What is Aggregate Demand? • A schedule or curve showing amounts of real output that buyers collectively desire to purchase at each possible price level. Think: Why does AD slope downward?
Think: Why does AD slope downward? Vertical axis represents Price level for ALL final goods And services The aggregate price level Is measured by either GDP Deflator or CPI Price level The horizontal axis represents the real quantity of all G&S purchased as measured by the level of REAL GDP AD Real domestic output, GDP Inverse Relationship
Vertical and Horizontal Axis Horizontal axis = GDP Vertical axis = GDP deflator (includes C+I+G) or CPI…. Government uses the deflator* so it get a lower number. *A broader measure of price level… includes airplanes, dentist Visits, pizzas, new shopping centers, etc.
ASSUMPTION for Aggregate demand IS: If Price level is decreasing, so are incomes. Economy moves down its AD curve Moves to lower price level *remember circular flow model- (when consumers pay lower prices for goods and services – Less nominal income flows to resource suppliers .
There are 3 Reasons that cause the Aggregate Demand Curve to be downward sloping. Real Balance Effect (Wealth effect) Interest Rate Effect International Trade Effect
Real Balance Effect • Price level falls- causes purchasing power to rise… translates into more money to spend or monetary wealth improves. • Real Balance Effect (or wealth effect) – Higher price level means less consumption spending.
Real Balance EffectHigher price level reduces real value of purchasing power of public’s accumulated savings The change in the purchasing power of dollar- Relates to assets that result from a change in the price level
Interest Rate Effect • Inverse relationship between price level and quantity demanded of GDP – because households and businesses adjust to interest rates for those interest-sensitive purchases. • Price level falls (bundle of goods costs less) rest of money into savings, more money available for borrowing interest rate down. • Think of money as stationary… demand drives up price of money.
Interest Rate continued • Now if bundle of goods increases… want to purchase interest sensitive good, cost to borrow is up. • An increase in money demand will drive up the price paid for its use … use of money = interest rate • As price level rises, houses and firms require more money to handle transactions…
International Trade Effect (Open Economy Effect) FYI: An open economy is global, a closed economy is domestic. The Open Economy Effect Higher price levels result in foreigners’ desiring to buy fewer American-made goods while Americans desire more foreign-made goods (i.e., net exports fall). Equivalent to a reduction in the amount of real goods and services purchased in the U.S. When Demand for exports decreases, this is an unfavorable balance of trade (imports exceed exports)
Macro AD vs Micro D Aggregate Demand versus Demand for a Single Good When the aggregate demand curve is derived, we are looking at the entire circular flow of income and product.(if AD moves to lower general price level- circular flow tells us when consumers pay lower prices – less nominal income flows to resource suppliers
Demand for Single good (deals with income effect and substitution effect When a market demand curve is derived, we are looking at a single product in one market only. (i.e. income effect and substitution effect) *If prices go down for cars, have more income to spend someplace else. *If price of certain items go up, we can substitute in many cases.
Change in QAD and Change in AD What is the difference? PL PL A B AD 2 AD1 GDP GDP
Difference between Quantity of AD and Change of AD QAD = movement up or down as result of price level changing (ONLY) Change in AD = Change in any of the component parts of AD (C + I + G + Net Exports)
DETERMINANTS OF AGGREGATE DEMAND Change in Consumer Spending • Consumer Wealth • Consumer Expectations (expect higher prices) • Interest rate (interest sensitive durables) • Taxes • Think in aggregate terms
Changes in Investment Spending • Real Interest Rates (rates high- not much I taking place) • Expected Future Sales (health of economy- confidence is big) • Business Taxes (higher taxes less profit)
Government Spending This will be discussed further, but anytime government spends, it has an affect on GDP. Infrastructure – Health CareSupplies for military Education Etc.
Net Export Spending • National Income Abroad-(when foreign nations do well, their incomes are higher- can buy more U.S. goods and services. – U.S. exports rise) • Exchange Rates- Price of one nation’s currency in terms of another. Dollar vs Euro • Our currency appreciates if it takes more foreign $ to buy it.. (depreciates if it takes more of ours to buy theirs.) $1.00 to $1.25 Euro. • Depreciation of nation’s currency makes foreign goods more expensive (but attracts foreigners to buy our goods.) Our exports rise. *this is why the Fed has not worried about our low dollar valuation.
Factors That Change Aggregate Demand & Consumption/Interest Rates Interest Rate ↑ → C↓ →AD↓ Interest Rate ↓ → C ↑ →AD↑
Factors That Change Aggregate Demand & Investment/ Interest Rates Interest rates ↑ → I↓ →AD↓ Interest rates ↓ → I ↑ →AD↑
Factors That Change Aggregate Demand & Investment/ Business Taxes Business taxes↓ → I↑ →AD↑ Business taxes↑ → I↓ →AD↓
Long-Run Equilibrium and the Price Level For the economy as a whole, long-run equilibrium occurs at the price level where the aggregate demand curve (AD) crosses the long-run aggregate supply curve (LRAS).
