10/22/20141 Aggregate Demand & Aggregate Supply Chapter 07

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Aggregate Demand & Aggregate Demand & Aggregate SupplyAggregate Supply

Chapter 07Chapter 07

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OutlineOutline

Aggregate Demand (AD)Aggregate Demand (AD) Aggregate Supply (AS)Aggregate Supply (AS) Equilibrium Price Level (Pe) and Real Equilibrium Price Level (Pe) and Real

GDP (Qe= Ye)GDP (Qe= Ye)

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AD-AS ModelAD-AS Model

AD-AS model is the macroeconomic AD-AS model is the macroeconomic model that uses AD and AS to model that uses AD and AS to determine and explain the price level determine and explain the price level (P) and the level of real domestic (P) and the level of real domestic output (Q = Y).output (Q = Y).

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Aggregate Demand (AD)Aggregate Demand (AD)

AD is a schedule or curve that shows AD is a schedule or curve that shows the total quantity of goods and the total quantity of goods and services demanded (purchased) at services demanded (purchased) at different price levels (P).different price levels (P).

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The AD CurveThe AD CurvePrice Level

GDP Deflator (P)

Real GDP (Q = Y)

Aggregate Demand(AD)

P1

Q1

A

At the price level P1, the economy purchases Q1.At the price level P2, the economy purchases Q2.

P2

Q2

B

Lower price levels increase the quantity of real GDPdemanded, and vice versa.

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Changes in ADChanges in ADPrice Level

GDP Deflator (P)

Real GDP (Q = Y)

AD1

P1

Q1

A1

A rightward shift from AD1 to AD2 represents an increase in AD. P stays unchanged, but Q rises.

AD2

AD3

A2A3

Q3 Q2

A leftward shift from AD1 to AD3 represents a decrease in AD. P stays unchanged, but Q falls.

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Changes in ADChanges in ADGDP = Q = C + I + G + NX

If P is unchanged; any change in C, or I, or G, or NX changes AD.

Changes in consumer spending (C) and AD

Up – rightward shift

Down – leftward shift

Household borrowing

More borrowing/less saving

Less borrowing/more saving

Up (Wealth effect)

Down (Reverse wealth effect)

increases

decreases

ADConsumer wealth C



increases

decreases

ADC

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Changes in consumer spending (C) and AD



Personal income taxes

Tax reductions

Tax increases

Positive

Negative

increases

decreases

ADConsumer expectations C



increases

decreases

ADC

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Changes in investment spending (I) and AD



Expected returns

Higher

Lower

Declines

Increases

increases

decreases

ADReal interest rate I



increases

decreases

ADI

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Future business conditions

Optimistic increases

ADExpected returns

I

Down – leftward shiftPessimistic decreases


Technology

New and improved increases

ADExpected returns

I

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Excess capacity

Declines increases

ADExpected returns

I

Down – leftward shiftIncreases decreases


Business taxes

Decreases increases

ADExpected returns

I

Down – leftward shiftIncreases decreases

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Changes in government spending (G) and AD



increases

decreases

ADG

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Changes in net export spending (NX) and AD



increases

decreases

ADNX

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Changes in net export spending (NX) and AD

Up – rightward shiftIncreases increases

ADNational income abroad NX

Down – leftward shiftDecreases decreases

Up – rightward shiftDollar depreciation increases

ADExchange rates NX

Down – leftward shiftDollar appreciation decreases

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Summary

Up – rightward shift increases

AD C, or I, or G, or NXwhen

Consumer wealth increases

Consumer borrowing increases

Consumer expectations are positive

Personal income taxes reduce

Real interest rates falls

Expected returns are higher

Government purchases increase

National income abroad increases

Domestic currency (dollar) depreciates

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Aggregate Supply (AS)Aggregate Supply (AS)

AS is a schedule or curve that shows AS is a schedule or curve that shows the total quantity of goods and the total quantity of goods and services supplied (produced) at services supplied (produced) at different price levels.different price levels.

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The AS CurveThe AS CurvePrice Level

GDP Deflator (P)

Real GDP (Q = Y)

ASISR

A

The immediate short-run AS is horizontal,as both input and output prices stay fixed.

P1

Qf

ASSR

ASLR

The short-run AS is upward-sloping. With input pricesfixed, changes in P will raise or lower real firm profits.The long-run AS is vertical. The economy will producefull-employment output level Qf no matter what P is.

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Aggregate Supply (AS)Aggregate Supply (AS)

Name

AS in the immediateshort-run

Label

ASISR

Shape

horizontalInput and output prices stay fixed.Firms supply G&S at fixed prices.

