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Aggregate Demand. Up to this point in macroeconomics we have looked at the basic concepts of RGDP, unemployment and inflation from a definitional point of view. This is good because we have to have a solid understanding of these ideas. - PowerPoint PPT Presentation

Text of Aggregate Demand

Chapter 24

1Aggregate Demand12Up to this point we have looked at the basic concepts of RGDP, unemployment and inflation. This is good because we have to have a solid understanding of these ideas.Next we build a model of the economy that we will use to help us understand why RGDP, unemployment, inflation and other related concepts change. If we can understand why changes happen, then perhaps performance of these macroeconomic variables can be managed. The model we will work with is called the model of Aggregate Demand (AD) and Aggregate Supply (AS). For a while our focus will be on Ad and AS separately, then we will bring the two parts together. Our model is about AD and AS interacting to produce the results in the economy. But, we look at the mechanics of each part first.2Aggregate Demand3Aggregate demand refers to the amount of real output, RGDP, that buyers collectively desire to purchase at each possible price level.

Remember from our earlier work that the buyers referred to here are in 1 of 4 groups:Households undertaking consumption (C),Businesses undertaking investment (I),Governments undertaking government purchases (G), andThe rest of the world undertaking net exports (Xn)(the buying of goods made in US, net of any items purchased here but made in other countries).

AD in a graph4Price levelRGDPAD5Note the downward slope of the AD curve as you look at the curve from left to right. The relationship between the price level and the amount of RGDP desired is said to be inverse. Now we want to give this idea economic meaning.There are 3 reasons for the downward sloping AD curve.1) Real balance or real wealth effect as the price level rises the purchasing power of peoples assets such as savings accounts or bonds declines. Folks are poorer and thus causes households to reduce C and save a bit so they can afford essentials in the future.Downward slope of AD curve562) Interest rate effect (we see this idea more later) as the price level rises you and I demand more money (the gallon of milk we buy for 2.00 goes up to, say about two fifty, and so we need more money to make our transactions). With a given money supply, a higher money demand makes the interest rate rise and thus consumption and investment fall. 3) Foreign purchases effect as the price level domestically rises (assuming the rate does not change in other countries), it becomes increasingly difficult for foreigners to buy our goods and we want more of their goods and thus net exports fall.Downward slope of AD curve67The AD line can also shift left or right. What things make the AD line shift (we call these things demand shifters or determinants of AD)? Remember we saidHouseholds undertake consumption (C),Businesses undertake investment (I),Governments undertake government purchases (G), andThe rest of the world undertakes net exports (Xn)(the buying of goods made in US, net of any items purchased here but made in other countries).Anything that changes these components (except for a price level change) will shift the AD curve. Shift AD curve78The greater the wealth, w, the greater will consumption be and AD shifts right.expc, or consumer expectations about the future, has an influence on C. The more confident about the future consumers are, the more will consumption spending be now and AD shifts right.

The higher the level of household debt, HD, the more consumption can occur and AD shifts to the right.

If taxesc (= taxes on households) rise then consumption will fall. In fact if taxesc go up by X the C falls by MPC times X and the AD curve shifts to the left.(The reverse of each factor follows the same basic pattern.) Consumption89I = I(amo, bt, tc, expb, i), where I = investment plans, amo = Acquisition, maintenance, and operating costs, bt = Business taxes, tc = technological change, expb = expectations business have about the future, and i = the interest rate.If amo goes up I goes down and AD shifts left. If bt goes up I goes down and AD shifts left. If tc goes up I goes up and AD shifts right. The higher the business expectation about the future the more investment will be today and AD shifts right. A higher interest rate means it is more costly to invest, so less will happen and AD will shift to the left.Investment910Government Spending and Net ExportsG = G(politics), so government spending is largely determined in the political arena. An increase in G shifts AD right.

Xn = Xn(for, e) where Xn = net exports and for = the health of foreign economies and e = relative strength of dollar against other currencies.

If foreign economies get better then Xn rises and AD shifts right.

