Aggregate Demand Copyright ACDC Leadership 2015.

Aggregate Demand Copyright ACDC Leadership 2015

What is Aggregate Demand?
Aggregate- “added all together.” When we use aggregates we combine all prices and all quantities. Aggregate Demand is all the goods and services (real GDP) that buyers are willing and able to purchase at different price levels. The Demand for everything by everyone in the US. There is an inverse relationship between price level and Real GDP. If the price level: Increases (Inflation), then real GDP demanded falls. Decreases (deflation), the real GDP demanded increases. Copyright ACDC Leadership 2015

Aggregate Demand Curve
AD is the demand by consumers, businesses, government, and foreign countries Price Level What definitely doesn’t shift the curve? Changes in price level cause a move along the curve AD = C + I + G + Xn Real domestic output (GDPR) Copyright ACDC Leadership 2015

Why is AD downward sloping?
The Wealth Effect- Higher price levels reduce the purchasing power of money. This decreases the quantity of expenditures Lower price levels increase purchasing power and increase expenditures Example: If the price level doubles, people are going to buy less stuff because they have less purchasing power. So…price level goes up, GDP demanded goes down. Copyright ACDC Leadership 2015

Why is AD downward sloping?
2. Interest-Rate Effect- When the price level increases, lenders need to charge higher interest rates to get a REAL return on their loans. Higher interest rates discourage consumer spending and business investment. Example: An increase in prices leads to an increase in the interest rate from 5% to 25%. You are less likely to take out loans to improve your business. So…price level goes up, GDP demanded goes down. Copyright ACDC Leadership 2015

Shifters of Aggregate Demand
GDP = C + I + G + Xn Copyright ACDC Leadership 2015

Shifts in Aggregate Demand
An increase in spending shift AD right, and decrease in spending shifts it left Price Level AD1 AD = C + I + G + Xn AD2 Real domestic output (GDPR) 7 Copyright ACDC Leadership 2015

Aggregate Supply Copyright ACDC Leadership 2015

What is Aggregate Supply? The supply for everything by all firms.
Aggregate Supply is the amount of goods and services (real GDP) that firms will produce in an economy at different price levels. The supply for everything by all firms. Aggregate Supply differentiates between short run and long-run and has two different curves. Short-run Aggregate Supply Wages and Resource Prices will not increase as price levels increase. Long-run Aggregate Supply Wages and Resource Prices will increase as price levels increase. Copyright ACDC Leadership 2015

Short-Run Aggregate Supply
In the Short Run, wages and resource prices will NOT increase as price levels increase. Example: If a firm currently makes 100 units that are sold for $1 each. The only cost is $80 of labor. How much is profit? Profit = $100 - $80 = $20 What happens in the SHORT-RUN if price level doubles? Now 100 units sell for $2, TR=$200. Profit = $120 With higher profits, the firm has the incentive to increase production. Copyright ACDC Leadership 2015

Short-Run Aggregate Supply
Price Level AS AS is the production of all the firms in the economy Real domestic output (GDPR) 11 Copyright ACDC Leadership 2015

Long-Run Aggregate Supply
In the Long Run, wages and resource prices WILL increase as price levels increase. Same Example: The firm has TR of $100 an uses $80 of labor. Profit = $20. What happens in the LONG-RUN if price level doubles? Now TR=$200 In the LONG RUN workers demand higher wages to match prices. So labor costs double to $160 Profit = $40, but REAL profit is unchanged. If REAL profit doesn’t change the firm has no incentive to increase output. Copyright ACDC Leadership 2015

In long run, price level increases but GDP doesn’t
Long- Run Aggregate Supply In long run, price level increases but GDP doesn’t LRAS Price level Long-run Aggregate Supply Full-Employment (Trend Line) QY GDPR We assume that in the long-run the economy will be producing at full employment. Copyright ACDC Leadership 2015

Shifters Aggregate Supply
R. A. P.

