Business Economics ( ECO 341) Fall: 2012 Semester
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Transcript of Business Economics ( ECO 341) Fall: 2012 Semester
Business Economics (ECO 341)Fall: 2012 Semester
Khurrum S. Mughal
1
Aggregate Demand and Supply
3
PriceLevel
RealGDP
Aggregate Demand Curve
Aggregate Supply Curve
The Two-Way Relationship Between Output and the Price Level
4
There exist a two-way relationship between price level and output
Changes in price level cause changes in
real GDP – illustrated by Aggregate Demand curve
Changes in real GDP cause changes in price level – illustrated by Aggregate Supply curve
AD and AS
Aggregate Demand
Define aggregate demand as the total demand for an economy’s output (production of goods and services) over a given period of time.
Demand may come from households (consumption), firms (investment), the public sector (government spending) or foreign households, firms, or governments (net exports).◦ YAD = C + I + G + NX
We assume an inverse relationship between price and aggregate demand
Aggregate Demand
Suppose aggregate prices in the economy fell
This would cause the demand for money to decrease, causing interest rates to decline◦ Alternatively, the real money supply (M/P) rises, causing
interest rates to fall.
With lower interest rates, the opportunity cost of consumption is lower: ◦ P↓ Md↓ i↓ C↑
With lower interest rates, the direct cost of investment falls: ◦ P↓ Md↓ i↓ I↑
With lower interest rates a country’s currency will depreciate. A weaker currency makes exports cheaper and imports more expensive◦ P↓ Md↓ i↓ Exchange Rate↓ NX↑
Aggregate Demand Rises as Price Falls
P
Y
AD
2
1
100 180
The Aggregate Demand Curve
9
A variety of events can cause the price level to change, and move us along the AD curve
◦It’s important to understand what happens in the economy as we make such a move
Movements Along The AD Curve
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Movements Along The AD Curve
Opposite sequence of events will occur if the price level falls, moving us rightward along the AD curve
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(a)
Real GDP
Price Level
P3
Q3 Q1 Q2
AD
P1
P2
Price level ↑ moves us leftward along the AD curve
Price level ↓ moves us rightward along the AD curve
Effects of Key Changes on the Aggregate Demand Curve
Anything (other than price!) that causes C, I, G, or NX to increase will shift the AD curve to the right.
C increases when…◦ There is an increase in consumer confidence, leading to
more current consumption and less current savings◦ Taxes are cut leaving consumers with more income to
spend
I increases when…◦ Business confidence rises, prompting firms to invest more
for the future.
Factors that Shift the AD Curve
G increases when…◦ Government spending increases
NX increases when…◦ There is increased preference for domestically produced
goods.
An increase in the money supply will cause AD to shift right◦ Interest rates are lower, so C and I rise. The currency
weakens, so NX increases.
Factors that Shift the AD Curve
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Entire AD curve shifts rightward if:• a, IP, G, or NX increases• Net taxes decrease• The money supply increases
AD2
AD1
(b)
Real GDP
Price Level
Effects of Key Changes on the Aggregate Demand Curve
Aggregate Supply
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Price Level
Real GDP ($ Trillions)
130
100
80C
AS
13.5106
A
B
Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises.
Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price level falls.
Short Run Aggregate Supply Curve
17
Figure in last slide assumed that a number of important variables remained unchanged◦ Unit costs sometimes change for reasons other than a
change in output
In general, we distinguish between a movement along AS curve, and a shift of curve itself, as follows◦ When a change in real GDP causes the price level to change,
we move along AS curve When anything other than a change in real GDP causes price level
to change, AS curve itself shifts
What can cause unit costs to change at any given level of output?◦ Changes in world oil prices◦ Changes in the weather◦ Technological change◦ Nominal wage, etc.
Shifts of the AS Curve
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When a change in output causes price level to change, we move along economy’s AS curve
◦ What happens in economy as we make such a move?◦ As we move upward along AS curve, we can represent
what happens as follows
Movements Along the AS Curve
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(a)
Real GDP
Price Level
P3
Q2 Q1 Q3
P1
P2
ASReal GDP ↑ moves us rightward along the AS curve
Real GDP ↓ moves us leftward along the AS curve
Movements Along the AS Curve
Tightness in the labor market.◦ Suppose that because of a big economic expansion, the economy is
producing at an output level Y that is greater than YP. ◦ This suggests that the economy is using more labor than it normally does.◦ To get people to work longer hours, you have to pay them more.◦ This increase in labor costs will shift the SRAS curve left, as profit per output
falls when labor costs rise.
Expectations about inflation◦ If workers expect inflation to be higher in the future, they will demand higher
wages in anticipation of this increase in the cost of living.◦ Higher wages reduce firm profit and shift SRAS left
Supply shocks to critical raw materials◦ Suppose a war broke out between the US and Iran. Oil prices would rise
dramatically◦ Since oil is such a pervasive part of nearly everything we produce,
production costs would rise significantly.◦ The SRAS curve would shift left as the return on production fell.
Short Run Aggregate Supply Curve
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Real GDP
Price Level(b)
AS1
AS2
Entire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP
Shifts of the AS Curve
P
Y
P*
SRAS
Y*
AD
PH
PL
Surplus
Shortage
Short Run Equilibrium
In the long run, money is neutral◦ Any changes in the money supply will be met by a
proportionate change in prices◦ Increasing the money supply will not affect the economy’s
output in the long run.
Long run output is determined entirely by an economy’s productive capacity◦ Production Function: YP = A*F(K,L,H,N)
Only changes in real variables can affect potential output.◦ Price does not have any effect on YP
In the long run, all resources are being efficiently utilized such that unemployment equals the natural rate
Long Run Aggregate Supply
P
Y
2
1
LRAS
YP = 140
Long Run Aggregate Supply