If the dollar appreciates more exports from US are more difficult for foreigners and it is easier for us to make imports. Xn falls and the AD shifts to the left.

AD shifting and the multiplier11Price levelRGDPAD1 AD2AD shifting and the multiplier12On the previous slide I have AD1, AD2 and an AD curve between the 2. When we look back at all the items that can shift the AD, if we get a shift from one of these items then the first shift is from AD1 to the dashed line. Recall that the multiplier concept was about an initial change in spending is transformed into a larger change in RGDP. Here this means after the initial change due to a demand shifter change, the multiplier will kick in and shift the AD curve even more. 13Aggregate SupplyThe AS is the part of our national economy model where the production side is studied.1314An Analogy and a definitionWhich blade cuts the paper when you use a pair of scissors on the paper?The answer is that you need both to cut the paper.Up to now in our theory about the national economy we have talked about aggregate demand, AD. But, just like we need both blades in the scissors, we also have to build in aggregate supply into our theory.Aggregate Supply AS is about the relationship between the price level and the amount of real domestic output (RGDP) that firms in the economy produce.Recall an earlier story15Please recall our earlier work about a single firm and its production when prices were sticky and when they could freely adjust. With sticky prices we saw a horizontal supply and with flexible prices we saw a vertical supply.

In the larger, full economy we recall this earlier story and build on it. In macro we will think about three scenarios:1) Input prices and output prices are fixed, or are sticky,2) Input prices are fixed but output prices can change, and3) Both input prices and output prices can change.

Lets explore each of these scenarios next.16The Immediate Short RunPrice levelRGDPP1ASISRFact about our economy: 75% of a typical firms costs are wage and salary and these are fixed either by contract (like for me) or there is an implicit understanding that wages are negotiated only every so often (maybe yearly). A good deal of input prices are fixed in this time frame.1617The Immediate Short RunAlso in the immediate short run output prices are fixed. Firms print up menus and price lists and in the very short term they stick with these prices.So, the immediate short run is anywhere from a few days to a few months. The more important point is that it is that period of time when both input prices and output prices are fixed (sticky!).Hey, try not to be confused by input prices and output prices. Example: Say the output is pizza. The output price is the price of the cooked pizza. What are the inputs to making pizza? The dough, sauce and other ingredients are inputs that will have prices, as will the labor that is making the pizza (and the price of labor is often called the wage!).1718The Immediate Short RunPrice levelRGDPP1ASISRNote that the level of output in this immediate short term will depend on aggregate demand and the RGDP level that corresponds to full employment will only occur if demand is AD Full. In other words the full employment level of output is not guaranteed in the economy.FullLowHighAD LowAD FullAD High1819Short RunPP1ASRGDP1 RGDP2RGDPThe AS has an upward slope to it as we view it from left to right. This means the price level and the level of RGDP firms will offer for sale is positively, or directly, related. P21920Short RunNote that the short run is defined here as the time frame in which input prices are fixed but output prices can change. Higher (lower) output prices with fixed input prices means profits would be higher (lower) and this is the incentive (disincentive) firms need to increase (decrease) real output.

On the last screen you can see that at low levels of RGDP the AS is somewhat flat and as the level of RGDP rises the curve is becomes steeper.Lets look at this next.20Per Unit Production Cost21In order to see the points about AS we need to think about the following ratio:Total input cost/units of output.This ratio is the per unit production cost (on average) of output. Ultimately the price per unit of output has to cover this or firms would not be able to produce because they wouldnt be making any profit. The AS is a curve showing what price levels have to be to get the various levels of output produced.Now, if more units of output are made, additional inputs are needed (but remember the short run has the input prices fixed!). 22When output is already low, below the full employment level, this means many resources are underutilized. To add output resources that are idle get put back to work and the ratio of input cost to output does not change much. So the price level does not have to expand much to get more output. With the higher price level firms have an incentive to produce more.Now, when output is already at the full employment level of output or above, additional output is that much harder to come by. Adding inputs, when a great deal of output is already being made does not yield as much output as before and thus per unit

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