AGGREGATE DEMAND (AD): The quantity of real GDP demanded at different price levels. -The price level is measured using the GDP deflator. -The quantity of real GDP demanded is composed of C+I+G+(X-M) -The AD curve is NOT the same as a market demand curve. -A market demand curve illustrates the total demand of all consumers for ONE particular product. The AD curves illustrates the total demand of all agents in the economy for all goods and services in the economy.

The AD Curve: Negatively sloped.

Wealth effect: (aka real balances effect, Pigou effect) Real wealth is the amount of money in the bank, bonds, stocks and other assets people own (ex: art) measured in terms of what they will buy. Wealth effect: (aka real balances effect, Pigou effect) Real wealth is the amount of money in the bank, bonds, stocks and other assets people own (ex: art) measured in terms of what they will buy. People save and hold money, bonds and stocks. One reason is to build up funds for future spending (ex: college fund or retirement savings). People save and hold money, bonds and stocks. One reason is to build up funds for future spending (ex: college fund or retirement savings). If price level, real wealth. People then try to restore their real wealth by increasing their saving and decreasing consumption. So the quantity of real GDP demanded falls (movement ALONG the AD curve) If price level, real wealth. People then try to restore their real wealth by increasing their saving and decreasing consumption. So the quantity of real GDP demanded falls (movement ALONG the AD curve)

Wealth effect: (aka real balances effect, Pigou effect) Real wealth is the amount of money in the bank, bonds, stocks and other assets people own (ex: art) measured in terms of what they will buy. Wealth effect: (aka real balances effect, Pigou effect) Real wealth is the amount of money in the bank, bonds, stocks and other assets people own (ex: art) measured in terms of what they will buy. People save and hold money, bonds and stocks. One reason is to build up funds for future spending (ex: college fund or retirement savings). People save and hold money, bonds and stocks. One reason is to build up funds for future spending (ex: college fund or retirement savings). If price level, real wealth. People can reduce the amount they put into saving as their real wealth is increasing. They can (and do) increase their consumption consumption. So the quantity of real GDP demanded rises (movement ALONG the AD curve). If price level, real wealth. People can reduce the amount they put into saving as their real wealth is increasing. They can (and do) increase their consumption consumption. So the quantity of real GDP demanded rises (movement ALONG the AD curve).

Substitution effect: (International and intertemporal). Substitution effect: (International and intertemporal). An in the P L means the price of domestic goods is changing relative to the prices of foreign goods…foreign goods could be more attractive due to this change is relative prices. Thus M and X (which are relatively more expensive to the foreigners buying them). Domestic goods are substituted by foreign goods. An in the P L means the price of domestic goods is changing relative to the prices of foreign goods…foreign goods could be more attractive due to this change is relative prices. Thus M and X (which are relatively more expensive to the foreigners buying them). Domestic goods are substituted by foreign goods. An in the P L also means people need more money to maintain C, so they borrow money. This the interest rate. Opportunity cost of C is now higher so people save more…savings now allows for higher consumption in future. Thus current spending is substituted by spending in the future (intertemporal: Occurring across time, or across different periods of time. An in the P L also means people need more money to maintain C, so they borrow money. This the interest rate. Opportunity cost of C is now higher so people save more…savings now allows for higher consumption in future. Thus current spending is substituted by spending in the future (intertemporal: Occurring across time, or across different periods of time.

Substitution effect: (International and intertemporal). Substitution effect: (International and intertemporal). A in the P L means the price of domestic goods is changing relative to the prices of foreign goods…foreign goods could be less attractive due to this change is relative prices. Thus M and X (which are relatively more expensive to the foreigners buying them). Foreign made goods are substituted by domestic goods (by both domestic and foreign consumers). A in the P L means the price of domestic goods is changing relative to the prices of foreign goods…foreign goods could be less attractive due to this change is relative prices. Thus M and X (which are relatively more expensive to the foreigners buying them). Foreign made goods are substituted by domestic goods (by both domestic and foreign consumers). A in the P L also means people need less money to maintain C, so there is less borrowing of money. This will the interest rate. Opportunity cost of C is now lower so people save less…less savings now allows for higher consumption in present but less in the future. Thus current spending is substitutes spending in the future (intertemporal: Occurring across time, or across different periods of time). A in the P L also means people need less money to maintain C, so there is less borrowing of money. This will the interest rate. Opportunity cost of C is now lower so people save less…less savings now allows for higher consumption in present but less in the future. Thus current spending is substitutes spending in the future (intertemporal: Occurring across time, or across different periods of time).

