1. Aggregate Demand and Aggregate Supply 29 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Aggregate Demand (AD) is a schedule or curve that shows the amount of a nation’s output, or real GDP, that buyers collectively desire to purchase at each possible price level. These buyers include the nation’s households, businesses, and government along with consumers located abroad. LO1 29-2

3. The relationship between the price level and the amount of real GDP demanded is inverse or negative as shown in figure 29.1 where the AD curve slopes downward.

4. Aggregate Demand Real domestic output, GDP Price level AD LO1 0 29-4

5. Reasons for Down-sloping AD 1.Real-Balances Effect- A higher price level reduces the real value or purchasing of the public’s accumulated savings balances. In particular, the real value of assets with fixed money values, such as savings accounts or bonds, diminishes. Because a higher price level erodes the purchasing power of such assets, the public is poorer in real terms and will reduce its spending.

6. 2.Interest-rate Effect- When we draw the AD curve, we assume that the supply of money is fixed. But when the price level rises, consumers need more money for purchases and businesses need more money to meet their payrolls and to buy other resources.

7. The higher price level will increase the demand for money. So, given a fixed supply of money, an increase in money demand will drive up the price paid for its use which is the interest rate. Higher interest rates curtail investment spending and interest sensitive consumption spending.

8. 3.Foreign Purchases Effect- When the U.S. price level rises relative to foreign price levels, foreigners buy fewer U.S. goods and Americans buy more foreign goods. Therefore, U.S. exports fall and U.S. imports rise. In short, the rise in the price level reduces the quantity of U.S. goods demanded as net exports.

9. Changes in Aggregate Demand A change in the price level will change the amount of aggregate spending and therefore change the amount of real GDP demanded by the economy. Movements along a fixed aggregate demand curve represent these changes in real GDP. However, if 1 or more of those “other things” change, the entire aggregate demand curve will shift. LO1 29-9

10. We call these other things determinants of aggregate demand or aggregate demand shifters and are listed in figure 29.2.

11. Changes in AD has 2 Components  A change in 1 of the determinants of AD  A multiplier effect that produces a greater ultimate change in AD than the initiating change in spending

12. Changes in Aggregate Demand Real domestic output, GDP Price level AD 1 AD 3 AD 2 LO1 0 29-12

13. Determinants of AD 1.Consumer spending- Even when the U.S. price level is constant, domestic consumers may alter their purchases of U.S. produced real output. If those consumers decide to buy more output at each price level, the AD curve will shift rightward. If they decide to buy less output, the AD curve will shift to the left. LO1 29-13

14. Consumer Wealth- includes the value of all assets like stocks, bonds and real estate, minus liabilities like mortgages, car loans, and credit card balances. Household Borrowing- Consumers can increase their consumption spending by borrowing. Doing so shifts the AD curve to the right.

15. Consumer Expectations- Changes in expectations about the future may alter consumer spending. Examples include future income or future price level changes. Personal Taxes- A reduction in personal taxes raises take-home income and increases consumer spending at each possible price level. These tax cuts shift AD to the right. Tax increases shift the AD curve leftward.

16. 2.Investment Spending- The purchase of capital goods is a second determinant of AD. Real interest rates- Other things equal, an increase in real interest rates will raise borrowing costs, lower investment spending, and reduce AD. LO1 29-16

17. Expected Returns- Higher expected returns on investment projects will increase the demand for capital goods and shift the AD curve to the right. Remember that expected returns are influenced by several factors.  Expectations about future business conditions  Technology  Degree of excess capacity  Business taxes

18. 3.Government Spending- An increase in government purchases will shift the AD curve to the right, while a decrease in government spending shifts AD to the left. Remember we do not include transfer payments here. LO1 29-18

19. 4.Net Export Spending- The final determinant of AD is net exports. An increase in net exports shifts AD to the right, while a decrease in net exports shifts AD to the left. Net exports are affected by the following. LO1 29-19

20.  National Income Abroad- Rising national income abroad encourages foreigners to buy more products, some of which are made in the U.S. Our net exports thus rise, and the AD demand curve shifts to the right.

21.  Exchange Rates- Changes in the dollar’s exchange rate, the price of foreign currencies in terms of the U.S. dollar, may affect U.S. exports and therefore AD. Suppose the dollar depreciates in terms of the euro, or the euro appreciates relative to the dollar. The new, relatively lower value of dollars and higher value of euros enables European consumers to obtain more dollars with each euro.

