The central element of the macroeconomic system is the black box. The operation of the black box determines the quality of the output variables. The two forces that determine the operation of the macroeconomic black box are aggregate demand and aggregate supply.
Viewing: What is Aggregate demand
I. Model of aggregate demand and aggregate supply
1. Aggregate Demand: AD
Definition: Aggregate demand is the total domestic output that economic agents (households, firms, government, foreigners) are willing and able to buy at a given price, other things being equal. change.
Components of aggregate demand:
+ Household consumption (C): nondurable and durable goods and services
+ Investment (I): nonresidential investment (fixed capital and inventory) and residential investment
Government spending (G)
+ Net exports (NX): export value (X) minus import value (M)
Aggregate demand in the economy will be represented by the equation
AD = C + I + G + NX
Aggregate demand curve (AD curve)
Definition: Aggregate demand curve is the set of all points representing aggregate demand in the economy at a given price level
Features: The AD curve is a downward sloping line (inverse relationship between the general price level and the quantity demanded).
Why does the aggregate demand curve slope downward?
Price level & consumption: Wealth effect P increases → C decreases: A falling price level increases the real value of money, making consumers richer, encouraging them to spend more.Price and investment: Interest rate effect P increases → I decreases: A falling price level lowers interest rates, encourages more spending on investment goods, increases the quantity of goods and services demanded. Price level and net exports: Exchange rate effect exchange rate (international trade) P increases → NX decreases
Vertical movements and shifts in the aggregate demand curve
Vertical movement: general price level changes, other factors constant Shift of AD curve: general price level remains unchanged, other factors change (at the same price, quantity demanded is more or less)
The origin of the shift in the aggregate demand curve
Shifts stem from changes in consumption C
+ Shifts stem from changes in investment I
The shift is due to changes in government spending
+ The shift stems from changes in NX net exports
2. Aggregate supply (AS)
Definition: The aggregate supply of an economy is the level of domestic output that firms are willing and able to produce and supply at a given price, other factors being held constant.
Because the effect of the price level on the aggregate supply curve in the short run and the long run is very different, we will use two aggregate supply curves: the short run aggregate supply (SRAS) curve long run aggreagate supply (LRAS)
a. Long run aggregate supply curve (LRAS)
The long run aggregate supply curve is the set of all points representing the economy’s aggregate supply at certain prices in the long run.
Why is the long run aggregate supply curve vertical?
Potential GDP is the level of GDP achieved when the economy is at full employment – unemployment is at its natural rate, machinery is used at average capacity.
In the long run, potential GDP depends only on the productive capacity of the economy, which does not depend on the vertical P → LRAS.
The shift of LRAS
The movement comes from labor (L) The shift comes from capital/capital (K) The movement comes from natural resources (R) The shift comes from technological knowledge (T)
Long run aggregate supply curve shift
b. Short-run aggregate supply curve (SRAS)
The short run aggregate supply curve is the set of all points representing an economy’s aggregate supply at certain prices in the short run.
Characteristics of the SRAS . line
The SRAS is comfortable when the actual output is lower than the Y* level. The reason: the economy now has many unused resources, so a small change in P can make Y increase a lot.
SRAS slopes when real output is higher than Y*. The reason: now the economy has very few unused resources (high input prices), so a large change in P only causes Y to increase slightly.
In the case of studying the economy over a very short period (monthly, quarterly) or economists following absolute short-run price rigidity, the short-run aggregate supply curve is horizontal.
Why is the short run aggregate supply curve sloping up?
Misperception theory → imperfect-information model Sticky-wage theory Sticky-price theory
Vertical movement and displacement of the SRAS . line
Vertical movement: when the general price level changes, other factors remain constant
Shift of the SRAS . line
4 factors that cause the shift of the LRAS curve also cause the shift of the SRAS curve, in addition, there are 3 more factors
+ Expected price changes in the future
+ Changes in prices of important fuels
+ Changes in government tax rates
II. Macro balance in the short and long term
1. Determine output and equilibrium price
a. Equilibrium in the short run
In the short run, the economy is in equilibrium at the intersection of AD with the SRAS . curve
At price P1 At price P2 > P0, aggregate supply exceeds aggregate demand, P falls to P0
b. Equilibrium in the long run:
In the long run, the economy is in equilibrium at the intersection of the AD curve with the SRAS curve lying on the LRAS curve.
In fact, in the short run, the intersection of the AD line with the SRAS line is not always on the LRAS line. When this happens, it is called short run economic fluctuations.
