Aggregate Demand and Aggregate Supply 29 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Aggregate Demand The curve shows Real GDP desired at each price level – there’s an inverse relationship – so….there’s a DOWNWARD slope Because……. LO1 29-2

Real balances effect - The real value of money is measured by how many goods and services your money will buy Interest effect - With lower prices, consumers need to borrow less, the demand for loans diminishes, so interest rates drop. Foreign purchases effect - When the U.S. price level falls, Americans buy fewer foreign produced goods and foreigners buy more U.S produced goods.

Aggregate Demand Real domestic output, GDP Price level AD LO

Changes in Aggregate Demand Determinants of aggregate demand Shift factors affecting C, I, G, X n 2 components involved Change in one of the determinants causes a change in spending Multiplier effect – magnifies the initial change in spending into larger changes in AD LO1 29-5

Changes in Aggregate Demand Real domestic output, GDP Price level AD 1 AD 3 AD 2 LO

Consumer Spending Consumer wealth Household borrowing Consumer expectations Personal taxes LO1 29-7

Investment Spending Real interest rates rise, borrowing costs rise and fall in investment and fall in AD Expected returns (positive/negative) Expectations about future business conditions Technology Degree of excess capacity Business taxes LO1 29-8

Government Spending Government spending increases Aggregate demand increases (as long as interest rates and tax rates do not change) More transportation projects Government spending decreases Aggregate demand decreases Less military spending LO1 29-9

Net Export Spending National income abroad Exchange rates Dollar depreciation – rise in exports and fall in imports, AD shifts right Dollar appreciation – fall in exports and rise in imports, AD shifts left LO

Aggregate Supply Total real output produced at each price level Relationship depends on time horizon Immediate short run Short run –the most used in our book! Long run LO

AS: Immediate Short Run Real domestic output, GDP Price level AS ISR QfQf Immediate-short-run aggregate supply P1P1 0 LO Labor is 75% of costs Input and output prices are fixed

Aggregate Supply: Short Run Real domestic output, GDP Price level 0 QfQf AS Aggregate supply (short run) LO Output prices are flexible, input prices are fixed

Aggregate Supply: Long Run Real domestic output, GDP Price level AS LR QfQf 0 Long-run aggregate supply LO All prices are flexible and will produce the full employment level no matter the price

Changes in Aggregate Supply Real domestic output, GDP Price level AS 1 AS 3 AS 2 0 LO

Input Prices Domestic resource prices Labor Capital Land Prices of imported resources Imported oil Exchange rates – rise in exchange rates = more foreign $ for each US $ - shift right LO

Productivity Real output per unit of input – usually because of a change in technology Increases in productivity reduce costs Decreases in productivity increase costs LO2 Per-unit production cost = total input cost total output Productivity = total output total inputs 29-17

Legal-Institutional Environment Legal changes alter per-unit costs of output Taxes and subsidies Extent of government regulation LO

Equilibrium Real domestic output, GDP (billions of dollars) Price level (index numbers) a b AD AS Real Output Demanded (Billions) Price Level (Index Number) Real Output Supplied (Billions) $506108$ LO Figure 29.7

ADAS WmPJS0http:// WmPJS0

AD Increases: Demand-Pull Inflation Real domestic output, GDP Price level AD 1 AS P1P1 P2P2 Q2Q2 Q1Q1 QfQf AD 2 0 LO The shift in AD beyond full employment leads to inflation The rise in the Price Level REDUCES the multiplier

Decreases in AD: Recession Real domestic output, GDP Price level AD 1 AS P1P1 P2P2 Q1Q1 Q 2 QfQf AD 2 c a b 0 LO Deflation a to b downward price inflexibility a to c price flexible downward

Decreases in AD: Recession Prices are downwardly inflexible Fear of price wars - Strength Menu costs - Sessions Wage contracts - Walton Efficiency wages - Wilson Minimum wage law - Carroll LO

Decreases in AS: Cost-Push Inflation Real domestic output, GDP Price level AD AS 1 P1P1 P2P2 Q1Q1 QfQf AS 2 a b 0 LO Recession occurs

Increases in AS: Full-Employment Real domestic output, GDP Price level AD 1 AS 2 P1P1 P2P2 Q 2 Q1Q1 AS 1 b AD 2 c P3P3 Q3Q3 a 0 LO AD1 to AD2 = a to b = inflation AS1 to AS2 = a to c = mild inflation