Chapter 10 Aggregate Demand & Supply ECON 201 Chapter 10 Aggregate Demand & Supply

Review Chapter 3 talked about Demand & Supply, but it was discussed in terms of the price of one item. 2 items that greatly effected them were the income effect and the substitution effect. Aggregate Demand & Supply deal with the prices of all products overall.

Aggregate demand (AD)-Aggregate Supply (AS) Models Used in discussion of Unemployment Inflation Economic growth Determine an economy’s equilibrium price level and level of real GDP AD-AS model explains periods of demand-pull inflation, cost-push inflation, and recession

Aggregate Demand A schedule or curve that shows the various amounts of real domestic output (GDP) that domestic & foreign buyers will desire to purchase at each possible price level. Shows an inverse relationship between price level and Real Domestic Output

Aggregate Demand Curve Fig 10.1 on pg 188 Aggregate Demand Price Level AD Real Domestic Output, GDP

Specific items that cause the AD curve to slope downward Real-balances effect: higher price levels reduce the purchasing power of consumers. Which means that higher prices reduce consumption spending Interest-rate effect: with a fixed supply of money, an increase in the demand for money means that the cost of the money goes up… that cost is the interest rate.

Specific items that cause the AD curve to slope downward Foreign-purchases effect: when prices in the US rise, foreigners buy fewer US goods, and we buy more from foreigners. That means that as prices go up here, we export fewer things and import more things….so we have a bigger trade deficit.

Determinates (other things – besides price level that can cause a shift) of Aggregate Demand (AD) 1. Changes in Consumer Spending Consumer wealth Consumer Expectations Household debt Taxes Aggregate Demand Price Level AD Real Domestic Output, GDP

Determinates of AD 2. Changes in Investment Spending Interest rates: an increase in real interest rates will lower investment spending & reduce aggre. demand Expected Returns: if you expect higher returns, the demand for capital will shift the curve to the right. Aggregate Demand Price Level AD Real Domestic Output, GDP

Determinates of AD 3. Changes in Government Spending. 4. Changes in Net Export spending unrelated to price level. Can be caused by changes in : National Income Exchange Rates Aggregate Demand Price Level AD Real Domestic Output, GDP

Aggregate Supply (AS) Schedule or curve showing the level of real domestic output available at each possible price level. AS – in the long run AS – in the short run

Aggregate Supply in the Long Run AS Curve is vertical at the economy’s full-employment output. Vertical – because in the long run, resources prices adjust to changes in the price-level, leaving no incentive for firms to change their output. ASLR Price Level Long Run Aggregate Supply Real Domestic Output, GDP

Aggregate Supply (AS) in the Short Run (Qf – full-employment output) Price Level Qf Real Domestic Output, GDP

Short Run (references to “aggregate supply” from now on in the chapter refer to short run curve) To the left of full-employment output, the curve is relatively flat. The relative abundance of idle inputs means that firms can increase output without substantial increases in production costs To the right of full employment output the curve is relatively steep. Shortages of inputs and production bottlenecks will require substantially higher prices to induce firms to produce. Aggregate Supply (Short Run) Price Level Qf Real Domestic Output, GDP

Determinants of AS Determinants are the “other things” besides price level that cause changes or shifts in aggregate supply. 1. A change in input prices, which can be caused by changes in several factors: Domestic resource prices Prices of imported resources Market power in certain industries Aggregate Supply (Short Run) Price Level Qf Real Dom. Output, GDP

Determinants of AS Changes in productivity (productivity = real output / input) If productivity rises, unit production costs will fall. This can shift aggregate supply to the right and lower prices. The reverse is true when productivity falls. Productivity improvement is very important in business efforts to reduce costs.

Productivity Major determinate of Aggregate supply. Measure of the relationship between a nation’s level of real output and the amount of resources used to produce that output. Measure of average real output, or of real output per unit of input.

Understanding Productivity Total Output Total Inputs = Total Output Total Inputs = 10 5 2 Per-Unit Production Cost Total Input Cost Units of Output =

Other Determinants of AS Change in legal/institutional environment, which can be caused by changes in other factors. Business taxes and/or subsidies Government regulation.

Equilibrium: Real Output and the Price Level Equilibrium price and quantity are found where the aggregate demand and supply curves intersect. AS Price Level Equilibrium 100 92 a b AD 502 510 514 Real Domestic Output, GDP (Billions of Dollars)

Increase in AD: Demand Pull Inflation When the price level is being pulled up by the increase in the demand. Example: If the government increases their spending beyond what the full-employment level is, this can cause inflation.

Real Domestic Output, GDP Demand Pull Inflation Increase in Aggregate Demand AS Demand-Pull Inflation P2 Price Level P1 AD1 AD Qf Q1 Q2 Real Domestic Output, GDP

Decrease in AD: Recession & Cyclical Unempl. When the price level is being pulled up by the increase in the demand. Example: If the government increases their spending beyond what the full-employment level is, this can cause inflation.

Recession & Cyclical Unempl. Decrease in Aggregate Demand AS Price Level b P1 a P2 c Creates a Recession AD1 AD2 Q1 Q2 Qf Real Domestic Output, GDP

Why don’t prices go down? Fear of price wars: if we lower our prices, others will go even lower. Menu costs: re-pricing inventory, advertising new prices, printing new catalogs Wage Contracts: union agreements Morale & productivity: lowering wages hurts morale and reduces productivity Minimum wage: we can’t lower wages

Decrease in AS: Cost-Push Inflation When the price level is being pushed up by higher price levels. Example: a major terrorist attack disrupts the supply of oil to the world. We are very close to this right now.

Real Domestic Output, GDP Cost-Push Inflation Decrease in Aggregate Supply AS1 AS Cost-Push Inflation b P2 Price Level a P1 AD Q1 Qf Real Domestic Output, GDP

Increase in AS: Full employment & Price Stability Prices go up, but so does output. Demand also goes up, so everything is positive!

Real Domestic Output, GDP It’s all good! AS1 AS2 P3 b P2 c P1 a Price Level AD2 AD1 Q1 Q2 Q3 Real Domestic Output, GDP

End