Aggregate Demand A schedule or curve that shows the amounts of real output (GDP) at various price levels A schedule or curve that shows the amounts of real output (GDP) at various price levels Price level is measured with the GDP price index: Price level is measured with the GDP price index: Definition—a price index for all goods and services that make up Gross Domestic ProductDefinition—a price index for all goods and services that make up Gross Domestic Product

Aggregate Demand Curve AD Real GDP PL PL 1 PL 2 Y1Y1 Y2Y2

Why the downward slope? For individual products the reasons are: For individual products the reasons are: Income effect—as price falls, the consumer’s income allows for larger purchases of the productIncome effect—as price falls, the consumer’s income allows for larger purchases of the product Substitution effect—as price falls, the product becomes relatively less expensive than other substitutesSubstitution effect—as price falls, the product becomes relatively less expensive than other substitutes The income effect and substitution effect do not apply to aggregate demand. Why? The income effect and substitution effect do not apply to aggregate demand. Why?

Why the downward slope? The income effect does not apply because as the PL falls, less $ goes to resource suppliers in the form of wages, rents, interest, profits, etc. The income effect does not apply because as the PL falls, less $ goes to resource suppliers in the form of wages, rents, interest, profits, etc. The substitution effect does not apply because there are no substitutes for all goods and services The substitution effect does not apply because there are no substitutes for all goods and services So, once again, why the downward slope? So, once again, why the downward slope?

Aggregate Demand and the downward slope explained (finally!) Real-Balances Effect-- higher prices means our assets have less value so people are poorer and consume less Real-Balances Effect-- higher prices means our assets have less value so people are poorer and consume less Interest-rate effect—higher prices drive up the demand for money and so drive up interest rates, at higher interest rates, investment falls (more later) Interest-rate effect—higher prices drive up the demand for money and so drive up interest rates, at higher interest rates, investment falls (more later)

Aggregate Demand and the downward slope explained (cont.) Foreign-purchases effect—at higher prices, foreign goods are cheaper, so net exports falls (more later) Foreign-purchases effect—at higher prices, foreign goods are cheaper, so net exports falls (more later)

Changes in AD: Determinants (factors other than Price level) Change in consumer spending (C): Change in consumer spending (C): Consumer WealthConsumer Wealth Think of appreciating/depreciating assets like stocks, bonds, real-estate, and land Think of appreciating/depreciating assets like stocks, bonds, real-estate, and land Not income (remember, the income effect does not apply to aggregate demand) Not income (remember, the income effect does not apply to aggregate demand) Consumer expectations—about prices, income, etc.Consumer expectations—about prices, income, etc. Household debt—Think borrowingHousehold debt—Think borrowing TaxesTaxes

Changes in AD: Determinants (factors other than Price level) Change in investment spending (I): Change in investment spending (I): Interest rates—remember the investment demand curve?Interest rates—remember the investment demand curve? Expected ReturnsExpected Returns Expected future business conditions Expected future business conditions Technology Technology Degree of excess capacity—stock of capital goods Degree of excess capacity—stock of capital goods Business taxes Business taxes

Changes in AD: Determinants (factors other than Price level) Change in government spending (G) Change in government spending (G) Change in net export spending (Xn): Change in net export spending (Xn): Rising income in foreign countriesRising income in foreign countries Exchange rates (more later)Exchange rates (more later)

PL Real GDP AD 1 Initial increase in Aggregate demand

PL Real GDP AD 1 AD 2 Increase in aggregate demand after multiplier effect takes hold

PL Real GDP AD 1 Initial decrease in aggregate demand

PL Real GDP AD 1 AD 3 Decrease in aggregate demand after multiplier effect takes hold

PL Real GDP AD 1 AD 3 AD 2

Aggregate Supply The level of Real Output (GDP) that firms will produce at each price level The level of Real Output (GDP) that firms will produce at each price level Aggregate supply has two distinct curves: Aggregate supply has two distinct curves: Long Run Aggregate Supply (LRAS)Long Run Aggregate Supply (LRAS) Short Run Aggregate Supply (SRAS)Short Run Aggregate Supply (SRAS) Let’s start with LRAS Let’s start with LRAS

Long Run Aggregate Supply PL Real GDP LRAS QfQf

PL RGDP LRAS QfQf LRAS The LRAS represents the level of output at full-employment The LRAS represents the level of output at full-employment This is the level of sustainable production in the long run given efficient use of available resources This is the level of sustainable production in the long run given efficient use of available resources Think PPF Think PPF

PL RGDP LRAS QfQf LRAS LRAS does not change as the price level changes LRAS does not change as the price level changes Only changes technology or in the factors of production will cause the LRAS to shift left or right Only changes technology or in the factors of production will cause the LRAS to shift left or right

PL RGDP LRAS 1 QfQf LRAS What would happen if the labor force increased? What would happen if the labor force increased?

