1. Aggregate Demand and Aggregate Supply

2. Aggregate Demand
Relationship between price level and real GDP demanded
“schedule or a curve showing the various amounts of goods and services—the amounts of real output—that domestic consumers, businesses, government,and foreign buyers collectively desire to purchase at each possible price level”
AD f (C, I, G, X, M)

3. Why is the Aggregate Demand Curve downward sloping?
Real-Balances (Wealth) effect: higher price level reduces real value of public’s accumulated financial assets
Interest-Rate effect: as prices rise, assuming money supply is fixed, interest rates rise because consumers and businesses need more money to buy goods and pay for inputs
Foreign purchases effect: increases in prices reduce our exports and increase imports

4. Why is the Aggregate Demand Curve downward sloping?
NOT Because of:
Income effect: at lower price levels, less income is likely to be generated so real income does not necessarily go up
Substitution effect: most prices are decreasing so no one set of goods/services is getting cheaper

5. Derivation of aggregate demand curve from aggregate expenditures model
If price level falls, wealth increases and consumption expenditures increase; interest rate decreases and investment increases

6. Derivation of Aggregate Demand Curve:1 2
Aggregate Expenditures 3
GDP GDP 2 GDP 1
GDP
Derivation of Aggregate Demand Curve:
Price Level 3 2 1 AD
GDP GDP 2 GDP 1
GDP

7. Determinants of Aggregate Demand
“Increase in aggregate demand” independent of price changes
Rightward movement of aggregate demand curve
Consumer wealth (non-price related): increases in stock prices, or increases in housing values
Expect prices to rise in the future
Household indebtedness low
Decrease in interest rates (not caused by price level change) from money supplying increasing
Higher expected returns on investment projects

8. Determinants of Aggregate Demand
“Increase in aggregate demand” independent of price changes
Decrease in business taxes
Improved technology
A decline in excess capacity
Increase in government spending (assuming taxes and price level do not increase as a result)
Net export spending
Rising national income abroad
Dollar depreciates
Shift of AD curve = initial change in spending x multiplier

9. Shift in Aggregate Demand
Increase in AD
Price Level
Decrease in AD
AD 1 AD
AD 2
Real GDP

10. Aggregate Supply
“Schedule or curve showing the level of real domestic output which will be produced at each price level”
Horizontal range: less than full employment
Upsloping (intermediate) range: full employment is not reached simultaneously in all factor markets
Vertical range: economy is at full capacity

11. Short Run vs. Long Run
Short Run: period in which nominal wages (and other resource prices) do not respond to price-level changes
Long Run: period in which nominal wages (and other resource prices) match changes in the price level

12. Long Run AS
Vertical at economy’s full employment output (potential output) level
Assume: $20 profit needed to produce full employment output of 100 units (price = $1)
Hires 10 units of labor at $8 wage
Profit =$20
Suppose price level doubles: $200 revenue and wage bill will double to $160
Nominal profit = $ =40
Real profit = $40/2 = $20 [price index $2/$1=1]

13. Short Run AS Real Profit = $200 - $80 = $120/2 = $60
Rise in real profit gives incentive for firm to want to produce more

14. Determinants of Aggregate Supply
What causes the AS to increase (shift to the right)?
Lower input prices (domestic or imported)
Increases in resource (factors of production) availability
Increased productivity
Market power of input sellers decreases
Lower business taxes
Increased subsidies
Decreased government regulation

15. Aggregate Supply Price GDP Horizontal Range- Less than full employment
Vertical Range
Horizontal Range- Less than full employment
Intermediate Range- Approaching Full Employment
Vertical Range- Full employment
Price
Intermediate Range
Horizontal Range
GDP

16. Equilibrium AS Price Level Pequilibrium AD GDP 1 Real GDP Equilibrium

17. Equilibrium Aggregate amount demanded equals aggregate amount supplied
“For any increase in aggregate demand, the resulting increase in real GDP will be smaller the greater the increase in the price level
The multiplier is diminished by rising price level
Ratchet effect: an increase in demand will not lead to the same equilibrium quantity as the same decrease in demand since prices and wages are sticky downwards [see diagram]

18. Demand Pull Inflation
AD shifts to the right

19. Decreases in AD: Recession and Cyclical Unemployment
AD shifts to the left, but prices do not easily go down.

20. Why are prices sticky downwards?
Wage contracts
Lower wages decrease morale and productivity
Training investments might make it more costly to lay off more experienced workers
Minimum wage
Menu costs: it is expensive to print new menus
Fear of price wars

21. Decreases in AS: Cost-Push Inflation
AS shifts to the left