“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 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 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 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)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 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)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 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) Reminder: GDP = C + I + G + (X - M) Aggregate Demand Curve Price Level AD Real Domestic Output, GDP
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 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 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 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 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 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 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 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 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 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 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 SupplyShifts in the Short-Run AS Curve AS3 AS1 Decrease in Aggregate Supply AS2 Price Level Increase in Aggregate Supply Real GDP
EquilibriumUsing a Table Equilibrium occurs at the price level where the value of real output demanded equals the value of the real output supplied.
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)
EquilibriumDemand-Pull Inflation ASLR Price Level AS P2 P1 AD1 AD Qf Q1 Q2 Real GDP
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
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.
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 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 • 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