LRAS What is possible to produce in the long run has increased due to the increase in one of the factors of production What is possible to produce in the long run has increased due to the increase in one of the factors of production PL RGDP LRAS 1 QfQf LRAS 2 QfQf

Short Run Aggregate Supply PL Real GDP SRAS PL 1 PL 2 Q2Q2 Q1Q1 NOTE: You can use Y to show the level of output

Determinants for Short-Run Aggregate Supply Input prices: Input prices: Wages make up about 75% of all business costsWages make up about 75% of all business costs Domestic resource pricesDomestic resource prices Prices of imported resourcesPrices of imported resources Supply shocks due to market power—ex. OPECSupply shocks due to market power—ex. OPEC Changes in productivity: Changes in productivity: usually a result of new technology, better organization of resources, and job training/educationusually a result of new technology, better organization of resources, and job training/education Taxes, subsidies, and regulation Taxes, subsidies, and regulation

Shifts in Short Run Aggregate Supply PL Real GDP SRAS 1 PL 1 Q1Q1 SRAS 2 Q2Q2

What is the difference between the long-run and the short-run? In the short-run, the prices of inputs like labor and raw materials cannot adjust to increases in the price level In the short-run, the prices of inputs like labor and raw materials cannot adjust to increases in the price level As households see an increase in overall prices, they will demand higher prices for their resources (i.e. labor, land) to maintain their standard of living As households see an increase in overall prices, they will demand higher prices for their resources (i.e. labor, land) to maintain their standard of living The long-run has been reached once wages and cost of inputs have adjusted to the new higher price level The long-run has been reached once wages and cost of inputs have adjusted to the new higher price level

AD/AS Equilibrium The intersection of AD and SRAS establishes the equilibrium price level and RGDP The intersection of AD and SRAS establishes the equilibrium price level and RGDP This is the current level of productivity This is the current level of productivity PL 1 PL Real GDP SRAS 1 Q1Q1 AD 1

Shifts in AD/AS Increase in aggregate demand Increase in aggregate demand A.K.A. Demand-Pull Inflation A.K.A. Demand-Pull Inflation AD 2 PL 1 PL SRAS 1 Q1Q1 AD 1 RGDP Q2Q2 PL 2

Shifts in AD/AS Decrease in aggregate supply Decrease in aggregate supply A.K.A. Cost- Push Inflation A.K.A. Cost- Push Inflation AD 1 PL 1 PL SRAS 1 Q1Q1 SRAS 2 RGDP Q2Q2 PL 2

Downward Inflexibility of Prices While decreases in AD will theoretically cause the price level to drop, this usually does not happen in reality. Why? While decreases in AD will theoretically cause the price level to drop, this usually does not happen in reality. Why? Fears of price wars (gas stations in the 50’s)Fears of price wars (gas stations in the 50’s) Menu CostsMenu Costs Wage ContractsWage Contracts Morale (state workers)Morale (state workers) Minimum WageMinimum Wage A reduction in AD might slow inflation, but the price level rarely goes backwards A reduction in AD might slow inflation, but the price level rarely goes backwards One major exception was The Great Depression One major exception was The Great Depression

AD/AS and LRAS The economy is operating at full employment if AD and SRAS intersect at LRAS The economy is operating at full employment if AD and SRAS intersect at LRAS The goal for policy makers is to craft fiscal and monetary policy that targets the LRAS The goal for policy makers is to craft fiscal and monetary policy that targets the LRAS PL 1 PL Real GDP SRAS 1 QfQf AD 1 LRAS

AD/AS and LRAS If the AD/AS equilibrium is to the left of the LRAS, the economy is in recession If the AD/AS equilibrium is to the left of the LRAS, the economy is in recession PL 1 PL Real GDP SRAS 1 QfQf AD 1 LRAS Q1Q1

AD/AS and LRAS If the AD/AS equilibrium is to the right of the LRAS, the economy is in an inflationary period If the AD/AS equilibrium is to the right of the LRAS, the economy is in an inflationary period How can we produce beyond the LRAS? How can we produce beyond the LRAS? Only for short periods of time Only for short periods of time Real GDP PL 1 PL SRAS 1 QfQf AD 1 LRAS Q1Q1

Different types of AD/AS graphs ynesianclassical2.swf ynesianclassical2.swf ynesianclassical2.swf ynesianclassical2.swf