2Chapter ObjectivesAggregate Demand and the Factors That Cause it to ChangeAggregate Supply and the Factors That Cause it to ChangeHow AD and AS Determine an Economy’s Equilibrium Price Level and the Level of Real GDPHow the AD-AS Model Explains Periods of Demand-Pull Inflation, Cost-Push Inflation, and Recession
3AD – AS Model Aggregate Demand AD is a schedule, graphically represented as a curve, which shows the various amounts of goods and services – the amount of real domestic output – which domestic consumers, businesses, government and foreign buyers collectively will desire to purchase at each possible price level.
4AGGREGATE DEMAND CURVE Price levelADReal domestic output, GDP
5AD – AS Model Why the Downward Slope? Real-Balances Effect Interest-Rate EffectForeign Purchases Effect
6Why the Downward Slope? Real-Balances Effect / Wealth Effect A higher price level will reduce the real value or purchasing power of the public’s accumulated financial assets
7Why the Downward Slope? Interest-Rate Effect A higher price level – by increasing the demand for money and the interest rate – reduces the amount of real output demanded.The AD curve assumes that the supply of money in the economy is fixed.
8Why the Downward Slope? Foreign Purchases Effect The volume of imports and exports depend on, among other things, relative price level in the country and abroad.Thus if the price level rises in Pakistan relative to foreign countries, Pakistani buyers will buy more imports at the expense of domestic goods. Similarly, foreigners will buy fewer Pakistani goods, reducing Pakistan’s exports
9Changes in Aggregate Demand Law of DemandAn increase in the price level, other things being equal, will decrease the quantity of real output demanded.Determinants of Aggregate Demand (Other Things)
11Changes in Aggregate Demand Expected ReturnsAbout Future Business ConditionsTechnologyDegree of Excess CapacityBusiness TaxesGovernment SpendingNet Export SpendingNational Income AbroadExchange Rates
12Changes in Aggregate Demand Increase inAggregateDemandPrice LevelDecrease inAggregateDemandAD2AD1AD3Real Domestic Output, GDP
13AGGREGATE SUPPLY Levels of Real Domestic Output At Each Possible Price LevelLong-run Supply CurveWages and Resource Prices Match Price LevelShort-run Supply CurveWages and Resource Prices Do Not Match Price Level
14Long Run P ASLR Q Price level Long-run Aggregate Supply Full-EmploymentQfQReal domestic output, GDP
15AGGREGATE SUPPLY Short Run P AS Q Aggregate Supply Short-run Price levelFull-EmploymentQQfReal domestic output, GDP
16AGGREGATE SUPPLY Changes in Aggregate Supply P Q Decrease In Aggregate Price levelIncrease InAggregateSupplyQReal domestic output, GDP
17Input Prices Domestic Resource Prices Labor Land Capital DETERMINANTS OF AGGREGATE SUPPLYInput PricesDomestic Resource PricesLaborLandCapitalPrices of Imported GoodsMarket Power
18Legal-Institutional Environment DETERMINANTS OF AGGREGATE SUPPLYProductivityProductivity=Total OutputTotal InputsLegal-Institutional EnvironmentBusiness Taxes and SubsidiesGovernment Regulation
19Equilibrium and Changes in Equilibrium The equilibrium price level and amount of real domestic output are determined at the intersection of the AD and AS curves.
20Equilibrium Price Level and Equilibrium Price Level Real OutputDemanded(Billions)Real OutputSupplied(Billions)Price Level(Index Number)$5065085105125141081041009692$513512510507502Equilibrium Price Level andEquilibrium Price Level
21Equilibrium and Changes in Equilibrium ASPrice LevelEquilibrium10092abAD502510514Real Domestic Output, GDP(Billions of Dollars)
22Equilibrium and Changes in Equilibrium Increase in Aggregate DemandASDemand-PullInflationP2Price LevelP1AD1ADQfQ1Q2Real Domestic Output, GDP
23DECREASES IN AD: RECESSION & CYCLICAL UNEMPLOYMENT baP1Price LevelcQQ1QfReal Domestic Output, GDP
24Equilibrium and Changes in Equilibrium Decrease in Aggregate SupplyAS1ASCost-PushInflationbP2Price LevelaP1ADQ1QfReal Domestic Output, GDP
25Aggregate Demand Curve Aggregate Expenditures Model Derivation of theAggregate Demand Curvefrom theAggregate Expenditures Model…
26Aggregate expenditures DERIVATION OF THE AGGREGATE DEMAND CURVEAE1 at P 11AE2 at P 2AE3 at P 3Aggregate expenditures(billions of dollars)23Q3Q2Q13’P3The Aggregate DemandCan Be ConstructedPrice level2’P21’P1ADQ3Q2Q1Real Domestic Output
27Increase in Aggregate Expenditures Increase in Aggregate Demand SHIFTS IN THE AGGREGATE EXPENDITURESSCHEDULE & THE AGGREGATE DEMAND CURVEAE2 at P 1AE1 at P 1Aggregate expenditures(billions of dollars)Increase inAggregateExpendituresQ1Q2Increase inAggregateDemandPrice levelP1AD2AD1Q1Q2Real Domestic Output
28SUMMARYAD reflects an inverse relationship between the price level and the amount of real domestic output demanded.Changes in the price level produce wealth, interest rate, and foreign purchases effects which explain the downward slope of the AD curve.Changes in one or more of the determinants of AD alter the amounts of real domestic output demanded at each price level; they shift the AD curve.An increase in AD is shown as a rightward shift of the AD curve; a decrease entails a leftward shift of the curve.
29Quick ReviewThe equilibrium price level and amount of real domestic output are determined at the intersection of the AD and AS curves.Increase in the AD in upsloping and vertical ranges of AS cause Demand Pull Inflation.Decrease in AS curve cause Cost push inflation.Increase in AS expand real domestic output; they result in economic growth.