Aggregate Demand andAggregateSupply

January 12, 2011

2

Aggregate Demand

• Amount of real GDP purchased at each price level

• Why the downward slope?–Real-balances effect–Interest-rate effect–Foreign purchases effect

• Consumption, investment, and net exports

3

Aggregate Demand Curve

Real Domestic Output, GDP

Pri

ce L

evel

AD

AggregateDemand

4

Aggregate Demand

• Determinants of aggregate demand–Fixed variables along the demand curve

• Change in fixed variable • Multiplier effect• Consumer spending variables:

–Consumer wealth–Consumer expectations–Household borrowing–Personal taxes

5

Aggregate Demand

• Investment spending variables –Real interest rates–Expected returns

• Future business conditions• Technology• Degree of excess capacity• Business taxes

6

Aggregate Demand

• Government spending• Net export spending variables

•National income abroad•Exchange rates

7

Changes in Aggregate Demand

Real Domestic Output, GDP

Pri

ce L

evel

AD1

Increase inAggregateDemand

AD3

AD2

Decrease in AggregateDemand

8

• Amount real GDP produced at each price level

• Three time horizons• Immediate short run

–Few days to a few months–All prices fixed–Implicit price agreements –Contractual agreements

Aggregate Supply

9

Aggregate Supply

Real Domestic Output, GDP

Pri

ce L

evel ASISR

Immediate-short-run Aggregate

Supply

Qf

10

• Short run–Input prices fixed–Output prices variable–Real profit changes

• Long run–All prices variable–Full employment GDP–All prices adjust

Aggregate Supply

11Real Domestic Output, GDP

Pri

ce L

evel

0 Qf

Aggregate Supply(Short Run)

Slope not constant: per unit production cost and firm capacity

Aggregate Supply

12

Aggregate Supply

Real Domestic Output, GDP

Pri

ce L

evel

ASLR

Long-runAggregate

Supply

Qf

13

• Determinants of aggregate supply• Change in input price

–Domestic resource prices–Prices of imported resources

• Change in productivity• Change in legal-institutional

environment–Business taxes and subsidies–Government regulation

Aggregate Supply

14Real Domestic Output, GDP

Pri

ce L

evel

AS1

Increase inAggregate

Supply

AS3

AS2

Decrease inAggregate

Supply

Aggregate Supply

15

Equilibrium

Real OutputDemanded(Billions)

Price Level(Index Number)

Real OutputSupplied(Billions)

$506

508

510

512

514

108

104

100

96

92

$513

512

510

507

502Equilibrium Price Level and

Equilibrium Real GDP

16

Real Domestic Output, GDP(Billions of Dollars)

Pri

ce L

evel

100

92

502 510 514

a b

AD

AS

Equilibrium

Equilibrium

17

Changes in Equilibrium

Real Domestic Output, GDP

Pri

ce L

evel

AD

AS

P1

P2

Q2Q1Qf

AD1

Increase in Aggregate Demand

Demand-PullInflation

18

Changes in Equilibrium

Real Domestic Output, GDP

Pri

ce L

evel

AD1

AS

P1

P2

Q1Q2 Qf

AD2

Decrease in Aggregate Demand

Creates aRecession

a

c

b

19

• Decrease in aggregate demand–Recession and cyclical unemployment–Deflation?

• Downward price inflexibility:–Fear of price wars–Menu costs–Wage contracts–Morale, effort, and productivity

• Efficiency wages–Minimum Wage

Changes in Equilibrium

20

Real Domestic Output, GDP

Pri

ce L

evel

AD

AS1

P1

P2

Q1 Qf

Decrease in Aggregate Supply

Cost-PushInflation

AS2

a

b

Changes in Equilibrium

21Real Domestic Output, GDP

Pri

ce L

evel

AD1

AS2

P1

P2

Q2Q1

Increases in Aggregate Supply – Full-Employment With Price-Level Stability

AS1

b

AD2

c

P3

Q3

a

Changes in Equilibrium