1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–1 Chapter 11 Aggregate Demand and Aggregate Supply

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–2 Learning Objectives Introduce the concepts of aggregate demand and aggregate supply. Distinguish between short-run and long-run aggregate supply. Discuss the relationship that exists between the aggregate expenditures model and the aggregate demand curve.

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–3 Learning Objectives (cont.) Combine the aggregate demand and aggregate supply curves to provide a model of macroeconomic equilibrium. Discuss how the aggregate demand–aggregate supply model may be used to analyse the circumstances outlined in Chapter 5. Contrast demand-pull and cost-push inflation.

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–4 Learning Objectives (cont.) Discuss the reasons why the general level of prices is downwards ‘sticky’— the ratchet effect. Explain the impact of price-level changes on the size of the multiplier.

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–5 Aggregate Demand (AD) Represents the amount of goods and services that consumers, businesses, government and foreign buyers are willing and able to buy at various price levels

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–6 AD Curve The AD curve is downsloping due to: Interest-rate effect Real-balances effect (wealth effect) Foreign-purchases effect

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–7 Aggregate Demand Curve 0 Price level Real gross domestic output AD

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–8 Interest-Rate Effect Rising price level causes higher nominal interest rates, which causes reduction in certain kinds of consumption and investment spending—most importantly, investment spending

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–9 Real-Balances Effect Also known as ‘wealth effect’ At a higher price level, the real value or purchasing power of the accumulated financial assets held by the public falls (real wealth falls), leading to a fall in consumption spending

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–10 Foreign-Purchases Effect Higher domestic prices cause the relative price of foreign goods (local goods) to decrease (increase) This causes increased imports and decreased exports, resulting in a fall in net exports

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–11 Deriving the AD Curve Aggregate expenditure model – drawn at a constant price level Aggregate demand model – real GDP at various price levels

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–12 (C + I + G + NX) 2 at P 2 (C + I + G + NX) 2 at P 3 The Aggregate Demand can be Constructed Deriving the AD Curve (cont.) Spending (billions of dollars) 0 0 Price level Real GDP P1P1 (C + I + G + NX) 1 at P 1 1′1′ 1 GDP 1 P2P2 GDP 2 2 2′2′ 3 P3P3 GDP 3 3′3′

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–13 Non-Price Determinants of Aggregate Demand Results in shift in the AD curve Changes in consumer spending – Consumer wealth – Consumer expectations – Consumer indebtedness – Taxes

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–14 Non-Price Determinants of Aggregate Demand (cont.) Changes in investment spending – Interest rates – Profit expectation on investment projects – Business taxes – Technology – Degree of excess capacity Changes in Government spending

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–15 Non-Price Determinants of Aggregate Demand (cont.) Changes in net export spending: Growth in foreign GDP The level of the exchange rates

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–16 Changes in Aggregate Demand 0 Price level Real gross domestic output AD 1 AD 3 AD 2 Increase in AD Decrease in AD

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–17 Shifts of AD Caused by changes of non-price determinants Movements left or right Degree of shift affected by the multiplier Shift in AD = change in spending times the multiplier

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–18 Shifts in AD and AE Spending (billions of dollars) 0 0 Price level GDP 1 P1P1 AD 1 (C + I + G + NX) 1 at P 1 GDP 1 GDP 2 (C + I + X + G) 2 at P 1 GDP 2 AS AD 2 Real GDP

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–19 Aggregate Supply (AS) Indicates the level of real GDP that will be produced at each possible price level

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–20 Short-Run Period Short run is a period in which input prices, particularly nominal wages remain fixed while other prices change Input prices are fixed due to: – workers not being aware of higher or lower prices – existence of fixed wage contracts

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–21 Long-Run Period This is a period in which input prices—wages etc., are fully responsive to changes in the price level Workers are freed from existing wage contracts and can negotiate new nominal wages and salaries

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–22 Short-Run Aggregate Supply Curve Upward sloping and is constructed on the basis of two assumptions: – a given price level – nominal wages have been established on the expectations that the given price level will persist

