Chapter 10 Aggregate Demand and Aggregate Supply McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives Aggregate demand (AD) Aggregate supply (AS) How AD and AS determine equilibrium price and real GDP The AD-AS model

Aggregate Demand Amount of real GDP purchased at each price level Why the downward slope? Real-balances effect Interest-rate effect Foreign purchases effect Consumption, investment, and net exports

Aggregate Demand Curve Price Level AD Real Domestic Output, GDP

Aggregate Demand Determinants of aggregate demand Fixed variables along the demand curve Change in fixed variable Multiplier effect Consumer spending variables: Consumer wealth Consumer expectations Household borrowing Personal taxes

Aggregate Demand Investment spending variables Real interest rates Expected returns Future business conditions Technology Degree of excess capacity Business taxes

Aggregate Demand Government spending Net export spending variables National income abroad Exchange rates

Changes in Aggregate Demand Increase in Aggregate Demand Price Level Decrease in Aggregate Demand AD2 AD1 AD3 Real Domestic Output, GDP

Aggregate Supply Amount real GDP produced at each price level Three time horizons Immediate short run Few days to a few months All prices fixed Implicit price agreements Contractual agreements

Immediate-short-run Aggregate Supply ASISR Price Level Immediate-short-run Aggregate Supply Qf Real Domestic Output, GDP

Aggregate Supply Short run Long run Input prices fixed Output prices variable Real profit changes Long run All prices variable Full employment GDP All prices adjust

Aggregate Supply Slope not constant: per unit production cost and firm capacity Aggregate Supply (Short Run) Price Level Qf Real Domestic Output, GDP

Aggregate Supply Long-run Aggregate Supply ASLR Price Level Qf Real Domestic Output, GDP

Aggregate Supply Determinants of aggregate supply Change in input price Domestic resource prices Prices of imported resources Change in productivity Change in legal-institutional environment Business taxes and subsidies Government regulation

Aggregate Supply AS3 Decrease in AS1 Aggregate Supply AS2 Increase in Price Level Increase in Aggregate Supply Real Domestic Output, GDP

Equilibrium Price Level and Real Output Demanded (Billions) Real Output Supplied (Billions) Price Level (Index Number) $506 508 510 512 514 108 104 100 96 92 $513 512 510 507 502 Equilibrium Price Level and Equilibrium Real GDP

Real Domestic Output, GDP Equilibrium AS Price Level Equilibrium 100 92 a b AD 502 510 514 Real Domestic Output, GDP (Billions of Dollars)

Changes in Equilibrium Increase in Aggregate Demand AS Demand-Pull Inflation P2 Price Level P1 AD1 AD Qf Q1 Q2 Real Domestic Output, GDP

Changes in Equilibrium Decrease in Aggregate Demand AS Price Level b P1 a P2 c Creates a Recession AD1 AD2 Q1 Q2 Qf Real Domestic Output, GDP 19

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

Real Domestic Output, GDP Changes in Equilibrium Decrease in Aggregate Supply AS2 AS1 Cost-Push Inflation b P2 Price Level a P1 AD Q1 Qf Real Domestic Output, GDP

Real Domestic Output, GDP Changes in Equilibrium Increases in Aggregate Supply – Full-Employment With Price-Level Stability AS1 AS2 P3 b P2 c P1 a Price Level AD2 AD1 Q1 Q2 Q3 Real Domestic Output, GDP

Impact of Oil Prices Aggregate supply shocks Cost push inflation Oil prices affected core inflation prior to 1980 Core inflation unaffected post 1980 Energy efficiency Composition of GDP Fed vigilance

Key Terms aggregate demand-aggregate supply (AD-AS) model real-balances effect interest-rate effect foreign purchases effect determinants of aggregate demand aggregate supply immediate-short-run aggregate supply curve short-run aggregate supply curve long-run aggregate supply curve determinants of aggregate supply productivity equilibrium price level equilibrium real output menu costs efficiency wages

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Appendix The Relationship of the Aggregate Demand Curve to the Aggregate Expenditures Model

Aggregate Expenditures Deriving the AD Curve AE1 (at P1 ) AE2 (at P2 ) AE3 (at P3 ) As Price Levels Increase… Aggregate Expenditures (billions of dollars) 45° P3 Real GDP Declines Price Level P2 P1 AD Q1 Q2 Q3 Real Domestic Product, GDP

Aggregate Expenditures Deriving the AD Curve Price Level Aggregate Expenditures 45° Real Domestic Product, GDP AE2 (at P1 ) AE1 (at P1 ) Increase in Aggregate Expenditures Increase in Aggregate Demand P1 AD2 AD1 Q1 Q2

Aggregate Expenditures Deriving the AD Curve Price Level Aggregate Expenditures 45° Real Domestic Product, GDP AE2 (at P1 ) AE1 (at P1 ) The Shift in the Aggregate Demand Curve is a Multiple of the initial Change in Aggregate Expenditures P1 AD2 AD1 Q1 Q2