1. Chapter 8: Aggregate Demand and Aggregate Supply
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2. In This Lecture….. Aggregate Demand
Factors That Can Change C, I, and X (EX-IM) and Therefore Change AD
Money Supply and Velocity
Short-Run Aggregate Supply
Short-Run Equilibrium
Long-Run Aggregate Supply and Long-Run Equilibrium
Three States of an Economy
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Aggregate Demand
Buying side of the economy = Aggregate demand (AD)
Producing side of the economy = Aggregate supply
Short-run aggregate supply (SRAS) is production in the short-run
Long-run aggregate supply (LRAS) is production in the long-run
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4. Aggregate Demand and Aggregate Supply
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Aggregate Demand
Aggregate Demand - The quantity demanded of all goods and services (Real GDP) at different price levels, ceteris paribus.
Aggregate Demand (AD) Curve - A curve that shows the quantity demanded of all goods and services (Real GDP) at different price levels, ceteris paribus.
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6. The Aggregate Demand Curve
The aggregated demand curve is downward-sloping, specifying an inverse relationship between the price level and the quantity demanded of Real GDP.
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7. The Aggregate Demand Curve
Click the graph to the right for a tutorial on aggregate demand
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8. Why Does the Aggregate Demand Curve Slope Downward?
Real Balance Effect
Interest Rate Effect
International Trade Effect
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Real Balance Effect
The change in the purchasing power of dollar-denominated assets that results from a change in the price level
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10. Real Balance Effect – Definitions
Monetary Wealth is the value of a person’s monetary assets. Wealth, as distinguished from monetary wealth, refers to the value of all assets owned, both monetary and nonmonetary. In short, a person’s wealth equals his or her monetary wealth (e.g., $1,000 cash) plus nonmonetary wealth (e.g., a car or a house).
Purchasing Power is the quantity of goods and services that can be purchased with a unit of money. Purchasing power and the price level are inversely related: As the price level goes up (down), purchasing power goes down (up)
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Interest Rate Effect
Changes in household and business buying as the interest rate Changes
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12. International Trade Effect
The change in foreign sector spending as the price level changes
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13. Change in Quantity Demanded
A change in the quantity demanded of Real GDP is the result of a change in the price level.
A change in the quantity demanded of Real GDP is graphically represented as a movement from one point, A, on AD1 to another point, B, on AD1.
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14. Change in Aggregate Demand
A change in aggregate demand is graphically represented as a shift in the aggregate demand curve from AD1 to AD2. It is caused by a change in spending.
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15. Change in Aggregate Demand
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16. Factors That Change Aggregate Demand & Consumption/Wealth
Wealth - The value of all assets owned, both
monetary and non- monetary
Wealth ↑ → C ↑→ AD ↑
Wealth↓ → C ↓→ AD ↓
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17. Factors That Change Aggregate Demand & Consumption/Prices
Expect higher future prices → C↑ → AD↑
Expect lower future prices → C↓ → AD↓
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18. Factors That Change Aggregate Demand & Consumption/Income
Expect higher future income → C ↑ → D↑
Expect lower future income → C↓ → AD↓
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19. Factors That Change Aggregate Demand & Consumption/Interest Rates
Interest Rate ↑ → C↓ → AD↓
Interest Rate ↓ → C ↑ → AD↑
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20. Factors That Change Aggregate Demand & Consumption/Income Taxes
Income taxes ↑ → C↓ → AD↓
Income taxes ↓ → C ↑ → AD↑
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21. Factors That Change Aggregate Demand & Investment/ Interest Rates
Interest rates ↑ → I↓ → AD↓
Interest rates ↓ → I ↑ → AD↑
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22. Factors That Change Aggregate Demand & Investment/ Future Sales
Optimistic about future sales → I ↑ → AD↑
Pessimistic about future sales → I↓ → AD↓
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23. Factors That Change Aggregate Demand & Investment/ Business Taxes
Business taxes↓ → I↑ → AD↑
Business taxes↑ → I↓ → AD↓
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Factors That Change Aggregate Demand & Net Exports/ Foreign Real National Income
Foreign real national income ↑ → EX↑ → NX↑ →AD↑
Foreign real national income ↓ → EX↓ → NX↓ →AD↓
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25. Factors That Change Aggregate Demand & Net Exports/ Exchange Rate
US $ depreciates → EX↑ and IM ↓ → NX↑ →AD↑
US $ appreciates → EX↓ and IM ↑ → NX↓ →AD↓
Appreciation
An increase in the value of one currency relative to other currencies.
