conclusion: P Y or P Y



b. Misperceptions of workers

Economic boom Demand of good Price level Workers notice that money wages rise Mistakenly regard as a rise in real wages Supply more labour (beyond full employment level)

Economic recession Demand of good Price level Workers notice that money wages fall Mistakenly regard as a fall in real wages Supply less labour (below full employment level)

Conclusion: P Y or P Y

From SAS to LAS (graphical presentation)

Economic boom Price level In the short-run, misperceptions lead to

P [from P1 to P2] Y [from YF to Y2]

In the long-run, prices will fully adjust to clear the market, or misperceptions are corrected Y return to the potential output [from Y2 to YF]

Economic recession Price level

In the short-run,

P [from P1 to P3]

Y [from YF to Y3]

In the long-run,

Y return to the potential output

[from Y3 to YF]

SAS

Price level

Aggregate output0 YF

P3

P1

Y2

LAS

Y3

P2

Short-run AS vs. Long-run AS

In the short run Decision of production is misled by price level changes Upward sloping SAS curve

In the long run Misperceptions about the price level are corrected Production should not be affected by the price level Vertical LAS curve

Shift of the SAS curve

Factors leading to the change in the short-run aggregate supply:

1. Money prices of factors of production(assume the quantity of resources and technologyremain constant)

a. Cost of production MC Output at any price level SAS curve shifts leftward (from SAS1 to SAS2)

At P1, output decreases from YF to Y2

b. Cost of production MC Output at any price level SAS curve shifts rightward (from SAS1 to SAS3)

At P1, output increases from YF to Y3

Price level

Aggregate output0

SAS1

YF

LAS

Y2

SAS2

P1

Price level

Aggregate output0

SAS3

YF

LAS

Y3

SAS1

P1



2. Expected price level (in the future)(assume the actual price level remains unchanged)

a. Expected price level Labour side

Same wage earned at the moment means lower purchasing power in the future

Real wage Workers are less willing to work Labour supply SAS

Firm side Same return earned at the moment means

lower purchasing power in the future Real return Firm will produce less at current

price level Production SAS

SAS curve shifts leftward (from SAS1 to SAS2)

At P1, output decreases from YF to Y2

Price level

Aggregate output0

SAS1

YF

LAS

Y2

SAS2

P1



2. Expected price level (in the future)(assume the actual price level remains unchanged)

b. Expected price level Labour side

Same wage earned at the moment means higher purchasing power in the future

Real wage Worker is more willing to work Labour supply SAS

Firm side Same return earned at the moment means

higher purchasing power in the future Real return Firm will produce more at current

price level Production SAS

SAS curve shifts rightward (from SAS1 to SAS3)

At P1, output increases from YF to Y3

Price level

Aggregate output0

SAS3

YF

LAS

Y3

SAS1

P1



3. Long-run factor: Change in quantity of resources Productivity Population Technology

e.g. Unstable political conditions / Wars

Mass emigration Labour supply

SAS curve shifts leftward (from SAS1 to SAS2)

Potential output (YF) LAS curve shifts leftward (from LAS1 to LAS2)

Price level

Aggregate output0

SAS1

Y1Y2

SAS2

P1

LAS1LAS2

Short-run equilibrium

Short-run equilibrium price level and aggregate output Short-run equilibrium refers to

Quantity of output demanded = Quantity of output supplied Equilibrium where AD intersect SAS

At P1, AD = SASi.e. quantity of output demand equalsquantity of output supplied

P1 = the short-run equilibrium price level

Y1 = the short-run equilibrium aggregate output

At P2, AS > AD Firms will produce less and cut price Aggregate output and price level will achieve equilibrium

At P3, AS < AD Firms will produce more and raise price Aggregate output and price level will achieve equilibrium

Price level

Aggregate output

0AD

SAS

Y1

P1

P2

P3


Changes in short-run equilibrium

Increase in aggregate demand AD curve shifts rightward (from AD1 to AD2)

Price level (from P1 to P2)

Aggregate output (from Y1 to Y2)

Decrease in aggregate demand AD curve shifts leftward (from AD1 to AD3)



Price level

Aggregate output

0AD1

SAS

Y1

P1

AD2

Y2

P2

Price level

Aggregate output

0AD3

SAS

Y3

P3

AD1

Y1

P1


Changes in short-run equilibrium

Increase in short-run aggregate supply SAS curve shifts rightward (from SAS1 to SAS2)



