The Basics of Aggregate Demand and Aggregate Supply: Understanding the Relationship

1. Chapter 10 Aggregate Demand and Aggregate Supply: The Basic Model

2. The Basics of Aggregate Demand • Aggregate demand refers the real value of all new, final, domestically produced goods and services that households, firms, governments, and the foreign sector are willing and able to purchase at a given set of price levels, ceteris paribus.

3. The Basics of Aggregate Demand (cont’d) • AD equals: • Consumption Spending by Households, plus • Investment Expenditures by Firms, plus • Government Expenditures, plus • Net Exports

4. The Price Level and Aggregate Demand • The overall price level is the major determinant of total spending in the economy. • Aggregate demand curve shows relationship between the price level and total spending • What is the relationship??

5. Figure 10.1The Aggregate Demand Curve

6. Why the Aggregate Demand Curve Slopes Downward • There are three basic reasons: • The Wealth Effect • As prices decrease you feel wealthier because you can buy more • The Interest Rate Effect • As prices fall don’t have to spend as much  save more interest rates fall encourage borrowing changes AD • The International Trade Effect • As prices fall buy more US good imports fall  other countries see that our goods are cheaper exports increase

7. Basic Movements in Aggregate Demand • Change in aggregate quantity demanded • Caused by a change in the overall price level. • Shown by a movement along the aggregate demand curve

8. Basic Movements in Aggregate Demand (cont’d) • A change in aggregate demand is caused by changes in forces other than the price level: • Macroeconomic policy influences • Changing interest rates, changing taxes, changes in government spending • Expectations • Consumer confidence • Global influences • Purchasing power of the dollar • Represented by a shift of the aggregate demand curve

9. Table 10.1 Key Influences on Changes in Aggregate Demand

10. Figure 10.2Change in Aggregate Demand

11. Can we do it?? • Let’s try number 2… • How will the following actions of macroeconomic policy affect the US aggregate demand curve? • Social Security taxes are increased to extend the life of the Social Security system • AD shift to the left • The federal government expends its spending on prescription drug benefits under Medicare • AD shift to the right • Consumers expect more disposal income in the future as temporary tax cuts are made permanent • AD shift to the right

12. The Basics of Aggregate Supply • Aggregate supply is the real value of all final, domestically produced goods and services that firms are willing to offer for sale at various price levels, ceteris paribus. • There are two different aggregate supply curves: • The Short-Run AS Curve • The Long-Run AS Curve

13. Aggregate Supply in the Short Run • The short run is a period of time that is too short for firms to adjust fully to changes in the price level. • Workers face sticky wages. • Can’t change nominal wages easily when prices change • Firms face sticky prices. • Can’t always increase the price of your product • Firms and workers may have mistaken estimates of nominal prices. • May not have all the information right  OOPS

14. The Price Level and Short-Run Aggregate Supply • In the short run, a higher price level will cause firms to produce more goods and services. • The short-run aggregate supply curve is upward-sloping.

15. Why the Short-Run Aggregate Supply Curve Slopes Upward • A higher price level provides an incentive for firms to increase output. • Based on the process of profit maximization • Note: If price rises faster than costs, profitability increases.

16. Why the Short-Run Aggregate Supply Curve Slopes Upward (cont’d) • Resource prices (such as nominal wages) are sticky. • They change more slowly than output prices. • As price levels rise faster than production costs, profit per unit increases, and firms have an incentive to increase output.

17. Basic Movements in Short-Run Aggregate Supply (cont’d) • A change in the price level is represented by a movement along a short-run aggregate supply curve. • This is called a change in aggregate quantity supplied.

18. Figure 10.3The Short-Run Aggregate Supply Curve

19. Changes in Short-Run Aggregate Supply • Changes in other factors other than price can affect profitability at a given price level: • Nominal resource prices, especially nominal wages • Wages account for 2/3 of total production costs • Productivity • Workers become more efficient and produce more • Producers’ expectations • What do firms think will happen in the future? • These changes will shift the entire aggregate supply curve.

20. Figure 10.4Change in Short-Run Aggregate Supply

21. Can we do it?? • Let’s try number 6… • For a given industry, let the product price per unit = $5 and the production cost per unit = $3 • Based on this information, what is the profit per unit for this producer? • $2 * number of units sold • Now let the product price increase to $6 per unit, and the production cost per unit increase to $3.50 per unit. What is the profit per unit now for this producer? • $2.50 * number of units sold • How should this producer change his production plans in the face of the changing profit per unit? • Should increase production • If many producers faced the same situation, how would this affect the AS curve? • Because it is a PRICE change AS will not shift  change in Aggregate Quantity Supplied