Depreciation
A decrease in the value of one currency relative to other currencies.
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26. Factors That Change Investment/Interest Rate
Interest rate ↑ → I↓ → AD↓
Interest rate ↓ → I↑ → AD↑
As the interest rate falls, the cost of an investment project falls and businesses invest more. Consequently, aggregate demand increases.
As the interest rate rises, the cost of an investment project rises and businesses invest less. As investment decreases, aggregate demand decreases.
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27. Factors That Change Investment/Expectations About Future Sales
Businesses invest because they expect to sell the goods they produce.
Optimistic↑ → I ↑ → AD ↑
Pessimistic↓ → I ↓ → AD ↓
If businesses become optimistic about future sales, investment spending grows and aggregate demand increases.
If businesses become pessimistic about future sales, investment spending contracts and aggregate demand decreases.
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28. Factors That Change Investment/Business Taxes
Businesses naturally consider expected after-tax profits when making their investment decisions.
Business taxes ↑ → I↓ → AD↓
Business taxes ↓ → I↑ → AD↑
An increase in business taxes lowers expected profitability. With less profit expected, businesses invest less. As investment spending declines, so does aggregate demand.
A decrease in business taxes, on the other hand, raises expected profitability and investment spending. This increases aggregate demand.
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29. Factors That Change Net Exports/Dollar Depreciates
Foreign real national income↑ → EX ↑ → AD ↑
Foreign real national income ↓ → EX ↓ → AD ↓
As foreign real national income rises, foreigner buy more U.S. goods and services. Thus U.S. exports (EX) rise. As exports rise, net exports (X) rise, ceteris paribus. As net exports rise, aggregate demand increases
This process works in reverse. As foreign real national income falls, foreigners buy fewer U.S. goods and exports fall. This lowers net exports, reducing aggregate demand .
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30. Factors That Change Net Exports/Exchange Rate
Dollar depreciates → EX ↑ IM ↓ → AD ↑
Dollar appreciates → EX↓ →IM ↑ AD ↓
As the dollar depreciates, foreign goods become more expensive, Americans cut back on imported goods, and foreigners (whose currency has appreciated) increase their purchases of U.S. exported goods. If exports rise and imports fall, net exports increase and aggregate demand increases
As the dollar appreciates, foreign goods become cheaper, Americans increase their purchases of imported goods, and foreigners (whose currency has depreciated) cut back on their purchases of U.S. exported goods. If exports fall and imports rise, net exports decrease, thus lowering aggregate demand. .
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31. Factors That Change Aggregate Demand
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32. Money Supply and Aggregate Demand
One way to explain the effect of money supply on is as follows:
(1) A change in the money supply affects interest rates,
(2) a change in interest rates changes consumption and investment, and
(3) a change in consumption and investment affects aggregate demand. Therefore a change in the money supply is a catalyst in a process that ends with a change in aggregate demand. .
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33. Money Supply and Aggregate Demand
If both the money supply and velocity *are constant, a rise in one spending component (such as consumption) necessitates a decline in one or more other spending components.
If either the money supply or velocity rises, one spending component can rise without requiring other spending components to decline. .
* Velocity - The average number of times a dollar is spent to buy final goods and services in a year.
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Self-Test
Explain the real balance effect.
Real balance effect: a rise (fall) in the price level causes purchasing power to fall (rise), which decreases (increases) a person’s monetary wealth. As people become less (more) wealthy, the quantity demanded of Real GDP falls (rises).
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35. Click to return to “In this Lesson”
Self-Test
2. Explain what happens to the AD curve if the dollar appreciates relative to other currencies.
If the dollar appreciates, it takes more foreign currency to buy a dollar and fewer dollars to buy foreign currency. This makes U.S. goods (denominated in dollars) more expensive for foreigners and foreign goods cheaper for Americans. In turn, foreigners buy fewer U.S. exports, and Americans buy more foreign imports. As exports fall and imports rise, net exports fall. If net exports fall, total expenditures fall, ceteris paribus. As total expenditures fall, the AD curve shifts to the left.