Shifts in Aggregate Supply
An increase or decrease in national production can shift the curve right or left AS2 Price Level AS AS1 Real domestic output (GDPR) 15 Copyright ACDC Leadership 2015

Shifters of Aggregate Supply
1. Change in Resource Prices Prices of Domestic and Imported Resources (Increase in price of Canadian lumber…) (Decrease in price of Chinese steel…) Supply Shocks (Negative Supply shock…) (Positive Supply shock…) Inflationary Expectations (If people expect higher prices in the future…) If producers expect higher prices in the future, workers will demand higher wages and costs will increase. This will decrease AS 16 Copyright ACDC Leadership 2015

Shifters of Aggregate Supply (NOT Government Spending)
2. Change in Actions of the Government (NOT Government Spending) Taxes on Producers (Lower corporate taxes…) Subsidies for Domestic Producers (Lower subsidies for domestic farmers…) Government Regulations (EPA inspections required to operate a farm…) 3. Change in Productivity Technology (Computer virus that destroy half the computers…) (The advent of a teleportation machine…) 17 Copyright ACDC Leadership 2015

Putting AD and AS together to get Equilibrium Price Level and Output
Copyright ACDC Leadership 2015

Use the AD and AS model to show an economy at full employment output
LRAS Price Level AS PLe AD QY GDPR 19 Copyright ACDC Leadership 2015

#1. Assume there is an increase in consumer spending
#1. Assume there is an increase in consumer spending. What happens to PL and output in the short- run? LRAS Price Level AS PL and Q will Increase PL1 PLe AD1 AD QY Q1 GDPR 20 Copyright ACDC Leadership 2015

Inflationary and Recessionary Gaps
21 Copyright ACDC Leadership 2015

The economy can only be in one of three places at any time
Max Capacity 0% Unemployment Real GDP Capital Goods Real GDP Consumer Goods Time Recessionary Gap Full Employment 5% Unemployment Full Employment Inflationary Gap 22 Copyright ACDC Leadership 2015

Example: Assume the government increases spending
Example: Assume the government increases spending. What happens to PL and Output? LRAS Price Level AS PL and Q will Increase PL1 PLe AD1 AD QY Q1 GDPR 23 Copyright ACDC Leadership 2015

Inflationary Gap Output is high and unemployment is less than NRU LRAS
Price Level AS Actual GDP above potential GDP PL1 AD1 QY Q1 GDPR 24 Copyright ACDC Leadership 2015

Example: Assume consumer spending falls. What happens to PL and Output?
LRAS Price Level AS PL and Q will decrease PLe PL1 AD AD1 Q1 QY GDPR 25 Copyright ACDC Leadership 2015

Recessionary Gap Output low and unemployment is more than NRU LRAS
Price Level AS Actual GDP below potential GDP PL1 AD1 Q1 QY GDPR 26 Copyright ACDC Leadership 2015

Stagnate Economy + Inflation Still considered recessionary gap
Example: If there is a negative “supply shock” of oil. What happens to PL and Output? LRAS Price Level AS1 AS Stagflation Stagnate Economy + Inflation PL1 PLe Still considered recessionary gap AD Q1 QY GDPR 27 Copyright ACDC Leadership 2015

What Happens In the Long-Run?
28 Copyright ACDC Leadership 2015

In the long-run, wages and costs increase
If consumer spending increases, what will happen in the short-run and in the long-run? In the long-run, wages and costs increase LRAS AS1 Real GDP Price Level AS PL2 PL1 Real GDP PLe AD AD1 QY Q1 GDPR Time 29 Copyright ACDC Leadership 2015

In the long-run, wages and costs increase
If consumer spending increases, what will happen in the short-run and in the long-run? In the long-run, wages and costs increase LRAS AS1 Real GDP Price Level PLe Real GDP AD1 QY GDPR Time 30 Copyright ACDC Leadership 2015

In the long-run, wages & costs eventually decrease
If consumer spending decreases, what will happen in the short-run and in the long-run? In the long-run, wages & costs eventually decrease LRAS Real GDP Price Level AS AS2 PLe PL1 Real GDP PL2 AD2 AD Q1 QY GDPR Time 31 Copyright ACDC Leadership 2015