Decrease in short-run aggregate supply SAS curve shifts leftward (from SAS1 to SAS3)



Price level

Aggregate output

0AD

SAS1

Y1

P1

SAS2

Y2

P2

Price level

Aggregate output

0

SAS3

SAS1

Y3

P3

AD

Y1

P1

Short-run and long-run economic adjustments

Assumption The economy is as full employment level Long-run AS is fixed. Constant (vertical) LAS curve

Basic concepts

1. Long-run equilibrium implies short-run equilibrium

2. Deviation from long-run equilibrium


Basic concepts

1. Long-run equilibrium implies short-run equilibrium Long-run equilibrium:

Quantity of output demanded = Quantity of output supplied = Potential output


Equil. price level = P1

Aggregate output = Y1 = YF

Price level

Aggregate output0

AD

SAS

Y1 = YF

P1

LAS


Basic concepts

2. Deviation from long-run equilibrium

The short-run equilibrium aggregate output is lower or higher than the potential output.

Short-run aggregate output deviates from long-run potential output


Basic concepts

2. Deviation form long-run equilibrium

a. Deflationary gap Short-run aggregate output (Y2) < Potential output (YF)

Amount of YF in excess of Y2 is called a deflationary gap Price level tends to fall later

Price level

Aggregate output0

AD

SAS

YF

P1

LAS

Y2

Deflationary gap


Basic concepts

2. Deviation form long-run equilibrium

b. Inflationary gap Short-run aggregate output (Y3) > Potential output (YF)

Amount of Y3 in excess of YF is called a inflationary gap Price level tends to rise later

Price level

Aggregate output0

AD

SAS

YF

P1

LAS

Y3

Inflationary gap


Fluctuations caused by changes in AD

(Suppose the economic starts at point A)

1. The effects of a fall in AD If people feel pessimistic, cut investment AD ( from AD1 to AD2)

In the short run economy will adjust to point B P (from P1 to P2)

Y (from YF to Y2) deflationary gap

**Remarks: Reasons for P Y Sticky-price theory Sticky-wage theory Misperceptions theory

Price level

Aggregate output0

AD2

SAS

YF

P2

LAS

Y2

AD1

P1 A

B




1. The effects of a fall in AD (con’t) In the long run, price level will be corrected.

expected price level will fall SAS (from SAS1 to SAS2)

The short-run equilibrium will shiftto point C P (from P2 to P3)

Y (from Y2 to YF)

Return to potential output The long-run equilibrium is attained Finally, YF remains unchanged, P

Price level

Aggregate output0

AD2

SAS1

YF

P2

LAS

Y2

AD1

P1 A

B

SAS2

CP3




2. The effects of a rise in AD If NX increases caused by overseas economic prosperity

AD ( from AD1 to AD2)


Y (from YF to Y2) inflationary gap

Price level

Aggregate output0

AD2

SAS

Y2

P1

LAS

YF

AD1

P2

A

B




2. The effects of a rise in AD (con’t) In the long run, price level will be corrected.

expected price level will rise SAS (from SAS1 to SAS2)

The short-run equilibrium will shiftto point C P (from P2 to P3)

Y (from Y2 to YF)

Return to potential output The long-run equilibrium is attained Finally, YF remains unchanged, P

Price level

Aggregate output0

AD2

SAS1

Y2

P1

LAS

YF

AD1

P2

A

B

SAS2

P3

C



Fill in the table below:

Short-run effects Long-run effects

Price level Aggregate output Price level Aggregate output

AD falls Remains constant

AD rises Remains constant



Conclusion:

Changes in AD In the short run

Change in price level AD P or AD P

Change in aggregate output AD Y or AD Y

In the long run Further change in price level only

AD P or AD P

No change in aggregate output


Fluctuations caused by changes in SAS


1. The effects of a fall in SAS If cost of production increases, e.g. higher wages SAS ( from SAS1 to SAS2)


Y (from YF to Y2) deflationary gap

**Remarks: Reasons for P Y Wealth effect Interest rate effect Exchange rate effect

Price level

Aggregate output0

SAS2

SAS1

YF

P2

LAS

Y2

AD

P1 A

B




1. The effects of a fall in SAS (con’t) Since Y2 < YF

factors are not fully employed surplus in factor market factor price SAS (from SAS2 to SAS1)

