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Aggregate Demand (AD) and Aggregate Supply (AS) Model

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Introduction AE model is fixed price model, unrealistic Need for a model that considers variable prices Aggregate all individual product markets and equilibrium price levels for products Create the AD-AS model

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Need for a Model Single product S&D models are insufficient –Why do prices fall in general? –What determines level of aggregate output? –What determines changes in level of aggregate output? Economists created aggregate model –All prices of individual g/s combined –Combines equil. Q of all g/s into real domestic output

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Aggregate Demand Aggregate Demand--curve that shows how much domestic consumers will purchase at various price levels Inverse relationship between PL and real domestic output downward sloping AD curve Why? –Not substitution or income effects –Wealth effect –Interest rate effect –Foreign purchase effect

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PL Real GDP Aggregate Demand Curve PL1 GDP1 PL2 GDP2

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Shifts of the AD Curve “Other things” besides PL can cause a shift in AD –Change in consumer spending Consumer wealth Expectations Consumer debt Taxes –Change in investment spending Interest rates Profit expectations Taxes (business) Tech. Amount of excess capacity –Change in govt. spending –Change in net export spending Income abroad Exchange rates AD1 AD2 AD3 Increase in AD Decrease in AD

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Shifts and the Multiplier PL GDP 1 Real GDP (billions/$) PL1 GDP 2 Increase in AD AD 1 AD 2 { Initial Increase in Spending

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Shifting AD Any increase in total spending (C,I, G, Xn) will shift the AD right –Shift of AD = change in spending x multiplier

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Aggregate Supply AS curve showing the level of real domestic output which will be produced at each level All “other things equal,” movement L R along the curve shows real output increases up to a point

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Aggregate Supply Curve AS Horizontal Range Intermediate Range Vertical Range Price Level Real GDPGDP c GDP u PL1 PL2

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Determinants of AS The everything else part –Input prices –Productivity Prod = total output/total inputs Per unit prod costs = total input cost total output total output –Legal institutional environment

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Shifts of the AS Curve AS 1 Price Level AS 3 AS 2 PL2 PL1 PL3 Decrease in AS Increase in AS Real GDP

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Equilibrium GDP ASPrice Level PL e PL Real GDP AD GDP e

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Shift of AD Curve ASPrice Level PL AD 1 AD 2 Real GDP GDP 1 GDP 2 AD 3 GDP 3

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Shifts of AS Recall determinants of AS Lead to shifts of AS curve Decrease of AS reflects cost push inflation

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AS 1 Price Level AS 3 AS 2 Real GDP AD PL1 GDP1GDP3GDP2 PL2 PL3 Result of cost-push inflation

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Ratchet Effect Complications in vertical and int. ranges ↓ AD does not restore original equilibrium price Prices rise but are “sticky” or downwardly inflexible

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Ratchet Effect? AS 1 Price Level PL 1 AD1 GDP e Real GDP AD2 PL 2 AS 2 GDP c A B C GDP r

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Why? Wage contracts Morale, productivity Training investments Minimum wage Menu costs Price war fears

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11 - 1 Copyright McGraw-Hill/Irwin 2002 Aggregate Demand Derivation of the AD Curve Changes in AD Determinants of AD Shifts in AE Schedule and Curve Aggregate.

11 - 1 Copyright McGraw-Hill/Irwin 2002 Aggregate Demand Derivation of the AD Curve Changes in AD Determinants of AD Shifts in AE Schedule and Curve Aggregate.

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