The Aggregate Demand/Aggregate Supply Model Real Domestic Output Price Level [Production cost] AD PLe Ye SRAS

Aggregate Demand A curve that shows the amount of goods & services that will be demanded at various price levels by householders, businesses, government and foreigners. (The demand for everything by everybody). Aggregate Supply A curve that shows the amount of goods and services that businesses will produce at various price levels. (It refers all price levels in the market)

Consumption (billions of dollars) o 45 o Real GDP (billions of dollars) C + I g C + I g + X n C + I g + X n + G 550 Whereas the aggregate expenditure model examines consumption at a fixed-price-level, in order to see how it affects real GDP (its fixed in time).

fig O SRAS Price level GDP r The AD-AS model enables us to analyze changes in both real GDP and price levels simultaneously. FE

fig O SRAS AD 1 GDP 1 Price level FE PL1

fig O SRAS AD 1 GDP 1 GDP r AD 2 GDP 2 PL1 PL2 FE

fig O SRAS AD1 GDP 1 GDP r GDP 2 PL1 PL2 AD 3 FE PL3 GDP 3 AD 2

fig O SRAS AD 1 GDP 1 GDP r GDP 2 PL 1 PL 2 AD 3 PL 3 GDP 3 AD 2 AD 4 PL 4 GDP 4

PL 1 Like the demand curve, there is an inverse relationship between AD and PL (downward slopping). But for different reasons. AQD 1 PL AQD AQD 2 PL 2

BUSINESSES HOUSEHOLDS RESOURCE MARKET RESOURCESINPUTS $ COSTS $ INCOMES PRODUCT MARKET GOODS & SERVICES SERVICES $ CONSUMPTION $ REVENUE Income effect; the circular flow model shows that when consumers pay lower prices for goods and services, the result is lower income in the resource market. Lower prices lead to lower income.

Substitution effect; the AD-AS model deals with the entire economy. There is no substitution effect when you are counting all domestically produced goods.

Reasons For Downward Sloping AD Curve Real-balances E ffect Real-balances E ffect – lower price levels increases the real value (purchasing power) of the public, so lower PL means more aggregate consumption spending. Market Basket

interest rate (i) % 6 4 % QMQM QM QM DIgDIg Interest-rate Effect Interest-rate Effect – Higher price levels increase the demand for money to make transactions. Since the money supply is fixed, an increase in money demanded will drive up the price to use money (interest rates). Higher interest rates discourage investment spending reducing the amount of real GDP output.

Foreign Purchases E ffect Foreign Purchases E ffect – A rise in the price level makes domestic goods more expensive and foreign goods cheaper. So the quantity of U.S. goods demanded by the world will decrease, X n will decrease, and GDP output will decrease.

fig O AD GDP 1 GDP r GDP 2 PL1 PL2 YPYP PL3 GDP 3 An increase in the economy’s price levels will cause a decrease in aggregate quantity demanded, which will cause GDP output to decline.

Consumption (billions of dollars) o 45 o Real GDP (billions of dollars) GDP3 GDP2 AE3 AE3 AE1 GDP1 AE2 It will also shift the aggregate expenditures schedule downward resulting in reduced real GDP output.

But the entire AD curve can shift to the left or right. Caused not by a change in PL but due to non-price level determinants called CIG-X. PL AQD 1 AD 2 AD 3 AD 1 RDO Change in AD AQD 2 AQD 3 AD Shifters AD Shifters [C+Ig+G+Xn] [C+Ig+G+Xn]Consumption Gross Investment Gov. Purchases Net Exports CIG-XCIG-XCIG-XCIG-X

1. Consumer Spending; Consumer Wealth; an increase in the real value of consumer wealth encourages people to buy more, thus shifting AD to the right. Consumer Expectations; when people expect real income to rise they will increase spending today, thus shifting the AD to the right. Household debt; consumption on credit increases AD, but interest payments on debt decrease AD. Taxes; A reduction in taxes increases consumption, thus shifts the AD to the right. AD 1 AD 2 PL High Debt

2. Investment Spending; Real Interest Rates; a decrease in interest rates will increase investment spending and shift the AD to the right. Expected returns; higher expected returns on investments will shift the AD to the right. AD 1 AD 2 PL

3. Government Spending; increases in government purchases will shift the AD to the right. AD 1 AD 2 PL

4.Net Export Spending; an increased foreign demand for U.S. goods means a greater level of U.S. exports. So a rise in X n will cause AD to shift to the right. National Income Abroad; National Income Abroad; rising foreign incomes encourages foreigners to buy more U.S. stuff. Exchange Rates; Exchange Rates; depreciation of the dollar makes U.S. good cheaper to foreign goods, which increases X n. More Exports [Our products are cheaper]

fig O AD 1 GDP 1 RGDP AD 2 GDP 2 PL1 YPYP A shift right of the AD curve (from AD1-AD2) results in increased AD, increased GDP output but no change in price level.

Consumption (billions of dollars) o 45 o Real GDP (billions of dollars) GDP1 GDP2 AE1 AE1 AE2 The same shift in the AD curve is translated as a shift upward in the AE schedule (from AE1-AE2) resulting in increased GDP output.

