Dr.

Mohammed Alwosabi

Econ 141 - Ch.3

Notes on Chapter 3 AGGREGATE DEMAND AND AGGREGATE SUPPLY

The AD-AS model determines RGDP and GDP Deflator and helps us understand the performance of three macroeconomic fundamentals: 1. Growth of potential GDP 2. Inflation 3. Business cycle fluctuations (expansion and recession)

AGGREGATE DEMAND (AD) AD is the total amount of goods and services produced in a country (i.e., the quantity of RGDP demanded) that people, businesses, government, and foreigners are willing and able to buy at different price levels within a given period. AD = RGDP = Y = C + I + G + NX
P

Aggregate Demand (AD) Curve The aggregate demand curve (AD) shows the inverse relationship between RGDP demanded and the price level (using either the GDP Deflator or CPI) when all other things remain the same.
0 RGDP Y1 Y0 P0 AD P1

AD curve has negative slope (slopes downward) because of two effects:

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

Wealth Effect: o Real wealth is measured as the amount of goods and services wealth will buy. o When price level increases but other things remain the same, real wealth decreases. To restore their wealth, people increase saving and decrease current consumption ⇒ RGDP demanded decreases o Conversely, if the price level of goods and services fall but the value of your assets do not, you feel wealthier and may start consuming more ⇒ RGDP demanded increases o Example: Suppose an individual holds BD50,000 in saving account. If the price level in Bahrain rises by 6%, then the individual’s real wealth decreases is worth less in terms of what it can purchase. As a result, consumption expenditure decreases and saving increases to restore the original wealth.

Substitution Effect: 1. Inter-temporal substitution effect (interest rate effect): o The substitution effect involves substituting goods in the future for goods in the present or goods in the present for goods in the future. This is called inter-temporal substitution effect (a substitution across time). o This effect is mainly a result of changes in the real interest rate, which affect the decisions of households and businesses in terms of their willingness and ability to borrow.

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

o As the price level falls, causing demand for money to decrease and interest rate to decrease, consumers may decide that it is not worth it to save since they do not receive as much return. On the other hand, they may decide that since it is now cheaper to borrow, they will increase their borrowing to finance their consumption and investment, which would increase RGDP demanded. The net effect of the decline of the interest rate is increasing present consumption and decreasing saving o Alternatively, when price level increases and other things remain the same, demand for money increases ⇒ interest rate increases ⇒ spending on consumption and investment decreases ⇒ RGDP demanded decreases. Saving increases to increase future consumption 2. International substitution effect: o When the domestic price level rises, and other things remain the same, domestically made goods and services become more expensive relative to foreign made goods and services. This change in relative prices encourage people to spend less in the domestically made goods and more on foreign made products (export decreases and import increases ⇒net export decreases) o Conversely, when the domestic price level falls, and other things remain the same, domestically made goods and services become less expensive relative to foreign made goods and services. This change in relative prices encourage people to spend more in the domestically made goods and less on foreign made products (export increases and import decreases)

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

Changes in RGDP demanded (Movement along AD Curve) The change in the quantity of RGDP demanded as a result of changes in price level is represented by movement along AD curve. When price level increases, other things remain the same, ⇒ RGDP demanded decreases ⇒ an upward movement along AD curve When price level decreases, other things remain the same, ⇒ RGDP demanded increases ⇒ a downward movement along AD curve

Changes in AD (Shift of AD Curve) AD change if one or more of factors, other than price level, change. When AD change AD curve shifts rightward or leftward The shifts in AD means an increase (or a decrease) in the quantity of RGDP demanded at every price level The main factors that influence AD are: 1. Expectations 2. Fiscal and monetary policies 3. The world economy
AD2 0 Y2 Y0 Y1 P AD1 AD0 RGDP P

Expectations

An increase in the expected future income increases the amount of consumption goods that people plan to buy today ⇒ AD increases ⇒ AD curve shifts rightward An increase in the expected future inflation rate in the future increases the present AD because people have an incentive to buy more goods and services now, before prices go up ⇒ AD curve shifts

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

rightward. Expectation of falling prices (deflation) in the future will reduce present AD. An increase in the expected future profit increases the investment that firms plan to undertake today and AD increases ⇒ AD curve shifts rightward

