Aggregate DemandAggregate Demand

A schedule or curve that shows the A schedule or curve that shows the amounts of real output (GDP) at amounts of real output (GDP) at various price levels various price levels

Price level is measured with the GDP Price level is measured with the GDP price index: price index: • Definition—a price index for all goods Definition—a price index for all goods

and services that make up Gross and services that make up Gross Domestic ProductDomestic Product

Aggregate Demand Curve

AD

Real GDP

PL

PL1

PL2

Y1Y2

Why the downward slope?Why the downward slope?

For individual products the reasons are:For individual products the reasons are:• Income effect—as price falls, the consumer’s Income effect—as price falls, the consumer’s

income allows for larger purchases of the income allows for larger purchases of the productproduct

• Substitution effect—as price falls, the product Substitution effect—as price falls, the product becomes relatively less expensive than other becomes relatively less expensive than other substitutessubstitutes

The income effect and substitution effect The income effect and substitution effect do not apply to aggregate demand. Why?do not apply to aggregate demand. Why?

Why the downward slope?Why the downward slope?

The income effect does not apply The income effect does not apply because as the PL falls, less $ goes because as the PL falls, less $ goes to resource suppliers in the form of to resource suppliers in the form of wages, rents, interest, profits, etc.wages, rents, interest, profits, etc.

The substitution effect does not The substitution effect does not apply because there are no apply because there are no substitutes for substitutes for allall goods and services goods and services

So, once again, why the downward So, once again, why the downward slope?slope?

Aggregate Demand and the Aggregate Demand and the downward slope explained (finally!)downward slope explained (finally!)

Real-Balances Effect--Real-Balances Effect-- higher higher prices means our assets have less prices means our assets have less value so people are poorer and value so people are poorer and consume lessconsume less

Interest-rate effect—Interest-rate effect—higher prices higher prices drive up the demand for money and drive up the demand for money and so drive up interest rates, at higher so drive up interest rates, at higher interest rates, investment falls (more interest rates, investment falls (more later)later)

Aggregate Demand and the Aggregate Demand and the downward slope explained (cont.)downward slope explained (cont.)

Foreign-purchases effect—Foreign-purchases effect—at at higher prices, foreign goods are higher prices, foreign goods are cheaper, so net exports falls (more cheaper, so net exports falls (more later)later)

Changes in AD: DeterminantsChanges in AD: Determinants(factors other than Price level)(factors other than Price level)

Change in consumer spending (C):Change in consumer spending (C):• Consumer WealthConsumer Wealth

Think of appreciating/depreciating assets Think of appreciating/depreciating assets like stocks, bonds, real-estate, and landlike stocks, bonds, real-estate, and land

Not income (remember, the income effect Not income (remember, the income effect does not apply to aggregate demand)does not apply to aggregate demand)

• Consumer expectations—about prices, Consumer expectations—about prices, income, etc.income, etc.

• Household debt—Think borrowingHousehold debt—Think borrowing• TaxesTaxes

Changes in AD: DeterminantsChanges in AD: Determinants(factors other than Price level)(factors other than Price level)

Change in investment spending (I):Change in investment spending (I):• Interest rates—remember the Interest rates—remember the

investment demand curve?investment demand curve?• Expected ReturnsExpected Returns

Expected future business conditionsExpected future business conditions TechnologyTechnology Degree of excess capacity—stock of capital Degree of excess capacity—stock of capital

goodsgoods Business taxesBusiness taxes

Changes in AD: DeterminantsChanges in AD: Determinants(factors other than Price level)(factors other than Price level)

Change in government spending (G)Change in government spending (G) Change in net export spending (Xn):Change in net export spending (Xn):

• Rising income in foreign countriesRising income in foreign countries• Exchange rates (more later)Exchange rates (more later)

PL

Real GDP

AD1

Initial increase in Aggregate demand

PL

Real GDP

AD1

AD2

Increase in aggregatedemand after multipliereffect takes hold

PL

Real GDP

AD1

Initial decrease in aggregate demand

PL

Real GDP

AD1

AD3

Decrease in aggregatedemand after multipliereffect takes hold

PL

Real GDP

AD1

AD3

AD2

Aggregate SupplyAggregate Supply

The level of Real Output (GDP) that The level of Real Output (GDP) that firms will produce at each price levelfirms will produce at each price level

Aggregate supply has two distinct Aggregate supply has two distinct curves:curves:• Long Run Aggregate Supply (LRAS)Long Run Aggregate Supply (LRAS)• Short Run Aggregate Supply (SRAS)Short Run Aggregate Supply (SRAS)

Let’s start with LRASLet’s start with LRAS

Long Run Aggregate SupplyPL

Real GDP

LRAS

Qf

PL

RGDP

LRAS

Qf

LRASLRAS

The LRAS represents The LRAS represents the level of output at the level of output at full-employmentfull-employment

This is the level of This is the level of sustainable sustainable production in the long production in the long run given efficient run given efficient use of available use of available resourcesresources

Think PPFThink PPF

PL

RGDP

LRAS

Qf

LRASLRAS

LRAS does LRAS does notnot change as the change as the price level price level changeschanges

Only changes Only changes technology or technology or in the factors in the factors of production of production will cause the will cause the LRAS to shift LRAS to shift left or rightleft or right

PL

RGDP

LRAS1

Qf

LRASLRAS

What would What would happen if the happen if the labor force labor force increased?increased?