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Self-Test
3. The money supply has risen, but total spending has declined. Is this possible? Explain your answer.
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37. Short-Run Aggregate Supply
Aggregate Supply - The quantity supplied of all goods and services (Real GDP) at different price levels, ceteris paribus.
Short-Run Aggregate Supply (SRAS) Curve - A curve that shows the quantity supplied of all goods and services Real GDP) at different price levels, ceteris paribus.
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38. Short-Run Aggregate Supply Curve
The short-run aggregate supply curve (SRAS) is upward- sloping, specifying a direct relationship between the price level and the quantity supplied of Real GDP.
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39. Why Does the Aggregate Supply Curve Slope Upward?
Two possible explanations:
Sticky wages
Worker misconceptions
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40. Sticky Wages, the Real Wage Rate, and SRAS
Wages are “locked in” for a few years due to labor contracts or perhaps because of social conventions or perceived notions of fairness.
While firms pay nominal wages, they often decide how many workers to hire based on real wages.
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41. Sticky Wages and the Real Wage Rate - Workers
The Real wage = Nominal wage/Price level.
Price level ↑→Real wage ↓, ceteris paribus
Price level ↓→Real wage ↑, ceteris paribus
More individuals are willing to work, and current workers are willing to work more at higher real wages than at lower real wages and vice versa.
Real wage↑→ Quantity supplied of labor ↑
Real wage↓→ Quantity of labor supplied ↓
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42. Sticky Wages and the Real Wage Rate - Firms
Firms will employ more workers the cheaper it is to hire them.
Real wage↑→ Quantity of labor demanded↓
Real wage↓→ Quantity of labor demanded↑
Thus, if wages are sticky, an increase in the price level (which pushes real wages down) will result in a increase in output. This is what an upward-sloping SRAS curve represents: As the price level rises, the quantity supplied of goods and services rises. The opposite occurs if price levels fall.
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43. Worker Misconceptions
If workers misperceive real wage changes, then a fall in the price level will bring about a decline in output, ceteris paribus, which is illustrative of an upward-sloping SRAS curve.
In response to (the misperceived) falling real wage, workers may reduce the quantity of labor they are willing to supply. With fewer workers (resources), firms will end up producing less.
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Changes in SRAS
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Changes in SRAS
Shifts in the SRAS curve may be caused by changes in:
Wage rates
Prices of non-labor inputs
Productivity
Supply shocks
Adverse
Beneficial
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Changes Wage Rates
The impact of a rise or fall in equilibrium wage rates can be understood in terms of the following equation:
Profit per unit = Price per unit - Cost per unit
Higher wage rates mean higher costs and, at constant prices, translate into lower profits and a reduction in the number of units (of a given good) that firms will want to produce.
Lower wage rates mean lower costs and, at constant prices, translate into higher profits and an increase in the number of units (of a given good) firms will decide to produce.
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47. Changes in the Price of Non-labor Inputs
Changes in the prices of non-labor inputs affect the SRAS curve in the same way as changes in wage rates do. An increase in the price of a non-labor input (e.g., oil) shifts the SRAS curve leftward; a decrease in their price shifts the SRAS curve rightward.
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48. Changes in the Productivity
Productivity is the output produced per unit of input employed over some period of time. Although various inputs can become more productive, let’s consider the labor input. An increase in labor productivity means businesses will produce more output with the same amount of labor, causing the SRAS curve to shift rightward. A decrease in labor productivity means businesses will produce less output with the same amount of labor, causing the SRAS curve to shift leftward. A host of factors lead to increased labor productivity, including a more educated labor force, a larger stock of capital goods, and technological advancements.
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Supply Shocks
Major natural or institutional changes that affect aggregate supply are referred to as supply shocks. Supply shocks are of two varieties.
Adverse supply shocks shift the SRAS curve leftward.
Beneficial supply shocks shift the SRAS curve rightward
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50. Click to return to “In this Lesson”
Changes in SRAS
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51. Click to return to “In this Lesson”
Self-Test
If wage rates decline, explain what happens to the short-run aggregate supply (SRAS) curve.
