The Aggregate Demand Aggregate Supply Model Please listen to the audio as you work through the slides.

Learning objectives Students should be able to thoroughly and completely explain: 1.The Aggregate Demand Aggregate Supply Model and how it operates. 2.The 3 factors supporting its slope of the Aggregate Demand curve, the determinants of the AD curve. 3.The aggregate supply curve, the 3 time horizons associated with AS, the determinants of the AS curve.

Defined: Amounts of Real Output Buyers Collectively Desire at Each Possible Price Level. Aggregate Demand Aggregate Demand Curve Downward Sloping Due To: 1. Real-Balances Effect 2. Interest-Rate Effect 3. Foreign Purchases Effect

Aggregate Demand Aggregate Demand Curve Downward Sloping Due To: Real-Balances Effect 1.Price level changes impact the purchasing power of real balances 2.Prices rise, real balances fall and spending falls 3.Aggregate Demand falls

Aggregate Demand Aggregate Demand Curve Down Sloping Due To: Interest-rate Effect We assume the supply of money fixed 1.Price level rises, consumers and businesses need more money (demand for money rises). 2.Price of money (interest rate) rises 3.Investment spending and interest sensitive consumer spending falls. 4.Demand for real output falls 5.Aggregate Demand falls

Aggregate Demand Aggregate Demand Curve Down Sloping Due To: Foreign purchases Effect 1.US price level rises relative to rest of the world. 2.(assumption) Exchange rates not responsive 3.US exports fall – because? 4.US imports rise – because? 5.Price rise causes a drop in demand for US goods demanded as US exports. 6.Net exports fall 7.Aggregate Demand falls

Aggregate Demand Curve Real Domestic Output, GDP Price Level AD Aggregate Demand

Changes in Aggregate Demand – two parts Real Domestic Output, GDP Price Level AD 1 Increase in Aggregate Demand AD 3 AD 2 Decrease in Aggregate Demand

Determinants of Aggregate Demand (curve shifters) Change in Consumer Spending Consumer Wealth Consumer Expectations Household Indebtedness Taxes Change in Investment Spending Real Interest Rates – (due to change in money supply) Expected Rates of Return change due to: Expected Future Business Conditions Technology Degree of Excess Capacity Business Taxes

Determinants of Aggregate Demand (curve shifters) Government Spending Net Export Spending National Income Abroad Exchange Rates: depreciation of the $ Dollar depreciates relative to euro – US goods cheaper, while euro goods more expensive – AD curve shifts to right. appreciation of the $ Dollar appreciates relative to euro – US goods more expensive, while euro goods cheaper – AD curve shifts to leftDollar appreciates relative to euro – US goods more expensive, while euro goods cheaper – AD curve shifts to left

Aggregate Supply A Schedule or curve showing the relationship between the price level and the amount of domestic output the firms in the economy produce. Three time horizons – Immediate short run Assumptions: – Input prices and output prices are fixed » Time period - Few days to a few months » Possible implicit price agreements » Contractual agreements

Aggregate Supply – immediate short run Real Domestic Output, GDP Price Level AS ISR Immediate-short-run Aggregate Supply. Firms supply the level of output that is demanded at that price. Perfectly elastic supply curve. QfQf

Short run Assumptions: – Input prices fixed – Output prices variable – Real profit changes (output adjustments) Aggregate Supply

Real Domestic Output, GDP Price Level 0 QfQf Aggregate Supply (Short Run) As output increases, Per unit production costs Increase, output increases Become more limited. Slope not constant: per unit production cost and firm capacity Aggregate Supply – short run

Long run Assumptions: – All prices variable – Full employment GDP achieved (no output adjustment) – All prices adjust Aggregate Supply

Aggregate Supply – long run Real Domestic Output, GDP Price Level AS LR Long-run Aggregate Supply. Wages and other input prices rise and fall to match output price level changes. Price level changes do not alter output QfQf Input prices fully Adjust to output price level Changes.

Real Domestic Output, GDP Price Level AS 1 Increase in Aggregate Supply AS 3 AS 2 Decrease in Aggregate Supply Aggregate Supply

Determinants of Aggregate Supply Input Prices Domestic Resource Prices Labor – supply increases or decreases Land – discoveries or depletion of resources Capital – input prices change Prices of Imported Goods Market Power – like OPEC

Determinants of Aggregate Supply Productivity = Total Output Total Inputs Legal-Institutional Environment Business Taxes and Subsidies Government Regulation

Changes in Equilibrium Real Domestic Output, GDP Price Level AD AS P1P1 P2P2 Q1Q1 QfQf AD 1 Increase in Aggregate Demand Demand-Pull Inflation

Changes in Equilibrium Real Domestic Output, GDP Price Level AD 1 AS P1P1 P2P2 Q2Q2 QfQf AD 2 Decrease in Aggregate Demand Creates a Recession a c b

Decrease in Aggregate Demand – Recession and cyclical unemployment – Deflation? Reasons for Downward price inflexibility: – Fear of price wars – Menu costs – Wage contracts – Morale, effort, and productivity Efficiency wages – Minimum Wage Changes in Equilibrium

Real Domestic Output, GDP Price Level AD AS 1 P1P1 P2P2 Q1Q1 QfQf Decrease in Aggregate Supply Cost-Push Inflation AS 2 a b Changes in Equilibrium

Real Domestic Output, GDP Price Level AD 1 AS 2 P1P1 P2P2 Q2Q2 Q1Q1 Increases in Aggregate Supply – Full-Employment With Relative Price-Level Stability AS 1 b AD 2 c P3P3 Q3Q3 a Changes in Equilibrium

Aggregate Demand- aggregate supply (AD- AS) model Aggregate Demand real-balances effect interest-rate effect foreign purchases effect determinants of Aggregate Demand aggregate supply long-run aggregate supply curve short-run aggregate supply curve Determinants of Aggregate Supply productivity equilibrium price level equilibrium real output efficiency wages menu costs