Aggregate Demand and Supply Chapter 22. 2 Copyright © Houghton Mifflin Company. All rights reserved. Why the Aggregate Demand Curve Slopes Downward (1)

Aggregate Demand and SupplyAggregate Demand and Supply

Chapter 22Chapter 22

2

Copyright © Houghton Mifflin Company. All rights reserved.

Why the Aggregate Demand Curve Why the Aggregate Demand Curve Slopes Downward (1)Slopes Downward (1)

Aggregate demand (AD) is the economy-wide demand for goods and services.

Like the market demand curve, the aggregate demand curve slopes downward, but for different reasons.

The reasons for its downward slope are price-level effects:– Wealth Effect (Real Wealth/Real Balances) – Interest Rate Effect– International Trade Effect (Substitution)

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The Interest Rate EffectThe Interest Rate Effect

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The The Aggregate Aggregate Demand Demand CurveCurve

Note that changes in prices result in changes in the aggregate quantity demanded.

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Factors that Affect ADFactors that Affect AD

Consumption– Income– Wealth– Expectations– Demographics– Taxes

Investment– Interest Rates– Technology– Cost of Capital Goods– Capacity Utilization

AD = C + I + G + XAD = C + I + G + XNN

Government Spending Net Exports

– Domestic & Foreign Income

– Domestic & Foreign Prices– Exchange Rates– Government Policy

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Non-price Determinants: Changes in Non-price Determinants: Changes in Aggregate Demand (1)Aggregate Demand (1)

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Nonprice Determinants: Changes in Nonprice Determinants: Changes in Aggregate Demand (2)Aggregate Demand (2)

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Non-price Determinants: Changes in Non-price Determinants: Changes in Aggregate Demand (3)Aggregate Demand (3)

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Shifting the Shifting the Aggregate Aggregate Demand CurveDemand Curve

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Effects of a Effects of a Change in Change in Aggregate Aggregate DemandDemand

Demand-pull inflation: rapid increases in AD outpace the growth of AS, causing price level increases (inflation).

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Short-run Aggregate SupplyShort-run Aggregate Supply

Aggregate Supply (AS) is the total of all the firm (market) supply curves.

It shows the quantity of real GDP produced at different price levels.

Short-run AS slopes upward because an increase in the price level (while production costs and capital are held constant on the short-run), means higher profit margins—firms will want to produce more.

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Aggregate Aggregate SupplySupply

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Shape of Short-run AS (SRAS)Shape of Short-run AS (SRAS)

In the short-run, the capital stock (the number of factories and machines, etc.) are held constant.

Increasing the number of workers increases output, but at a diminishing rate.

Diminishing returns manifest as an ever-steeper SRAS curve.

In the short-run, some prices do not adjust quickly:– Labor Costs (wages)– Contracted supplies– “Sticky” prices effect the short-run equillibrium

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The Shape of The Shape of the Short-Run the Short-Run Aggregate Aggregate Supply CurveSupply Curve

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The Shape of Long-run AS (LRAS)The Shape of Long-run AS (LRAS)

Resource costs are NOT fixed.– As prices rise, workers will want higher wages

and will eventually get them. The amount of capital is not fixed—firms

can build new plants and buy new equipment over the long-run.

In the long-run, AS is set by the production possibilities curve—the capacity of the economy, and is not affected by prices, hence is vertical.

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The Shape of the The Shape of the Long-Run Long-Run Aggregate Aggregate Supply CurveSupply Curve

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Determinants of Aggregate Supply (1)Determinants of Aggregate Supply (1)

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Shifting the Shifting the Long-Run Long-Run Aggregate Aggregate Supply CurveSupply Curve

Growth occurs as the labor force and the capital stock grow, as technological innovation improves production efficiency.

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Changes in Changes in Short-Run Short-Run Aggregate Aggregate SupplySupply

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Effects of a Effects of a Change in Change in Aggregate Aggregate SupplySupply

Cost-push inflation: cost increases push AS to the left (relative to AD), causing price level increases (inflation).

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Aggregate Aggregate Demand and Demand and Aggregate Aggregate Supply Supply EquilibriumEquilibrium

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Aggregate Aggregate Demand and Demand and Supply Supply EquilibriumEquilibrium

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Economic Insight: Economic Insight: OPEC and OPEC and Aggregate SupplyAggregate Supply

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Aggregate Demand and Supply Chapter 22. 2 Copyright © Houghton Mifflin Company. All rights reserved. Why the Aggregate Demand Curve Slopes Downward (1)