Fiscal and Monetary Policies Fiscal Policy: o Fiscal policy exists when government tries to influence the economy by changing taxes, making transfer payments and changing its purchases of goods and services o If tax decreases ⇒ disposable income increases ⇒ C increases ⇒ AD increases ⇒ AD curve shifts rightward o If transfer payments increase ⇒ disposable income increases ⇒ C increases ⇒ AD increases ⇒ AD curve shifts rightward (Disposable income = Aggregate income – taxes + transfer payments) o Government purchase of goods and services is a component of AD. Thus, if government purchase increases ⇒ AD increases ⇒ AD curve shifts rightward Monetary Policy: o Monetary policy consists of changes in the interest rates and in the quantity of money in the economy. The monetary policy is conducted by the Central Bank. o A lower interest rate ⇒ C and I increases ⇒ AD increases ⇒ AD shifts rightward

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

o An increase in the quantity of money ⇒ C and I increases ⇒ AD increases ⇒ AD shifts rightward

The World Economy: The world economy affects AD through foreign exchange rate and foreign income. Foreign exchange rate o To buy Bahraini products, foreigners first have to buy Bahraini dinar. To buy foreign products, Bahrainis first have to buy foreign currency. o The value of the dinar relative to other currencies will influence Bahrain's exports (sales) to other countries and Bahrain's imports (purchases) from other countries. o Foreign exchange rate is the amount of foreign currency that you can buy with the domestic currency. o Foreign exchange rate increases ⇒ domestic goods become more expensive ⇒ export decreases ⇒ AD decreases ⇒ AD shifts leftward. How? If the dinar is very strong, Bahrainis can buy more of foreign currencies, so, foreign products seem cheap ⇒ Bahrain's imports go up. At the same time, foreigners find Bahraini goods seem expensive ⇒ Bahrain exports go down. If Exports go down and imports go up, net exports go down, and AD decreases. o If the dinar depreciates and foreign currencies appreciate, Bahraini goods are cheap to foreigners and foreign products are

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

expensive to Bahrainis ⇒ Exports go up and imports go down ⇒ net exports go up ⇒ AD increases o Example: The current exchange rate between Bahraini Dinar and Saudi Rial is about BD1 = SR10. If the exchange rate increases to become BD1 = SR15 we can see now that Saudis cannot buy the same quantity of the Bahraini goods and services as before since they cost more. A one-dinar Bahraini good that used to cost the Saudis YR10 is costing them now YR15. Bahrainis, on the other hand, would find Saudi products less expensive than before. A 10-rial Saudi product used to cost the Bahrainis one dinar but now is costing them only 750 Fils The opposite would be true if the exchange rate decreases to become BD1 = SR5 Foreign income o Foreign income increases ⇒ foreigners can buy more of domestic products ⇒ export increases ⇒ AD increases ⇒ AD shifts rightward

In conclusion, in the SR, an increase in AD increases the price level and increases RGDP; and a decrease in AD decreases the price level and decreases PGDP.

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

AGGREGATE SUPPLY (AS) Aggregate Supply (AS) shows the total supply of all goods and services (RGDP) produced in the economy at a given time. AS curve depicts the quantity of RGDP supplied at different price level. The RGDP supplied at full employment (FE) is called the potential GDP (PGDP). The quantity of RGDP produced depends on 1. The quantity of labor (L) 2. The quantity of capital (K) 3. The state of technology (T) The aggregate production function is written as the equation: RGDP = Y = F (L, K, T). In words, the RGDP supplied depends on (is a function of) the quantity of labor employed, the quantity of capital, and the state of technology. The larger is L, K, or T, the greater is Y. A country can supply more RGDP if technology improves and/or has more factors of production. At any given time, the quantity of capital and the state of technology are fixed but the quantity of labor is not fixed (can vary). So, over the business cycle, employment fluctuates around FE and RGDP fluctuates around PGDP. Labor market can be: 1) at full employment (FE), 2) above FE, or 3) below FE. To study AS in different states of the labor market we distinguish between short run aggregate supply (SAS) and long run aggregate supply (LAS)

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

The macroeconomic short run is a period during which RGDP has fallen below or risen above PGDP. Equivalently, the unemployment rate has fallen below or risen above the natural unemployment rate. The macroeconomic long run is a time frame that is sufficiently long for all adjustments to be made so that RGDP = PGDP and UR = NRU. That is, when the economy is at full employment.