22. As a result, U.S. goods are now less expensive, because it takes fewer euros to obtain them. So European consumers buy more U.S. goods, and U.S. exports rise. But American consumers can now obtain fewer euros for each dollar. As a result, Americans reduce their imports from Europe.

23. Key Point: Dollar depreciation increases net exports and therefore AD. Dollar appreciation decreases net exports and therefore AD.

24. Aggregate Supply (AS) is a schedule or curve showing the relationship between a nation’s price level and the amount of real domestic output that firm’s in the economy produce. This relationship varies depending on the time horizon and how quickly output prices and input prices can change. LO2 29-24

25. 3 Time Periods 1.Immediate Short Run- Both input prices as well as output prices are fixed. Depending on the type of firm, this time period can last anywhere from a few days to a few months. Input prices are fixed in both the immediate short run and the short run by contractual agreements.

26. Generally, 75% of the average firm’s costs are wages and salaries, and these are almost always fixed by labor contracts for months or years at a time. Output prices are also typically fixed during this period. Firms will set fixed prices for their customers and then agree to supply whatever quantity demanded results at those fixed prices.

27. Figure 29.3 shows the resulting AS curve which is horizontal. The horizontal shape implies that the total amount of output supplied depends directly on the volume of spending that results at the existing price level. If total spending is low, firms will supply a small amount of output to match the low level of spending.

28. Notice that firms will respond in this manner to changes in total spending only as long as output prices are fixed. As soon as firms are able to change their product prices, they can respond to changes is AD not only by increasing or decreasing output but also by raising or lowering prices.

29. AS: Immediate Short Run Real domestic output, GDP Price level AS ISR QfQf Immediate-short-run aggregate supply P1P1 0 LO2 29-29

30. 2.Short Run- Input prices are fixed or highly inflexible, but output prices can vary. As seen in figure 29.4 the short run AS curve is up-sloping because, with input prices fixed, changes in the price level will raise or lower real firm profits. Ex. Mega Buzzer-pg. 595-596.

31. Notice that the slope of the AS curve is not constant. It is flatter at output below Qf and steeper at outputs above it. This has to do with the fact that per-unit production costs underlie the short run AS curve. Per-unit production costs = total input cost ÷ units of output

32. As the economy expands in the short run, per-unit production costs generally rise because of reduced efficiency. But the extent of that rise depends on where the economy is operating relative to its capacity. When operating below Qf the economy has large amounts of unused machinery and equipment and large numbers of unemployed workers.

33. Firms can put these idle resources back to work with little upward pressure on the per-unit production costs. On the other hand, when the economy is operating beyond Qf the vast majority of its available resources are already employed.

34. Adding more workers to a relatively fixed number of highly used capital resources such as plant and equipment creates congestion in the workplace and reduces the efficiency of workers. Under these circumstances, total input costs rise more rapidly than total output. The result is rapidly rising per-unit production costs.

35. Aggregate Supply: Short Run Real domestic output, GDP Price level 0 QfQf AS Aggregate supply (short run) LO2 29-35

36. 3.Long Run- Input prices as well as output prices can vary. Figure 29.5 shows the long run AS curve is vertical at the economy’s full-employment level of output, Qf. In the long run the economy will produce the full-employment output level no matter what the price level is.

37. Let’s look at the Mega Buzzer example again but now assume that input prices rise in step with output prices. The result is that real profits remain unchanged and so the firm has no incentive to change its output level.

38. Aggregate Supply: Long Run Real domestic output, GDP Price level AS LR QfQf 0 Long-run aggregate supply LO2 29-38

39. Focusing on the Short Run Our focus for the remainder of this chapter and the several chapters that immediately follow will be on short run AS curves, such as the AS curve shown in figure 29.4. Unless explicitly stated otherwise, all references to AS are to the short run curve.

40. Changes in Aggregate Supply Figure 29.6 shows the other factors that cause a shift in the AS curve. These are called determinants of AS or supply shifters. Changes in these determinants raise or lower per-unit production costs at each price level and because cost changes affect profits, firms will alter the amount of output they are willing to produce. A drop in per-unit costs will increase profits and increase AS. Higher costs will reduce profits and decrease AS. LO2 29-40

41. Changes in Aggregate Supply Real domestic output, GDP Price level AS 1 AS 3 AS 2 0 LO2 29-41

42. Determinants of AS 1.Input Prices- This represents the prices of domestic or imported resources. Domestic Resource Prices- include the price of labor, land, capital and entrepreneurship. Imported Resource Prices- Resources imported from abroad such as oil, tin, and copper will add to our AS. LO2 29-42

43. A decrease in the price of imported resources increases our AS. The oil price hikes in the 1970’s, caused by OPEC, raised production costs in the United States and decreased AS.

