1. Aggregate Supply – Aggregate Demand

2. GDP 2007 to 2010

3. What is Aggregate Demand?  A schedule or curve showing amounts of real output that buyers collectively desire to purchase at each possible price level. Think: Why does AD slope downward?

4. Real domestic output, GDP AD Price level Vertical axis represents Price level for ALL final goods And services The aggregate price level Is measured by either GDP Deflator or CPI The horizontal axis represents the real quantity of all G&S purchased as measured by the level of REAL GDP Inverse Relationship

5. Vertical and Horizontal Axis Horizontal axis = GDP Vertical axis = GDP deflator (includes C+I+G) or CPI…. Government uses the deflator* so it get a lower number. *A broader measure of price level… includes airplanes, dentist Visits, pizzas, new shopping centers, etc.

6. ASSUMPTION for Aggregate demand IS: If Price level is decreasing, so are incomes. Economy moves down its AD curve Moves to lower price level *remember circular flow model- (when consumers pay lower prices for goods and services – Less nominal income flows to resource suppliers.

7. There are 3 Reasons that cause the Aggregate Demand Curve to be downward sloping. Real Balance Effect (Wealth effect) Interest Rate Effect International Trade Effect

8. Real Balance Effect Price level falls- causes purchasing power to rise… translates into more money to spend or monetary wealth improves. 1) Real Balance Effect (or wealth effect) – Higher price level means less consumption spending.

9. Real Balance Effect Higher price level reduces real value of purchasing power of public’s accumulated savings The change in the purchasing power of dollar- Relates to assets that result from a change in the price level

10. Interest Rate Effect Inverse relationship between price level and quantity demanded of GDP – because households and businesses adjust to interest rates for those interest-sensitive purchases. Price level falls (bundle of goods costs less) rest of money into savings, more money available for borrowing interest rate down. Think of money as stationary… demand drives up price of money.

11. Interest Rate continued  Now if bundle of goods increases… want to purchase interest sensitive good, cost to borrow is up.  An increase in money demand will drive up the price paid for its use … use of money = interest rate  As price level rises, houses and firms require more money to handle transactions…

12. International Trade Effect ( Open Economy Effect) FYI: An open economy is global, a closed economy is domestic. The Open Economy Effect Higher price levels result in foreigners’ desiring to buy fewer American-made goods while Americans desire more foreign-made goods (i.e., net exports fall). Equivalent to a reduction in the amount of real goods and services purchased in the U.S. When Demand for exports decreases, this is an unfavorable balance of trade (imports exceed exports)

13. Macro AD vs Micro D Aggregate Demand versus Demand for a Single Good When the aggregate demand curve is derived, we are looking at the entire circular flow of income and product.(if AD moves to lower general price level- circular flow tells us when consumers pay lower prices – less nominal income flows to resource suppliers

14. Demand for Single good (deals with income effect and substitution effect When a market demand curve is derived, we are looking at a single product in one market only. (i.e. income effect and substitution effect) *If prices go down for cars, have more income to spend someplace else. *If price of certain items go up, we can substitute in many cases.

15. Change in QAD and Change in AD What is the difference? PL GDP A B PL GDP AD1 AD 2

16. Difference between Quantity of AD and Change of AD QAD = movement up or down as result of price level changing (ONLY) Change in AD = Change in any of the component parts of AD (C + I + G + Net Exports)

17. DETERMINANTS OF AGGREGATE DEMAND Change in Consumer Spending Consumer Wealth Consumer Expectations (expect higher prices) Interest rate ( interest sensitive durables) Taxes Think in aggregate terms

18. Changes in Investment Spending  Real Interest Rates ( rates high- not much I taking place)  Expected Future Sales ( health of economy- confidence is big)  Business Taxes ( higher taxes less profit)

19. Government Spending This will be discussed further, but anytime government spends, it has an affect on GDP. Infrastructure – Health Care Supplies for military Education Etc.

20. Net Export Spending  National Income Abroad- (when foreign nations do well, their incomes are higher- can buy more U.S. goods and services. – U.S. exports rise)  Exchange Rates- Price of one nation’s currency in terms of another. Dollar vs Euro  Our currency appreciates if it takes more foreign $ to buy it.. (depreciates if it takes more of ours to buy theirs.) $1.00 to $1.25 Euro.  Depreciation of nation’s currency makes foreign goods more expensive (but attracts foreigners to buy our goods.) Our exports rise. *this is why the Fed has not worried about our low dollar valuation.

21. Factors That Change Aggregate Demand & Consumption/Interest Rates Interest Rate ↑ → C ↓ → AD ↓ Interest Rate ↓ → C ↑ → AD ↑

22. Factors That Change Aggregate Demand & Investment/ Interest Rates Interest rates ↑ → I ↓ → AD ↓ Interest rates ↓ → I ↑ → AD ↑

23. Factors That Change Aggregate Demand & Investment/ Business Taxes Business taxes ↑ → I ↓ → AD ↓ Business taxes ↓ → I ↑ → AD ↑

24. Long-Run Equilibrium and the Price Level For the economy as a whole, long-run equilibrium occurs at the price level where the aggregate demand curve (AD) crosses the long-run aggregate supply curve (LRAS).