Short Run Aggregate Supply (SAS) Curve The SAS curve is the relationship between the RGDP supplied and the price level (P) in the SR when the money wage rate, the prices of other resources, and the PGDP remain constant. The costs of production will be fixed in the short run because the firm previously entered
0 Po

P SAS P1

Y0

Y1

RGDP

into long-term contracts. Firm has fixed its interest rates on loans from banks for the next year, labor costs are pre-determined for years at a time, lease agreements for real estate and equipment are generally agreed upon for years, firm has negotiated contracts with its suppliers for parts, raw materials, etc. Those costs of production were set and pre-determined for a year or more A typical SAS curve is positively sloped (upward sloping) because a rise in the price level provides profit incentive for the firms. As price level increases from P0 to P1, revenues increase but costs of production do not increase as much because money wage rate and the prices of other resources remain constant. Therefore, profits increase. The increase in profits encourages the existing firms to

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

produce more and encourages new firms to enter the business. Thus, the quantity of RGDP supplied increases. A fall in the price level with no change in costs induces firms to decrease production to lower marginal cost. Along SAS curve, when P increases real wage rate decreases Along the SAS curve, real GDP might be above potential GDP or below potential GDP.
P LAS

Long Run Aggregate Supply (LAS) Curve LAS curve shows the relationship between RGDP supplied and the price level (P) in the LR when RGDP = PGDP and the economy is at full employment. Potential GDP is independent of the price
P1 Po 0

Yp

RGDP

level. The country always produces the PGDP in the LR (has FE in the LR) regardless of the price level. Thus, the long-run, AS curve is vertical at the level of PGDP. In LR, RGDP is determined by the amount of L, K and T not by price level.

Combining SAS and LAS At P*, RGDP = PGDP, UR= NRU (the economy is at FE) If P >P* (at P1) ⇒ RGDP > PGDP, (At P1 the economy is producing Y1 >Yp) UR < NRU (the economy is above FE) If P < P* (at P2) ⇒ RGDP < PGDP,
0

P P1 P* P2

LAS SAS

Y2

Yp

Y1

RGDP

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

(At P2 the economy is producing Y2 <Yp) AND UR > NRU (the economy is below FE) Thus, RGDP may be more or less than PGDP

Change in RGDP Supplied (Movements along SAS and LAS curves) Along SAS, the quantity of RGDP supplied increases as the price level increases because total revenue increases more than the increase in the cost of production and as a result profit increases. And this is a movement along SAS. When price level increases, and at the same time nominal wage rate and other resource prices increase by the same proportion, relative prices remain constant and RGDP remains at PGDP. There is a movement along the LAS curve. Conclusion: a change in the price level brings a movement along the AS curves (both SAS and LAS) but does not change the aggregate supply (no shift in AS curve).
0 Yp RGDP LAS SAS P

Changes in AS (Shifts in SAS and LAS) What if AD stays the same and there is change in AS? We have to determine if the change is permanent or temporary. If the change is permanent, the LAS and the SAS both change. If the change is temporary, only the SAS shifts. LAS does not shift in response to temporary changes in AD.

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

AS changes when factors other than price level change. This includes (1) changes in potential GDP and (2) changes in money wage rate and other resource prices.

(1) Change in potential GDP: The factors that change LAS are the same factors that shift the PPF When potential GDP changes, both LAS and SAS change and both LAS and SAS curves shift. Why? Since RGDP fluctuates around PGDP, SAS fluctuates around LAS Potential GDP changes as a result of three reasons 1. Change in full employment (FE) level of labor 2. Change in capital 3. Change in technology When one or some of these factors change, potential GDP changes when potential GDP change, both LAS and SAS change. Change in full employment level of labor PGDP increases because of the increase in labor. But (with fixed K&T) PGDP increases only if FE quantity of labor increases. Fluctuations in employment over the business cycle bring fluctuations in RGDP around PGDP. They are not change in PGDP or LAS. Change in capital: The larger the capital, the more productive is the labor force and the greater is the PGDP. Capital includes human capital - skills, knowledge, and experience. The larger is the human capital the larger is the PGDP
0
Y0

P

LAS0

LAS1

SAS0 SAS1

P0

Y1

RGDP

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

Change in technology: Even with fixed quantities of labor and capital, if the country experiences technological progress or improvement, the country’s PGDP increases and the both LAS and SAS shift to the right. The increase in PGDP is called economic growth. Economic growth is represented by the increase in the PGDP and the shift of LAS and AS curve rightward.

