Lecture 5: Finding Macroeconomic Equilibrium

Deriving Aggregate Demand

Impact of Price Level on Aggregate Expenditure and Demand

The Aggregate Demand (AD) curve shows the relationship between the overall price level (p) and the total quantity of real GDP (Y) demanded in the economy. Changes in the price level affect both consumption and net exports, which in turn influence aggregate expenditure and aggregate demand.

• Aggregate Expenditure Function (AEF): Represents planned spending at each income level. A rise in the price level reduces real wealth and net exports, shifting the AEF downward.

• Tracing AEF to AD: For each price level, the corresponding equilibrium output (where AE = Y) is determined. Plotting these pairs yields the AD curve.

• AD Equation Example: $Y = 1000 - 2p$ shows that as the price level increases, real GDP demanded decreases.

Example: If the price level rises from 100 to 200, equilibrium output falls from 800 to 600, illustrating the negative relationship between p and Y on the AD curve.

Shifts in Aggregate Demand and Aggregate Expenditure

Price Level and Wealth Effects

• Increase in Price Level: Reduces real wealth and net exports, shifting AE and AD leftward (downward).

• Increase in Household Wealth: Boosts consumption, shifting AE and AD rightward (upward).

Example: A rise in household wealth increases AE at each price level, shifting the AD curve to the right.

Other Determinants of AE and AD

• Consumer and Business Confidence: Higher confidence increases autonomous spending, shifting AE and AD rightward.

• Foreign Income: A decrease in foreign income reduces net exports, shifting AE and AD leftward.

Example: A global recession reduces demand for exports, shifting the AD curve to the left.

The Simple Multiplier and Aggregate Demand

Multiplier Effect on AD

The simple multiplier measures how much equilibrium output changes in response to a change in autonomous spending. In the context of AD, it describes how shifts in autonomous components (like investment or government spending) cause the AD curve to shift.

• Multiplier Formula: $\text{Multiplier} = \frac{1}{1 - MPC}$, where MPC is the marginal propensity to consume.

• Application: An increase in autonomous spending shifts the AD curve by the multiplier times the initial change.

Aggregate Supply (AS)

Shape and Determinants of Aggregate Supply

The Aggregate Supply (AS) curve shows the relationship between the price level and the quantity of goods and services firms are willing to supply. In the short run, AS is upward sloping due to increasing costs as output rises.

• Short-Run Aggregate Supply (SRAS): Upward sloping because higher prices increase profits, encouraging more production.

• Non-linear SRAS: As output increases, costs rise at an increasing rate due to capacity constraints and diminishing returns. This gives the SRAS a convex shape.

• Shifts in AS: Caused by changes in input prices and technology/productivity.

Example: Improved technology shifts AS right (more output at lower cost); higher input costs shift AS left (less output at higher cost).

AD & AS Equilibrium

Short-Run Equilibrium

Short-run equilibrium occurs where the AD and AS curves intersect, determining the equilibrium price level and output.

• Equilibrium Condition: $AD = AS$

• Excess Supply: When AS > AD, leading to downward pressure on prices and output.

• Excess Demand: When AD > AS, leading to upward pressure on prices and output.

• Adjustment: Prices and output adjust until equilibrium is restored.

Example: A positive AD shock (e.g., increased government spending) shifts AD right. The effect on price and output depends on the slope of AS at the initial equilibrium.

Effects of Shocks on Equilibrium

• Technology/Productivity Increase: AS shifts right, equilibrium output rises, price level falls.

• Input Cost Increase: AS shifts left, equilibrium output falls, price level rises.

Stagflation

Definition and Causes

Stagflation is an economic condition characterized by the simultaneous occurrence of high inflation and low output (stagnation). It typically results from a leftward shift in the AS curve (e.g., due to rising input costs).

• Key Features: Rising prices (inflation) and falling real GDP (output).

• Policy Challenge: Difficult to address with standard demand-side policies, as stimulating demand may worsen inflation.

Example: An oil price shock increases production costs, shifting AS left, causing both higher prices and lower output.

Summary Table: Determinants and Effects on AD and AS

Factor	Effect on AD	Effect on AS	Equilibrium Outcome
Increase in Price Level	Movement along AD (lower Y)	No shift	Lower output, higher prices
Increase in Wealth	AD shifts right	No shift	Higher output, higher prices
Increase in Confidence	AD shifts right	No shift	Higher output, higher prices
Decrease in Foreign Income	AD shifts left	No shift	Lower output, lower prices
Improved Technology	No shift	AS shifts right	Higher output, lower prices
Higher Input Costs	No shift	AS shifts left	Lower output, higher prices

Key Equations

• Aggregate Demand: $Y = 1000 - 2p$

• Simple Multiplier: $\text{Multiplier} = \frac{1}{1 - MPC}$

Additional info: Where the original notes were incomplete, standard macroeconomic theory was used to fill in definitions, examples, and explanations of the AD/AS model, the multiplier, and the effects of shocks.