In the long run economy will adjust to point A P (from P2 to P1)

Y (from Y2 to YF)

Return to potential output The long-run equilibrium is attained Finally, YF and P remain unchanged

Price level

Aggregate output0

SAS2SAS1

YF

P2

LAS

Y2

AD

P1 A

B




2. The effects of a rise in SAS If the actual price level remains unchanged but the expected price level falls SAS ( from SAS1 to SAS2)


Y (from YF to Y2) inflationary gap

Price level

Aggregate output0

SAS2

SAS1

Y2

P1

LAS

YF

AD

P2

A

B




2. The effects of a rise in SAS (con’t) People correct their expected price level

factor price SAS (from SAS2 to SAS1)

In the long run economy will adjust to point A P (from P2 to P1)

Y (from Y2 to YF)

Return to potential output The long-run equilibrium is attained Finally, YF and P remain unchanged

Price level

Aggregate output0

SAS2

SAS1

Y2

P1

LAS

YF

AD

P2

A

B



Fill in the table below:

Short-run effects Long-run effects

Price levelAggregate

outputPrice level Aggregate output

SAS falls Remains constant Remains constant

SAS rises Remains constant Remains constant


Changes in LAS


1. The effects of a rise in LAS If the technology improves LAS ( from LAS1 to LAS2)

In the short run deflationary gap

Economic adjustments economy will adjust to point B SAS ( from SAS1 to SAS2)

P (from P1 to P2)

Y (from Y1 to Y2)

It’s beneficial to improve technology.

Price level

Aggregate output0

SAS2

SAS1

Y2

P1

LAS1

Y1

AD

P2

A

B

LAS2


Changes in LAS


2. The effects of a fall in LAS If there is mass emigration LAS ( from LAS1 to LAS2)

In the short run inflationary gap

Economic adjustments economy will adjust to point B SAS ( from SAS1 to SAS2)

P (from P1 to P2)

Y (from Y1 to Y2)

Price level

Aggregate output0

SAS2

SAS1

Y1

P2

LAS2

Y2

AD

P1 A

B

LAS1

Stagflation (滯漲 )It comes from two words: Stagnation: High unemployment rate Inflation: High inflation rate

Case: Sharp rise in oil prices in the 1970s

The effects of a fall in SAS SAS ( from SAS1 to SAS2) In the short run

economy will adjust to point B P (from P1 to P2)

Y (from YF to Y2)

If increase in oil prices is temporary, In the long run

Price will return to P1 Aggregate output will return to YF

However, the case was not as expected!!!

Stagflation (滯漲 )Case: Sharp rise in oil prices in the 1970s

The oil prices continued to increase Firms

avoid using too much oil change production method Lower productivity

In the long run LAS ( from LAS1 to LAS2)

Economy further adjusted to point C SAS ( from SAS2 to SAS3)

P (from P2 to P3)

Y (from Y2 to Y3)

As a result Price level increased (inflation) Aggregate output decreased (stagnation = far away from full employment)

Price level

Aggregate output0

SAS2

SAS1

Y1

P2

LAS2

Y2

AD

P1 A

B

LAS1

SAS3

P3

Y3

C

Case study (p.128)

Country A1. Short-run equilibrium

Point B

2. Possible reasons for short-run changes AD

Interest rates Exchange rates Profit tax rates

SAS Production costs Expected price level

3. Adjustment SAS (SAS curve shifts rightward)

4. Long-run equilibrium Point C

Price level

Aggregate output0

AD

SASLAS

A

B

C

Case study (p.128)

Country B1. Short-run equilibrium

Point R

2. Possible reasons for short-run changes AD

Interest rates Exchange rates Profit tax rates

SAS Production costs Expected price level

3. Adjustment SAS (SAS curve shifts leftward)

4. Long-run equilibrium Point Q

Price level

Aggregate output0

AD

SAS

LAS

Q

R

S

87

Short question, Q5 p.135

With the aid of a diagram, use the AS-AD model to explain why, in the long rum, aggregate output is solely determined by aggregate supply, and the price is determined by aggregate demand. (7 marks)