Change in money (nominal) wage rate and/or other resource prices: When money wage rate or the money prices of other resources change, SAS changes but LAS does not change. o A decrease in money wage rate increases SAS from SAS0 to SAS1. The money wage rate (and other resource prices) affect SAS because they influence firms' costs. But they do not change LAS curve. o The higher the money wage rate (or money prices of other resources), the higher are the firms’ costs and the smaller is the quantity that firms are willing to supply at each price level. So an increase in the money wage rate decreases aggregate supply and shifts the AS curve leftward (from SAS0 to SAS2) In LR, The change in money wage rate (and other resource prices) is accompanied by an equal percentage change in the price level. With no change in relative prices, firms have no incentive to change production and GDP remains constant at PGDP.
0 YP P0 P1 P2 C
A

SAS2 P LAS SAS0 SAS1

B

RGDP

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

MACROECONOMIC EQUILIBRIUM The equilibrium level of P and RGDP in the economy will be where the desired total level of expenditures in the goods markets exactly matches the desired total level of output to be sold. The equilibrium price level and equilibrium RGDP in the economy exists where the quantity of RGDP demanded = the quantity of RGDP supplied (when AD curve intersects AS curve). However, there is macroeconomic equilibrium for each time frame (SR and LR). SR equilibrium is the normal state of the economy as it fluctuates around PGDP; and the UR fluctuates around the NRU LR equilibrium is the state forward, which the economy is heading. AD-AS model studies the relationship between the price level and unemployment.
P SAS

SR Macroeconomic Equilibrium SR equilibrium occurs when the quantity of RGDP demanded equal the quantity of RGDP supplied at the intersection of AD curve and SAS curve In SR, we assume that money wage and price of other factors are fixed. If P >P*, RGDP supplied > RGDP demanded surplus Firms will not be able to sell all their output firms
Y0 AD RGDP P*

decrease production and lower prices If P < P*, RGDP demanded > RGDP supplied shortage

Inventories are unexpectedly less than the quantity of RGDP Demanded firms increase production and raise prices.

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

These changes bring a movement along the SAS curve toward equilibrium. In short-run equilibrium, real GDP can be greater than or less than potential GDP because in the SR money wage is fixed. In macroeconomic SR equilibrium, there exists frictional and structural unemployment and the economy might not be at the natural rate of unemployment

LR Macroeconomic Equilibrium LR equilibrium occurs when RGDP = PGDP at the intersection of AD curve and LAS curve (when the economy is at full employment). In the LR, AD determines price level and has P* no impact on RGDP. The money wage rate adjusts in the LR SAS curve intersects the LAS curve at the equilibrium price level and LR equilibrium point.
Yp AD RGDP P LAS SAS

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

Economic Growth and Inflation Economic growth is the persistent increase in PGDP. It occurs because the quantity of labor at FE grows, capital accumulated and/or technology advances increases PGDP

P LAS0 P1 P0 AD1 AD0 Yp0 Yp1 RGDP LAS
1

LAS curve shifts rightward.

The growth rate of PGDP is determined by the

pace at which labor, capital, and technology change. (Economic Growth = Yp1 – Yp0) Inflation is the persistent rise in the price level. Inflation occurs because the quantity of money grows faster than potential GDP, which increases AD by more than LAS. AD curve shifts rightward by

more than the rightward shift in the LAS curve. (Inflation = P1 – P0) Deflation occurs if AD curve shifts is less than the shift in the LAS curve If the increase in AD is the same as the increase of LAS, PGDP will grow with no inflation (price level is constant). In LR, the main influence on AD is the growth rate of the quantity of money (Qm). Quantity of money increases AD increases inflation

rate increases. When the growth rate of quantity of money slows, the inflation rate decreases.

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

The Equilibrium and Business Cycle The business cycle occurs because AD and SAS fluctuate but the money wage rate does not adjust quickly enough to keep RGDP at PGDP. To simplify our analysis of the business cycle, we ignore economic growth
SAS recessionary gap LAS

(a) Recessionary gap o Below FE equilibrium is a macroeconomic SR equilibrium where AD curve intersects SAS curve at RGDP of Y1 (less than Yp) and price level P1. o The amount by which RGDP < PGDP is called a recessionary gap.

P1

AD Y1 Yp

o In the LR, money wage rate decreases ⇒ SAS shifts rightward ⇒ unemployment decreases and price level decreases.

(b) Inflationary gap o An above FE equilibrium is a macroeconomic
LAS

Inflationary gap SAS

equilibrium in which RGDP > PGDP. o It occurs when AD intersects SAS at RGDP = Y2 (more than Yp) and P = P2. o The amount by which real GDP exceeds potential GDP is called an inflationary gap, o In the LR money wage rate increases ⇒ SAS
Yp Y2 P2

AD

shift leftward ⇒price level increases and above full employment goes back to full employment.

