Like any good newsman i believe that if you re not scared i m not doing my job stephen colbert
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“Like any good newsman, I believe that if you're not scared, I'm not doing my job.” Stephen Colbert. Aggregate Demand and Aggregate Supply. Chapter Objectives. Aggregate Demand and the Factors That Cause it to Change Aggregate Supply and the Factors That Cause it to Change

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Like any good newsman i believe that if you re not scared i m not doing my job stephen colbert

“Like any good newsman, I believe that if you're not scared, I'm not doing my job.”Stephen Colbert

Aggregate Demand and

Aggregate Supply


Chapter objectives
Chapter Objectives

Aggregate Demand and the Factors That Cause it to Change

Aggregate Supply and the Factors That Cause it to Change

How AD and AS Determine an Economy’s Equilibrium Price Level and the Level of Real GDP

How the AD-AS Model Explains Periods of Demand-Pull Inflation, Cost-Push Inflation, and Recession


Ad as model
AD – AS Model

Aggregate = total, or sum

Analyzes simultaneous changes in real GDP and price levels

In this model, we can see inflation, recession, unemployment and economic growth.


Aggregate demand ad downward slope
Aggregate Demand (AD) Downward Slope

  • Aggregate Demand reflects negative relationship between the price level and real GDP (output).

  • Demand curve for individual market slopes downward because we substitute away from higher priced goods to lower priced goods (Ch 3, substitution effect).

    • Aggregatedemand (AD) is downward sloping, but not for that same reason – AD is demand for EVERYthing, so we cannot substitute away from one good to another.

    • Allgoods (real GDP) are represented in the AD curve.


Aggregate demand ad why downward slope
Aggregate Demand (AD)WhyDownward Slope?

Real-Balances Effect or "Wealth Effect"

  • When prices go up, the purchasing power of wealth (accumulated savings) falls.

    • Real value of wealth falls.

    • Consumers are poorer in real terms, and feel less wealthy, so they will reduce consumption.

  • So, when general price levels increase, consumption spending decreases (real output qty demanded decreases).


Aggregate demand ad why downward slope1
Aggregate Demand (AD)Why Downward Slope?

Interest Rate Effect

  • The interest rate is the price of money.

    • When prices increase, consumers and businesses need more money, even if they are consuming the same amount of goods.

    • When demand for money increases, the price of money increases (interest rates go up)

    • Higher interest rates reduce consumption and investment, so higher price levels reduce amount of real output qty demanded.


Aggregate demand ad interest rate effect
Aggregate Demand (AD) Interest-Rate Effect


Aggregate demand ad why downward slope2
Aggregate Demand (AD)Why Downward Slope?

Foreign Purchases Effect or the “International Effect”

  • When prices increase in US relative to prices in rest of the world, foreigners will buy fewer US goods, and US consumers will buy more foreign goods.

  • Exports will fall, imports will increase, so higher price level reduces quantity of US goods demanded as net exports.


Aggregate demand ad why downward slope3
Aggregate Demand (AD)Why Downward Slope?

Price Level 

Real Value of Wealth 

Consumption 

Price Level 

Demand for Money 

Interest Rate 

Consumption and Investment

US Price Level 

Foreign Price Levels 

US Exports 

US Imports 

Net Exports

Qty demanded falls

Price Level Increases

C, I , and NX Decreases


Aggregate demand ad
Aggregate Demand (AD)

Reminder: GDP = C + I + G + (X - M)

Aggregate

Demand

Curve

Price Level

AD

Real Domestic Output, GDP


Changes in aggregate demand shifts in ad
Changes in Aggregate DemandShifts in AD

Changes in the determinants of AD shift the AD curve

  • Consumer Spending (C)

    • Consumer Wealth

      • Increased wealth = Increased AD

    • Consumer Expectations

      • Expecting future income to increase = Increased AD

    • Personal Income Tax Rates

      • Tax cuts = Increased AD


Changes in aggregate demand shifts in ad1
Changes in Aggregate DemandShifts in AD

Changes in the determinants of AD shift the AD curve

  • Investment Spending (I)

    • Real Interest Rates

      • Lower interest rates = increased investment and increased AD

      • NOT the same as the interest rate effect from changes in price levels. This interest rate change is due to monetary policy of the Federal Reserve.


Changes in aggregate demand shifts in ad2
Changes in Aggregate DemandShifts in AD

Changes in the determinants of AD shift the AD curve

  • Investment Spending (I)

    • Real Interest Rates

    • Expected Returns

      • Increased expected returns = increased investment, increased AD


Changes in aggregate demand shifts in ad3
Changes in Aggregate DemandShifts in AD

Changes in the determinants of AD shift the AD curve

  • Government Purchases (G)

    • Increase in government purchases (perhaps due to military spending, universal health care, etc.) = Increased AD


Changes in aggregate demand shifts in ad4
Changes in Aggregate DemandShifts in AD

Changes in the determinants of AD shift the AD curve

  • Net Exports(X - M)

    • When incomes increase in other nations, they will buy more US goods. So foreign incomes increase = increased exports, increased AD.

