2. Aggregate Demand and Aggregate Supply 11 C H A P T E R

3. Aggregate demand is a schedule Aggregate demand is a schedule or curve that shows the various amounts of real domestic output that domestic and foreign buyers will desire to purchase at each possible price level. It shows an inverse relationship between price level and real domestic output. Note: The explanation of the inverse relationship is not the same as for demand for a single product, which centered on substitution and income effects.

4. a.Substitution effect doesn’t apply within the scope of domestically produced goods, since there is no substitute for “everything.” b.Income effect also doesn’t apply in the aggregate case, since income now varies with aggregate output (not constant).

5. Explanation of the inverse relationship between price level and real output in aggregate demand. 1.Real balances effect: An increase in the price level reduces the purchasing power of the public’s accumulated saving balances. The public feels poorer and will reduce spending When price level falls, the purchasing power of existing financial balances rises, which can increase spending.

6. 2.Interest ‑ rate effect: Given constant money supply, a price rise will mean more demand for money (for transaction purposes). This will drive up interest rates and interest sensitive spending (e.g., investment) will decrease. A higher price level reduces the amount of output demanded. A decline in price level means lower interest rates that can increase levels of certain types of spending. 3.Foreign purchases effect: When price level falls, other things being equal, Kuwait’s prices will fall relative to foreign prices, which will tend to increase spending on Kuwait’s exports and also decrease import spending in favor of Kuwait’s products that compete with imports.

7. Aggregate expenditures (billions of dollars) 0 0 Price level Q1Q1 P1P1 AE 1 at P 1 1 1’ P2P2 AE 2 at P 2 2 2’ AE 3 at P 3 3 P3P3 3’ The Aggregate Demand Can Be Constructed DERIVATION OF THE AGGREGATE DEMAND CURVE Q3Q3 Q2Q2 Q1Q1 Q3Q3 Q2Q2 AD Real Domestic Output

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

9. Determinants of aggregate demand Change in price level will change AD from one point to another on the AD curve. AD will not Shift. Determinants of AD are the “other things” that can cause a shift or change in demand (AD shifters): 1.Changes in consumer spending If consumers decide to buy more, AD will shift to the right and vice versa. Factors affecting consumer spending are: a)Consumer wealth (financial and real): An increase in the real value of wealth prompts people to save less and buy more; AD shifts to RHS, and vice versa.

10. b)Consumer expectations: When consumers expect their real incomes to increase, they spend more of their income. When they expect surging inflation in the near future, they will spend more before prices escalate, AD will shift to RHS, and vice versa. c)Household indebtedness: If households’ indebtedness rises beyond normal levels, consumers may be forced to consume less in order to pay interest and principle on their debt, and vice versa. d)Taxes: A tax rise reduces disposable income of the public and forces the public to buy less, AD shifts to LHS, and vice versa

11. 2.Changes in investment spending An increase in investment spending shifts AD to the RHS, and vice versa. Changes in investment can be caused by changes in several factors, such as: a)Real interest rates: An increase in interest rates will lower investment spending, AD shifts to the LHS. Remember, we are not referring here to the interest rate effect resulting from a change in price level, but due to changes in money supply. b)Expected returns: higher expected returns will increase investment and AD shifts to the RHS, and vice versa. Expected returns are affected by:

12. -Expectations about future business conditions. -Technology -Degree of excess capacity -Business taxes 3.Changes in government spending: An increase in G will shift AD to the RHS, and vice versa. 4.Changes in net export spending (unrelated to price level): A rise in net exports, will shift AD to the RHS and vice versa. Remember that these changes are not prompted by changes in price level. These are due to changes in other factors such as:

13. – National income abroad: Rising national incomes abroad encourages foreigners to buy more of our products, NX rises and AD shifts to the RHS. –Exchange rates: Depreciation of the KD encourages Kuwait’s exports since Kuwait’s products become less expensive when foreign buyers can obtain more KDs for their currency. Conversely, dollar depreciation discourages buying imports in Kuwait because our KD can’t be exchanged for as much foreign currency.

14. Price level Real domestic output, GDP CHANGES IN AGGREGATE DEMAND AD 1 AD 2 Aggregate Demand Can Increase

15. Price level Real domestic output, GDP CHANGES IN AGGREGATE DEMAND AD 1 AD 3 …or Decrease Aggregate Demand Can Increase

16. Aggregate demand shifts and the aggregate expenditures model Given constant prices, an increase in (e.g., investment) shifts aggregate expenditures up, there will be a multiplied increase in GDP. The immediate impact will be an increase in AD (e.g., =∆ I ), then the multiplier process magnifies the initial increase in spending. Hence: Shift in AD = ∆ I × multiplier

17. Aggregate expenditures (billions of dollars) 0 0 Price level Q2Q2 AE 2 at P 1 P1P1 AE 1 at P 1 SHIFTS IN THE AGGREGATE EXPENDITURES SCHEDULE & THE AGGREGATE DEMAND CURVE Q1Q1 Q2Q2 Q1Q1 AD 1 AD 2 Increase in Aggregate Expenditures Increase in Aggregate Demand Real Domestic Output

18. Aggregate supply Aggregate supply is a schedule or curve showing the level of real domestic output available at each possible price level. Higher price levels provide an Incentive to produce more Aggregate supply in the long run: 1. In the long run the aggregate supply curve is vertical at the economy’s full-employment output 2.The curve is vertical because in the long run resource prices adjust to changes in the price level, leaving no incentive for firms to change their output.

