MARGINAL REVENUE PRODUCT AND FACTOR DEMAND: A perfectly competitive firm's factor demand curve is that negatively-sloped portion of its marginal revenue product curve. A perfectly competitive firm maximizes profit by hiring the quantity of input that equates factor price and marginal revenue product. As such, the firm moves along its negatively-sloped marginal revenue product curve in response to changing factor prices.
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AGGREGATE DEMAND INCREASE, LONG-RUN AGGREGATE MARKET:
A shock to the long-run aggregate market caused by an increase in aggregate demand resulting in and illustrated by a rightward shift of the aggregate demand curve. An increase in aggregate demand in the long-run aggregate market results in an increase in the price level but no change in real production. The level of real production resulting from the aggregate demand shock is full-employment real production. While a wide range of specific aggregate demand determinants can cause an increase in the four aggregate expenditures and thus an increase in aggregate demand, the following rank among the more important:
- An increase in consumer confidence brought on by periods of prosperity that prompts the household sector to spend a larger proportion of disposable income on consumption.
- Expectations of higher inflation rates in the near future that entice the household sector to increase consumption expenditures in the present before prices rise.
- A decline in interest rates associated with natural business-cycle activity or specifically induced by expansionary monetary policy from the Federal Reserve System that induces the household and business sectors to increase consumption and investment expenditures.
- Prosperity in other nations that induces the foreign sector to increase the purchases of domestic exports, thus increasing net exports.
- An increase in purchases and/or a decrease in taxes by the federal government resulting from expansionary fiscal policy.
- An increase in state or local government purchases, and/or a decrease in state or local taxes.
The long-run aggregate market presented in the graph to the right sets the stage for analyzing the effect of an increase in aggregate demand resulting from a change in an aggregate demand determinant. The vertical axis measures the price level (GDP price deflator) and the horizontal axis measures real production (real GDP). The negatively-sloped curve, labeled AD, is the aggregate demand curve and the vertical curve, labeled LRAS, is the long-run aggregate supply curve. The current long-run equilibrium, found at the intersection of the AD and LRAS curves, is a price level of 10 and real production of $100 billion. This equilibrium level of real production is also full-employment real production.
Long-Run Aggregate Market
Consider what happens to this long-run aggregate market with an increase in aggregate demand. Suppose, for example, that the Federal Reserve System undertakes a bit of expansionary monetary policy, which causes a decline in interest rates, which then prompts the household and business sectors to increase consumption and investment expenditures. The result of this action is a rightward shift of the AD curve. Click the [AD Increase] button to illustrate.
The result of this rightward AD curve shift is that a new long-run equilibrium is achieved at a higher price level (12) BUT THE SAME amount of real production ($100 billion). This result is similar to that for a standard market, with one small difference. An increase in market demand results in a higher equilibrium price and a LARGER equilibrium quantity. The small difference is that the "quantity" in the aggregate market DOES NOT CHANGE. The original equilibrium and the new equilibrium levels of real production are both full-employment real production.
A comparative static analysis of the original equilibrium and the new equilibrium is useful and important. However, it is also instructive to dissect the adjustment process.
- First, the AD curve shifts rightward due to the increase in consumption and investment induced by lower interest rates. This "extra" aggregate demand creates an imbalance in the aggregate market. At the existing price level (which has NOT yet changed), producers are willing and able to sell $100 billion worth of real production. Buyers, however, are now willing and able to purchase more, something like $120 billion worth of real production. This creates economy-wide product market shortages.
- Second, motivated to satisfy this extra demand and to fill these shortages, producers TRY to increase production. In the short run they can do so. But in the long run, they cannot. In the long run, wages and other resource prices are flexible. Wage increases are matched by equal increases in the price level. As such, labor and other resource markets remain in equilibrium, meaning only the full-employment level of production is supplied. The only result of attempts by producers to increase production is a rising price level.
- Third, with the rising price level, buyers are induced to decrease aggregate expenditures. The decrease in aggregate expenditures acts to reduce the existing economy-wide product market shortages. In fact, as long as economy-wide product market shortages persist, the price level rises and aggregate expenditures decline. This continues until aggregate expenditures exactly match full-employment production. The end result is the new long-run equilibrium price level of 12 and original full-employment real production of $100 billion.
AGGREGATE DEMAND INCREASE, LONG-RUN AGGREGATE MARKET, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: February 27, 2024].
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