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–23 AS 1 Short-Run AS Price level Real gross domestic output 0 P1P1 A1A1 QPQP P3P3 A3A3 Q3Q3 P2P2 A2A2 Q2Q2

24. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–24 Long-Run AS Price level Real gross domestic output, GDP 0 P3P3 P1P1 P2P2 AS 3 A1A1 AS 1 AS 2 C1C1 B1B1 AS LS QPQP A3A3 A2A2

25. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–25 Non-Price Determinants of AS Shift the AS curve Changes in input prices – Domestic resource availability  land  labour  capital  entrepreneurial ability – Imported resource prices – Market power

26. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–26 Non-Price Determinants of AS (cont.) Changes in productivity Changes in the legal and institutional environment – Business taxes & subsidies – Government regulation

27. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–27 Changes in Short-Run AS Price level Real gross domestic output 0 AS 1 AS 2 Decrease in Short-run AS

28. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–28 Changes in Short-Run AS Price level Real gross domestic output 0 AS 3 AS 1 Increase in Short-run AS

29. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–29 AS LS1 QPQP Changes in Long-Run AS Price level Real gross domestic output 0 AS LS2 QPQP Decrease in Long-run AS

30. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–30 Changes in Long-Run AS Price level Real gross domestic output, GDP 0 AS LS1 QPQP QPQP AS LS3 Increase in Long-run AS

31. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–31 Equilibrium Intersection of AS and AD determines equilibrium real GDP and the price level At all other points there will be pressure on real GDP and/or prices to change

32. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–32 AS LS QpQp AS Equilibrium Real GDP and Equilibrium Price Level Price level Real domestic output AD Q1Q1 P3P3 Q2 Q2 P2P2 QeQe PePe

33. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–33 Shift in Aggregate Demand and the Price Level The effects of an increase in aggregate demand on the price level depend upon the position of the short-run aggregate supply in which it occurs Demand-pull inflation is a situation of rising prices due to shift in AD

34. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–34 Effects of an Increase in AD AS LS QpQp Price level Real gross domestic output AD 1 AD 2 AD 3 AS Q2Q2 Q1Q1 Q2Q2 P1P1 P2P2 P3P3 Low Employment and the Price Level

35. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–35 Effects of an Increase in AD AS LS QpQp Price level Real gross domestic output AD 3 AS High Employment and the Price Level Q3Q3 P3P3 P4P4 Q4Q4 P5P5

36. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–36 Ratchet Effect The result of the tendency for prices of both products and resources to be individually ‘sticky’ or inflexible in a downward direction, leading to a loss in downward flexibility of the general level of prices

37. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–37 Price Inflexibility Causes: Wage inflexibility Employers’ interests Monopoly power Menu costs

38. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–38 Shift in Aggregate Supply and the Price Level Causes Higher production costs shift the AS leftwards, resulting in higher prices and lower real GDP Leads to cost-push inflation Adverse shifts in the aggregate supply result in stagflation, a situation of higher prices and higher unemployment

39. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–39 Effects of a Decrease in AS AS LS QpQp Price level Real domestic product AS 1 AD Q1Q1 Q2Q2 P1P1 P2P2 AS 2

40. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–40 Effects of an Increase in AS AS LS QpQp Price level Real domestic output, GDP AS 1 AD QeQe P1P1 P3P3 Q3Q3 AS 3

41. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–41 Price-Level Changes and the Multiplier Shifts of AD in the – Horizontal range = Full multiplier effect – Intermediate range = Reduced multiplier effect – Vertical = No multiplier effect

42. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–42 Multiplier and the Price Level Price level Real gross domestic product AS AD 3 Q1Q1 Q2Q2 AD 2 P1P1 P3P3 } Full Multiplier Full Multiplier AD 1

43. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–43 Multiplier and the Price Level Price level Real domestic output, GDP AS AD 3 Q1Q1 Q2Q2 AD 2 P1P1 P3P3 Q3Q3 } Reduced Multiplier Reduced Multiplier Q4Q4

44. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 11–44 Next Chapter: Fiscal Policy and the Public Debt