#1. Assume there is an increase in government spending
#1. Assume there is an increase in government spending. What happens to PL and output in the short- run? LRAS Price Level AS PL and Q will Increase PL1 PLe AD1 AD QY Q1 GDPR 32 Copyright ACDC Leadership 2015

Price Level decreases and output stay s the same
#2. Consumer expectations fall and consumer spending plummets. What happens to price level and output in the long-run? Price Level LRAS AS AS1 Price Level decreases and output stay s the same PLe Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment PL1 PL2 AD AD AD1 Q1 QY GDPR 33 Copyright ACDC Leadership 2015

Price level increases and output stays the same
#3. If consumer spending increases, what happens to price level and output in the long-run? LRAS Price Level AS1 AS PL2 Price level increases and output stays the same PL1 PLe AD1 AD QY Q1 GDPR 34 Copyright ACDC Leadership 2015

Economic Growth 35 Copyright ACDC Leadership 2015

If investment increases, what happens in the short-run and long-run?
Capital Stock- Machinery and tools purchased by businesses that increase their output Price Level LRAS LRAS1 The PPC shifts outward since producers can make more AS AS1 Capital Goods PL1 PLe AD AD1 QY Q1 QY1 GDPR Consumer Goods 36 Copyright ACDC Leadership 2015

Only Investment causes growth since firms increase their capital stock
An increase in consumption or government spending doesn’t cause economic growth. Only Investment causes growth since firms increase their capital stock Price Level LRAS1 AS1 Capital Goods PLe AD1 QY1 GDPR Consumer Goods 37 Copyright ACDC Leadership 2015

Classical vs. Keynesian
Adam Smith John Maynard Keynes Copyright ACDC Leadership 2015

Debates Over Aggregate Supply
Classical Theory A change in AD will not change output even in the short run because prices of resources (wages) are very flexible. AS is vertical so AD can’t increase without causing inflation. AS Price level AD Qf Real domestic output, GDP Copyright ACDC Leadership 2015

Classical Theory A change in AD will not change output even in the short run because prices of resources (wages) are very flexible. AS is vertical so AD can’t increase without causing inflation. AS Recessions caused by a fall in AD are temporary. Price level Price level will fall and economy will fix itself. No Government Involvement Required AD AD1 Qf Real domestic output, GDP 40 Copyright ACDC Leadership 2015

Keynesian Theory A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. Increase in AD during a recession doesn’t cause inflation AS Price level AD Qf Real domestic output, GDP 41 Copyright ACDC Leadership 2015

Keynesian Theory A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. Increase in AD during a recession puts no pressure on prices AS Price level “Sticky Wages” prevents wages from falling. The government should deficit spend to close the gap AD AD1 Q1 Qf Real domestic output, GDP 42 Copyright ACDC Leadership 2015

Keynesian Theory A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. Increase in AD during a recession puts no pressure on prices AS When there is high unemployment, an increase in AD doesn’t lead to higher prices until you get close to full employment Price level AD3 AD1 AD2 Q1 Qf Real domestic output, GDP 43 Copyright ACDC Leadership 2015

The Car Analogy The economy is like a car…
You can drive 120mph but it is not sustainable. (Extremely Low unemployment) Driving 20mph is too slow. The car can easily go faster. (High unemployment) 70mph is sustainable. (Full employment) Some cars have the capacity to drive faster then others. (industrial nations vs. 3rd world nations) If the engine (technology) or the gas mileage (productivity) increase then the car can drive at even higher speeds. (Increase LRAS) The government often speeds up or slows down the economy by using fiscal and/or monetary policy. Copyright ACDC Leadership 2015

How does the Government Stabilizes the Economy?
The Government has two different tool boxes it can use: 1. Fiscal Policy- Actions by Congress to stabilize the economy. OR 2. Monetary Policy-Actions by the Federal Reserve Bank to stabilize the economy. Copyright ACDC Leadership 2015