LRASLRAS

What is possible What is possible to produce in the to produce in the long run has long run has increased due to increased due to the increase in the increase in one of the one of the factors of factors of productionproduction

PL

RGDP

LRAS1

Qf

LRAS2

Qf

Short Run Aggregate SupplyShort Run Aggregate SupplyPL

Real GDP

SRAS

PL1

PL2

Q2 Q1

NOTE: You can use

Y to show the level of output

Determinants for Short-Run Determinants for Short-Run Aggregate SupplyAggregate Supply

Input prices:Input prices:• Wages make up about 75% of all business Wages make up about 75% of all business

costscosts• Domestic resource pricesDomestic resource prices• Prices of imported resourcesPrices of imported resources• Supply shocks due to market power—ex. OPECSupply shocks due to market power—ex. OPEC

Changes in productivity:Changes in productivity:• usually a result of new technology, better usually a result of new technology, better

organization of resources, and job organization of resources, and job training/educationtraining/education

Taxes, subsidies, and regulationTaxes, subsidies, and regulation

Shifts in Short Run Aggregate Shifts in Short Run Aggregate SupplySupply

PL

Real GDP

SRAS1

PL1

Q1

SRAS2

Q2

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

In the short-run, the prices of inputs like In the short-run, the prices of inputs like labor and raw materials cannot adjust to labor and raw materials cannot adjust to increases in the price levelincreases in the price level

As households see an increase in overall As households see an increase in overall prices, they will demand higher prices for prices, they will demand higher prices for their resources (i.e. labor, land) to their resources (i.e. labor, land) to maintain their standard of livingmaintain their standard of living

The long-run has been reached once The long-run has been reached once wages and cost of inputs have adjusted to wages and cost of inputs have adjusted to the new higher price levelthe new higher price level

AD/AS EquilibriumAD/AS Equilibrium

The intersection The intersection of AD and SRAS of AD and SRAS establishes the establishes the equilibrium price equilibrium price level and RGDPlevel and RGDP

This is the This is the current level of current level of productivityproductivity

PL1

PL

Real GDP

SRAS1

Q1

AD1

Shifts in AD/ASShifts in AD/AS

Increase in Increase in aggregate aggregate demanddemand

A.K.A. A.K.A. Demand-Pull Demand-Pull InflationInflation

AD2

PL1

PL SRAS1

Q1

AD1

RGDPQ2

PL2

Shifts in AD/ASShifts in AD/AS

Decrease in Decrease in aggregate aggregate supplysupply

A.K.A. Cost-A.K.A. Cost-Push InflationPush InflationAD1

PL1

PL SRAS1

Q1

SRAS2

RGDPQ2

PL2

Downward Inflexibility of PricesDownward Inflexibility of Prices While decreases in AD will theoretically While decreases in AD will theoretically

cause the price level to drop, this usually cause the price level to drop, this usually does not happen in reality. Why?does not happen in reality. Why?• Fears of price wars (gas stations in the 50’s)Fears of price wars (gas stations in the 50’s)• Menu CostsMenu Costs• Wage ContractsWage Contracts• Morale (state workers)Morale (state workers)• Minimum WageMinimum Wage

A reduction in AD might slow inflation, but A reduction in AD might slow inflation, but the price level rarely goes backwards the price level rarely goes backwards

One major exception was The Great One major exception was The Great DepressionDepression

AD/AS and LRASAD/AS and LRAS

The economy is The economy is operating at full operating at full employment if AD employment if AD and SRAS intersect and SRAS intersect at LRASat LRAS

The goal for policy The goal for policy makers is to craft makers is to craft fiscal and fiscal and monetary policy monetary policy that targets the that targets the LRASLRAS

PL1

PL

Real GDP

SRAS1

Qf

AD1

LRAS

AD/AS and LRASAD/AS and LRAS

If the AD/AS If the AD/AS equilibrium is equilibrium is to the left of to the left of the LRAS, the the LRAS, the economy is in economy is in recessionrecession

PL1

PL

Real GDP

SRAS1

Qf

AD1

LRAS

Q1

AD/AS and LRASAD/AS and LRAS

If the AD/AS If the AD/AS equilibrium is to equilibrium is to the right of the the right of the LRAS, the LRAS, the economy is in economy is in an inflationary an inflationary periodperiod

How can we How can we produce beyond produce beyond the LRAS?the LRAS?

Only for short Only for short periods of timeperiods of timeReal GDP

PL1

PL

SRAS1

Qf

AD1

LRAS

Q1

Different types of AD/AS graphsDifferent types of AD/AS graphs

http://apecon.us/aggregatesupplykeyhttp://apecon.us/aggregatesupplykeynesianclassical2.swfnesianclassical2.swf