Chapter 20 Aggregate Demand and Supply

1. Chapter 20Aggregate Demand and Supply • Key Concepts • Summary • Practice Quiz • Internet Exercises

2. In this chapter, you will learn to solve these economic puzzles: Why does the aggregate supply curve have three different segments? Was John Maynard Keynes’s prescription for the Great Depression right? Would the greenhouse effect cause inflation, unemployment, or both?

3. What is the Aggregate Demand Curve? The curve shows the level of real GDP purchased by households, businesses, government, and foreigners at different price levels during a time period, ceteris paribus

4. What does the Horizontal Axis measure? The value of final goods and services included in real GDP measured in base year dollars

5. What does the Vertical Axis measure? It is an index of the overall price level, such as the GDP deflator or the CPI

6. Why does the Aggregate Demand Curve slope downward to the right? • Real balance wealth effect • Interest rate effect • Net exports effect

7. What is theReal Balance Effect? Consumers spend more on goods and services because lower prices make their dollars more valuable

8. What is theInterest Rate Effect? Assuming fixed credit, an increase in the price level translates through higher interest rates into a lower real GDP

9. What is theNet Exports Effect? A higher domestic price level makes U.S. goods more expensive compared to foreign goods, exports decrease, imports increase, decreasing real GDP

10. The Aggregate Demand Curve $200 Price Level A $150 B $100 AD $50 Real GDP 12 4 8 6 10 2

11. What can cause a shift in the Aggregate Demand Curve? Consumption, investments, government spending and net exports can change

12. A Shift in the Aggregate Demand Curve 200 150 Price Level (CPI) A B 100 AD2 50 AD1 Real GDP 12 4 6 10 2 8

13. What is theAggregate Supply Curve? The curve that shows the level of real GDP produced at different price levels during a time period, ceteris paribus

14. Why did Keynes assume fixed product prices and wages? During a deep recession or depression, there are many idle resources in the economy

15. Why do idle Resources mean Fixed Prices? Producers are willing to sell additional output at current prices because there is plenty of resources to go around for everyone who wants them

16. Why do idle Resources mean Fixed Wages? The supply of unemployed workers willing to work for the prevailing wage rate diminishes the power of workers to increase their wages

17. What kind of Supply Curve would explain Fixed Prices and Wages? A horizontal supply curve

18. The Keynesian Horizontal Aggregate Supply Curve 200 150 Price Level (CPI) E1 E2 AS 100 AD2 50 AD1 Real GDP 12 4 8 6 10 2

19. Price level remains constant, while real GDP and employment rise Aggregate demand increases and the economy moves from E1 to E2 Government spending (G) increases

20. According to Keynes, what will a shift in Aggregate Demand do? It will restore a depressed economy to full employment

21. The Keynesian Horizontal Aggregate Supply Curve 200 Full employment 150 Price Level (CPI) E1 E2 AS 100 AD2 50 AD1 Real GDP 12 4 8 6 10 2

22. What is the Classical view of the Aggregate Supply Curve? It is a vertical line at the full employment output

23. According to the Classical Economists, where does the economy normally operate? The economy normally operates at its full employment level

24. How do the Classical Economists view Prices and Costs? The price level of products and production costs change by the same percentage in order to maintain full employment

25. The Classical Aggregate Supply Curve AS Surplus 200 Full employment E1 150 E Price Level (CPI) 100 E2 AD1 50 AD2 Real GDP 12 14 16 17 6 2 4 8 10

26. Three Ranges of the Aggregate Supply Curve AS Classical Range Full Employment Intermediate Range Price Level Keynesian Range Real GDP YK YF

27. Increasing Demand AS 200 Price Level 150 AD6 100 AD5 Full Employment AD4 50 AD3 AD2 Real GDP AD1 6 0 2 4 8 10 12

28. What factors can cause a shift in theAggregate Supply Curve? A change in ~ • resource prices • technology • taxes • subsidies • regulations

29. A Rightward Shift in the Aggregate Supply Curve AS1 AS2 200 E1 E2 150 Full employment 100 Price Level AD 50 Real GDP 12 14 16 17 6 2 4 8 10

30. Increase in the aggregate supply curve Change in one or more nonprice-level determinants: resource prices, technological change, taxes, subsidies, and regulations

31. What are the two types of Inflation? • Cost push • Demand pull

32. What isCost Push Inflation? A rise in the general price level resulting from an increase in the cost of production

33. Cost Push Inflation AS2 AS1 200 Price Level E2 150 Full employment 100 E1 AD 50 Real GDP 12 14 16 17 6 2 4 8 10

34. What isDemand Pull Inflation? A rise in the general price level resulting from an excess of total spending

35. Demand Pull Inflation AS 200 Price Level Full employment 150 E2 AD2 100 E1 50 AD1 Real GDP 12 14 16 17 6 2 4 8 10

36. What determines the Business Cycle? Shifts in the aggregate demand and aggregate supply curves

37. Key Concepts

38. Key Concepts • What is the Aggregate Demand Curve? • Why does the Aggregate Demand Curve slope downward to the right? • What can cause a shift in the Aggregate Demand Curve? • What is the Aggregate Supply Curve? • Why did Keynes assume fixed product prices and wages? • What kind of Supply Curve would explain Fixed Prices and Wages?

39. Key Concepts cont. • According to Keynes, what will a shift in Aggregate Demand do? • What is the Classical view of the Aggregate Supply Curve? • According to the Classical Economists, where does the economy normally operate? • What factors can cause a shift in the Aggregate Supply Curve? • What are the two types of Inflation?

40. Summary

41. The aggregate demand curve shows the level of real GDP purchased in the economy at different price levels during a period of time.

42. Reasons why the aggregate demand curve is downward-sloping include the following three effects:

43. (1) The real balances or wealth effect is the impact on real GDP caused by the inverse relationship between the purchasing power of fixed value financial assets and inflation, which causes a shift in the consumption schedule.

44. (2) The interest-rate effect assumes a fixed money supply, and, therefore, inflation increases the demand for money. As the demand for money increases, the interest rate rises, causing consumption and investment spending to fall.

45. (3) The net exports effect is the impact on real GDP caused by the inverse relationship between net exports and inflation. An increase in the U.S. price level tends to reduce U.S. exports and increase imports, and vice versa.

46. A Shift in the Aggregate Demand Curve 200 150 Price Level (CPI) A B 100 AD2 50 AD1 Real GDP 12 4 6 10 2 8

47. The aggregate supply curve shows the level of real GDP that the economy will produce at different possible price levels. The shape of the aggregate supply curve depends on the flexibility of prices and wages as real GDP expands and contracts. The aggregate supply curve has three ranges:

48. (1) The Keynesian range of the curve is horizontal because neither the price level nor production costs will increase when there is substantial unemployment in the economy.

49. (2) In the intermediate range, both prices and costs rise as real GDP rises toward full employment. Prices and production costs rise because of bottlenecks, the stronger bargaining power of labor, and the utilization of less productive workers and capital

50. (3) The classical range is the vertical segment of the aggregate supply curve. It coincides with the full-employment output. Because output is at its maximum, increases in aggregate demand will only cause a rise in the price level.