Aggregate Demand and Aggregate Supply

Aggregate Demand Relationship between price level and real GDP demanded “schedule or a curve showing the various amounts of goods and services—the amounts of real output—that domestic consumers, businesses, government,and foreign buyers collectively desire to purchase at each possible price level” AD f (C, I, G, X, M)

Why is the Aggregate Demand Curve downward sloping? Real-Balances (Wealth) effect: higher price level reduces real value of public’s accumulated financial assets Interest-Rate effect: as prices rise, assuming money supply is fixed, interest rates rise because consumers and businesses need more money to buy goods and pay for inputs Foreign purchases effect: increases in prices reduce our exports and increase imports

Why is the Aggregate Demand Curve downward sloping? NOT Because of: Income effect: at lower price levels, less income is likely to be generated so real income does not necessarily go up Substitution effect: most prices are decreasing so no one set of goods/services is getting cheaper

Derivation of aggregate demand curve from aggregate expenditures model If price level falls, wealth increases and consumption expenditures increase; interest rate decreases and investment increases

Derivation of Aggregate Demand Curve: 1 2 Aggregate Expenditures 3 GDP 3 GDP 2 GDP 1 GDP Derivation of Aggregate Demand Curve: Price Level 3 2 1 AD GDP 3 GDP 2 GDP 1 GDP

Determinants of Aggregate Demand “Increase in aggregate demand” independent of price changes Rightward movement of aggregate demand curve Consumer wealth (non-price related): increases in stock prices, or increases in housing values Expect prices to rise in the future Household indebtedness low Decrease in interest rates (not caused by price level change) from money supplying increasing Higher expected returns on investment projects

Determinants of Aggregate Demand “Increase in aggregate demand” independent of price changes Decrease in business taxes Improved technology A decline in excess capacity Increase in government spending (assuming taxes and price level do not increase as a result) Net export spending Rising national income abroad Dollar depreciates Shift of AD curve = initial change in spending x multiplier

Shift in Aggregate Demand Increase in AD Price Level Decrease in AD AD 1 AD AD 2 Real GDP

Aggregate Supply “Schedule or curve showing the level of real domestic output which will be produced at each price level” Horizontal range: less than full employment Upsloping (intermediate) range: full employment is not reached simultaneously in all factor markets Vertical range: economy is at full capacity

Short Run vs. Long Run Short Run: period in which nominal wages (and other resource prices) do not respond to price-level changes Long Run: period in which nominal wages (and other resource prices) match changes in the price level

Long Run AS Vertical at economy’s full employment output (potential output) level Assume: $20 profit needed to produce full employment output of 100 units (price = $1) Hires 10 units of labor at $8 wage Profit 100-80=$20 Suppose price level doubles: $200 revenue and wage bill will double to $160 Nominal profit = $200-160=40 Real profit = $40/2 = $20 [price index $2/$1=1]

Short Run AS Real Profit = $200 - $80 = $120/2 = $60 Rise in real profit gives incentive for firm to want to produce more

Determinants of Aggregate Supply What causes the AS to increase (shift to the right)? Lower input prices (domestic or imported) Increases in resource (factors of production) availability Increased productivity Market power of input sellers decreases Lower business taxes Increased subsidies Decreased government regulation

Aggregate Supply Price GDP Horizontal Range- Less than full employment Vertical Range Horizontal Range- Less than full employment Intermediate Range- Approaching Full Employment Vertical Range- Full employment Price Intermediate Range Horizontal Range GDP

Equilibrium AS Price Level Pequilibrium AD GDP 1 Real GDP Equilibrium

Equilibrium Aggregate amount demanded equals aggregate amount supplied “For any increase in aggregate demand, the resulting increase in real GDP will be smaller the greater the increase in the price level The multiplier is diminished by rising price level Ratchet effect: an increase in demand will not lead to the same equilibrium quantity as the same decrease in demand since prices and wages are sticky downwards [see diagram]

Demand Pull Inflation AD shifts to the right

Decreases in AD: Recession and Cyclical Unemployment AD shifts to the left, but prices do not easily go down.

Why are prices sticky downwards? Wage contracts Lower wages decrease morale and productivity Training investments might make it more costly to lay off more experienced workers Minimum wage Menu costs: it is expensive to print new menus Fear of price wars

Decreases in AS: Cost-Push Inflation AS shifts to the left