Aggregate Demand

**Assumes a constant Money Supply** Aggregate Demand is: A schedule, graphically represented as a curve, which shows the various amounts of goods and services--the amounts of real domestic output--which domestic consumers, businesses, governments, and foreign buyers collectively will desire to purchase at each possible price level **Assumes a constant Money Supply**

Price Level AD Real Domestic Output (Real GDP) Less Domestic output will be produced and purchased at higher price levels and visa-versa

Determinants of A.D. Wealth Effect--different price levels either increase or decrease the purchasing power of accumulated assets Interest Rate Effect--different interest rates (due to different price levels) will either increase or decrease consumption of domestic output Foreign Purchases Effect--different price levels will either increase or decrease foreign purchases of domestic output (net exports)

Factors that Shift Aggregate Demand Changes in Consumer Spending -- Consumer Wealth -- Consumer Expectations -- Consumer Indebtedness -- Taxes (Changes in...)

Factors that Shift Aggregate Demand Changes in Investment Spending (Business) Interest Rates Profit expectations on investment projects Business Taxes Technology Degree of Excess Capacity

Factors that Shift Aggregate Demand Change in Government Spending -- New national spending priorities -- Budgetary cutbacks Change in Net Export Spending -- National income abroad -- Exchange Rates

Price Level AD+ AD AD- Real Domestic Output (Real GDP)

Examples: Higher consumer indebtedness from past spending will curtail current spending causing AD to shift left. Increases in Business taxes will curtail current investment spending causing AD to shift left (inward). Depreciation of the $dollar will cause foreign currencies to be more valuable, increasing exports, decreasing imports. AD will shift right (outward)

Examples (Cont’d): Decreases in interest rates, caused by changes in the money supply, will increase consumer spending and investment shifting the AD curve to the right. Government cutbacks in purchases (e.g. military budget) will result in lower government spending, shifting AD curve to the left New technology stimulates investment spending, shifting AD to the right.,

Aggregate Supply

Aggregate Supply A schedule, graphically represented by a curve, showing the level of real domestic output (GDP) available at each possible price level

Real Domestic Output (GDP) AS Classical Range Price Levels Intermediate Range Keynesian Range Real Domestic Output (GDP)

Aggregate Supply: Keynesian Range GDP levels in this range indicate unused or idle resources GDP levels in this range implies economic contraction with accompanying unemployment GDP output can be increased due to idle resources without an increase in price levels, resulting in horizontal AS.

Aggregate Supply: Intermediate Range Increases in Real GDP are accompanied by increases in price levels Uneven expansion in different product and factor markets results in increases in price levels in some market segments but not others “Bottlenecks” in labor and capital use result in uneven price level increases in different market segments.

Aggregate Supply: Classical Range At some specific level of GDP output, productive capacity is fully utilized. Because economy is at a level of full employment and productive capacity, higher price levels will not result in greater production.

Factors that Shift Aggregate Supply Change in Input Prices Resource availability and prices Market Power of resource providers Labor Unions Monopoly resource owners Changes in Productivity Changes in Legal-Institutional Environment Business Taxes and Subsidies Government regulation

Real Domestic Output (GDP) AS- AS AS+ Decreased AS Price Levels Increased AS Real Domestic Output (GDP)

Classical Theory Jean-Baptiste Say (1767-1832) Assumes highly competitive marketplace with little or no government interaction Assumes natural state of equilibrium at full employment Say’s Law: Supply creates its own Demand Predominant economic theory until 1930’s

Keynesian Theory John Maynard Keynes: The General Theory of Prices and Equilibrium There is no “natural” balance in the economy Aggregate Demand is the primary influence on employment and price levels. Advocated use of “Fiscal Policy” by government to adjust equilibrium toward full employment Fiscal Policy is the use of government taxing and spending authorities to achieve economic goals.

Monetary Theory (Monetarism) Milton Friedman (Nobel Prize) The supply of money in the economy will affect interest rates therefore investment, and consumption. Too much $$ results in inflation; too little in unemployment. Advocated a balance between $$ supply and economic productivity and less gov’t involvement http://pw1.netcom.com/~garretc/politics/friedman.html

Monetarist Model S S’ money Interest Rate D Q1 Q2 Quantity of Money

Neo-Classical (Supply-Side) Gained prominence during 1970’s “Stagflation”. a.k.a. “Voodoo Economics”(G.Bush) Re-focus on Aggregate Supply Advocated: Lower Taxes on business and investors Increased privatization of gov’t programs Decreased regulation of business Stagflation = high inflation with high unemployment

Supply-Side Model AS1 FE AS2 Price Level AD GDP FE= Full Employment