25. Figure 10-5 Long-Run Economywide Equilibrium

26. OK… One more time….. Component parts of GDP? C + I + G + (X-M) = GDP Long-Run Aggregate Supply Curve (LRAS) A vertical line representing the real output of goods and services after full adjustment has occurred It represents the real GDP of the economy under conditions of full employment; the economy is on its production possibilities curve

27. The Production Possibilities and the Economy’s Long-Run Aggregate Supply Curve

28. Output Growth and the Long-Run Aggregate Supply Curve (cont'd)  LRAS is vertical Input prices fully adjust to changes in output prices Suppliers have no incentive to increase output Unemployment is at the natural rate Determined by endowments and technology (or existing resources)

29. Output Growth and the Long-Run Aggregate Supply Curve (cont'd)  Growth is shown by outward shifts of either the production possibilities curve or the LRAS curve caused by Growth of population and the labor-force participation rate Capital accumulation Improvements in technology

30. What does Long Run Equilibrium Mean?  Economy is a full employment  Any additional production would be difficult to achieve.  Economy operating at natural rate of unemployment (anyone wanting job=have it.)  Equate the LRAS curve with bowed line on PPC.  To extend either would be to discover new resources – R&D

31. Full Employment  The condition that exists when the unemployment rate is equal to the natural unemployment rate.  Full productive capacity has been  Reached.

32. Image Cylinder= Economy… Businesses, factories, economy not working at full capacity

33. Full Employment AS AD LRAS

34. SRAS (short run aggregate supply)  Period where adjustment occurs.  Direct relationship  As the output increases that puts upward pressure on price.  Movement on the curve denotes the relationship between price level and real output.

35. SRAS………….Shift  Shift in the curve denotes determinates that affect more or less real output production at various price levels.  Determinants: Change in input prices (steel, plastic, wool change in resource availability ) Change in productivity (+ = Shift right; - = Shift left) (more for less is the object) Change in legal environment (contracts, taxes, subsidies)

36. AD and SRAS

37. LRAS = long-run aggregate supply LRAS is a vertical line reflecting that LR Aggregate Supply is not affected by changes in PL. The LRAS is labeled as the natural level of real GDP The natural level of real GDP is defined as the level of real GDP that arises when the economy is fully employing all of its available input resources ( We are in agreement that it hovers around 5%)

38. Long Run Aggregate Supply Price level Real domestic output, GDP Q P LRAS LR Long-run Aggregate Supply QfQf Full-Employment

39. Real Rate Of Interest Money Supply D1 D2D2 Can a Change in Money Supply Change AD? Probably… but it is a chain of events. MS changes, then Interest Rates, then chance in consumption and investment. Then Change in AD

40. Equilibrium States of the Economy During the time an economy moves from one equilibrium to another, it is said to be in disequilibrium.

41. LRAS G oods & S ervices (real GDP) P rice level P 100 Y F SRAS 1 AD 1 Unanticipated Increase in Aggregate Demand  In response to an unanticipated increase in AD for goods & services (shift from AD 1 to AD 2 ), prices will rise to P 105 and output will temporarily exceed full- employment capacity (increases to Y 2 ). P 105 Y 2 AD 2 Short-run effects of an unanticipated increase in AD

42. LRAS 1 G oods & S ervices (real GDP) P rice level Y F AD P 1 SRAS 1 Y F1 SRAS 2 Y F2 LRAS 2 Y F2  Here we illustrate the impact of economic growth due to capital formation or a technological advancement, for example.  Both LRAS and SRAS increase (to LRAS 2 and SRAS 2 ); the full employment output of the economy expands from Y F1 to Y F2. P 2 Growth in Aggregate Supply  A sustainable, higher level of real output and real income is the result. ***If the money supply is held constant, a new long-run equilibrium will emerge at a larger output rate (Y F2 ) and lower price level (P 2 ).

43. LRAS G oods & S ervices (real GDP) P rice level AD Y F P 100 SRAS 1 (P r 1 ) A P 110 Y 2  The higher resource prices shift the SRAS curve to the left; in the short-run, the price level rises to P 110 and output falls to Y 2.  What happens in the long-run depends on whether the reduction in the supply of resources is temporary or permanent. Effects of Adverse Supply Shock  If temporary, resource prices fall in the future, permitting the economy to return to its original equilibrium (A).  If permanent, the productive potential of the economy will shrink (LRAS shifts to the left) and (B) will become the long-run equilibrium. SRAS 2 (P r 2 ) B

44. Price Level Real Domestic Output, GDP Q P AS AD 1 INCREASES IN AD: DEMAND-PULL INFLATION P2P2 P1P1 AD 2 QfQf Q1Q1 Q2Q2

45. Price Level Real Domestic Output, GDP Q P AS 1 AD 1 DECREASES IN AS: COST-PUSH INFLATION P2P2 QfQf Q1Q1 a b AS 2 P1P1

47.  Non-governmental actions that shift AS  Shift AS left: Raw materials cost rise Wages rise faster than productivity Worker productivity decreases Obsolescence Wars Natural disasters

48. Fiscal Policy  Governmental actions that shift AD  Shift AD right: Govt spending increases Taxes decreases Money Supply increases  Shift AD left: G decreases T increases MS decreases