Ch. 7: Aggregate Demand and Aggregate Supply

Del Mar College

John Daly©2003 South-Western Publishing, A Division of Thomson Learning

Aggregate Demand

• Aggregate Demand refers to the quantity demanded of goods and services, or the quantity demanded of the Real GDP, at various price levels.

Aggregate Demand Curve

• Notice the curve is downward sloping, indicating an inverse relationship between the price level and the quantity demanded of Real GDP: as the price level rises, the quantity demanded of Real GDP falls, and as the price level falls, the quantity of GDP demanded of Real GDP rises.

Why Does the Aggregate Demand Curve Slope

Downwards??• The Real BalanceReal Balance effect states that the inverse

relationship between the price level and the quantity demanded of Real GDP is established through changes in the value of monetary wealth.

• A fall in the price level causes purchasing power to rise, which increases a person’s Monetary Monetary WealthWealth. As people become wealthier, the quantity demanded from the GDP rises.

• A rise in the price level causes Purchasing PowerPurchasing Power to fall which decreases a person’s monetary wealth.

Why Does the Aggregate Demand Curve Slope

Downwards??• The Interest Rate EffectInterest Rate Effect states that the inverse

relationship between the price level and the quantity demanded of Real GDP is established through changes in household and business spending that is sensitive to changes in interest rates.

• The International Trade EffectInternational Trade Effect states that the inverse relationship between the price level and the quantity demanded of Real GDP is established through foreign sector spending, which includes US spending on foreign goods and foreign spending on US goods.

A Change in the Quantity Demanded of Real GDP versus a

Change in Aggregate Demand• A Change in the quantity demanded of Real GDP

is brought about by a change in the price level. This would cause a shift down the Aggregate Demand Curve, but would not move the curve.

• A Change in Aggregate Demand is a shift in the Aggregate Demand Curve. An increase is a right shift of the curve, while a decrease in Aggregate Demand would cause a left shift to the curve.

A Shift in the Aggregate Demand Curve

Changes in Aggregate Demand

• If at a given price level, Consumption, Investment, Government Purchases, or Net Exports INCREASE, then Aggregate Demand will INCREASE as well.

• If at a given price level, Consumption, Investment , Government Purchases, or Net Exports DECREASE, the Aggregate Demand will DECREASE as well.

How Spending Components Affect Aggregate Demand

• Components of Spending: – Consumption– Investment– Government Purchases– Net Exports

• A change in some or all of these components can affect aggregate demand.

What Causes Consumption to Increase?

• Wealth• Expectations about

Future Prices and Income

• Interest Rate• Income Taxes

What Causes Investment to Increase?

• The Interest Rate• Expectations about

Future Sales• Business Taxes

What Would Increase Net Exports?

• Foreign Real National Income: As exports rise, net exports rise, and so does the Real GDP.

• Exchange Rate: whether or how far a different monetary unit has appreciated or depreciated when compared to your own monetary units.

Q & A

• Explain the Real Balance effect.

• Explain what happens to the Aggregate Demand curve if the dollar appreciates relative to other currencies.

• Explain what happens to the Aggregate Demand curve if personal income taxes decline.

Short Run Aggregate Supply

• The quantity supplied of all goods and services at different price levels.

• The Short Run Aggregate Supply Curve is upward sloping.

Short-Run Aggregate Supply Curve

Short-Run Aggregate Supply Curve: What is it, why is it

upward-sloping??• “Sticky” Wages: Some economists believe

that wages are sticky or inflexible. Wages may also become sticky because of certain social conventions or perceived notion of fairness.

• Most individuals are willing to work, and current workers are willing to work more, at higher than at lower real wages.

Short-Run Aggregate Supply Curve: What is it, why is it

upward-sloping??• Prices are also sometimes “sticky”: some prices

adjust quickly in an economy, others do not.• Some prices are sticky because there are costs to

changing prices, called Menu Costs.• If some prices are sticky, a decline in the price

level is linked with a decrease in output, which is illustrative of an upward-sloping SRAS curve.

Short-Run Aggregate Supply Curve: What is it, why is it

upward-sloping??• Producer Misperceptions: Economists generally

agree that producers will produce more output as their relative price of their good rises and produce less output as the relative price of their good falls.