As wage rates decline, the cost per unit of production falls. In the short run (assuming prices are constant), profit per unit rises. Higher profit causes producers to produce more units of their goods and services. In short, the SRAS curve shifts to the right.
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52. Click to return to “In this Lesson”
Self-Test
2. Give an example of an increase in labor productivity.
Last year, 10 workers produced 100 units of good X in 1 hour. This year, 10 workers produced 120 units of good X in 1 hour.
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53. Click to return to “In this Lesson”
Self-Test
3. Discuss the details of the worker misperceptions explanation for the upward-sloping SRAS curve.
Workers initially misperceive the change in their real wage due to a change in the price level. For example, suppose the nominal wage is $30 and the price level is 1.50; it follows that the real wage is $20. Now suppose the nominal wage falls to $25 and the price level falls to 1.10.The real wage is now $ But suppose workers misperceive the decline in the price level and mistakenly believe it has fallen to They will now perceive their real wage as $17.85 ($25/1.40).
(continued)
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54. Click to return to “In this Lesson”
Self-Test
In other words, they will misperceive their real wage as falling when it has actually increased. How will workers react if they believe their real wage has fallen? They will cut back on the quantity supplied of labor, which will end up reducing output (or Real GDP). This process is consistent with an upward-sloping SRAS curve: A decline in the price level leads to a reduction in output.
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55. Short-run Equilibrium
At P1, the quantity supplied of Real GDP is greater than the quantity demanded. As a result, the price level falls and firms decrease output.
At P2, the quantity demanded of Real GDP is greater than the quantity supplied. As a result, the price level rises and firms increase output.
Short-run equilibrium occurs at point E, where the quantity demanded of Real GDP equals the (short-run) quantity supplied.
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56. Changes in Short-Run Equilibrium in the Economy
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58. Click to return to “In this Lesson”
AD and SRAS
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59. Natural Real GDP & Natural Unemployment
The Real GDP that is produced at the natural unemployment* rate.
The Real GDP that is produced when the economy is in long-run equilibrium.
*Unemployment caused by frictional and structural factors in the economy.
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60. Long-Run Aggregate Supply (LRAS )Curve
The LRAS curve is a vertical line at the level of Natural Real GDP.
It represents the output the economy produces when all economy wide adjustments have taken place and workers do not have any relevant misperceptions.
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61. Equilibrium States of the Economy
During the time an economy moves from one equilibrium to another, it is said to be in disequilibrium.
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62. Short-Run Equilibrium
The condition that exists in the economy when the quantity demanded of Real GDP equals the (short-run) quantity supplied of Real GDP. This condition is met where the aggregate demand curve intersects the short-run aggregate supply curve.
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Long-run Equilibrium
The condition that exists in the economy when wages and prices have adjusted to their (final) equilibrium levels and workers do not have any relevant misperceptions.
Graphically, long-run equilibrium occurs at the intersection of the AD and LRAS curves.
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64. Three States of an Economy
An economy can be in short-run equilibrium, long-run equilibrium, or disequilibrium.
When the economy is in neither short-run nor long-run equilibrium, it is said to be in disequilibrium.
Essentially, disequilibrium is the state of the economy as it moves from one short-run equilibrium to another or from short-run equilibrium to long-run equilibrium.
In disequilibrium, the quantity supplied and the quantity demanded of Real GDP are not equal.
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Self-Test
What is the difference between short-run equilibrium and long-run equilibrium?
In long-run equilibrium, the economy is producing Natural Real GDP. In short-run equilibrium, the economy is not producing Natural Real GDP, although the quantity demanded of Real GDP equals the quantity supplied of Real GDP.
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Self-Test
2. Diagrammatically represent an economy that is in neither short-run equilibrium nor long-run equilibrium.
The diagram should show the price level in the economy at P1 and Real GDP at Q1 but the intersection of the AD curve and the SRAS curve at some point other than (P1, Q 1). In addition, the LRAS curve should not be at Q 1 or at the intersection of the AD and SRAS curves.
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© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Wall Street Journal
The Wall Street Journal is a is a rich source of information which provides real life examples of micro- and macro economic activities. Check today’s issue to see the most current news.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with certain product , service, or otherwise on password-protected website for classroom use