Aggregate Supply and Demand.
Not a predictive model, but it helps explain how things work.
The model will explain short and long run variations in economic variables.
A. Economic fluctuations are irregular and unpredictable.
B. Most economic variables we talk about fluctuate together.
Consumption flows really closely with GDP.
This occurs because if you make more, you consume more.
Consumption is not that sensitive.
Investment flows really closely with investment.
When GDP/output goes down, so does investment. It’s very sensitive.
It’s also very sensitive when the government runs a deficit.
GDP and government spending are counter-cyclical. They don’t move together.
They move together.
GDP, C, I.
They don’t move together, because of automatic stabilizers.
Automatic stabiliziers: TANF, Medicaid, etc.
C. As output falls, unemployment rises.
Usually, you think of output as a function of unemployment.
This is true, but the level of unemployment itself is affected by how much output is
The causation is more so that output affects unemployment
During a recession, the demand for goods and services decrease. The firms are selling
as much, so there isn’t as much need for the workers anymore.
GDP and unemployment move counter-cyclically.
SR (In the short run):
Money neutrality (money has no effect on real variables—output, unemployment.) is not an
appropriate assumption, because in the SR, money can affect real variables.
Aggregate Demand: A demand curve for real GDP, output, or all
goods and services.
What we’re going to be graphing here is the average price level of all goods and services.
What causes the AD curve to slope downwards?
All these things affect the SLOPE of the curve… They don’t shift it.
The higher the price level, the less people want to consume.
1. Consumption. As the price level goes up, ceteris paribus, output goes down.
This is called the wealth effect.
As the price level goes up, real wealth goes down, and consumption must decrease.
Real weath = purchasing power of salary over time.
2. Interest rate effect.
(Intertemporal substitution effect).