    • When exchange rate of US dollar decreases (dollar is cheaper relative to other currencies), US goods are cheaper for foreign buyers, and foreign goods are more expensive for US buyers.

      • So exports increase, imports fall = Increased net exports, increased AD.


Changes in aggregate demand curves
Changes in Aggregate Demand Curves

Increase in

Aggregate

Demand

Price Level

Decrease in

Aggregate

Demand

AD2

AD1

AD3

Real Domestic Output, GDP


Aggregate supply as long run aggregate supply
Aggregate Supply (AS)Long-Run Aggregate Supply

  • Aggregate Supply reflects the level of real GDP that firms will produce at each price level.

  • Long Run Aggregate Supply (ASLR)

    • Vertical at economy’s full employment output (potential GDP).

    • In the long run, wages are fully adjusted to price level (wages have caught up to price increases).

    • In long run, changes in price level do NOT alter the amount of GDP produced.


Aggregate supply as long run aggregate supply1
Aggregate Supply (AS)Long-Run Aggregate Supply

ASLR

Potential GDP does not change when prices change.

Potential GDP change = economic growth.

Price Level

Long Run

Aggregate

Supply

Qf = Full employment, potential output

Qf

Real GDP


Aggregate supply as short run aggregate supply
Aggregate Supply (AS)Short-Run Aggregate Supply

  • Aggregate Supply reflects the level of real GDP that firms will produce at each price level.

  • Short Run Aggregate Supply (ASSR)

    • Nominal wages are NOT fully adjusted to price changes.

    • Firm’s profit will increase when prices increase, because costs have not yet adjusted to inflation.

    • When profit increases, firms will produce more, so in SR the relationship between price level and output is positive (upward sloping).


Aggregate supply as short run aggregate supply1
Aggregate Supply (AS)Short-Run Aggregate Supply

Curve becomes steeper as output increases because there are fewer and fewer resources to employ – output increase slows down, but prices keep going up.

Aggregate Supply

(Short Run)

  • Workers can work overtime to move the economy past Qf, but long hours are not permanently sustainable.

  • Like cramming for exams

Price Level

0

Qf

Real GDP


Changes in aggregate supply shifts in the short run as curve
Changes in Aggregate SupplyShifts in the Short-Run AS Curve

Changes in:

  • Input Prices

    • Increase in input prices (wages, oil, steel) leads to decreased ASSR.

  • Productivity

    • Increased productivity (more units of output per unit of input) results in increased ASSR.


Changes in aggregate supply shifts in the short run as curve1
Changes in Aggregate SupplyShifts in the Short-Run AS Curve

AS3

AS1

Decrease in

Aggregate

Supply

AS2

Price Level

Increase in

Aggregate

Supply

Real GDP


Equilibrium using a table
EquilibriumUsing a Table

Equilibrium occurs at the price level where the value of real output demanded equals the value of the real output supplied.


Equilibrium using a graph
EquilibriumUsing a Graph

AS

Price Level

Equilibrium:

Price level = 100,

GDP = $510 B

Equilibrium

100

92

b

a

What if the price level were 92?

AD

502

510

514

Real Domestic Output, GDP($B)


Equilibrium demand pull inflation
EquilibriumDemand-Pull Inflation

ASLR

Price Level

AS

P2

P1

AD1

AD

Qf

Q1

Q2

Real GDP


Equilibrium changes in equilibrium decrease in aggregate demand
Equilibrium & Changes in EquilibriumDecrease in Aggregate Demand

ASLR

Price Level

AS

b

P1

a

P2

c

Creates a

Recession

AD1

AD2

Q1

Q2

Qf

Real GDP


Equilibrium recession and cyclical unemployment
EquilibriumRecession and Cyclical Unemployment

GDP < Potential GDP

Unemployment  and Cyclical Unemployment > 0

Recession

  • There is no cyclical unemployment at potential GDP.

    • By definition, this is full employment.

  • When output falls below potential GDP, unemployment increases due to cyclical unemployment.

  • This is a recession.


Equilibrium decrease in aggregate supply
EquilibriumDecrease in Aggregate Supply

Cost-Push

Inflation

ASLR

AS1

AS

Price Level

b

P2

a

P1

AD

Q1

Qf

Real GDP


Aggregate supply and aggregate demand wrap up
Aggregate Supply and Aggregate DemandWrap-Up

Aggregate Supply

Long-Run

Short-Run

Aggregate Demand

Real Balances

Interest Rates

International

Aggregate Supply Shifts

Aggregate Demand Shifts

Short-Run Equilibrium

Demand-Pull Inflation

Cost-Push Inflation

Recession


Key terms
Key Terms

  • Aggregate Demand-Aggregate Supply (AD-AS) model

  • Aggregate Demand

  • Real-Balances Effect

  • Interest-Rate Effect

  • Foreign Purchases Effect

  • Determinants of Aggregate Demand

  • Aggregate Supply

  • Long-Run Aggregate Supply Curve

  • Short-Run Aggregate Supply Curve

  • Determinants of Aggregate Supply

  • Productivity

  • Equilibrium Price Level

  • Equilibrium Real Output


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