Aggregate supply
The model of aggregate supply and aggregate demand provides a framework for analyzing fluctuations of real GDP around potential GDP and changes in the price level. Aggregate supply is the relationship between the quantity of real GDP supplied (i.e., the quantities of final goods and services produced by all firms in the economy) and the price level, all other things being equal.
In considering how real GDP supplied and the price level are likely to be related, it is necessary to distinguish between the long run and the short run. In economics, the long run is normally a period of sufficient length such that everything is variable (cf., production, with labor and capital variable), while the short run is defined as a period when some things are variable while others are fixed (cf., production).
In our story here, there are two key sets of influences: output prices and input prices. In the long run, both sets of prices are variable, while in the short run input prices (i.e., prices of the factors of production, such as wages and raw materials prices) are assumed to be fixed while output prices are variable.
A dynamic economy is always being subjected to influences or shocks (such as the oil price increases of the 1970s, or introduction of technological change) that push real GDP away from potential GDP, where potential GDP reflects the aggregate quantity of labor available and also labor productivity. However, the system responds to these shocks (via adjustments made by economic actors) so as to take real GDP back toward potential GDP.
With this in mind, then, we can define the macroeconomic long run as a time frame of sufficient length to permit real GDP to reach potential GDP (i.e., to attain full employment). [Note that because shocks are always taking place, this long run may not actually be attained, but it's a useful analytical concept.]
The long-run aggregate supply (LAS) curve thus is the relationship between real GDP supplied and the price level when real GDP equals potential GDP. But since potential GDP at any point in time is fixed (we'll discuss changes over time in potential GDP shortly), this means that the LAS curve will be vertical -- i.e., the level of real GDP corresponding to potential GDP is independent of the price level.
This independence is a consequence of the fact that movements along the LAS curve are accompanied by changes in both output prices (the price level) and prices of the factors of production. More specifically, a higher output price level is matched by a correspondingly higher level of wages and other factor prices. This results in no change in relative prices nor in the real wage rate.
The macroeconomic short run, by contrast, is a period during which prices of the factors of production (as well as potential GDP) are fixed. During the short run, real GDP fluctuates around potential GDP (i.e., this is the normal state of the economy). The short-run aggregate supply (SAS) curve shows the relationship between the quantity of real GDP supplied and the output price level when factor prices (and potential GDP) are constant. The SAS curve has a positive slope because of the fact that increasing production and hence real GDP supplied entails increases in firms' costs, so higher output prices are required to draw forth greater supply of output.
Movements along the aggregate supply curves reflect changes in prices and the nature of those changes. If output prices change but input prices do not, we have a movement along the SAS curve. If both output and input prices change at the same rate, then we have a movement along the LAS curve.
Shifts of the aggregate supply curves also occur. The LAS curve shifts when potential GDP changes. Increases in potential GDP occur in response to two factors: growth of labor input (aggregate labor hours), and growth of labor productivity (as a consequence of increases in the stock of physical K and/or human K, and of improvements in technology).
Short-run shifts in aggregate supply occur in response to changes in the long-run factors just discussed. That is, changes in those factors that increase potential GDP also will increase real GDP supplied at each price level (i.e., shift out the SAS curve).
In addition, money wages and other input prices influence the SAS curve. Increases in the costs of factors of production shift the SAS curve to the left, in the same way that they decrease supply for individual firms. This reflects the fact that the higher are the costs of production, the lower the quantity of output that firms will be willing to supply at each price level.
[Note that factor prices do not influence the LAS curve because along the LAS curve when factor prices change the output price level changes by the same percentage (and hence real GDP remains constant at potential GDP).]
Aggregate demand
Aggregate demand is the relationship between the quantity of real GDP demanded (i.e., the quantities of final goods and services demanded by households for consumption, by firms for investment, by government, and net exports demanded by foreigners) and the price level, all other things being equal. The aggregate demand (AD) curve slopes downward, indicating that at higher output prices the quantity of real GDP demanded will decline.
This downward slope reflects three influencing factors: the real money balances effect, the intertemporal substitution effect, and the international substitution effect. These will be discussed later this week in the recitations. Each of these three factors contributes to the downward slope of the aggregate demand curve. Changes in the price level lead to corresponding changes in the opposite direction in the quantity of real GDP demanded -- i.e., a movement along the AD curve.
Four main factors influence the position of the aggregate demand curve (bring about shifts in the curve): expectations, international factors, fiscal policy, and monetary policy.
Expectations about the economic future are important because they influence people's consumption decisions as well as the decisions about investment by firms. Higher expected future incomes increase current consumption (and hence aggregate demand) -- cf., consumer confidence surveys. Higher expected inflation means that future prices are expected to be higher, and this stimulates current consumption. Higher expected inflation also reduces the incentive to hold money and other financial assets, and contributes in this way to higher current consumption. Finally, expected future profits influence business investment decisions: higher expected profits in the future stimulate current investment and hence aggregate demand.
International factors that influence the aggregate demand curve include the foreign exchange rate and foreign income. The foreign exchange rate is the amount of a foreign currency that a dollar can buy. A stronger dollar (higher foreign exchange rate against other currencies) makes imports to the U.S. cheaper and exports to foreign countries more expensive; hence, a stronger dollar will reduce net exports. Since aggregate demand includes net exports, it should be clear that a higher foreign exchange rate for the dollar will reduce aggregate demand, cet. par.
Foreign income growth will increase the demand for U.S. exports, and hence contribute to increased aggregate demand, cet. par.
Fiscal policy refers to government efforts to influence the economy by varying its purchases of goods and services, taxes and transfer payments, and its deficit and debt. Increased government purchases of goods and services during wartime constitute an important influence on aggregate demand, and the WPA during the Great Depression also served to stimulate demand. Much fiscal policy operates through changes in taxes and transfer payments. Reduced taxes and increased transfer payments both stimulate aggregate demand, because they both increase disposable income.
Monetary policy is the purview of the Federal Reserve Board (the Fed), and refers to efforts by the Fed to influence the money supply and interest rates. The money supply is determined by the Fed and banks (we'll look at this directly in chs. 13 and 14). Increases in the money supply tend to increase the level of aggregate demand directly. In addition, there is an indirect effect operating through interest rates: an increased money supply makes more funds available for investment, and hence tends to lower interest rates and stimulate greater quantity of investment demanded. Likewise, direct action by the Fed on interest rates results in changes in aggregate demand opposite to the change in the interest rate.