Explanation

Input prices stay sticky, but outputare flexible.

Firms supply more when prices riseand less when prices fall.

upward-sloping

AS in theshort-run

ASSR

Input prices change to match changes in the price level.

Firms have no incentive to altertheir output.

verticalAS in thelong-run

ASLR

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The Short-Run AS CurveThe Short-Run AS CurvePrice Level

GDP Deflator (P)

Real GDP (Q = Y)

ASSR

P1

Q1

A

At the price level P1, the economy supplies Q1.At the price level P2, the economy supplies Q2.

P2

Q2

B

Higher price levels increase the quantity of real GDPsupplied, and vice versa.

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Changes in ASChanges in ASPrice Level

GDP Deflator (P)

Real GDP (Q = Y)

AS1

P1

Q1

A1

A rightward shift from AS1 to AS2 represents an increase in AS. P stays unchanged, but Q rises.

AS2AS3

A2A3

Q3Q2

A leftward shift from AS1 to AS3 represents a decrease in AS. P stays unchanged, but Q falls.

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Changes in ASChanges in ASGDP = Q = A F (L, K, H, N)

If P is unchanged; any change in L, or K, or H, N, or A changes AS.

Changes in input prices and AS

Domestic resourcesLabor/wages; land/rent;

capital/interest

ASInputs/Prices Input prices



decreases

increases

ASInput prices

Per-unit production cost = Total input costs / Units of output

Imported resources

$ appreciates

$ depreciates

Exchange rates



decreases

increases

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increases

decreases

ASProductivity


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Legal-institution environment



Lower

Higher

ASBusiness taxes




Fewer

More

ASRegulations

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Equilibrium Price Level (P) and Equilibrium Price Level (P) and Real GDP (Qe = Ye = AEe)Real GDP (Qe = Ye = AEe)

Pe and QePe and Qe Changes in the price level and real Changes in the price level and real

GDPGDP– Demand-pull inflationDemand-pull inflation– Cost-push inflationCost-push inflation

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Macroeconomic Macroeconomic EquilibriumEquilibrium

P

Real GDP (Q = Y)

ASSR

P1

Pe

Qe

E

The economy is illustrated by the AD and AS curves below.

ADShortage

P2

Surplus

The intersection point between AD and AS curves determinesthe economy’s equilibrium price level Pe, and real GDP Qe.

At P1 < Pe, there is a shortage of G&S, which will causethe price level to increase to Pe.

At P2 > Pe, there is a surplus of G&S, which will causethe price level to fall to Pe.

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Demand-Pull InflationDemand-Pull InflationP

Real GDP (Q = Y)

ASSR

Pe

Qf

E1


AD1

P2

An increase in AD causes a demand-pull inflation and a positive GDP gap (Q1 – Qf).

AD2

E2

Q2

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Cost-Push InflationCost-Push InflationP

Real GDP (Q = Y)

AS1

Pe

Qf

E1


AD

P2

Q2

E2

AS2

A leftward shift of the AS causes a cost-push inflation anda negative GDP gap.

AS2

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Downward price level inflexibilityDownward price level inflexibility– Fear of price warsFear of price wars– Menu costsMenu costs– Wage contractsWage contracts– Morale, effort, and productivityMorale, effort, and productivity– Minimum wageMinimum wage– The ratchet effectThe ratchet effect– Recession and cyclical unemploymentRecession and cyclical unemployment

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Recession and Cyclical Recession and Cyclical UnemploymentUnemployment

P

Real GDP (Q = Y)

ASSR

P2

Q2

E2


AD2

P1

A decrease in AD causes a recession. There is deflation and a negative GDP gap.

AD1

E1

Qf

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The multiplier effectThe multiplier effect– The multiplier is the ratio of a change in The multiplier is the ratio of a change in

GDP to an initial change in government GDP to an initial change in government spending (G)spending (G)

– Multiplier = Change in real GDP Multiplier = Change in real GDP / Initial change in G / Initial change in G

– Change in real GDP = multiplier Change in real GDP = multiplier x Initial change in G x Initial change in G

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Self-correction?Self-correction?– In theory, price and wage flexibility In theory, price and wage flexibility

would allow the economy to automatically would allow the economy to automatically self-correct from a recession.self-correct from a recession.

– In reality, downward price and wage In reality, downward price and wage flexibility make the process slow and flexibility make the process slow and uncertain.uncertain.

– The government and the Fed often The government and the Fed often intervene to increase AD.intervene to increase AD.

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10/22/20141 Aggregate Demand & Aggregate Supply Chapter 07