Aggregate Demand and Aggregate Supply Chapter 29 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

29-2 Chapter Objectives Aggregate demand (AD) Aggregate supply (AS) How AD and AS determine equilibrium price and real GDP The AD-AS model

29-3 Aggregate Demand Amount of real GDP purchased at each price level Why the downward slope? –No income or substitution effect –Real-balances effect: purchasing power of held assets (C) –Interest-rate effect: demand for $ (I) –Foreign purchases effect (X) Consumption, investment, and net exports

29-4 Aggregate Demand Curve Real Domestic Output, GDP Price Level AD Aggregate Demand

29-5 Aggregate Demand Determinants of aggregate demand –Fixed variables along the demand curve Change in fixed variable (C I G X) Multiplier effect Consumer spending variables: –Consumer wealth: value of assets –Consumer expectations: income and prices –Household borrowing: borrowing vs. repaying –Personal taxes

29-6 Aggregate Demand Investment spending variables –Real interest rates (related to money supply) –Expected returns on investment Future business conditions Technology Degree of excess capacity Business taxes – r = i

29-7 Aggregate Demand Government spending Remember - Non-transfers only Net export spending variables National income abroad Exchange rates –UK vs. US

29-8 Changes in Aggregate Demand Real Domestic Output, GDP Price Level AD 1 Increase in Aggregate Demand AD 3 AD 2 Decrease in Aggregate Demand

29-9 Amount real GDP produced at each price level Three time horizons Immediate short run –Few days to a few months –Sticky prices and wages All prices fixed (input and output) Implicit price agreements (output) Contractual agreements (input) Aggregate Supply

29-10 Aggregate Supply Real Domestic Output, GDP Price Level AS ISR Immediate-short- run Aggregate Supply QfQf

Aggregate Supply 29-11

29-12 Short run –Input prices fixed, Output prices variable In the Short Run, do firms prefer increase or decrease in Price Level? –Increase! – Fixed input contracts –Real profit changes Long run –All prices variable – inputs and outputs –Full employment GDP –All prices adjust Aggregate Supply

29-13 Real Domestic Output, GDP Price Level 0 QfQf Aggregate Supply (Short Run) Slope not constant: per unit production cost and firm capacity Aggregate Supply Competition for resources hikes ATC Plentiful resources limit growth of ATC

29-14 Aggregate Supply Real Domestic Output, GDP Price Level AS LR Long-run Aggregate Supply QfQf

29-15 Determinants of aggregate supply Change in input price (land, labor, capital) –Domestic resource prices –Prices of imported resources Change in productivity Change in legal-institutional environment –Business taxes and subsidies –Government regulation Aggregate Supply

Determinants of Aggregate Supply RPG –R –Resource Prices –P –Productivity –G –Government taxes, subsidies, regulation 29-16

29-17 Real Domestic Output, GDP Price Level AS 1 Increase in Aggregate Supply AS 3 AS 2 Decrease in Aggregate Supply Aggregate Supply

29-18 Equilibrium Real Output Demanded (Billions) Price Level (Index Number) Real Output Supplied (Billions) $ $ Equilibrium Price Level and Equilibrium Real GDP

29-19 Real Domestic Output, GDP (Billions of Dollars) Price Level a b AD AS Equilibrium

29-20 Changes in Equilibrium Real Domestic Output, GDP Price Level AD AS P1P1 P2P2 Q2Q2 Q1Q1 QfQf AD 1 Increase in Aggregate Demand Demand-Pull Inflation **increase in price level diminishes the multiplier effect Positive (Inflationary) GDP gap

29-21 Changes in Equilibrium Real Domestic Output, GDP Price Level AD 1 AS P1P1 P2P2 Q1Q1 Q2Q2 QfQf AD 2 Decrease in Aggregate Demand Creates a Recession a c b **No change in price level protects full multiplier effect Negative (recessionary) GDP gap

29-22 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: output per hour of input –Minimum Wage Changes in Equilibrium

29-23 Real Domestic Output, GDP Price Level AD AS 1 P1P1 P2P2 Q1Q1 QfQf Decrease in Aggregate Supply Cost-Push Inflation AS 2 a b Changes in Equilibrium

29-24 Real Domestic Output, GDP Price Level AD 1 AS 2 P1P1 P2P2 Q2Q2 Q1Q1 Increases in Aggregate Supply – Full-Employment With Price-Level Stability AS 1 b AD 2 c P3P3 Q3Q3 a Changes in Equilibrium

29-25 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

29-26 Key Terms aggregate demand- aggregate supply (AD- AS) model aggregate demand 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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