1. Unit 3 Macroeconomic Models & Fiscal Policy
Chapter 12
Aggregate Demand & Aggregate Supply
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2. Aggregate demand
A schedule or curve that shows the amounts of real output (real GDP) that buyers collectively want to buy at each price
Why AD curve slopes downward:
Aggregate demand curve
Real-balances effect
Higher price levels reduce the real value or purchasing power of the public’s accumulated savings
Interest-rate effect
A higher price level increases the demand for money.
Foreign purchases effect
When the U.S. price level rises relative to foreign levels, foreigners buy fewer US goods & Americans buy more foreign goods
2. Figure 10.1 (page 188)…inverse relationship between the price level & real GDP. Why? Explanation centers around income & substitution effect. When the price of an individual product falls, the consumer’s income allows for a larger purchase of the product (income effect). They buy more because it becomes relatively less expensive than other goods (substitution effect)…problem though when the economy moves down its aggregate demand curve, it moves to a lower general price level. This means that when we pay a lower price that there is less income being received by “resource suppliers” in the form of wages. As a result, a decline in the price level does not necessarily mean an increase in the nominal income of the economy as a whole.
4. So, given a fixed supply of money, an increase in money demand will drive up the price paid for its use…That price is the interest rate…Higher interest rates curtail investment spending & “interest-sensitive” consumption spending…i.e. when interest rates are high, spending levels dip
5. Rise in price level reduces the quantity of US goods demanded as net exports
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3. Changes in aggregate demand
Movements along a fixed aggregate demand curve represent changes in real GDP
If one or more of the things listed below changes, the entire aggregate demand curve will shift
Changes in aggregate demand involve two components:
Change in one of the determinants of AD that directly changes the amount of real GDP demanded
A multiplier effect that produces a greater ultimate change in AD than the initial change in spending
First…other things equal, a change in the price level will change the amount of aggregate spending & there change the amount of real GDP demanded by the economy.
Figure 10.2 on page 190
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4. Consumer spending Consumer wealth Consumer expectations Household debt
Includes both financial assets (stocks) & physical assets (houses)
Consumer expectations
Re: income, inflation, etc.
Household debt
Spending increase debt (AD to the right)
Personal taxes
Less income tax raises take-home pay
Even when the price-level is constant, consumers alter their purchases. If they decide to buy more, the AD curve will shift right and vice versa.
Several factors other than a price change will affect consumer spending & therefore shift the AD curve.
1a) a sharp increase in the real value of consumer wealth prompts people to save less & buy more products. The resulting increase in consumer spending (wealth effect) will shift the AD curve to the right.
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5. Investment spending Purchase of capital goods Real interest rates
Increase in real interest rates will lower investment spending & reduce AD
Expected returns
Higher expected returns on investment projects will increase demand for capital goods & shift AD curve to right.
Expected returns are influenced by several factors:
Expectations about future business conditions
Technology
Degree of excess capacity
Business taxes
i.e. a decline in investment spending will shift the curve to the left. Investment spending depends on the real interest rate & the expected return from the investment.
2. i.e. increase in money supply will lower the interest rate…money is easier to obtain
6a) if firms are optimistic about future business conditions, they are more likely to forecast high rates of return and invest more today.
6b) New & improved technologies increase returns on investment and increase AD.
6c) a rise in excess capacity – unused capital – will reduce the expected return on new investment & decrease AD
6d) increase in business taxes will reduce after-tax profits from capital investment & lower expected returns. So investment & AD will decline.
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6. Changes in AD (cont.) Government spending Net export spending
Increase in government purchases will shift the AD curve to the right as long as tax collections & interest rates don’t change
Net export spending
Increased foreign demand for US goods. A rise in net exports shifts the AD curve to the right.
What causes net exports to change?
National income abroad
Exchange rates
6. Rising national income abroad encourages foreigners to buy more products, some of which are made in the US.
7. When the Exchange rate depreciates, AD increases because US made products are now cheaper for foreign consumers & domestic.
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7. Aggregate supply
Schedule or curve showing the level of real GDP that firms will produce at each price level
Aggregate supply in the long run
AS curve is vertical at the economy’s full-employment output.
In the long run, wages and other input prices rise & fall to match changes in the price level. So price-level changes do not affect firms profits and thus they create no incentive for firms to alter their output.