OK… One more time….. Component parts of GDP? C + I + G + (X-M) = GDP Long-Run Aggregate Supply Curve (LRAS) • A vertical line representing the real output of goods and services after full adjustment has occurred • It represents the real GDP of the economy under conditions of full employment; the economy is on its production possibilities curve
The Production Possibilities and the Economy’s Long-Run Aggregate Supply Curve
Output Growth and the Long-Run Aggregate Supply Curve (cont'd) LRAS is vertical Input prices fully adjust to changes in output prices Suppliers have no incentive to increase output Unemployment is at the natural rate Determined by endowments and technology (or existing resources)
Output Growth and the Long-Run Aggregate Supply Curve (cont'd) Growth is shown by outward shifts of either the production possibilities curve or the LRAS curve caused by Growth of population and the labor-force participation rate Capital accumulation Improvements in technology
What does Long Run Equilibrium Mean? • Economy is a full employment • Any additional production would be difficult to achieve. • Economy operating at natural rate of unemployment (anyone wanting job=have it.) • Equate the LRAS curve with bowed line on PPC. • To extend either would be to discover new resources – R&D
Full Employment • The condition that exists when the unemployment rate is equal to the natural unemployment rate. • Full productive capacity has been • Reached.
Image Cylinder= Economy… Businesses, factories, economynot working at full capacity
Full Employment AD AS LRAS
SRAS (short run aggregate supply) • Period where adjustment occurs. • Direct relationship • As the output increases that puts upward pressure on price. • Movement on the curve denotes the relationship between price level and real output.
SRAS………….Shift • Shift in the curve denotes determinates that affect more or less real output production at various price levels. • Determinants: Change in input prices (steel, plastic, wool change in resource availability ) Change in productivity (+ = Shift right; - = Shift left) (more for less is the object) Change in legal environment (contracts, taxes, subsidies)
LRAS = long-run aggregate supply LRAS is a vertical line reflecting that LR Aggregate Supply is not affected by changes in PL. The LRAS is labeled as the natural level of real GDP The natural level of real GDP is defined as the level of real GDP that arises when the economy is fully employing all of its available input resources ( We are in agreement that it hovers around 5%)
Long Run Aggregate Supply P LRASLR Price level Long-run Aggregate Supply Full-Employment Q Qf Real domestic output, GDP
Real Rate Of Interest D2 D1 Money Supply Can a Change in Money Supply Change AD? Probably… but it is a chain of events.MS changes, then Interest Rates, then chance in consumption and investment. Then Change in AD
Equilibrium States of the Economy During the time an economy moves from one equilibrium to another, it is said to be in disequilibrium.
Price level LRAS SRAS1 Short-run effects of an unanticipated increase in AD P P 100 105 AD2 AD1 Goods &Services(real GDP) Y Y F 2 Unanticipated Increase in Aggregate Demand • In response to an unanticipated increase in AD for goods & services (shift from AD1 to AD2), prices will rise to P105 and output will temporarily exceed full-employment capacity (increases to Y2).
LRAS1 LRAS2 Price level SRAS1 SRAS2 P P 1 2 AD Goods &Services(real GDP) Y Y Y Y F2 F2 F1 F Growth in Aggregate Supply • Here we illustrate the impact of economic growth due to capital formation or a technological advancement, for example. • Both LRAS and SRASincrease (to LRAS2 and SRAS2); the full employment output of the economy expands from YF1 to YF2. • A sustainable, higher level of real output and real income is the result. ***If the money supply is held constant, a new long-run equilibrium will emerge at a larger output rate (YF2) and lower price level (P2).
Price level LRAS SRAS2 (Pr2) SRAS1 (Pr1) B A P P 100 110 AD Goods &Services(real GDP) Y Y F 2 Effects of Adverse Supply Shock • The higher resource prices shift the SRAS curve to the left; in the short-run, the price level rises to P110 and output falls to Y2. • What happens in the long-run depends on whether the reduction in the supply of resources is temporary or permanent. • If temporary, resource prices fall in the future, permitting the economy to return to its original equilibrium (A). • If permanent, the productive potential of the economy will shrink (LRAS shifts to the left) and (B) will become the long-run equilibrium.
INCREASES IN AD: DEMAND-PULL INFLATION P AS AD1 AD2 P2 Price Level P1 Q Q2 Q1 Qf Real Domestic Output, GDP
DECREASES IN AS: COST-PUSH INFLATION AS2 P AS1 b P2 Price Level a P1 AD1 Q Q1 Qf Real Domestic Output, GDP
Non-governmental actions that shift AS • Shift AS left: • Raw materials cost rise • Wages rise faster than productivity • Worker productivity decreases • Obsolescence • Wars • Natural disasters
Fiscal Policy • Governmental actions that shift AD • Shift AD right: • Govt spending increases • Taxes decreases • Money Supply increases • Shift AD left: • G decreases • T increases • MS decreases