44. Exchange rate changes are another factor that may alter the price of imported resources. When the dollar appreciates U.S. firms can import more foreign resources which increases our AS. A depreciated dollar has the opposite effect.

45. 2.Productivity- is a measure of output produced with a given amount of inputs. Productivity = total output ÷ total inputs Per-unit costs = total input cost ÷ total output LO2 29-45

46. An increase in productivity enables the economy to obtain more real output from its limited resources. Real output = 10 units Units of input = 5 Price of inputs = $2 Productivity = 2 Unit-production costs = $1

47. If productivity increases so that output increases to 20 units, what happens to production costs? They fall to.50 and the AS curve shifts to the right. Remember the main source of productivity growth is improved production technology. Other sources of productivity increases are a better educated and better trained workforce, and improved forms of business enterprises.

48. 3.Legal-Institutional Environment- The setting in which businesses operate can also affect AS. LO2 29-48

49.  Business taxes & Subsidies- Higher business taxes, such as sales, excise, and payroll taxes increase per-unit production costs and reduce short-run AS. Similarly, a business subsidy, which is a payment or tax break by government to producers, lowers production costs and increases short-run AS.

50.  Government Regulation- It is normally costly for businesses to comply with government regulations. More regulation therefore tends to increase per-unit production costs and shift the AS curve to the left.

51. Supply-side proponents of deregulation of the economy have argued forcefully that, by increasing efficiency and reducing the paperwork associated with complex regulation, deregulation will reduce per- unit costs and shift the AS curve to the right.

52. Equilibrium Price Level & Real GDP Of all the possible combinations of price levels and levels of real GDP, which combination will the economy gravitate toward, at least in the short run? Figure 29.7 and its accompanying table provide the answer. Equilibrium occurs at the price level that equalizes the amounts of real output demanded and supplied.

53. Equilibrium Real domestic output, GDP (billions of dollars) Price level (index numbers) 100 92 502510514 a b AD AS Real Output Demanded (Billions) Price Level (Index Number) Real Output Supplied (Billions) $506108$513 508104 512 510100 510 51296 507 51492 502 0 LO3 29-53

54. The intersection of the AD curve and the AS curve establishes the economy’s equilibrium price level and equilibrium real output. In our example, the equilibrium price level and level of real output are 100 and $510 billion.

55. Looking at the graph, why is a price level of 92 not sustainable? At that price level businesses want to produce real output of $502 billion at point (a). However, buyers want to purchase $514 billion as represented by point (b). Competition among buyers to purchase the lesser available real output will drive the price level up.

56. Assuming fixed input prices, as the price level rises businesses will begin to make more profit so they expand output to $510 billion. With the higher price level, buyers scale back their purchases from $514 billion to $510 billion. When equality occurs between the amounts of real output produced and purchased, the economy has achieved equilibrium.

57. Changes in Equilibrium We will now look at various situations that may confront the economy causing a change in the equilibrium price level and level of real output.

58. ↑ AD 1.Increases in AD: Demand Pull Inflation- Looking at figure 29.8 suppose the economy is operating at its full- employment output and businesses and government decide to increase their spending, actions that will shift the AD curve to the right. Notice the economy moves from P1/Qf to P2/Q1 resulting in demand pull inflation.

59. Also, the increase in demand expands real output to Q1. The distance between Q1 and Qf is called a positive, or inflationary GDP gap. Actual GDP exceeds potential GDP. The classic example of demand pull inflation occurred in the 1960’s. A careful look at figure 29.8 reveals an interesting point about the multiplier effect.

60. The increase in AD from AD1 to AD2 increases output only to Q1, not to Q2, because part of the increase in AD is absorbed as inflation as the price level rises from P1 to P2. Inflation has reduced the increase in real output, and thus the multiplier effect, by about one-half. For any initial increase in AD, the resulting increase in real output will be smaller the greater is the increase in the price level.

61. AD Increases: Demand-Pull Inflation Real domestic output, GDP Price level AD 1 AS P1P1 P2P2 Q2Q2 Q1Q1 QfQf AD 2 0 LO4 29-61

62. ↓ AD 2.Decreases in AD: Recession & Cyclical Unemployment- Decreases in AD describe the opposite end of the business cycle. Figure 29.9 shows a decline in AD from AD1 to AD2. Deflation, a decline in the price level, is not the norm in the U.S. economy. For reasons we will examine soon, many important prices in our economy are downwardly inflexible such that the price level is sticky downward even when AD substantially falls.