Answer

The long-run aggregate supply is the potential output, which is determined by resources and technology, independent of the price level. The long-run aggregate supply curve is vertical at the potential output. (3)

Suppose the long-run aggregate supply curveremains constant. A rise in aggregate demand will lead to a rise in the price level. A fall in aggregate demand will lead to a fall in the pricelevel, but aggregate output does not change. (2)

Correct diagram (2)

88

Structured question, Q3 p.136

Suppose there is a major breakthrough in the use of renewable energy. How does this affect the long-term economic growth and the price level? Explain with the AS-AD model. (5 marks)

Technological advances and more production resources push up potential output. The price level falls and real GDP rises. (3)

Diagram: a rightward shift of the long-run aggregate supply curve, a fall in the price level and a rise in real GDP. (2)

89


Suppose Country A was initially in long-run equilibrium. If large-scale enterprises of Country A expect the profits of the coming quarters to fall, answer the following questions with the AS-AD model, and explain the adjustment process with aid of a diagram.

a. In the short run, how do real GDP and the price level of Country A

change? (6 marks)

b. In the long run, how do real GDP and the price level of Country A

change? (6 marks)

90

Structured question, Q4 p.136a. In the short run, how do real GDP and the price level of Country A change? (6 marks)

The economy is initially at point A.

Short run: Aggregate demand falls to AD2. (1)

Due to sticky prices and sticky wages (or misperceptions about the price level), (1) both the price level and aggregate output move along SAS1 and fall toP2 andY2 respectively. (2)

Correct diagram (2)

91


b. In the long run, how do real GDP and the price level of Country A change? (6 marks)

Long run: Prices and wages fully adjust downward to clear the market (or the expected price level falls). (1)

The short-run aggregate supply curve shifts rightward to SAS2. (1)

The price level falls further to P3, (1) aggregate output returns to the potential output at YF. (1)

Correct diagram (2)

Revision Ex.10.3 Q.1 The economy is originally at point A. AD curve shifts rightward from AD1 to AD2.

In the short-run, equilibrium moves from point A to B. Price level rises from P1 to P2.

Aggregate output rises from YF to Y2.

There is an inflationary gap. In the long-run, prices are fully adjusted to clear the market.

Misperception of prices are corrected and the short-run aggregate supply decreases. SAS curve shifts leftward from SAS1 to SAS2. Equilibrium moves from point B to C.

Price level rises further from P2 to P3.

Aggregate output returns to the potential output from Y2 to YF.

Revision Ex.10.3 Q.2 The economy is originally at point A. AD curve shifts leftward from AD1 to AD2. In the short-run, equilibrium moves from point A to B. Price level falls from P1 to P2.

Aggregate output falls from YF to Y2. There is a deflationary gap. In the long-run, prices are fully adjusted to clear the market. Misperception

of prices are corrected and the short-run aggregate supply increases. SAS curve shifts rightward from SAS1 to SAS2. Equilibrium moves from point B to C.

Price level falls further from P2 to P3. Aggregate output returns to the potential

output from Y2 to YF.

Revision Ex.10.3 Q.3 The economy is originally at point A. SAS curve shifts rightward from SAS1 to SAS2. In the short-run, equilibrium moves from point A to B. Price level falls from P1 to P2.

Aggregate output rises from YF to Y2. There is an inflationary gap. In the long-run, prices are fully adjusted to clear the market. Misperception of

prices are corrected and the short-run aggregate supply decreases. SAS curve shifts leftward from SAS2 to SAS1. Equilibrium moves from point B back to A.

Price level rises from P2 to P1. Aggregate output returns to the potential


Revision Ex.10.3 Q.4 The economy is originally at point A. SAS curve shifts leftward from SAS1 to SAS2. In the short-run, equilibrium moves from point A to B. Price level rises from P1 to P2.

Aggregate output falls from YF to Y2. There is a deflationary gap. In the long-run, prices are fully adjusted to clear the market. Misperception of

prices are corrected and the short-run aggregate supply increases. SAS curve shifts rightward from SAS2 to SAS1. Equilibrium moves from point B back to A.

Price level falls form P2 to P1. Aggregate output returns to the potential


Revision Ex.10.3 Q.5 The economy is originally at point A. LAS curve shifts rightward from LAS1 to LAS2. In the short-run, equilibrium is at point A. There is a deflationary gap. In the long-run, prices are fully adjusted to clear the market. Misperception of

prices are corrected and the short-run aggregate supply increases. SAS curve shifts rightward from SAS1 to SAS2. Equilibrium moves from point A to B.