Aggregate Supply AS PL 2 QAS 2 QAS 1 PL 1 Like the supply curve there is a direct relationship between PL and the quantity of AS. As PL increase, QAS increases

QAS 2 But unlike the supply curve, the AS curve is segmented into three distinctive parts (ranges). AS QAS 1 QAS 1 PL 2 PL 1

Three Segmented AS Curve HorizontalKeynesian 1. Horizontal (Keynesian) Intermediate 2. Intermediate VerticalClassical 3. Vertical (Classical) Price level GDP r Q Horizontal[Keynesian]Range Upsloping or IntermediateRange Vertical[Classical]Range Think of the AS curve as a PPC on its back.

The horizontal range (Keynesian range) shows economic inefficiency. Movement in this range results in a change in real output but little or no change in price levels. Price level GDP r GDP 1 GDP 2 PL 1 Horizonta l AD 1 AD 2 AS

Because the economy is in a recessionary period, any shift right in AD means that firms are putting idle resources back to work. Since there is no shortage of resources, PL will remain unchanged. Price level GDP r GDP 1 GDP 2 PL 1 Horizonta l AD 1 AD 2 AS

The intermediate range shows economic efficiency. Movement in this range results in a change in GDP output and a change in price level. Price level GDP r Upsloping or IntermediateRange GDP 4 GDP 3 PL 1 PL 4 PL 3 AD 3 AD 4 AS

A shift to the right means that resources are becoming scarcer, thus the PL for these resources increases. This increases input cost and prices at stores. Price level GDP r Upsloping or IntermediateRange GDP 4 GDP 3 PL 1 PL 4 PL 3 AD 3 AD 4 AS

As the economy exceeds full employment, it enters the vertical range. This range shows little or no additional real output but larger changes in price level. Price level GDP r Vertical[Classical]Range GDP 5 PL 1 PureInflation PL 4 PL 3 PL 5 PL 6 AD 5 AD 6 AS FE

The economy is at 100% productivity, and can not add any new output. Any increase in AD will cause demand-pull inflation. Price level GDP r Vertical[Classical]Range GDP 5 PL 1 PureInflation PL 4 PL 3 PL 5 PL 6 AD 5 AD 6 AS FE

Shifts in the AS Curve (RAP) PriceLevel AD SRAS 1 SRAS 2 SRAS 3 Shortage Surplus GDP AQS GDP 3 GDP 2 AS Shifters AS Shifters [RAP] [RAP] Resource cost Actions of Gov. Productivity

1 Resource P rice C hanges; Lower input prices decrease per-unit production cost and increases AS (shift to the right). L,L,C,E;L,L,C,E; decreasing Overseas Resource;Overseas Resource; decreasing Market PowerMarket Power [# of sellers]; more sellers in the market. PL AS AS

2. Actions of Government; Fewer taxes and government regulations as well as more government subsidies tend to decrease per-unit production cost. Business Taxes /Subsidies; decreased taxes or increased subsidies shift AS to the right. Government Regulation; complying with govt. regulations increases input cost, so less regulations shifts the AS to the right.

3. Productivity changes 3. Productivity changes; Increased productivity reduces the per-unit production cost, and shifts the AS to the right. Productivity = Real Output Inputs

Productivity – how many outputs (pies) can be produced from a set amount of inputs (apples). Productivity [2] = outputs[10]/inputs[5]

An increase in productivity means more real output can be obtained from the same inputs. Example; If output = 10 units, input = 5 units, and the price of each input resource = $2, then our per unit production cost will = $1. Per unit production cost($1) = Total input cost($10)[$2x5] Units of output (10) Units of output (10) Suppose increased productivity doubles output to 20 units for the same input of 5 units, & price of each Input unit is still $2. Then our per unit production Cost will = $.50 P er unit production cost(.50) = T otal input cost ($10) Units of output (20) Units of output (20)

QS 1 Unlike a short run supply curve, a decrease in quantity aggregate supplied will not necessarily lead to a decrease in price level. S QS 2 QS 2 PL 1 PL 2

As you can see, once AD is in the Keynesian range, price levels stay fairly constant. Keynes argued that prices in this range will be sticky (inflexible) downward in the short run. Price level GDP r GDP 2 GDP 1 PL 1 Horizonta l AD 2 AD 1 SRAS

The Ratchet Effect: SRAS GDP r PL 2 PL 1 AD 1 AD 2 GDP 2 GDP AD 3 Increases in AD ratchet the PL upward. Once in place, the higher PL remains in place until it is ratcheted up again. The ratchet effect; prices are “flexible upward” but “inflexible downward.”

SRAS AD 1 AD 2 PL 2 PL 1 R eal D omestic O utput AD 3 “Full Employment” “Recession” During a period of FE, PL will increase due to demand-pull inflation. However, during a recessionary period, PL does not drop to their original levels. WHY?

Reasons for the Ratchet Effect Wage Contracts; a large part of the labor force works under contracts prohibiting wage cuts. Morale, Effort, & Productivity; lower wages decreases morale and effort, which lowers productivity and increases per-unit cost. Y3 Y1 Y2 Y3 Y1 Y2 LRAS PL 2 PL 1 AD 1 AD 2

Reasons for the Ratchet Effect Minimum Wage; businesses can not legally pay below this wage floor. Menu Costs; changes in prices create unwanted cost. It may be cheaper to keep prices stable. Fear of Price Wars; price cuts may lead to retaliation from rival businesses. Y3 Y1 Y2 Y3 Y1 Y2 LRAS PL 2 PL 1 AD 1 AD 2

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