2. Causes of short-term economic fluctuations and the role of counter-cyclical policy
The economy does not experience inflation (avoid adjustment of the short-run aggregate supply curve)
+ The economy is not experiencing growth in the long run (avoid shifting the long-run aggregate supply curve)
a. Bridge shock
– Short run: the economy moves from point A → B (lower Y, lower P)
– Long run: the economy moves from point B → C (Y remains the same potential level, P is lower)
Stabilization policy: The government will increase spending G to shift the AD curve to the right back to its original position (AD2→AD1)
b. Bow shock
– Short run: the economy moves from point A → B (lower Y, higher P)
– Long run: the economy moves back from point B → A (Y remains the same potential level, P stays the same)
The government has 2 options
+ increase spending G to shift the AD curve to the right, maintain the natural rate of unemployment, accept a high inflation rate (AD1→AD2)
+ reduce G spending to shift the AD curve to the left, maintain the same price level, accept a high unemployment rate (AD1→AD3)
Governments often decide to increase G to maintain unemployment at the natural rate, accepting inflation
Causes of short-term economic volatility and the role of stabilization policy
Limitations of stabilization policies
+ Policy lag: lag in (policy-making time); external latency (policy execution time)
+ Negative effects on other macro variables: when deciding to increase output (reducing unemployment), the government must accept a higher inflation rate or when deciding to reduce the inflation rate, the government must accept a decrease in output (increase in unemployment) (short-run trade-off between inflation and unemployment – Phillips curve).
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– The mechanism of maintaining the economy’s long-run potential equilibrium level of output (the intersection of AD and SRAS lies on the LRAS curve) are the same self-regulating mechanisms that the economy implements when there are demand shocks, supply shocks cause real GDP to fluctuate around potential GDP.
Classical dichotomy: The long-run effect of demand shocks changes nominal variables, but not real variables. do). In the long run, changes in aggregate demand affect only nominal variables but not real variables, and output is determined by technology and the supply of factors of production, not by total demand.
c. Expansion: Supply Side
The stabilization policies used above when the economy experiences shocks all affect the AD (demand side) curve. The government can also affect the AS (supply side) curve if:
+ Reduce corporate income tax, encourage investment in research and implementation of new technology (corporate income taxs cut)
+ Investment in human capital (human capital investment), infrastructure development (infrastructure development)
+ Remove unreasonable barriers and regulations in business management and resource management (deregulation)
+ Facilitating labor migration
* Unlike the short-term effects of the demand side, the supply side usually works in the long-term*
3. Dynamic model of aggregate demand curve
– Potential GDP increases continuously, shifting the long-run aggregate supply curve to the right.
– In most years, the aggregate demand curve will also shift to the right.
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Except for years when workers and firms expect high inflation, the short-run aggregate supply curve shifts to the right for the rest of the time.
Two special cases of the aggregate supply curve
+) According to the classical school: assuming flexible wages and prices, the aggregate supply curve is a vertical line, intersecting the horizontal axis at potential output Y*
Thus, according to the classical view, stock policies aimed at influencing aggregate demand only change the price level, but not the supply side.
+) According to the Keynesian school: with the assumption of rigid wages and prices, the aggregate supply curve is a horizontal line, implying that the economy has many unused resources.
Thus, according to the Keynesian view, the policies of the stock market are intended to affect the aggregate demand will have a large effect on output – output is determined by demand (demand side)
According to gravity theory: business cycle caused by AD
Keynesian theory: C, I, G, and/or (X-M) ∆AD → ∆real GDP
Monetary theory: money & credit borrowing I AD real GDP
According to supply theory: business cycle caused by AS
Other costs of production
From the point of view of the “real business cycle” school
Causes of the business cycle (CKKD):
Factors outside the economic system Factors inside the economic system External factors (politics, weather, population…) cause the initial shocks. These shocks are then transmitted into the economy. Internal factors – which contain the mechanisms that generate business liquidity (spending multiplier, investment acceleration multiplier) – react and amplify repeat business cycles
+ Investment increases → output increases (according to multiplier model) → investment increases (according to investment accelerator model) → output increases…. → peak period
+ External factors impact: natural disasters, war, market crash….
+ Output stops increasing → investment decreases (according to the accelerator) → output decreases (according to the multiplier model) → investment decreases (according to the accelerator) → output decreases…. → cycle bottom (trough)
There are also a number of other additional theories:
+) According to the weather theory (climate theory), CKD occurs with the cycle of sunspots (10-45 years), the root cause is the change of weather when there is a sunspot leading to crops. failed, farmers’ purchasing power decreased
+) According to the theory of underconsumption, business conditions appear because production is high but demand is low, the root cause is unequal income distribution.
+) According to the psychological theory, business failure occurs because the excitement in good economic conditions leads to more production, and the pessimism in bad economic conditions leads to less consumption.
+) According to political theory, CKD appears due to the policy of politicians to get re-elected
+) According to the theory of rational expectation (rational expectation theory), business performance depends on the cognitive ability of employees
Combining the theories we can conclude the following:
III. Summary of key terms in the section Aggregate Demand – Aggregate Supply
aggregate demand (AD curve) Aggregate supply short-run aggregate supply (SRAS curve) long-run aggregate supply curve (LRAS curve) AD-AS model Adverse shock Short run economic fluctuations Classical dichotomy Time lag Business cycle