Interest Rate Effect Interest Rate Effect As mentioned, an in the P L tends to interest rates as it costs more to buy things and people tend to borrow to maintain their spending. As mentioned, an in the P L tends to interest rates as it costs more to buy things and people tend to borrow to maintain their spending. The increase in borrowing (because of an increase in money demand) pushes up the price of money...which is the interest rate. The increase in borrowing (because of an increase in money demand) pushes up the price of money...which is the interest rate. As the interest gets higher it becomes too costly to borrow and people tend to buy fewer expensive goods (ex: houses, cars, luxury vacations, renovations) and the quantity of real GDP demand tends to falls. As the interest gets higher it becomes too costly to borrow and people tend to buy fewer expensive goods (ex: houses, cars, luxury vacations, renovations) and the quantity of real GDP demand tends to falls.

Interest Rate Effect Interest Rate Effect As mentioned, a in the P L tends to interest rates as it costs less to buy things and people tend to borrow less as they no longer need as much money in order to maintain their spending. As mentioned, a in the P L tends to interest rates as it costs less to buy things and people tend to borrow less as they no longer need as much money in order to maintain their spending. A decrease in borrowing (leads to a decrease in money demand) pushes down the price of money...which is the interest rate. A decrease in borrowing (leads to a decrease in money demand) pushes down the price of money...which is the interest rate. As the interest gets lower it becomes easier to borrow and people tend to buy more expensive goods (ex: houses, cars, luxury vacations, renovations) and the quantity of real GDP demand tends to rise. As the interest gets lower it becomes easier to borrow and people tend to buy more expensive goods (ex: houses, cars, luxury vacations, renovations) and the quantity of real GDP demand tends to rise.

NOTE: NOTE: In text on page 345 the real income effect is discussed. The real income effect only holds true if nominal wages remain constant as price level is falling. For workers on a contract it can be very difficult to lower wages BUT for new employees the wage rate will probably be lower and if their nominal wage is less than what it was then the real income effect does not hold. But the real wealth effect does as it is not tied to income. In text on page 345 the real income effect is discussed. The real income effect only holds true if nominal wages remain constant as price level is falling. For workers on a contract it can be very difficult to lower wages BUT for new employees the wage rate will probably be lower and if their nominal wage is less than what it was then the real income effect does not hold. But the real wealth effect does as it is not tied to income. RECALL: wages are the PRICE employees pay to hire workers...as price falls ALL prices fall, not only prices of consumption goods. RECALL: wages are the PRICE employees pay to hire workers...as price falls ALL prices fall, not only prices of consumption goods.

NOTE: NOTE: The interest rate effect can be tricky! If changes in the price level are CAUSING the change in the interest rate then the change in the interest rate is linked to a movement along the AD curve. The interest rate effect can be tricky! If changes in the price level are CAUSING the change in the interest rate then the change in the interest rate is linked to a movement along the AD curve. BUT the government can change the level of the interest rate completely separately from any changes in the price level. In this case the change in the interest rate will cause a SHIFT of the AD curve. BUT the government can change the level of the interest rate completely separately from any changes in the price level. In this case the change in the interest rate will cause a SHIFT of the AD curve.

