1. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 8 Aggregate Demand and Aggregate Supply

2. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Outline Aggregate Demand Aggregate Supply Shifts in Aggregate Demand and Aggregate Supply Causes of Inflation Supply-Side Economics

3. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Aggregate Demand Aggregate Demand: the amounts of real domestic output which domestic consumers, businesses, governments, and foreign buyers collectively will desire to purchase at each possible price level

4. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 1 Aggregate Demand RGDP PI AD

5. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Aggregate Demand is Downward Sloping Real Balances Effect –Because higher prices reduce real spending power, prices and output are negatively related. Foreign Purchases Effect –When domestic prices are high, we will export less to foreign buyers and we will import more from foreign producers. Therefore higher prices leads to less domestic output. Interest Rate Effect –higher prices lead to inflation which leads to less borrowing and a lowering of RGDP

6. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Aggregate Supply Aggregate Supply: the level of real domestic output available at each possible price level

7. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 2 The Aggregate Supply Curve RGDP PI Keynesian Range Classical Range Intermediate Range

8. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Ranges of AS Keynesian Range –Large amounts of unemployment make it so that increases in aggregate demand have no affect on wages or prices. Classical Range –Full employment makes it so that increases in aggregate demand only increase wages or prices. Intermediate Range –Some sectors of the economy reach full employment more quickly than others.

9. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Variables that Shift Aggregate Demand Taxes Interest Rates Confidence Strength of the Dollar Government Spending

10. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Determinants of AD Variable GDP Component Affected C,I,G,X Effect of an increase on AD Effect of a decrease on AD TaxesC,IDecrease so AD <= Increase so AD => Interest RatesC,IDecrease so AD <= Increase so AD => ConfidenceC,IIncrease so AD => Decrease so AD <= Strength of the Dollar X (exports- imports) Decrease so AD <= Increase so AD => Government Spending GIncrease so AD => Decrease so AD <=

11. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 3 AD Increases AD’ AS AD RGDP PI PI* RGDP* PI’ RGDP’

12. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 4 AD Decreases AD’ AS AD RGDP PI PI* RGDP* PI’ RGDP’

13. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Variables that Shift AS Input Prices Productivity Government Regulation

14. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Determinants of AS Variable Effect of an Increase on AS Effect of an Decrease on AS Input PricesDecrease so AS Increase so AS ProductivityIncrease so AS Decrease so AS Government Regulation Decrease so AS Increase so AS

15. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 5 Increase in AS AS AD RGDP PI PI* RGDP* AS’ PI’ RGDP’

16. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 6 Decrease in AS RGDP AS AD PI PI* RGDP* AS’ PI’ RGDP’

17. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Causes of Inflation Demand Pull Inflation: inflation caused by an increase in aggregate demand Cost Push Inflation: inflation caused by a decrease in aggregate supply

18. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply-Side Economics Supply-side economics: government policy intended to influence the economy via aggregate supply by lowering input costs and reducing regulation