63. If the price level is stuck at P1, the economy moves from point (a) to (b) along the broken horizontal line rather than from (a) to (c). The outcome is a decline of real output from Qf to Q1, with no change in the price level. This decline of real output constitutes a recession and since fewer workers are needed to produce the lower output, cyclical unemployment arises.

64. The distance between Q1 and Qf is a negative, or recessionary, GDP gap. Actual GDP now falls short of potential GDP. If the price level does not fall the multiplier is at full strength. All recent recessions in the U.S. have generally mimicked the GDP gap but no deflation scenario has occurred.

65. In the great recession of 2007-2009 the price level fell in some months and the rate of inflation declined, meaning that disinflation occurred. Considering the full period, however, deflation did not occur. Real output takes the brunt of declines in AD because the price level tends to be downwardly rigid in the immediate short run. Look at the “consider this” article on the Ratchet Effect.

66. Decreases in AD: Recession Real domestic output, GDP Price level AD 1 AS P1P1 P2P2 Q1Q1 Q 2 QfQf AD 2 c a b 0 LO4 29-66

67. Reasons for ↓ Price Stickiness  Fear of Price Wars- Some large firms may be concerned that if they reduce their prices, rivals not only will match their price cuts but may retaliate by making even deeper cuts. In this case each firm eventually ends up with far less profit or higher losses than would be the case if each had simply maintained its prices. Rather than lower prices, firms will choose to reduce production and lay off workers. LO4 29-67

68.  Menu Costs- involve the cost of changes prices, like a restaurant, when it decides to cut prices.

69.  Wage Contracts- firms rarely profit from cutting their product prices if they cannot also cut their wage rates. Wages are usually inflexible downward because large parts of the labor force work under contracts prohibiting wage cuts for the duration of the contract.

70.  Morale, Effort, & Productivity- Many employers view current wages as efficiency wages, wages that elicit maximum work effort and thus minimize labor costs per unit of output. Lower wages might impair worker morale and work effort, thereby reducing productivity. Lower productivity will raise per-unit production costs because less output is being produced.

71.  Minimum Wage- The federally mandated minimum wage imposes a legal floor that employers cannot go below.

72. ↓ AS 3.Decreases in AS: Cost-push Inflation- Suppose Iran threatens to cut off oil supplies to the U.S. or Syria is caught in a bitter civil war, both of which drives up oil prices which in turn increase production and distribution costs on a wide variety of goods and services. As shown in figure 29.10 the AS curve shifts to the left from AS1 to AS 2 causing cost-push inflation.

73. The effects of this cost-push inflation are doubly bad. The price level rises from P1 to P2 and real output declines from Qf to Q1 pushing the economy into a recession. The result is a negative GDP gap where actual GDP falls short of potential GDP.

74. Decreases in AS: Cost-Push Inflation Real domestic output, GDP Price level AD AS 1 P1P1 P2P2 Q1Q1 QfQf AS 2 a b 0 LO4 29-74

75. ↑ AS 4.Increases in AS: Full Employment w/ Price Level Stability- Between 1996 and 2000, the U.S. economy experienced a combination of full employment, strong economic growth, and very low inflation. Specifically, the unemployment rate fell to 4% and real GDP grew nearly 4% annually, without igniting inflation.

76. If AD increases from AD1 to AD 2, the economy would move from point (a) to (b) resulting in more growth and employment, but with higher inflation. However, between 1990 and 2000 larger than normal increases in productivity occurred because of a burst of new technology relating to computers, the internet, inventory management systems, and electronic commerce.

77. This boost in productivity growth shifted the AS curve from AS1 to AS 2. Instead of moving from (a) to (b), the economy moved from (a) to (c). Real output increased from Q1 to Q3, and the price level rose only modestly from P1 to P2. The shift in the AS curve accommodated the rapid increase in AD and kept inflation mild.

78. Increases in AS: Full-Employment Real domestic output, GDP Price level AD 1 AS 2 P1P1 P2P2 Q 2 Q1Q1 AS 1 b AD 2 c P3P3 Q3Q3 a 0 LO4 29-78

79. Impact of Oil Prices Diminished? 1970’s Reduced AS and negative GDP gap Cost-push inflation Rising unemployment 2000’s Core inflation steady Use 50% less oil and gas today Federal Reserve more vigilant 29-79