Chapter 13: Aggregate Demand and Aggregate Supply Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Aggregate-Demand- Aggregate-Supply Model The aggregate-demand-aggregate-supply model (AD-AS model) is a graphical model that allows us to analyze changes in real GDP and the price level simultaneously. The AD-AS model provides insights on inflation, unemployment, economic growth, and recession. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Aggregate Demand Aggregate demand is a schedule or curve that shows the total quantity of goods and services demanded at difference price levels. There is an inverse relationship between the price level (as measured by the GDP price index) and real output demanded (real GDP). Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Aggregate Demand Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Changes in Aggregate Demand Other things equal, a change in the price level will cause a movement along a fixed aggregate demand curve. As the price level rises, the amount of real output purchased falls, and vice versa. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Changes in Aggregate Demand The determinants of aggregate demand will cause the entire aggregate demand curve to shift. These include changes in consumer spending, investment spending, government spending, and net export spending. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

How AD Shifters Affect the Aggregate Demand Curve Determinant: Factor(s) of Determinant: AD shifts: Consumer Spending Consumer wealth increases Consumers’ real incomes rise Household indebtedness rises Tax increases RIGHT LEFT Investment Spending Increases in real interest rate Higher expected returns Government Spending Increase in government spending Net export Spending Rising national income abroad Depreciation of the dollar

Aggregate Supply Aggregate supply is a schedule or curve that shows the total quantity of goods and services supplied at difference price levels. The aggregate supply curve in the short run and in the long run vary by degree of wage adjustment; in the long run, the AS curve is vertical while in the short run, the AS curve is positively sloped.

Aggregate Supply in the Long Run In the long run, aggregate supply is vertical at the economy’s full-employment output. Changes in wages and other input prices respond completely to changes in the price level. Price-level changes do not affect firms’ profits, and thus they create no incentive for firms to alter their output. This is the long-run aggregate supply curve.

Aggregate Supply in the Long Run

Aggregate Supply in the Short Run In the short run, nominal wages and input prices adjust slowly to changes in the price level. A rise in the price level increases real output; a fall in the price level reduces real output. The short-run aggregate supply curve is an aggregate supply curve relevant to a time period in which wages and other input prices do not change in response to changes in the price level.

Aggregate Supply in the Short Run

Changes in Aggregate Supply Other things equal, a change in the price level will cause a movement along a fixed aggregate supply curve. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Changes in Aggregate Supply The determinants of aggregate supply will cause the entire aggregate supply curve to shift. These include changes input prices, changes in productivity, and changes in legal-institutional environment. Changes in the determinants raise or lower per-unit production costs at each price level (or each level of output). Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

How AS Shifters Affect the Aggregate Supply Curve Determinant: Factor(s) of Determinant: AS shifts: Input Prices Domestic resource prices rise Prices of imported resources rise Increased market power LEFT Productivity Increases in productivity RIGHT Legal-Institutional Environment Higher business taxes More government regulation

Equilibrium Price Level and Real GDP Equilibrium occurs at the price level that equalizes the amount of real output demanded and supplied. This occurs at the intersection of the aggregate demand curve and aggregate supply curve which establish the equilibrium price level and equilibrium real output

Equilibrium Price Level and Real GDP

Changes in the Price Level and Real GDP From period to period, aggregate demand and aggregate supply typical change. For example: if investment and government spending rises in an economy operating at its full-employment, aggregate demand will shift to the right, causing the price level and real output to rise (inflation and a positive output gap)  this is demand-pull inflation. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Changes in the Price Level and Real GDP Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Downward Price-Level Inflexibility The price level in the U.S. economy is readily flexible upward. However, the price level is “sticky” on the downside. Several possible reasons for downward price-level inflexibility include: Fear of price wars Menu costs Wage concerns Morale, effort, and productivity Minimum wage Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

An Important Caution This is some evidence that the price level and average level of wages are becoming more flexible downward in the U.S.. Intense international competition and declining union power seem to be undermining the ability of firms and workers to resist price and wage cuts when faced with falling aggregate demand. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

An Important Caution In theory, full flexible downward prices and wages would automatically “self-correct” a recession. In reality, the government, rather than wait for these slow and uncertain “corrections”, focus on trying to move the aggregate demand curve to its pre-recession location. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.