19. AGGREGATE SUPPLY Price level Real domestic output, GDP Q P Long Run AS LR Long-run Aggregate Supply QfQf Full-Employment

20. Aggregate supply in the short run The short-run aggregate supply curve is upward sloping. The lag between product prices and resource prices makes it profitable for firms to increase output when the price level rises. To the left of full-employment output, the curve is relatively flat. The relative abundance of idle inputs means that firms can increase output without substantial increases in production costs.

21. To the right of full-employment output the curve is relatively steep. Shortages of inputs and production bottlenecks will require substantially higher prices to induce firms to produce.

22. AGGREGATE SUPPLY Price level Real domestic output, GDP Q P Short Run AS Aggregate Supply Short-run QfQf Full- Employment

23. Determinants of aggregate supply As price level changes, AS moves from one point to another along the AS curve. Determinants are the “other things” that cause changes or shifts in aggregate supply (AS shifters). At each price level, these shift AS either to RHS or LHS. 1.Input prices: Higher input prices increase per-unit cost and reduces AS, and vice versa. Resources can either be domestic or imported.

24. a.Domestic resource prices: Increases in supply of resources reduce per-unit cost and shifts AS to RHS, and vice versa. –Capital. Additions to the stock of capital. A fall in Price of machinery and equipments decreases per-unit production costs and AS shifts to the RHS and vice versa. –Labor. Wages and salaries make up about 75% of all business costs. Immigration, influx of women to the labor market put downward pressures on wages and AS shifts to RHS. Labor supply increases because immigration reduce per-unit production costs. AS shifts to the RHS. Rapid early retirements increase wages and shift AS to the LHS. –Land. Discoveries of mineral deposits, irrigation, technical innovations. These lowers rents

25. b.Prices of imported resources: For example oil, tin…etc. when increase will shift AS to LHS, and vice versa. Exchange rate fluctuations are one factor that affects imported factor prices. c.Market power in certain industries: Ability to set market prices, e.g., OPEC can push oil price up and thus AS to LHS in oil importing countries. 2.Changes in productivity: productivity = real output / input If productivity rises, unit production costs will fall. This can shift aggregate supply to the right and lower prices.

26. 3.legal ‑ institutional environment: Change in legal ‑ institutional environment in which businesses operate. Examples of these changes are : - business taxes and subsidies - government regulation. More regulation tends to push per-unit costs and shifts AS to LHS.

27. Equilibrium: Real Output and the Price Level Equilibrium occurs at the price level that equalizes the amounts of real output demanded and supplied. Equilibrium price and quantity are found where the aggregate demand and supply curves intersect. If price level is less than equilibrium price, would encourage businesses to produce at most 502, AD would be 514. competition among buyers will push the price level to 100. This will encourage producers to increase output to 510. The economy has achieved equilibrium

28. Price Level Real Domestic Output, GDP Q P AS AD 510502514 EQUILIBRIUM AND CHANGES IN EQUILIBRIUM 92 100 ab Equilibrium Real Output

29. 1.Increases in aggregate demand: demand-pull inflation. Increases in aggregate demand create upward pressure on prices, especially when the economy operates at or above its full employment level of output. This is demand pull- inflation, because price level is being pulled up by increases in AD. The multiplier effect weakens the further right the aggregate demand curve moves along the aggregate supply curve. More of the increase in spending is absorbed into price increases rather than generating greater real output.

30. Price Level Real Domestic Output, GDP Q P AS AD 1 INCREASES IN AD: DEMAND-PULL INFLATION P2P2 P1P1 AD 2 QfQf Q1Q1 Q2Q2

31. Decreases in AD: Recession and Cyclical Unemployment If AD decreases, recession and cyclical unemployment may result. Concerning the price level, what goes up does not always go down. If the economy moves from a to b (not to c), output declines with no change in the price level. AS turns into a horizontal line. Output declines from Qf to Q1 (negative GDP gap). This represents a recession. Unemployment (cyclical) rises as a result.

32. Though real output declines prices stay the same because product prices tend to be sticky in a downward direction. There are several reasons for that: a)Wage contracts are not flexible: so businesses can’t afford to reduce prices. b)Morale, effort and productivity: Employers are reluctant to cut wages because of impact on employee effort, etc. Employers seek to pay efficiency wages – wages that maximize work effort and productivity, minimizing cost.

33. c)Minimum wage laws keep wages above that level. d)Menu costs are difficult to implement. Price decreases necessitate: estimating the magnitude and duration of the shift in demand to determine whether prices should be lowered Re-pricing items in inventory Printing and mailing new prices Communicating new prices to customers (advertising). For these costs firms may choose to retain current prices. e)Fear of price wars keeps prices from being reduced.

34. Price Level Real Domestic Output, GDP Q P AS AD 1 DECREASES IN AD: RECESSION & CYCLICAL UNEMPLOYMENT P1P1 AD 2 QfQf Q1Q1 a c b Horizontal AS

35. Shifts in Aggregate Supply Shifting aggregate supply occurs when a supply determinant changes. Decrease in AS: cost ‑ push inflation. Increase in AS: Full employment with price level stability

36. Price Level Real Domestic Output, GDP Q P AS 1 AD 1 DECREASES IN AS: COST-PUSH INFLATION P2P2 QfQf Q1Q1 a b AS 2 P1P1

37. Price Level Real Domestic Output, GDP Q P AS 1 AD 1 INCREASES IN AS: FULL EMPLOYMENT P1P1 Q2Q2 Q1Q1 a b AS 2 P2P2 …With Price-Level Stability AD 2 P3P3 Q3Q3