SHIFTS OF AD SHIFTS OF AD

Shifts of the AD Curve AD = C + I + G + (X-M) AD = C + I + G + (X-M) Anything that cause a change in any of the componets of AD will cause AD to shift. Anything that cause a change in any of the componets of AD will cause AD to shift. EX:C: changes in consumer wealth, expectations, taxes, indebtedness will each causes the level of AD to change (at the given price level!!) EX:C: changes in consumer wealth, expectations, taxes, indebtedness will each causes the level of AD to change (at the given price level!!) I: changes in interest rates, profit expectations or investment opportunities, business taxes, will each cause changes in AD for firms. I: changes in interest rates, profit expectations or investment opportunities, business taxes, will each cause changes in AD for firms. G: Changes in government spending. The use of fiscal and/or Monetary policy will cause AD to shift. G: Changes in government spending. The use of fiscal and/or Monetary policy will cause AD to shift. Net Exports: exchange rates, foreign national income/GDP Net Exports: exchange rates, foreign national income/GDP

Shifts of AD Consumption Consumption An increase in wealth increases consumption and AD shifts right. A decrease in wealth decreases consumtpion and AD shifts right. An increase in wealth increases consumption and AD shifts right. A decrease in wealth decreases consumtpion and AD shifts right. If consumers expect inflation to be higher they will buy more now to avoid price rises and AD will increase and shift left. If consumer expect inflation to be lower they will buy more when the prices are lower and lower current consumption. AD will shift left. If consumers expect inflation to be higher they will buy more now to avoid price rises and AD will increase and shift left. If consumer expect inflation to be lower they will buy more when the prices are lower and lower current consumption. AD will shift left. If consumers expect incomes or wealth to rise they know they will have more money and will increase their spending, Ad will rise and shift right. An expected fall in income or wealth will mean less consumption now to save for the time when they have less income. Ad will decrease and shift felt. If consumers expect incomes or wealth to rise they know they will have more money and will increase their spending, Ad will rise and shift right. An expected fall in income or wealth will mean less consumption now to save for the time when they have less income. Ad will decrease and shift felt. If taxes go down the overall price the cons pays for goods and services goes down and cons can buy more, AD shifts right. If taxes go up the overall price goes up and people cant buy as much and AD will fall and shift left. If taxes go down the overall price the cons pays for goods and services goes down and cons can buy more, AD shifts right. If taxes go up the overall price goes up and people cant buy as much and AD will fall and shift left. If cons are able to lower their debt payments more money can be spent on cons and Ad will rise and shift right. If people get more indebt a part of their income must go towards paying debt and less is available for consumption. AD falls and shifts left. If cons are able to lower their debt payments more money can be spent on cons and Ad will rise and shift right. If people get more indebt a part of their income must go towards paying debt and less is available for consumption. AD falls and shifts left.

If the interest rate goes down both cons and firms are affected. Easier to borrow means they have access to more money and C and I will go up, shifting AD to the right. If interest rates go up borrowing is more expensive and C and I will go down and AD will shift left. If the interest rate goes down both cons and firms are affected. Easier to borrow means they have access to more money and C and I will go up, shifting AD to the right. If interest rates go up borrowing is more expensive and C and I will go down and AD will shift left. Higher profit expectations will lead to higher I and thus AD. It will shift right. Lower profit expectations will lower I and thus AD. It will then shift left. Higher profit expectations will lead to higher I and thus AD. It will shift right. Lower profit expectations will lower I and thus AD. It will then shift left. Attractive investment opportunities will I and AD, AD shifts right. If investment opportunities seem unattractive (they will offer little gain) then firms will I and thus AD will and shift left. Attractive investment opportunities will I and AD, AD shifts right. If investment opportunities seem unattractive (they will offer little gain) then firms will I and thus AD will and shift left. Lower profit taxes or excise taxes mean the firm has more money to spend and I will as will AD (right shift). If these taxes increase then there is less money available for spending and I and thus AD will fall (AD shift left). Lower profit taxes or excise taxes mean the firm has more money to spend and I will as will AD (right shift). If these taxes increase then there is less money available for spending and I and thus AD will fall (AD shift left). NOTE capacity and technology affect AS not AD (sorry!!) NOTE capacity and technology affect AS not AD (sorry!!)