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8. AS in the short-run Short-Run AS curve
A rise in the price level increases real output
Positive or direct relationship
When economy is operating below full-employment (inside curve)
Lots of idle resources
Can be put back to use by firms at little or not increase in per-unit production costs
When beyond the curve
Resources are already employed
Adding more workers to capital resources creates congestion (inefficiency)
Adding capital leaves equipment idle & reduces efficiency
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9. Determinants of aggregate supply
Factors that shift the AS curve
Input prices
Domestic resource prices
Wages & salaries make up about 75% of all business costs
Prices of imported resources
Market power – ability to set prices of inputs can affect input prices and AS
Changes in these determinants raise or lower per-unit production costs at each price level.
When there is a decrease in per-unit production costs, the AS curve will shift to the right. (I.e. increase in immigrants –AS to right…retirement incentive decreases supply of labor so wage rates rise…AS curve goes to left). Cost of other resources can impact AS curve for labor as well…I.e. price of machinery falls, per-unit cost declines, and AS curve shifts to right
4. Price of imported resources adds to US AS as well. Adding supplies of resources (domestic or foreign) typically reduces per-unit production costs. A decrease in price of imported resources increases US AS….Exchange rate fluctuations are another factor that may alter the price of imported resources. I.e. if dollar appreciates, US firms can obtain more foreign currency with each dollar. This means that domestic producers face a lower dollar price of imported resources. This lowers production costs and increases AS 5.
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10. Factors that shift AS (cont)
Productivity
A measure of the relationship between a nation’s level of real output & the amount of resources used to produce that output
Total output/total inputs = productivity
Increase in productivity enable economy to obtain more real output from its limited resources
If productivity is able to reduce the per-unit production cost, the AS curve will shift to the right
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11. Sources of productivity advancements
Main source:
Improved production technology
New plant & equipment replaces old plant & equipment
Other sources of productivity increases
Better-educated & trained workforce
Improved forms of business enterprises
Reallocation of labor resources from lower-to-higher productivity uses
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12. Last AS determinant Legal-institutional environment
Changes may alter the per-unit costs of output and shift the AS Curve
Business taxes & subsidies
Higher taxes on sales & payroll raise per-unit costs & reduce AS
Subsidies lower production costs & increase AS
Government regulation
Costly for businesses
More regulation increases per-unit costs & decreases AS
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13. Equilibrium & changes in equilibrium
Occurs at the price level that equalizes the amounts of real output demanded & supplied (intersection of AS & AD curve)
Increases in AD: Demand-Pull Inflation
Increases in spending (either C, I, G, or x) will shift the AD curve to the right causing demand-pull inflation.
Also, observe that the increase in demand expands real output from Qf to Q1. The distance in between is a positive GDP gap. Actual GDP exceeds Potential GDP.
Multiplier effect – increase in AD rises real output only to Q1, not to Q2, because part of the increase in AD is absorbed as inflation rises price from P1 to P2.
If price had stayed at P1, output would have increased from Qf to Q2 & the multiplier would have been at full strength
2. Figure 10.7…increase in AD beyond the full-employment level of output causes inflation…
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14. Decreases in AD: Recession & Cyclical Unemployment
Decrease in AD that causes a recession
Output declines with no change in price level
Constitutes a recession and since fewer workers are needed to produce the lower output, cyclical unemployment arises.
Negative GDP gap
Figure 10.8…If economy moves from a to b, rather than from a to c. The outcome is a decline of real output from Qf to Q1, with no change in price level. It is as if the AS curve is horizontal at P1 as indicated by the dashed line.
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15. Why are prices inflexible?
Fear of price wars
Large firms are concerned about price wars if they lower prices
Instead, they choose to reduce production and layoff workers
Menu costs
Lowering prices creates other costs (I.e. printing new menus at a restaurant!)
Additional costs: length of recession, repricing items in inventory, printing new catalogs, advertising
Wage contracts
Firms rarely profit from cutting product prices unless wages drop too
Morale, effort, & productivity
Lower wages will probably lower productivity due to poor worker morale & effort
Minimum wage
Legal price floor that cannot be reduced
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16. Decreases in AS: Cost-push inflation
Higher resource prices drive up production & distribution costs on a wide variety of goods
Increase in price-level causes cost-push inflation and a recession
Increase in price level and decline in real output
Figure 10.9…curve shifts from as1 to as2 and the economy moves from a to b. price level rises from p1 to p2 & real output declines from qf to q1. Result=cost push inflation and a recession.
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17. Increases in AS: Full employment with price-level stability
Increases in AD along with increases in productivity which shifted the AS curve to the right as well.
Result…increase in real GDP along with only small increases in price level (inflation)
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