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

(c) Full Employment Equilibrium o A long-run equilibrium is an equilibrium in which PGDP = RGDP, where AD curve intersects SAS curve on a point at LAS. The economy is at FE. o RGDP=PGDP
Yp AD P* LAS

SAS

Business Cycle o The economy moves from one type of SR equilibrium to another as a result of fluctuations in AD and SAS. o These fluctuations produce fluctuations of RGDP around PGDP and unemployment rate around the natural rate of unemployment. o So, business cycle occurs because AD and SAS change at different rates.
recessionary gap RGDP=PGDP Inflationary gap

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

FLUCTUATIONS IN AD (AD shifts rightward) One reason that RGDP fluctuates around PGDP is the fluctuations in AD. AD fluctuate for any changes in consumption, investment, government purchase, exports and imports, and quantity of money.

P LAS P2 P1 P0 A AD0 Yp Y1 AD1 RGDP C B SAS1 SAS0

Initially, the economy is at LR equilibrium (FE equilibrium at point A), where the intersection of LAS, AD0 and SAS0. At this point, RGDP = PGDP and P = P0. Suppose some of C, I, NX increases or government may increase G or Qm ⇒ AD increases ⇒ AD curve shifts rightward to AD1 (firms expect higher future profits) Short- run effect: Faced with the increase in AD, firms increase production and raise the price. RGDP increases from Yp to Y1 and price increases from P0 to P1 (at B) The economy is now in an above-employment equilibrium (negative cyclical unemployment) where RGDP > PGDP and P1 > P0 ⇒ inflationary gap. At this stage, price level increases but wage rates have not change (as we move along SAS, money wage rate is constant) Long-run effect: The economy cannot produce in excess of PGDP forever. At point B, firms have higher profits but workers now have lower real wage because price level increased from P0 to P1 but money wage

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

remains the same as in point A. Thus, inflationary gap exists and the purchasing power of workers wages falls. Workers (and owners of other factors of production) demand higher wages and prices for their services and firms meet their demand in order to keep the higher level of production and profits (if firms do not raise the money wage rate they will either lose workers or have to hire less productive ones). As money wage and other resource prices increase (higher cost of production) SAS begins to shift leftward until it reaches SAS1 where it intersects with AD1 and LAS at point C. RGDP comes back to FE equilibrium (PGDP =Yp) and price level increases to P2 causing higher inflation In the LR, the increase in nominal (money) wage rate will decrease inflationary gap and reach FE with higher price level In LR, money wage rate increases by the same percentage as the increase in price level Firms' owners use this illustration to argue with labor unions that any increase in wages would result in higher price level, which, at the end, increases the cost of living for workers and for the entire population.

Firms expect a loss in the future (AD shifts leftward) A decrease in AD has similar but opposite effects to those of an increase in AD Initially, the economy is at LR equilibrium where the intersection of LAS, AD and SAS. At this point, RGDP = PGDP. Suppose some of AD components such as C, I, NX decreases or government may decreases G or Qm ⇒ AD decreases ⇒ AD curve
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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

shifts leftward ⇒ RGDP

⇒ recessionary gap ⇒ P

but money

wage remains constant along the same SAS ⇒ purchasing power of real wages increase and firms cost increased (relative to the output prices) ⇒ firms start decreasing wages and the prices of other factors of production ⇒ SAS start to shift rightward until RGDP = PGDP at lower price level

FLUCTUATIONS IN SAS When nominal wage and prices of other factors of production increase (cost of production increases)
P

Initially at point A, LR FE equilibrium, where RGDP = PGDP If nominal wages or prices of other factors of production increase ⇒ production cost increases ⇒ firms reduce production ⇒ SAS ⇒
Y1 B P1 P0

LAS SAS1 SAS0

A

AD RGDP Yp

SAS curve shifts leftward to SAS1⇒

(1) price level increases to P1 ⇒ the economy experiences inflation (2) RGDP decreases to Y1 (RGDP < PGDP) ⇒ the economy experiences recession A combination of recession (stagnation) and inflation is called stagflation Government should intervene to correct the situation In the LR, money wage decreases ⇒ SAS shifts rightward until FE equilibrium where RGDP = PGDP at lower price level.

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

When nominal wage and prices of other factors of production decrease (cost of production decreases)
P

The economy was initially at point A where RGDP = PGDP When prices of factors of production fall, cost of production falls ⇒ SAS increases ⇒ SAS curve shifts rightward to SAS2
Yp Y2 AD RGDP P0 P2 A C LAS SAS0 SAS2

New short run equilibrium is at point C. RGDP increases to Y2 (employment increases to more than FE equilibrium) and price level toP2 ⇒ deflation Low prices discourage firms from increasing their production ⇒ RGDP ⇒ SAS until it goes back to LR equilibrium at some higher price.

