Aggregate Demand and Aggregate Supply January 12, 2011

2 Aggregate Demand Amount of real GDP purchased at each price level Why the downward slope? –Real-balances effect –Interest-rate effect –Foreign purchases effect Consumption, investment, and net exports

3 Aggregate Demand Curve Real Domestic Output, GDP Price Level AD Aggregate Demand

4 Aggregate Demand Determinants of aggregate demand –Fixed variables along the demand curve Change in fixed variable Multiplier effect Consumer spending variables: –Consumer wealth –Consumer expectations –Household borrowing –Personal taxes

5 Aggregate Demand Investment spending variables –Real interest rates –Expected returns Future business conditions Technology Degree of excess capacity Business taxes

6 Aggregate Demand Government spending Net export spending variables National income abroad Exchange rates

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

8 Amount real GDP produced at each price level Three time horizons Immediate short run –Few days to a few months –All prices fixed –Implicit price agreements –Contractual agreements Aggregate Supply

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

10 Short run –Input prices fixed –Output prices variable –Real profit changes Long run –All prices variable –Full employment GDP –All prices adjust Aggregate Supply

11 Real Domestic Output, GDP Price Level 0 QfQf Aggregate Supply (Short Run) Slope not constant: per unit production cost and firm capacity Aggregate Supply

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

13 Determinants of aggregate supply Change in input price –Domestic resource prices –Prices of imported resources Change in productivity Change in legal-institutional environment –Business taxes and subsidies –Government regulation Aggregate Supply

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

15 Equilibrium Real Output Demanded (Billions) Price Level (Index Number) Real Output Supplied (Billions) $ $ Equilibrium Price Level and Equilibrium Real GDP

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

17 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

18 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

19 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 –Minimum Wage Changes in Equilibrium

20 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

21 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