Price level falls from P1 to P2. Aggregate output rises to the potential

output from Y1 to Y2.

Revision Ex.10.3 Q.6 The economy is originally at point A. LAS curve shifts leftward from LAS1 to LAS2. In the short-run, equilibrium is at point A. There is a inflationary gap. In the long-run, prices are fully adjusted to clear the market. Misperception of

prices are corrected and the short-run aggregate supply decreases. SAS curve shifts leftward from SAS1 to SAS2. Equilibrium moves from point A to B.

Price level rises from P1 to P2. Aggregate output falls to the potential

output from Y1 to Y2.

Revision Ex.10.3 Q.7a

Revision Ex.10.3 Q.7a

Aggregate demand increases as the government expenditure increases.

AD curve shifts rightward from AD1 to AD2. In the short-run, due to misperceptions about the price level,

both the price level and aggregate output move along SAS1.

Price level rises from P1 to P2.

Aggregate output rises from Y1 to Y2. In the long-run, prices and wages fully adjust upward to clear

the market. The short-run aggregate supply curve shifts leftward from SAS1 to SAS2.

Price level rises further from P2 to P3.

Aggregate output returns to the potential output from Y2 to YF.

Revision Ex 10.4 Q.1Wealth effect: A lower price level implies greater purchasing power of

money, so private consumption rises, the quantity of output demanded rises. (2)

Interest rate effect: As the price level falls, real money supply rises, real

interest rate falls, both consumption and investments rise, leading to a larger quantity of output demanded. (2)

Exchange rate effect: As the price level falls, real exchange rate falls, net

exports rises, leading to a larger quantity of output demanded. (2)

Revision Ex 10.4 Q.2Possible reasons for an upward sloping short-run aggregate supply curve include:

Sticky-price theory: As the price level falls, some firms choose to cut production instead

of price, leading to lower quantity of output supplied. (2)

Sticky-wage theory: As the price level falls, wages are not fully flexible. Firms produce

less due to higher real wage costs, leading to a lower quantity of output supplied. (2)

Revision Ex 10.4 Q.2 (con’t)Possible reasons for an upward sloping short-run aggregate supply curve include:

The misperceptions theory: As the price level falls, firms mistakenly believe that the relative

prices of their goods are lower and thus produce less. Workers mistakenly believe they have lower real wage and supply less labour. These bring a lower quantity of output supplied. (2)

Reasons for a vertical long-run aggregate supply curve: In the long run, both prices and wages can fully adjust, and the

misperceptions about the price level are corrected. Aggregate output equals potential output. (2)

Revision Ex 10.4 Q.3The tax rebate will increase disposable income and private consumption. (1)

Aggregate demand increases. (1)

Aggregate output and the price level increase. (1)

Correct diagram:

The aggregate demand curve shifts to the right. (1)

Aggregate output and the price level increase. (1)

Revision Ex 10.4 Q.4The discovery of a new natural resource will increase potential output. (1)

Long-run aggregate supply will increase. (1)

Aggregate output will increase and the price level will decrease. (1)

Correct diagram:

The long-run aggregate supply curve shifts to the right. (1)

Aggregate output increases and the price level falls. (1)

Revision Ex 10.4 Q.5

An inflationary gap exists when the short-run equilibrium aggregate output is higher than the potential output. (1)

In the long-run, all prices are flexible and the price level is fully anticipated by the public. As a result, all markets are cleared and all resources are efficiently employed. Aggregate output equals potential output and there is no inflationary gap. (3)

Correct diagram (2) + (2)


a.

The economy is initially at point A. Short run: Aggregate demand falls to AD2. (1) Due to sticky prices and sticky wages (or misperceptions

about the price level), (1) both the price level and aggregate output move along

SAS1 and fall to P2 andY2 respectively. (2)


b.

Long run: Prices and wages fully adjust downward to

clear the market (or the expected price level falls). (1)

The short-run aggregate supply curve shifts rightward to SAS2. (1)

The price level falls further to P3, (1) aggregate output returns to the potential

output at YF. (1)

Documents

Economics Chapter 10 Aggregate Demand and Aggregate Supply