Outline The price level and the money market The aggregate demand (AD) curve Movements along the AD curve Shifts of the AD curve The concept of markup pricing The aggregate supply (AS) curve Movements along the AS curve Shifts of the AS curve

Our first step is to explain how a change in the price level affects the money market.

Interest Rate Money ($Billions) 0 MsMs Md1Md1 Md2Md2 500 E 6% Recall that an increase in the price level, ceteris paribus, will shift M d to the right 9%

AE AD Real GDP ($Trillions) Price Level AE r = 6% AE r = 9% H H E E 1.Increase in the price level from 100 to 140 shifts the money demand function from M d 1 to M d 2 2.Equilibrium r increases to 9% 3.AE function shifts down. 4.New equilibrium at point H. 5.Hence P and Real GDP are inversely related, ceteris paribus

The AD curve indicates the level of equilibrium real GDP corresponding to any given price level. Price Level Real GDP ($Trillions) 0 H E AD When equilibrium real GDP = $10 billion, the price level is equal to 100. When equilibrium real GDP = $6 trillion, the price level is equal to 140.

Movements along the AD curve PP Increase in Money Demand r  a and I P  Equilibrium GDP  multiplier effect PP Decrease in Money Demand r  a and I P  Equilibrium GDP  multiplier effect

Any factor other than the price level that causes a change in equilibrium GDP will cause the AD function to shift. These factors will shift the AD curve: Change in government purchases (  G) Change in net taxes (  T) Change in autonomous consumption (  a) Change in investment spending (  I P ) Change in net exports (  NX) Change in the money supply (  M)

AE AD 1 Real GDP ($Trillions) Price Level AE 2 AE H H E E AD 2 1.Increase in G shifts the aggregate expenditure function from AE 1 to AE 2. 2.Equilibrium GDP increases to $13.5 trillion. 3.At each price level, GDP is higher than before, indicating that AD has shifted to the right

Bear in mind that ANY increase in autonomous spending (or decrease in net taxes) will have the same effect—that is, it will shift AD to the right

How do firms price goods and services? As a rule, the price of a good or service is equal to its unit production cost plus a mark-up

Price = Unit Cost + Markup Where: Unit cost is equal to total cost divided by units produced. The markup depends on the degree of market power possessed by the seller. The markup (expressed a a percent of unit cost) is much higher for Windows 2000 and Prozac than for bananas or rice

Quantity Total Cost($) Unit Cost($) Markup (%)Price($)

Supply of Hamburgers S $2.09 $ Price Quantity A B Moving from point A to B: Input prices are held constant— e.g., ground beef, buns, lettuce. Wages and benefits are held constant. Technology is held constant.

Shifts of the Supply of Hamburgers S1S1 $2.09 $ Price Quantity A B Moving from point S 1 to S 2 Input prices rise—e.g., ground beef, buns, lettuce. The markup rises. Wages and benefits increase Shift to inferior production techniques S2S2 H

The supply curve is upward sloping due to diminishing returns

The aggregate supply curve (AS) indicates the price level consistent with firms’ unit cost and markups for any level of output of real GDP You can think of AS as a “blown-up” or macroeconomic version of the supply curve.

Price Level Real GDP ($Trillions) 0 A B The AS Curve AS By expanding real GDP $10 to $13.5 trillion, firms experience rising unit production cost

Price Level Real GDP ($Trillions) 0 A B Shifts of the AS Curve AS 1 AS 2 Moving from point AS 1 to AS 2 Input prices rise—e.g.,oil, electricity, grains.. The ave. markup rises. Wages and benefits increase Shift to inferior production techniques K