Government spending Government spending Expansionary Monetary policy (MP) = lower interest rate and higher money supply. This will increase spending and AD shifts right. Expansionary Monetary policy (MP) = lower interest rate and higher money supply. This will increase spending and AD shifts right. Expansionary Fiscal policy (FP) = more government spending and/or lower taxes. This will increase spending and Ad shifts right. Expansionary Fiscal policy (FP) = more government spending and/or lower taxes. This will increase spending and Ad shifts right. Contractionary MP = higher interest rates and lower money supply = less spending, AD shifts left. Contractionary MP = higher interest rates and lower money supply = less spending, AD shifts left. Contractionary FP = higher taexs and/or a reduction in gov spending = less overall spending, AD shifts left. Contractionary FP = higher taexs and/or a reduction in gov spending = less overall spending, AD shifts left.

Net Exports. Net Exports. If the exchange rate (the price you pay using your own currency to buy another currency) goes up then it takes more of your currency to buy foreign goods, M will but X as it is easier for foreigners to buy our currency. So (X-M), and AD shifts right. If the exchange rate (the price you pay using your own currency to buy another currency) goes up then it takes more of your currency to buy foreign goods, M will but X as it is easier for foreigners to buy our currency. So (X-M), and AD shifts right. If the exchange rate (price of foreign currency) goes down it takes less domestic currency to buy foreign goods. M and X as it costs more in terms of foreign currency to buy our goods. (X-M) and AD shifts left. If the exchange rate (price of foreign currency) goes down it takes less domestic currency to buy foreign goods. M and X as it costs more in terms of foreign currency to buy our goods. (X-M) and AD shifts left. If GDP in foreign countries is rising they buy more of all goods including goods they buy from us, so our AD will and shift right. If GDP in foreign countries is rising they buy more of all goods including goods they buy from us, so our AD will and shift right. If GDP in foreign countries is falling they buy less of all goods including goods they buy from us, so our AD will and shift left. If GDP in foreign countries is falling they buy less of all goods including goods they buy from us, so our AD will and shift left.

Aggregate Supply (AS) The AS: the relationship between the quantity of real GDP supplied and the price level. The shape of the AS curve differs in the short run and the long run. The short run AS curve (SRAS)

The KEYNESIAN INTERVAL: (aka the depressionary interval) is horizontal. This indicates that the quantity of real GDP can be increased or decreased without having any impact on the price level. The KEYNESIAN INTERVAL: (aka the depressionary interval) is horizontal. This indicates that the quantity of real GDP can be increased or decreased without having any impact on the price level. This can only happen if there is such an abundance of unused resources available that the use of some of them does not threaten a shortage of them. This can only happen if there is such an abundance of unused resources available that the use of some of them does not threaten a shortage of them.

Intermediate range Over this range any attempt to increase the quantity of real GDP causes there to be an increase in the price level. There is no longer an over abundance of resources. It is now the case that resources start to become more scarce and different firms compete to own these resources. Over this range any attempt to increase the quantity of real GDP causes there to be an increase in the price level. There is no longer an over abundance of resources. It is now the case that resources start to become more scarce and different firms compete to own these resources. The greater the increase in real GDP the more scarce the resources become and the greater the pressure on the price level to rise. The greater the increase in real GDP the more scarce the resources become and the greater the pressure on the price level to rise.

The Classical Range/Physical capacity The SRAS curve becomes vertical at the maximum physical capacity the economy is capable of producing. All resources are being used to their maximum capacity. The SRAS curve becomes vertical at the maximum physical capacity the economy is capable of producing. All resources are being used to their maximum capacity. Any attempt to increase real GDP fails…the only consequence is an increase in the price level… Any attempt to increase real GDP fails…the only consequence is an increase in the price level… WHY does the price level increase? WHY does the price level increase?

Shifts of AD over different ranges of SRAS

Long Run Supply Curve (LRAS)

