McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 08 Aggregate Demand and Aggregate Supply

1- 2 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-2 Chapter Outline Aggregate Demand Aggregate Supply Shifts in Aggregate Demand and Aggregate Supply Causes of Inflation Supply-Side Economics How the Government Can Influence (but probably not control) the Economy

1- 3 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-3 Aggregate Demand Aggregate Demand: the amounts of real domestic output which domestic consumers, businesses, governments, and foreign buyers collectively will desire to purchase at each possible price level

1- 4 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-4 Figure 1 Aggregate Demand RGDP PI AD

1- 5 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-5 Why Aggregate Demand is Downward Sloping Real Balances Effect Because higher prices reduce real spending power, prices and output are negatively related. Foreign Purchases Effect When domestic prices are high, we will export less to foreign buyers and we will import more from foreign producers. Therefore higher prices leads to less domestic output. Interest Rate Effect higher prices lead to inflation which leads to less borrowing and a lowering of RGDP

1- 6 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-6 Aggregate Supply Aggregate Supply: the level of real domestic output available at each possible price level

1- 7 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-7 Figure 2 The Aggregate Supply Curve RGDP PI Keynesian Range Classical Range Intermediate Range AS

1- 8 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-8 The Ranges of AS Keynesian Range Large amounts of unemployment make it so that increases in aggregate demand have no affect on wages or prices. Classical Range Full employment makes it so that increases in aggregate demand only increase wages or prices. Intermediate Range Some sectors of the economy reach full employment more quickly than others.

1- 9 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-9 Variables that Shift Aggregate Demand Taxes Interest Rates Confidence Strength of the Dollar Government Spending

1- 10 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-10 Determinants of AD VariableGDP Component C,I,G,X Effect of an increase on AD Effect of a decrease on AD TaxesC,IDecrease so AD <= Increase so AD => Interest RatesC,IDecrease so AD <= Increase so AD => ConfidenceC,IIncrease so AD => Decrease so AD <= Strength of the Dollar X (exports- imports) Decrease so AD <= Increase so AD => Government Spending GIncrease so AD => Decrease so AD <=

1- 11 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-11 Figure 3 AD Increases AD AS AD RGDP PI PI* RGDP* PI RGDP

1- 12 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-12 Figure 4 AD Decreases AD AS AD RGDP PI PI* RGDP* PI RGDP

1- 13 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-13 Variables that Shift AS Input Prices Productivity Government Regulation

1- 14 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-14 Determinants of AS Variable Effect of an Increase on AS Effect of an Decrease on AS Input PricesDecrease so AS Increase so AS ProductivityIncrease so AS Decrease so AS Government Regulation Decrease so AS Increase so AS

1- 15 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-15 Figure 5 Increase in AS AS AD RGDP PI PI* RGDP* AS PI RGDP

1- 16 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-16 Figure 6 Decrease in AS RGDP AS AD PI PI* RGDP* AS PI RGDP

1- 17 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-17 Causes of Inflation Demand Pull Inflation: inflation caused by an increase in aggregate demand Cost Push Inflation: inflation caused by a decrease in aggregate supply

1- 18 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-18 Government Influence: Aggregate Demand Government can influence economic activity with aggregate demand side policies affecting: Taxes Government Spending Interest Rates

1- 19 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 8-19 Government Influence: Aggregate Supply Government can influence economic activity with aggregate supply side policies affecting input costs (labor and wage) reducing regulation Increase incentives to Work Take Risks The actions are call Supply Side Economics