FLUCTUATIONS IN BOTH AD AND AS Profit is expected to increase and cost of production is expected to decrease Initially the economy was at point A. If resource cost expected to decrease, AS curve shifts rightward and firms profit expected to increase AD curve shifts
P1 E A AD1 P LAS SAS0 SAS1

rightward 1. If the shift in ADC > the shift in SASC ⇒ RGDP ⇒ RGDP and P
AD0 Yp P0

2. If the shift in ADC < the shift in SASC but P

Y1

RGDP

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

3. If the shift in both curves is with the same pace, RGDP remains the same. Conclusion: When both curves shift rightward, RGDP remains the same (P is undetermined). Exercise: Starting from LR equilibrium, show graphically that

but P

but P , , or

a. When businesses expect loss in the future (C, I, G, NX, or Qm decreases) and at the same time nominal wage increases, RGDP definitely decreases but P may increase, decrease or stay the same b. When businesses expect higher profit in the future (C, I, G, NX, or Qm increases) and at the same time nominal wage increases, P definitely increases but RGDP may increase, decrease or stay the same c. When businesses expect loss in the future (C, I, G, NX, or Qm decreases) and at the same time nominal wage decreases, P definitely decreases but RGDP may increase, decrease or stay the same Exercise: Use graphical illustration to show that P increases if (a) ADC shifts right, (b) SASC shifts left, or (c) ADC shifts right and SASC shifts left

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

EFFECTS OF GOVERNMENT'S ECONOMIC POLICIES Government uses the tools of fiscal and monetary policies to achieve three main objectives: 1. Economic Growth (higher growth of the economy) 2. Price stability (low inflation) 3. Full employment (high employment)

Fiscal Policy Expansionary G, T, or both

Monetary Policy Qm, i, or both

AD Shift rightward

Contractionary

G, T, or both

Qm, i, or both

leftward

Eliminating (Cyclical) Unemployment Suppose the country experiences less than FE equilibrium (recessionary gap or positive cyclical unemployment) at the initial equilibrium at point B

P LAS SAS

P1 B P0

A

Government can eliminate this cyclical unemployment or recessionary gap
AD0 AD1 RGDP Y0 Yp

(which is equal to Y0 – Yp) by using expansionary fiscal policy, expansionary

monetary policy or both ⇒ AD increases ⇒ AD curve begins to shift rightward all the way to AD1 ⇒ the new equilibrium is at point A where the economy is back at FE equilibrium and cyclical unemployment is eliminated.

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

Eliminating Inflation The economy has more than FE equilibrium (inflationary gap or negative cyclical unemployment) equal to (Y1 – Yp) at the initial equilibrium at point C Government main concern here is to eliminate the inflation Government can eliminate the inflationary
P1 P2

P LAS SAS C A AD0 AD2 RGDP Yp Y1

gap by using contractionary fiscal policy, contractionary monetary policy, or both ⇒ AD decreases ⇒ AD curve starts to shift leftward all the way to AD2 ⇒ the new equilibrium at point A where the economy has FE and the inflationary gap has been eliminated (price level decreased from P1 to P2) In the long run, when AS is vertical, fiscal and monetary policy efforts to increase output will be ineffective.

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Dr. Mohammed Alwosabi

Econ 141 - Ch.3

Exercise: The following table shows AD, SAS, and LAS for a country (in billions of dollars) P AD SAS LAS 5 6 7 8 9 8.5 8.5 8.5 8.5 8.5 110 10 120 130 140 150 9 8 7 6

a. Find SR- equilibrium RGDP and price level b. What is the economic situation of the country when the economy at the SR- equilibrium (RGDP and unemployment rate)? c. When the economy is at its SR equilibrium, what will happen to SAS in the LR? d. How government should use its economic policies to achieve LR equilibrium? Show graphically e. What would be the full employment RGDP and P? f. Suppose the RGDP at full employment is $5 billions, now what is the economic situation of the country when the economy at the SRequilibrium (RGDP and unemployment rate) g. How government should use its economic policies to reach at LR equilibrium? h. What is the situation when the price is 120? (surplus - inventories rise (firms have unexpectedly low inventories) so the price level falls) i. What is the situation when the price is 150? (shortage - inventories falls (firms have unexpectedly low inventories) so the price level rise)

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