SRAS and LRAS

Shifts of AS Both the long run supply aggregate curve (LRAS) and the short run aggregate supply curve (SRAS) can shift. Both the long run supply aggregate curve (LRAS) and the short run aggregate supply curve (SRAS) can shift. There is only ONE situation in which SRAS will shift and not LRAS (actually I have already shown you this in class). There is only ONE situation in which SRAS will shift and not LRAS (actually I have already shown you this in class). When the price of raw materials (inputs) change SRAS is affected but LRAS is NOT. This is because the LRAS is independent of the price level and prices…it is what we can produce with the amount of resources we have…not the price of those resources. When the price of raw materials (inputs) change SRAS is affected but LRAS is NOT. This is because the LRAS is independent of the price level and prices…it is what we can produce with the amount of resources we have…not the price of those resources. SO, if the average price of inputs falls, SRAS shift right. If the average price of inputs rises, SRAS shifts left. SO, if the average price of inputs falls, SRAS shift right. If the average price of inputs rises, SRAS shifts left. Lots of things could occur to change the price of inputs! For example, minimum wage could be increased, the exchange rate could change the price of imported inputs, gov regulations could alter the price of land. An increase in the amount of raw materials will also cause their price to change BUT the fact that the price is changing because there are more or less resources also affects our potential production. Lots of things could occur to change the price of inputs! For example, minimum wage could be increased, the exchange rate could change the price of imported inputs, gov regulations could alter the price of land. An increase in the amount of raw materials will also cause their price to change BUT the fact that the price is changing because there are more or less resources also affects our potential production.

Shifts of SRAS and LRAS Shifts of SRAS and LRAS Advance in technology both shift right. Theoretically if technology were to go back both would shift left. Advance in technology both shift right. Theoretically if technology were to go back both would shift left. Increases in overall productivity would shift both right, decreases in overall productivity would shift both left. Increases in overall productivity would shift both right, decreases in overall productivity would shift both left. Government regulations have an impact on the ability of firms to produce. Stricter gov regulations (for ex with regard to the impact production has on the environment) might make it more costly or difficult to produce and both could shift left. But if the gov were to relax some buiness regulations (called deregulation) firms could produce more and both could shift right. Government regulations have an impact on the ability of firms to produce. Stricter gov regulations (for ex with regard to the impact production has on the environment) might make it more costly or difficult to produce and both could shift left. But if the gov were to relax some buiness regulations (called deregulation) firms could produce more and both could shift right. Business taxes also affect AS. Higher business taxes increase the cost of prod and lower AS. Lower business taxes usually lead to an increase in AS. Business taxes also affect AS. Higher business taxes increase the cost of prod and lower AS. Lower business taxes usually lead to an increase in AS.

The fundamentals of increasing long run aggregate supply The fundamentals of increasing long run aggregate supply These all relate to the supply-side of the economy These all relate to the supply-side of the economy Expanding the labour supply - e.g. by improving incentives for people to search for and then accept new jobs as they become available. Government policies seek to expand the available labour supply by encouraging more people to join the labour force and become economically active. The UK government has also been encouraging an influx of migrant labour which has added to the supply of labour although it is also causing concern about some of the social and political effects. Expanding the labour supply - e.g. by improving incentives for people to search for and then accept new jobs as they become available. Government policies seek to expand the available labour supply by encouraging more people to join the labour force and become economically active. The UK government has also been encouraging an influx of migrant labour which has added to the supply of labour although it is also causing concern about some of the social and political effects. Increase the productivity of labour and capital – e.g. by investment in training of the labour force and improvements in the quality of management and human resource management Increase the productivity of labour and capital – e.g. by investment in training of the labour force and improvements in the quality of management and human resource management Increase the occupational and geographical mobility of labour to reduce certain types of unemployment for example the level of structural unemployment which is caused by occupational immobility of labour. A reduction in structural unemployment will reduce the scale of unemployment and provide the economy with a great supply of available labour. Increase the occupational and geographical mobility of labour to reduce certain types of unemployment for example the level of structural unemployment which is caused by occupational immobility of labour. A reduction in structural unemployment will reduce the scale of unemployment and provide the economy with a great supply of available labour. Expand the capital stock – i.e. increase the level of capital investment and research and development spending by firms Expand the capital stock – i.e. increase the level of capital investment and research and development spending by firms Increase business efficiency by promoting greater competition within and between markets Increase business efficiency by promoting greater competition within and between markets Stimulate a faster pace of invention and innovation – this will hopefully in the long term promote lower production costs and also improvements in the dynamic efficiency of markets Stimulate a faster pace of invention and innovation – this will hopefully in the long term promote lower production costs and also improvements in the dynamic efficiency of markets