Discretionary vs Non-Discretionary
Discretionary Fiscal Policy Congress creates a new bill that is designed to change AD through government spending or taxation. Problem is time lags due to bureaucracy. Takes time for Congress to act. Ex: In a recession, Congress increase spending. Non-Discretionary Fiscal Policy AKA: Automatic Stabilizers Permanent spending or taxation laws enacted to work counter cyclically to stabilize the economy Ex: Welfare, Unemployment, Min. Wage, etc. When there is high unemployment, unemployment benefits to citizens increase consumer spending. 46 Copyright ACDC Leadership 2015

Non-Discretionary Fiscal Policy AKA: Automatic Stabilizers
Legislation that act counter cyclically without explicit action by policy makers. AKA: Automatic Stabilizers The U.S. Progressive Income Tax System acts counter cyclically to stabilize the economy. When GDP is down, the tax burden on consumers is low, promoting consumption, increasing AD. When GDP is up, more tax burden on consumers, discouraging consumption, decreasing AD. The more progressive the tax system, the greater the economy’s built-in stability. Copyright ACDC Leadership 2015

Expansionary Fiscal Policy (The GAS)
Contractionary Fiscal Policy (The BRAKE) Laws that reduce inflation, decrease GDP (Close a Inflationary Gap) Decrease Government Spending Increase Taxes (Decreasing disposable income) Combinations of the Two Expansionary Fiscal Policy (The GAS) Laws that reduce unemployment and increase GDP (Close a Recessionary Gap) Increase Government Spending Decrease Taxes (Increasing disposable income) Combinations of the Two 48 Copyright ACDC Leadership 2015

5 Problems With Fiscal Policy
When there is a recessionary gap what two options does Congress have to fix it? What’s wrong with combining both? 1. Deficit Spending!!!! A Budget Deficit is when the government’s expenditures exceeds its revenue. The National Debt is the accumulation of all the budget deficits over time. If the Government increases spending without increasing taxes they will increase the annual deficit and the national debt. Most economists agree that budget deficits are a necessary evil because forcing a balanced budget would not allow Congress to stimulate the economy. Copyright ACDC Leadership 2015

5 Problems with Fiscal Policy
2. Problems of Timing Recognition Lag- Congress must react to economic indicators before it’s too late Administrative Lag- Congress takes time to pass legislation Operational Lag- Spending/planning takes time to organize and execute ( changing taxing is quicker) 3. Politically Motivated Policies Politicians may use economically inappropriate policies to get reelected. Ex: A senator promises more welfare and public works programs when there is already an inflationary gap. Copyright ACDC Leadership 2015

4 Problems with Fiscal Policy
4. Crowding-Out Effect In basketball, what is “Boxing Out”? Government spending might cause unintended effects that weaken the impact of the policy. Example: We have a recessionary gap Government creates new public library. (AD increases) Now but consumer spend less on books (AD decreases) Another Example: The government increases spending but must borrow the money (AD increases) This increases the price for money (the interest rate). Interest rates rise so Investment to fall. (AD decrease) The government “crowds out” consumers and/or investors Copyright ACDC Leadership 2015

The Demand for Money At any given time, people demand a certain amount of liquid assets (money) for two different reasons: Transaction Demand for Money- People hold money for everyday transactions. Asset Demand for Money - People hold money since it is less risky than other assets What is the opportunity cost of hold keeping money in your pocket or checking account? The interest you could be earning from other financial assets like stocks, bonds, and real estate Copyright ACDC Leadership 2015

The Demand for Money 1. What happens to the quantity demanded of money when interest rates increase? Quantity demanded falls because individuals would prefer to have interest earning assets instead 2. What happens to the quantity demanded when interest rates decrease? Quantity demanded increases. There is no incentive to convert cash into interest earning assets There is a inverse relationship between the interest rate and the quantity of money demanded Copyright ACDC Leadership 2015

Nominal Interest Rate (ir)
The Demand for Money Inverse relationship between interest rates and the quantity of money demanded Nominal Interest Rate (ir) 20% 5% 2% MD Quantity of Money (billions of dollars) Copyright ACDC Leadership 2015

