1. Aggregate Demand
and
Aggregate Supply

2. I. AD/AS Model
To Analyze changes in real GDP & price level simultaneously
Provides insights on inflation, unemployment, & economic growth
Aggregate Demand
Amounts of real output
Buyers collectively desire
At each possible price level
Aggregate Supply
Levels of real domestic output firms will produce

3. II. Aggregate Demand Curve
Income & substitution effects do not apply
AD Curve – negative slope
Real-Balances effect
Higher price level means real value of savings decreases
Thus lowering consumption
Interest-rate effect
High demand for $ leads to high interest rates
High interest rates limit investment spending
Thus leads to less real output
Foreign purchases effect
US price level up then foreigners buy less US goods

4. AGGREGATE DEMAND CURVE
Price level AD
Real domestic output, GDP

5. CHANGES IN AGGREGATE DEMAND
Can Increase
Price level
AD2
AD1
Real domestic output, GDP

6. CHANGES IN AGGREGATE DEMAND
Can Increase
…or Decrease
Price level
AD1
AD3
Real domestic output, GDP

7. Determinants of AD Change in consumer spending (C)
Wealth effect
Consumer expectations
Household indebtedness
Personal income taxes
Change in investment spending (Ig)
Real interest rates
Expected returns
Future business conditions
Technology
Degree of excess capacity
Business taxes
Change in government spending (G)
Net export spending (Xn)
National income abroad
Exchange rates

8. III. Aggregate Supply Long-run AS curve Short-run AS curve
Vertical at full-employment level of real GDP
Resource prices adjust to changes in PL – no incentive for firms to change output
Short-run AS curve
Upward sloping
Rise in price level increases real output
Lag between product prices & resource prices make it profitable for firms to increase output when PL rises

9. AGGREGATE SUPPLY Short Run AS Aggregate Supply Short-run Price level
Full-
Employment Qf
Real domestic output, GDP

10. AGGREGATE SUPPLY Changes in Aggregate Supply Decrease In Aggregate
Price level
Increase In
Aggregate
Supply
Real GDP

11. AGGREGATE SUPPLY Long Run ASLR Price level Long-run Aggregate Supply
Full-Employment Qf
Real GDP

12. Three Segmented AS Curve [16]
AS - amount of real output firms will produce at each PL.
Higher price levels provide an incentive to produce more.
AS has three ranges:
1. Horizontal
(Keynesian)
2. Intermediate
3. Vertical
(Classical)
Three Segmented AS Curve [16] AS
Vertical
[Classical]
Range
Horizontal
[Keynesian]
Range
Price level
Upsloping or
Intermediate
Range Q
Real domestic output, GDP

13. IV. Determinants of AS Input prices Domestic
Land
Labor
Capital
Prices of imported resources
Market power (OPEC)

14. Productivity = Total output/total inputs
Legal-institutional environment
Business taxes and subsidies
Government regulation

15. EQUILIBRIUM AND CHANGES IN EQUILIBRIUMP AS
Price Level
Equilibrium
Real Output
100 a b 92 AD Q
502
510
514
Real Domestic Output, GDP

16. INCREASES IN AD: DEMAND-PULL INFLATION
Price Level P1 Q Qf Q1 Q2
Real Domestic Output, GDP
[“Good News” – more jobs; “Bad News” – higher prices]

17. DECREASES IN AD: RECESSION & CYCLICAL UNEMPLOYMENTb a P1
Price Level c Q Q1 Qf
Real Domestic Output, GDP
[“Good News”–lower prices; “Bad News”–job losses]

18. [“bad news” – job losses; “bad news” – inflation]
DECREASES IN AS:
COST-PUSH INFLATION
AS2 P
AS1 P2 b
Price Level a P1
AD1 Q Q1 Qf
Real Domestic Output, GDP
[“bad news” – job losses; “bad news” – inflation]

19. V. “Sticky Prices” – prices inflexible (rigid) in a downward direction
Wage Prices
Morale, effort, productivity
Minimum wage
Menu costs
Fear of price wars

20. Bath Tub Approach to Economics
Consumption
Investment
Gov. Spending
Exports
Full Employment
[Frictional & structural]
Injections
Income
Employment
Output
*Classicals – “A leakage down
the drain of saving is returned
thru the spigot of investment.”
Saving
Taxes
Imports
Leakages
An economy in equilibrium at FE

21. Review of the Marginal Propensities
If consumption increases from 465 to 480 and disposable income increases from 490 to 510. What is the marginal propensity to consume?
If the marginal propensity to consume is 0.8 then what is the marginal propensity to save?
Why will the MPC + MPS always equal 1?
15/20 = .75
MPS = 0.2
Consuming or saving is an either-or proposition

22. Aggregate Expenditures Model
Keynesian Cross Model

23. Building “Mult” = 4 [C + Ig] Private-closed [C + Ig + Xn] Private-open
[Simple [Basic] economy to Complex economy]
[C + Ig]
Private - closed
Private-closed
[C + Ig + Xn]
Private-open
Private-open
[C+Ig+G+Xn]
Mixed - open
Mixed-open
AE3 (C+Ig+G+Xn) (Complex Economy) [Mixed-open]
(AE3)630
AE2 (C+Ig+Xn) (Private-open) [X(40)-M(20)]
(AE2)550
+20 G
AE1(C+Ig)[Basic Economy][Private(no G)-Closed(no X or M)]
+20 Xn
(AE1)470
Consumption
AE(C+Ig+G)
+20 Ig
AE(C+Ig1)
C=390
AE(C+Ig+G)
+80
+80
+80
10 G
Real GDP
Real GDP
“Mult” = 4
YR Y*

24. I. AE Model / Keynesian Cross Model
Aggregate Expenditures means total spending
When AE fall – Total output & employment decrease
When AE rise – Total output & employment increase

25. II. Mixed Economy AE = C + Ig + G + Xn
Increase in public spending shifts AE upward & produces higher equilibrium GDP
In a mixed economy the Savings (Leakages) = planned investment (Injections)
Sa + M + T = Ig + X + G
Lump-sum tax (constant at each level of GDP) – Reduces C & S
Proposed balanced budget requirement (G spending = G revenue) would eliminate discretionary fiscal policy
Balance budget multiplier = 1 (equal increases in G & T) AE shift is equal to change in G or T

26. FULL-EMPLOYMENT GDP Recessionary Gap Recessionary Gap = $5 Billion
AE0
530
510
490
AE1
Recessionary Gap
= $5 Billion
Aggregate Expenditures (billions of dollars)
Full Employment 45 o o
Real domestic product, GDP (billions of dollars)

27. FULL-EMPLOYMENT GDP Inflationary Gap Inflationary Gap = $5 Billion
AE2
Inflationary Gap
= $5 Billion
AE0
530
510
490
Aggregate Expenditures (billions of dollars)
Full Employment 45 o o
Real domestic product, GDP (billions of dollars)

28. III. Limitations No price-level changes
Ignores premature demand-pull inflation
Limits real GDP to the full-employment level of output
Ignores cost-push inflation
Does not allow for self-correction