Aggregate Demand (AD) and Aggregate Supply (AS) Chapter 29 Aggregate Demand (AD) and Aggregate Supply (AS)

Learning objectives AD and the factors that cause it to change AS and the factors that cause it to change How AD and AS determine an economy’s equilibrium price level and level of real GDP How the AD-AS model explains periods of demand-pull inflation, cost-push inflation, and recession GUARANTEED TO BE A MAJOR EMPHASIS ON THE AP MACRO EXAM!

First, Let’s look at a couple of multipliers: The Tax Multiplier Simply: -MPC/MPS (ex: -.8/.2 = tax multiplier of -4) If MPC=.8 and Lump-Sum Tax increase = $10 billion, then RGDP declines by $40 bil = ($10 bil x -4) Rationale: C is reduced by the lump-sum tax amount multiplied by the MPC, not by full multiplier (of 5 in the example…why? Because a portion of the tax is “paid for” by a reduction in S.) If MPC = .8 and lump-sum tax = $10 billion, C is reduced by ($10 billion X .8) = $8 billion. S is reduced by $2 billion. so, -$8 X multiplier of 5 = -$40 bil RGDP Change in C = MPC x lump sum tax amount

The Balanced Budget Multiplier Equal increases in G and T (to maintain a balanced budget) will increase GDP by the amount of the increase in G (or T.) For example: +10 G and +10 T, GDP +10 Rationale: Government spending has a direct impact on AE while taxes affect AE indirectly by changing DI. Convince yourself: work out the change in GDP given MPC = .75 and G and T both increasing by $20 billion. The balanced budget multiplier = 1

Aggregate Demand (AD) A schedule or curve showing various amounts of g/s that domestic consumers, businesses, government and foreign buyers collectively desire to purchase at each price level (PL). Why does it slope downward? Wealth Effect (Real-Balances Effect)—higher price level reduces purchasing power of the public’s accumulated financial assets. Interest Rate Effect—As prices increase, so does the price of money, interest rates. Foreign Purchases Effect—an increase in a nation’s price level reduces its net export level. Explains movement along the AD curve…price level changes change output demanded!

Determinants of AD— “shifters” 1. Consumer Spending, even at constant prices, consumers sometimes alter their spending. Consumer wealth Consumer expectations Household indebtedness Taxes 2. Investment Spending Interest rates Expected returns on investment projects Business taxes Technology Degree of excess capacity

3. Government Spending (assume no changes in T or RIR) 4. Net Export Spending National income abroad—rising NI levels in foreign nations increase foreign demand for U.S. goods. Exchange rates Preferences Don’t forget: Any spending shift is subject to multiplier effect…(to some extent at least…more analysis required once we’re done with the model!) Shift in AD = change in spending X multiplier

Aggregate Supply (AS) A schedule or curve showing the level of real domestic output (GDP) that will be produced at each price level. There is a direct relationship between the price level and the amount of real output businesses offer for sale. The AS curve reflects what happens to per unit production costs as GDP expands. The AS curve has three ranges…

Intermediate (Upsloping) Range – SRAS Horizontal Range Implies recession and idle resources—output can be increased without pushing up prices because per unit production costs do not increase. Real output and employment may fall, but prices and wages stay constant (prices and wages are inflexible downward.) Intermediate (Upsloping) Range – SRAS An expansion of output is accompanied by an increase in prices (per unit production costs are increasing.) Some industries are at capacity while others are not. Vertical Range – LRAS The economy is at full capacity. Price increases will not increase output. Attempts to increase production cause resource prices to be “bid up” and transferred from one producer to another.

Determinants of AS (“shifters”) Each determinant change will affect per unit production costs at each price level. Input Prices (resource prices) Domestic resource availability—supply increase drops resource prices, AS shifts to the right. Land Labor Capital Entrepreneurial ability Prices of imported resources, exchange rates Market power of resource suppliers Labor unions OPEC

Legal-Institutional Environment Productivity—by reducing per unit production cost, an increase in productivity shifts the AS curve rightward. Increases in productivity allow an economy to expand output without increasing prices (1990’s expansion!) Example… Legal-Institutional Environment Business Taxes and Subsidies Government Regulation/Deregulation Study & bookmark pages 690-691 to review AD/AS determinants!

Equilibrium: real output and the price level Shifts of the AD curve—three possible intersection points: In the horizontal range, only output changes In the intermediate range, both price and real output change In the vertical range, only price changes Increases in AD in the intermediate and vertical range represent demand-pull inflation

Shifting of AS Decrease in AS leads to cost-push inflation and lower employment Increase in AS leads to lower prices and increased employment.

Multiplier with price level changes If the economy is in the horizontal range, any initial change in spending transmits fully into a change in real GDP and employment. The full strength multiplier works. If the economy is in either the intermediate or vertical range, part or all of any initial increase in spending (AD) will be dissipated by inflation. Inflation reduces the multiplier. For any initial increase in AD, the resulting increase in real GDP will be smaller the greater the increase in the price level. (reduced by inflation)

Ratchet effect Assumption: All prices (both product and resource prices) are inflexible downwards. Graph… Causes of downward price level inflexibility: Wage contracts Morale, effort and productivity (“efficiency wages”—that elicit maximum output and minimize labor costs per unit of output.) “menu” costs Minimum wage laws Fear of price wars