Aggregate Demand Chapter 9 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Principles of Economics: Macroeconomics - Econ101

9-2 Aggregate Demand Aggregate demand: The total quantity of output (real GDP) demanded at alternative price levels in a given time period, ceteris paribus The aggregate demand curve illustrates how the real value of purchases varies with the average level of prices The downward slope suggests that with a given (constant) income, at lower price levels people will buy more goods and services

9-3 Three Reasons for the Downward Slope Wealth Effect: The change in the purchasing power of dollar-denominated assets that results from a change in the price level. International Trade Effect: The change in foreign sector spending as the price level changes. Interest Rate Effect: Changes in household and business buying as the interest rate changes.

9-4 Components of Aggregate Demand The four components of aggregate demand are –Consumption (C) –Investment (I) –Government spending (G) –Net exports (X – M)

9-5 Determinants of AD on (C) Wealth ↓ → C ↓ → AD ↓ 1. Wealth - The value of all assets owned, both monetary and non- monetary Expect higher future prices → C↑ → AD↑ Expect lower future prices → C↓ → AD↓ 2. Expected Future Prices Wealth ↑ → C ↑ → AD ↑

9-6 Determinants of AD on (C) Expect lower future income → C↓ → AD↓ Expect higher future income → C ↑ →A D↑ 3. Expected Future Income Interest Rate ↑ → C↓ → AD↓ Interest Rate ↓ → C ↑ → AD↑ 4. Interest Rates Income taxes ↑ → C↓ → AD↓ Income taxes ↓ → C ↑ → AD↑ 5. Income Taxes

9-7 Determinants of AD on (I) Interest rates ↑ → I↓ → AD↓ Interest rates ↓ → I ↑ → AD↑ 1. Interest Rates Pessimistic about future sales → I↓ → AD↓ Optimistic about future sales → I ↑ → AD↑ 2. Expected Future Sales Business taxes↑ → I↓ → AD↓ Business taxes↓ → I↑ → AD↑ 3. Business Taxes

9-8 Determinants of AD on (NE) Foreign real national income ↓ → EX↓ → NX↓ →AD↓ Foreign real national income ↑ → EX↑ → NX↑ →AD↑ US $ appreciates → EX↓ and IM ↑ → NX↓ →AD↓ US $ depreciates → EX↑ and IM ↓ → NX↑ →AD↑ 2. Exchange Rates 1. Foreign Income

9-9 Aggregate Supply Aggregate supply: The total quantity of output (real GDP) producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus Two reasons for upward sloping curve: –The profit effect –The cost effect

9-10 ….because over the short-run, as the price level increases, the quantity of goods and services firms are willing to supply will increase. As prices of final goods & services rise, prices of inputs, such as the wages of workers or the price of a natural resources, rise more slowly. Profits rise when the prices of the goods & services firms sell rise more rapidly than the prices they pay for inputs.

9-11  Wage rates  Productivity  Supply shocks  Adverse  Beneficial

9-12 Macro Equilibrium Aggregate supply and demand curves summarize the market activity of the whole (macro) economy Equilibrium (macro): The combination of price level and real output that is compatible with both aggregate demand and aggregate supply PRICE LEVEL REAL OUTPUT QEQE PEPE Aggregate demand Aggregate supply E D1D1 S1S1 P1P1 Macro equilibrium

9-13 Competing Theories of Short-Run Instability Macro controversies focus on the shape of aggregate supply and demand curves and the potential to shift them Demand-side theories, such as Keynesian and Monetary, emphasize aggregate-demand shifts Supply-side theories center on shifts in supply

9-14 Keynesian Theory Keynes argued that a deficiency of spending tends to depress an economy and cause persistently high unemployment Advocated increasing government spending – a rightward AD shift – to move the economy toward full employment

9-15 Monetary Theories Monetary Theories emphasize the role of money in financing aggregate demand Money and credit affect ability and willingness to buy goods and services If credit isn’t available or is too expensive consumers reduce spending and businesses curtail investment

9-16 Supply-Side Theories Inadequate supply can keep the economy below its full-employment potential and cause prices to rise as well Increases in aggregate supply move us closer to goals of price stability and full employment

9-17 Long-Run Self Adjustment Some economists argue that the long-run trend of the economy is what really matters, not short-run fluctuations They assert a long-run aggregate supply curve anchored at the natural rate of output (Q N ) –Flexible prices (and wages) enable the economy to maintain the natural rate of output Q N

9-18 REAL OUTPUT PRICE LEVEL The “Natural” Rate of Output QNQN AS AD 2 AD 1 P2P2 P1P1 Fluctuations in aggregate demand affect the price level but not real output.

9-19 Short vs. Long-run Perspectives The long-run aggregate supply curve is likely to be vertical at Q N The short-run aggregate supply curve is likely to be upward-sloping Both aggregate supply and aggregate demand influence short-run macro outcomes

9-20 Policy Strategies Shift the aggregate demand curve: Use policy tools that affect total spending Shift the aggregate supply curve: Implement policy levers that influence the costs of production or otherwise affect output Laissez-faire: Don’t interfere with the market; let markets self adjust

9-21 Selecting Policy Tools There are a host of tools available: –Classical laissez faire –Fiscal policy –Monetary policy –Supply-side policy –Trade policy

9-22 Policy Tools The laissez-faire approach requires no tools, as the economy naturally self-adjusts to full employment Fiscal policy: The use of government taxes and spending to alter macroeconomic outcomes

9-23 Policy Tools Monetary policy: The use of money and credit controls to influence macroeconomic outcomes Supply-side policy: The use of tax incentives, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services

9-24 Policy Tools Trade policy can be used to affect international trade and money flows and shift the aggregate demand and/or the aggregate supply curve