National Income and Price Determination Unit 3 AP MACROECONOMICS

Introduction to Aggregate Supply & Demand

Purpose of Aggregate Supply & Demand Studies These studies seek to explain what is going on with rises and falls within the macroeconomy, which makes the theory of economic fluctuations super controversial. Within these studies, we must differentiate between the Long Term : The time frame in which various or all variables/factors can be changed in production and the Short Term : The time frame in which only one variable/factor can be changed in production

Aggregate Demand all the goods and services (real GDP) that all buyers in the U.S. are willing and able to purchase at different price levels. Price Level There is an inverse relationship between price level and Real GDP. If the price level: Increases (Inflation), then real GDP demanded falls. Decreases (deflation), the real GDP demanded increases. AD = C + I + G + Xn Real Domestic Output (GDPR)

Aggregate Demand – Why does it slope downward? Price Level The Wealth Effect Higher price levels reduce the purchasing power of money. This decreases the quantity of expenditures. Interest Rate Effect When the price level increases, lenders need to charge higher interest rates to get a REAL return on their loans. Higher interest rates discourage consumer spending and business investment. Foreign Trade Effect When U.S. price level rises, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods. Exports fall and imports rise causing real GDP demanded to fall. (XN Decreases) AD = C + I + G + Xn Wealth Effect : If the price level doubles, people are going to buy less stuff because they have less purchasing power. So…price level goes up, GDP demanded goes down. Interest Rate Effect : Example: An increase in prices leads to an increase in the interest rate from 5% to 25%. You are less likely to take out loans to improve your business. Example: If prices triple in the US, Canada will no longer buy US goods causing quantity demanded of US products to fall. So…price level goes up, GDP demanded goes down Real Domestic Output (GDPR)

Aggregate Demand – Shifters Factors that influence your GDP formula will shift the Demand Curve Change in Consumer Spending Change in Government Spending Change in Income (Higher incomes…) Government Expenditures (Decrease in defense spending…) (Increase in public works programs…) Consumer Expectations (People fear a recession…) Household Indebtedness (More consumer debt…) Change in Net Exports (X-M) Taxes (Decrease in income taxes…) Exchange Rates (If the us dollar depreciates relative to the euro…) Change in Investment Spending Real Interest Rates (Price of borrowing $) (If interest rates increase…) (If interest rates decrease…) National Income Compared to Abroad (If a major importer has a recession…) (If the US has a recession…) Future Business Expectations (High expectations…) Productivity and Technology (New robots…) Business Taxes (Higher corporate taxes means…)

With a partner determine what happens to the AD curve in each of the following scenarios? A. A ten-year-old investment tax credit expires. B. The U.S. exchange rate falls. C. A fall in prices increases the real value of consumers’ wealth. D. State governments replace their sales taxes with new taxes on interest, dividends, and capital gains. A. A ten-year-old investment tax credit expires. I falls, AD curve shifts left. B. The U.S. exchange rate falls. NX rises, AD curve shifts right. C. A fall in prices increases the real value of consumers’ wealth. Move down along AD curve (wealth-effect). D. State governments replace sales taxes with new taxes on interest, dividends, and capital gains. C rises, AD shifts right.

Aggregate Supply is the amount of goods and services (real GDP) that firms will produce in an economy at different price levels. Price Level Short-run Aggregate Supply (SRAS) Wages and Resource Prices will not increase as price levels increase. Example: If a firm currently makes 100 units that are sold for $1 each. The only cost is $80 of labor. How much is profit? Profit = $100 - $80 = $20 What happens in the SHORT-RUN if price level doubles? Short Run : Now 100 units sell for $2, TR=$200. How much is profit? Profit = $120 With higher profits, the firm has the incentive to increase production. Real Domestic Output (GDPR)

Aggregate Supply is the amount of goods and services (real GDP) that firms will produce in an economy at different price levels. Price Level We assume that in the long run, the economy will be producing at full employment, SO, we call this quantity the natural rate of output Yn Long Run Aggregate Supply (LRAS) Wages and resource prices WILL increase as price levels increase. Same Example: The firm has TR of $100 an uses $80 of labor. Profit = $20. What happens in the LONG-RUN if price level doubles? Now TR=$200 In the LONG RUN workers demand higher wages to match prices. So labor costs double to $160 Profit = $40, but REAL profit is unchanged. If REAL profit doesn’t changethe firm has no incentive to increase output. Real Domestic Output (GDPR)

Aggregate Supply – Shifters Use RAP to remember shifters for AS. Change in Resource Prices Change in Actions of the Government (NOT Government Spending) Prices of Domestic and Imported Resources (Increase in price of Canadian lumber…) (Decrease in price of Chinese steel…) Taxes on Producers (Lower corporate taxes…) Supply Shocks (Negative Supply shock…) (Positive Supply shock…) Subsidies for Domestic Producers (Lower subsidies for domestic farmers…) Government Regulations (EPA inspections required to operate a farm…) Inflationary Expectations (If people expect higher prices in the future…) Change in Productivity Technology (Computer virus that destroy half the computers…) (The advent of a teleportation machine…)

Headlines for AD/AS Select someone from your group to come collect 4 headlines from the basket. Glue each headline to your poster paper and respond to the following be prepared to explain your answers: Draw an AD/AS diagram with the relevant shift(s), be sure to label each curve. Explain why this shift has happened, or what shift this may cause. What is the consequence for real GDP and the price level? What are potential consequences for macroeconomics performance?

Classical Economic Theory Say’s Lay : supply creates its own demand Savings: If you were to decide to save instead of spend, prices would still adjust due to overproduction and QS Therefore, there will always be demand. Which in turn, means SUPPLY if the most important factor in the economy. Determined by resources and technology Fell out of favor during the Great Depression Output had dropped rapidly, but there had been no change in resources, not productivity/technology.

Keynesian Theory Keynes believed that spending motivated firms to supply goods and services. If consumers and firms were pessimistic about the future, firms would cut back production. Essentially – less spending would lead to less output. https://www.youtube.com/watch?v=d0nERTFo-Sk

Beggs, Jodi. "The Short Run Versus the Long Run in Economics Beggs, Jodi. "The Short Run Versus the Long Run in Economics." ThoughtCo, Aug. 7, 2017, thoughtco.com/the-short-run-versus-the-long-run-1147826.