1. Aggregate Demand and Aggregate Supply
Chapter 29

2. You should be able to
Define aggregate demand and explain factors that cause it to change
Define aggregate supply and explain factors that cause it to change
Discuss how AD and AS determine an economy’s equilibrium price level and level of real GDP
Describe how the AD-AS model explains periods of demand-pull inflation, cost-push inflation, and recession
ID how the aggregate demand curve relates to the aggregate expenditures model

3. PL
RGDP AD
Aggregate Demand
Aggregate Demand is the relationship between the price level and the real GDP
When the price level goes up, the demand for real GDP goes down

4. Aggregate Demand Why is the curve downward sloping?
Real-Balance Effect—a higher price level reduces the purchase power of households
Interest-Rate Effect—if the demand for money goes up, then interest rates will go up, causing demand for goods/services to go down
Foreign Purchases Effect—If our price level rises, foreigners buy fewer US products and Americans buy more foreign products
All of these price related issues causes us to move along the AD curve

5. Aggregate Demand
Aggregate Demand can shift due to several determinants:
Change in consumer spending:
Wealth effect: People will spend more if their assets become more valuable, spend less if their assets drop in value
Consumer expectations: If consumers expect their income to rise in the future, they will spend more now. If they expect prices/inflation to go up in the future, they will spend more now
Household indebtedness: If people are in too much debt, they will cut spending, if they don’t have a lot of debt, they will increase their spending
Taxes: If taxes go up, people spend less; if taxes go down, people spend more

6. Aggregate Demand Other determinants of AD: Investment Spending
Real Interest Rates: If interest rates go up, businesses will purchase less; if rates go down, they purchase more
Expected Returns: If future business is expected to be good, new technology is anticipated, if they are under excess capacity with current equipment/facilities, and if taxes are low businesses will spend more
Government Spending
If the government decides to spend more for whatever reason, AD goes up, if the government slows spending, AD goes down

7. Aggregate Demand
A final determinant of Aggregated Demand is Net Export Spending
There are a few things that can cause our exports to increase:
Our price level goes down
Our national income abroad goes up (thus more foreigners purchase American goods)
Our exchange rate depreciates making the dollar less valuable and thus easier to purchase more American goods

8. Aggregate Demand The government spends more on military?PL
RGDP
AD1
Aggregate Demand
The government spends more on military?
The average household debt drops?
Factories are operating well below capacity?
US exchange rate falls?
The stock market crashes?
AD2
AD3

9. Aggregate Supply
Aggregate Supply shows the relationship between price level and real GDP output
There is a difference between long run (where nominal wages, etc. match changes in price level) and short run (where nominal wages, etc. don’t respond to price level changes)

10. Long Run Aggregate Supply
Long Run AS shows that when a company is running at full employment output will stay the same regardless of price level
This is because in the LR as price goes up, so will the wages that are used to produce it
In the LR changes in price level does not change Real Profit—think inflation PL
RGDP
ASLR Qr

11. Aggregate Supply Short Run
In the Short Run wages adjust slowly to changes in price level
Until those wages catch up, firms will increase their output level
This is because firms see a higher real profit until wages rise
In other words, if you produce under employment, you are not making as much as you could; if you produce above employment, you are wasting resources (such as man power) PL
RGDP
AS1
Below full employment
Above full employment Qf

12. Aggregate Supply Usually when we discuss AS we are referring to the SR
Several determinants can shift the AS curve
Changes in input prices (wages, machinery, equipment, land, imports): if prices goes up it goes to the left;
if prices go down, the curve moves right
Market Power: the ability to set prices above competitive levels (monopolies, etc.); if prices can be set higher, curve moves left
Change in productivity: if productivity goes down, curve moves left (productivity = total outputs/total inputs)
Legal institutional environment: business tax increase will move curve left whereas an increase in subsidies ($ from Gov’t)
will move the curve right
Government regulation: Reduction of regulations move the curve to the right (deregulation that results in dishonest business practices or monopolization will move the curve left)

13. Equilibrium and Changes in Equilibrium
The equilibrium price level and equilibrium real output (GDP) show how much aggregate supply and aggregate demand will be created at a given price level

14. Equilibrium and Changes in Equilibrium
100 92 PL
RGDP
Equilibrium Point
Equilibrium and Changes in Equilibrium
Do we have a shortage or a surplus?
By how much?
If we sell at 92 we will see a shortage = 12 AS b AD

15. Equilibrium and Changes in EquilibriumP1 PL
RGDP
Equilibrium and Changes in Equilibrium
This is referred to as Demand-Pull inflation because an increase in demand will force an increase in Price Level if you move beyond full employment (Qf)
Raises in PL diminish the multiplier effect
Price goes up, but at least we are producing more too! AS P2
AD2
AD1 Qf Q1 Q2

16. Equilibrium and Changes in Equilibrium
You typically do not see a decrease in price levels
The reasons:
Wage contracts—suppliers cannot cut cost by cutting wages because their employees are on contracts
Morale, effort, and productivity—It does no good to cut someone’s pay if the result is they are going to produce less due to demotivation—you will still come up with the same profit
Minimum wage—government sets legal bottom to how much you can pay for domestic labor
Menu costs—To change prices of your goods is very expensive (printing fees, new catalogs, etc.) so it’s not worth it to drop price
Fear of price wars—if you drop your price, a competitor may drop theirs lower and so on and so forth until neither of you are turning a profit

17. Equilibrium and Changes in EquilibriumP1 PL
RGDP
Equilibrium and Changes in Equilibrium
AS2
When something causes supply to go down it is exceptionally bad for the economy—prices go up and GDP goes down
This is called Cost-Push Inflation
AS1 P2
AD1 Q1 Qf

18. Equilibrium and Changes in Equilibrium
If demand shifts forward (right) without an increase in supply, the price level will go up
If supply shifts right without an increase in demand, the price level will go down
If supply and demand shift right together, the result will be a much smaller rate of inflation and smaller increase in the price level
We saw this “macroeconomic bliss” during
In March 2000 a major decrease in investment spending sent AS in reverse starting the recession