Chapter 10 Aggregate Demand and Aggregate Supply: The Basic Model

The Basics of Aggregate Demand Aggregate demand refers the real value of all new, final, domestically produced goods and services that households, firms, governments, and the foreign sector are willing and able to purchase at a given set of price levels, ceteris paribus.

The Basics of Aggregate Demand (cont’d) AD equals:  Consumption Spending by Households, plus  Investment Expenditures by Firms, plus  Government Expenditures, plus  Net Exports

The Price Level and Aggregate Demand The overall price level is the major determinant of total spending in the economy. Aggregate demand curve shows relationship between the price level and total spending  What is the relationship??

Figure 10.1 The Aggregate Demand Curve

Why the Aggregate Demand Curve Slopes Downward There are three basic reasons:  The Wealth Effect As prices decrease you feel wealthier because you can buy more  The Interest Rate Effect As prices fall  don’t have to spend as much  save more  interest rates fall  encourage borrowing  changes AD  The International Trade Effect As prices fall  buy more US good  imports fall  other countries see that our goods are cheaper  exports increase

Basic Movements in Aggregate Demand Change in aggregate quantity demanded  Caused by a change in the overall price level.  Shown by a movement along the aggregate demand curve

Basic Movements in Aggregate Demand (cont’d) A change in aggregate demand is caused by changes in forces other than the price level:  Macroeconomic policy influences Changing interest rates, changing taxes, changes in government spending  Expectations Consumer confidence  Global influences Purchasing power of the dollar Represented by a shift of the aggregate demand curve

Table 10.1 Key Influences on Changes in Aggregate Demand

Figure 10.2 Change in Aggregate Demand

Can we do it?? Let’s try number 2… How will the following actions of macroeconomic policy affect the US aggregate demand curve?  Social Security taxes are increased to extend the life of the Social Security system AD shift to the left  The federal government expends its spending on prescription drug benefits under Medicare AD shift to the right  Consumers expect more disposal income in the future as temporary tax cuts are made permanent AD shift to the right

The Basics of Aggregate Supply Aggregate supply is the real value of all final, domestically produced goods and services that firms are willing to offer for sale at various price levels, ceteris paribus. There are two different aggregate supply curves:  The Short-Run AS Curve  The Long-Run AS Curve

Aggregate Supply in the Short Run The short run is a period of time that is too short for firms to adjust fully to changes in the price level.  Workers face sticky wages. Can’t change nominal wages easily when prices change  Firms face sticky prices. Can’t always increase the price of your product  Firms and workers may have mistaken estimates of nominal prices. May not have all the information right  OOPS

The Price Level and Short-Run Aggregate Supply In the short run, a higher price level will cause firms to produce more goods and services.  The short-run aggregate supply curve is upward-sloping.

A higher price level provides an incentive for firms to increase output.  Based on the process of profit maximization  Note: If price rises faster than costs, profitability increases. Why the Short-Run Aggregate Supply Curve Slopes Upward

Why the Short-Run Aggregate Supply Curve Slopes Upward (cont’d) Resource prices (such as nominal wages) are sticky.  They change more slowly than output prices. As price levels rise faster than production costs, profit per unit increases, and firms have an incentive to increase output.

Basic Movements in Short-Run Aggregate Supply (cont’d) A change in the price level is represented by a movement along a short-run aggregate supply curve.  This is called a change in aggregate quantity supplied.

Figure 10.3 The Short-Run Aggregate Supply Curve

Changes in Short-Run Aggregate Supply Changes in other factors other than price can affect profitability at a given price level:  Nominal resource prices, especially nominal wages Wages account for 2/3 of total production costs  Productivity Workers become more efficient and produce more  Producers’ expectations What do firms think will happen in the future?  These changes will shift the entire aggregate supply curve.

Figure 10.4 Change in Short-Run Aggregate Supply

Can we do it?? Let’s try number 6… For a given industry, let the product price per unit = $5 and the production cost per unit = $3  Based on this information, what is the profit per unit for this producer? $2 * number of units sold  Now let the product price increase to $6 per unit, and the production cost per unit increase to $3.50 per unit. What is the profit per unit now for this producer? $2.50 * number of units sold  How should this producer change his production plans in the face of the changing profit per unit? Should increase production  If many producers faced the same situation, how would this affect the AS curve? Because it is a PRICE change AS will not shift  change in Aggregate Quantity Supplied