Eco 200 – Principles of Macroeconomics

Chapter 9: Macroeconomic Equilibrium (AD/AS)

Aggregate demand and supply Aggregate demand – a relationship

between the price level and the equilibrium quantity of real GDP demanded.

Aggregate supply – a relationship between the price level and the equilibrium quantity of real GDP supplied.

Macroeconomic equilibrium

Demand-pull inflation Demand-pull inflation is caused by an

increase in AD

Business cycle expansion As AD rises, output rises, and

unemployment falls

Business cycle contraction As AD falls, output falls and

unemployment rises

Cost-push inflation Cost-push inflation is caused by a

reduction in AS.

Stagflation Rising prices and falling output

Aggregate demand Aggregate demand (AD) consists of

spending on GDP by: consumers (C) firms (I) the government (G), and the foreign sector (X)

Anything that increases C, I, G, or X at a given price level results in an increase in AD.

Factors affecting Consumption Income Wealth Expected future income and

wealth Demographics Taxes

Factors affecting Investment Interest rate Technology Cost of capital goods Capacity utilization

Government spending Determined by government

authorities

Factors affecting net exports Foreign and domestic income Foreign and domestic price levels Exchange rates Government policy (tariffs, trade

restrictions, etc.)

Aggregate expenditures AE = C+I+G+X AE is affected by any factor that

changes C, I, G, or X.

Aggregate demand Note that AD curve is not the same

as the demand curve for a particular good negative slope is NOT the result of

income and substitution effects Why is it downward sloping?

Wealth effect Interest rate International trade effect

Wealth effect As the price level rises:

the real value of dollar-denominated assets decline (real wealth declines)

this decline in wealth results in a reduction in consumption spending

This effect is also called the real-balance effect (or Pigou effect)

Interest-rate effect As the price level rises:

Individuals must hold more money to pay for transactions

To acquire more money, households sell bonds, and other financial assets.

As more bonds are sold, the price of bonds declines

A decline in bond prices results in a higher rate of return (interest rate) on bonds and other financial assets

A higher interest rate results in a reduction in investment and consumption spending

International trade effect As the domestic price level rises:

Imports become relatively cheaper, Exports become relatively more

expensive Exports decline, imports rise, and net

exports decline

Combined price-level effects As the price level rises, AE falls

due to the combined wealth, interest-rate, and international trade effects

Nonprice determinants of AD Anything that changes C, I, G, or X

at a given price level will cause the AD curve to shift

Effects of: Expectations (consumer and investor

confidence) Foreign income and price levels Government policy

Aggregate supply Price-level effects

Assumption: Resource prices adjust more slowly than output prices

As price level rises, production becomes more profitable and the quantity of output supplied rises.

Aggregate supply

Short-run Aggregate Supply

Long-run Aggregate Supply

Resource and output prices are assumed to be flexible in the long run. Output = potential real GDP.

Changes in Short-Run AS Resource prices Technology Expectations

Changes in Long-Run AS Changes in the quantity and/or

quality of resources Technology

Macroeconomic equilibrium

Short-run effect of an increase in AD

Long-run adjustment process