What happens if price level increase? Nominal Interest Rate (ir)
The Demand for Money What happens if price level increase? Money Demand Shifters Changes in price level Changes in income Changes in technology Nominal Interest Rate (ir) 20% 5% 2% MD1 MD Quantity of Money (billions of dollars) 55 Copyright ACDC Leadership 2015

This is called Monetary Policy.
The Supply for Money The U.S. Money Supply is set by the Board of Governors of the Federal Reserve System (FED) Interest Rate (ir) MS The FED is a nonpartisan government office that sets and adjusts the money supply to adjust the economy This is called Monetary Policy. 20% 5% 2% MD 200 Quantity of Money (billions of dollars) Copyright ACDC Leadership 2015

The Federal Reserve Created in 1913, the FED’s job is to regulate banks and make sure people have faith in our financial system 57 Copyright ACDC Leadership 2015

Increasing the Money Supply
Interest Rate (ir) MS MS1 If the FED increases the money supply, a temporary surplus of money will occur at 5% interest. The surplus will cause the interest rate to fall to 2% 10% 5% 2% How does this affect AD? MD 200 250 Quantity of Money (billions of dollars) Increase money supply Decreases interest rate Increases investment Increases AD Copyright ACDC Leadership 2015

Decreasing the Money Supply
Interest Rate (ir) MS1 MS If the FED decreases the money supply, a temporary shortage of money will occur at 5% interest. The shortage will cause the interest rate to rise to 10% 10% 5% 2% How does this affect AD? MD 150 200 Quantity of Money (billions of dollars) Decrease money supply Increase interest rate Decrease investment Decrease AD 59 Copyright ACDC Leadership 2015

How the FED Stabilizes the Economy
These are the three Shifters of Money Supply Copyright ACDC Leadership 2015

3 Shifters of Money Supply The FED is now chaired by Janet Yellen
The FED adjusting the money supply by changing any one of the following: 1. Setting Reserve Requirements (Ratios) 2. Lending Money to Banks & Thrifts Discount Rate 3. Open Market Operations Buying and selling Bonds The FED is now chaired by Janet Yellen Copyright ACDC Leadership 2015

#1. The Reserve Requirement
If you have a bank account, where is your money? Only a small percent of your money is held in reserve. The rest of your money has been loaned out. This is called “Fractional Reserve Banking” The FED sets the amount that banks must hold The reserve requirement (reserve ratio) is the percent of deposits that banks must hold in reserve (the percent they can NOT loan out) When the FED increases the money supply it increases the amount of money held in bank deposits. As banks keeps some of the money in reserve and loans out their excess reserves The loan eventually becomes deposits for another bank that will loan out their excess reserves. Copyright ACDC Leadership 2015

Using The Reserve Requirement
1. If there is a recession, what should the FED do to the reserve requirement? (Explain the steps.) Decrease the Reserve Ratio Banks hold less money and have more excess reserves Banks create more money by loaning out excess Money supply increases, interest rates fall, AD up 2. If there is inflation, what should the FED do to the reserve requirement? (Explain the steps.) Increase the Reserve Ratio Banks hold more money and have less excess reserves Banks create less money Money supply decreases, interest rates up, AD down Copyright ACDC Leadership 2015

#2. The Discount Rate The Discount Rate is the interest rate that the FED charges commercial banks. Example: If Banks of America needs $10 million, they borrow it from the U.S. Treasury (which the FED controls) but they must pay it bank with 3% interest. To increase the Money supply, the FED should _________ the Discount Rate (Easy Money Policy). To decrease the Money supply, the FED should _________ the Discount Rate (Tight Money Policy). DECREASE INCREASE Copyright ACDC Leadership 2015

#3. Open Market Operations How are you going to remember?
Open Market Operations is when the FED buys or sells government bonds (securities). This is the most important and widely used monetary policy To increase the Money supply, the FED should _________ government securities. To decrease the Money supply, the FED should _________ government securities. BUY SELL How are you going to remember? Buy-BIG- Buying bonds increases money supply Sell-SMALL- Selling bonds decreases money supply Copyright ACDC Leadership 2015

Aggregate Demand Copyright ACDC Leadership 2015.

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