• If producers misperceive relative price changes, then a higher price level will bring about an increase in output, which is illustrative of an upward-sloping SRAS curve.

Short-Run Aggregate Supply Curve: What is it, why is it

upward-sloping??• Worker

Misperceptions: if workers misperceive Real wage changes, then a fall in the price level will bring about a decline in output, illustrative of the upward-sloping curve.

Shifts in the Aggregate Supply Curve • Wage Rate: a rise

in equilibrium wage rates leads to a leftward shift in the aggregate supply curve.

• Price of Nonlabor units: An increase in the amount nonlabor input shifts the ASC leftward.

• A decrease in the amount nonlabor input shifts the ASC rightward,

Shifts in the Aggregate Supply Curve

• Productivity: describes the output produced per unit of input employed over some time.

• This causes the SRAS to shift rightward. A decrease in labor productivity means business will produce less output with the same amount of labor.

Shifts in the Aggregate Supply Curve

• Supply Shocks: Major natural or institutional changes on the supply side of the economy that affect aggregate supply are referred to as supply shocks.

• A Supply shock might include a drought in the Midwest, or finding even more oil in the middle ease.

Q & A

• If wage rates decline, explain what happens to the short-run aggregate supply curve?

• Give an example of an increase in labor productivity.

How Short-Run Equilibrium In The Economy Is Achieved

• Aggregate demand and short-run aggregate supply determine the price level, Real GDP, and the unemployment rate in the short run.

• In instances of both surplus and shortage, economic forces are moving the economy toward the short-run equilibrium point, where the quantity demanded of Real GDP is equal to the short-run quantity supplied of Real GDP.

• An increase in the short-run aggregate supply lowers the equilibrium price level and raises Real GDP.

The Unemployment Rate In The Short Run

• All other things held constant, we expect a higher Real GDP level to be associated with a lower unemployment rate and a lower Real GDP level to be associated with a higher unemployment rate.

• Since more workers are needed to produce more output (more Real GDP), fewer people remain unemployed and the unemployment rate drops.

• Since fewer workers are needed to produce less output, more people are unemployed and the employment rate rises.

Ceteris Paribus Makes All The Difference in the Relationship between Real GDP and the Unemployment Rate

• If some other things change, it may appear as if the inverse relationship between the unemployment rate and Real GDP doesn’t hold.

• Economics is about establishing a connection or link between an effect and a correct cause.

Q & A: Identify what will happen to the price level and Real GDP when

each of the following occurs:• Short-Run Aggregate

Supply rises• Short-Run Aggregate

Supply falls• Aggregate Demand

rises• Aggregate Demand

falls

• Aggregate Demand rises by more than the Short-Run Aggregate Supply rises

• Aggregate Demand falls by less than the Short-Run Aggregate Supply falls

Long Run Aggregate Supply

• Short-Run equilibrium identifies the Real GDP the economy produces when any of these conditions are held: sticky wages, sticky prices, producers’ misperceptions, workers’ misperceptions.

• Wages and prices eventually become unstuck and misperceptions will turn to accurate perceptions: when this happens the economy is said to be in The Long Run.

• An important question is: Will the Level of Real GDP the economy produces in the long run be the same as in the short-run?

Long-Run and Short-Run

When the economy is neither in the Short-Run nor the Long-Run, the economy is in a state of disequilibrium.

Questions Economists Ask

• What can cause the economy to move from one short-run equilibrium position to another short-run equilibrium position?

Questions Economists Ask

• What happens to certain economic variables such as the price level and Real GDP, as the economy moves from one short-run equilibrium to another short-run equilibrium?

• If the economy is in the short-run equilibrium, what path does it travel to long-run equilibrium?

• How long does it take the economy to move from short-run equilibrium to long-run equilibrium?

Questions Economists Ask

• If the economy is in long-run equilibrium, what must happen to move it to another long-run equilibrium?

• How long does it take to move from one long-run equilibrium position to another long-run equilibrium postion?

Questions Economists Ask

• Are some of the states of an economy better than other states?

• If some states of the economy are better than others, is there anything that government can do to move the economy from one state to another?

Q & A

• What is the difference between short-run equilibrium and long-run equilibrium?

• Diagrammatically represent an economy that is in neither short run equilibrium nor long run equilibrium.