Aggregate Demand and Aggregate Supply SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

In this chapter you will learn 8.1 What determines the shape of the aggregate demand curve and what factors shift the entire curve 8.2 What determines the shape of the aggregate supply curve, and what factors shift the entire curve 8.3 How the equilibrium price level and real GDP are determined 8.4 How the economy arrives at its long run equilibrium 8.5 Equilibrium vs. full-employment GDP ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Chapter 8 Topics 8.1 Aggregate Demand 8.2 Aggregate Supply 8.3 Equilibrium GDP & Changes in Equilibrium 8.4 From the Short Run to the Long Run 8.5 Equilibrium Versus Full-Employment GDP ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Aggregate Demand (AD) The amounts of real output that buyers collectively desire to purchase at each possible price level ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Aggregate Demand (AD) Aggregate Quantity Demanded (Real GDP) and the Price Level are inversely related as follows: Price Level Real GDP AD Figure 8 - 1 ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Aggregate Demand (AD) slopes downward because of the following effects of a change in price level: Real-balances Effect Interest-rate Effect Foreign Trade Effect Remember: these effects are caused by price level changes ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Changes in Aggregate Demand Figure 8 - 2 Price level Real domestic output, GDP AD1 AD Can Increase ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Changes in Aggregate Demand Figure 8 - 2 Price level Real domestic output, GDP AD1 AD Can Increase shift RIGHT AD2 ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Changes in Aggregate Demand Figure 8 - 2 Price level Real domestic output, GDP AD1 AD Can Decrease ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Changes in Aggregate Demand Figure 8 - 2 Price level Real domestic output, GDP AD1 AD Can Decrease shift LEFT AD3 ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Determinants of Aggregate Demand Consumer Spending Consumer wealth Consumer expectations Taxes Household indebtedness ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Determinants of Aggregate Demand Investment Spending Real Interest Rates Expected Returns Expectations about future business conditions Technology Degree of excess capacity Business taxes ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Determinants of Aggregate Demand Government Spending Net Export Spending National Income Abroad Exchange Rates ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Chapter 8 Topics  8.1 Aggregate Demand 8.2 Aggregate Supply 8.3 Equilibrium GDP & Changes in Equilibrium 8.4 From the Short Run to the Long Run 8.5 Equilibrium Versus Full-Employment GDP ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Aggregate Supply The level of real domestic output that will be produced at each price level Production responses to price level changes differ in the long run & the short run ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Aggregate Supply in the Long Run in the long run, the aggregate supply curve is vertical at the economy’s full-employment output (potential GDP) ASLR Price level Real domestic output, GDP GDPf ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Aggregate Supply in the Long Run in the long run, wages & other input prices rise or fall to match changes in the price level changes in the price level do not change real profit & there is no change in real output ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Aggregate Supply in the Short Run in reality, nominal wages adjust only slowly to changes in the price level short-run aggregate supply curve is upward-sloping AS Price level Real domestic output, GDP GDPf ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Aggregate Supply in the Short Run unless stated otherwise, “aggregate supply” refers to AS in the short run as the economy expands in the short run, per-unit production costs generally rise the extent of the rise depends on where the economy is operating, relative to its capacity an economy operating below its full-employment output has idle capital & labourlittle upward pressure on production costs when the economy is operating beyond its full-employment output, most available resources are already employedper-unit production costs increase as economy expands ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Determinants of Aggregate Supply Change in input prices Domestic resource price Price of imported resources Market power Change in productivity Change in legal-institutional environment Business taxes & subsidies Government regulation ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Chapter 8 Topics  8.1 Aggregate Demand 8.2 Aggregate Supply 8.3 Equilibrium GDP & Changes in Equilibrium 8.4 From the Short Run to the Long Run 8.5 Equilibrium Versus Full-Employment GDP  ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Equilibrium GDP Equilibrium occurs at the price level that equalizes the amount of real output demanded & supplied A price level too low would mean AD>AS, putting upward pressure on prices across the economy ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Price Level Too Low Figure 8-6 AS Price Level AD upward pressure PL1 AS1 AD1 Real GDP ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Equilibrium GDP similarly, a price level too high would mean AD<AS, putting downward pressure on prices across the economy ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Price Level Too High Figure 8-6 AS Price Level AD PL2 AD2 AS2 downward pressure Real GDP ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Changes in Equilibrium Are caused by changes (shifts) in AD and/or AS ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Increases in AD for any initial increase in aggregate demand, the resulting increase in real output will be smaller the greater is the increase in the price level demand-pull inflation… ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Increases in AD output does not increase all the way to GDP1 because of inflation Figure 8-7 AD2 AS GDP2 P2 Price level P1 GDP1 AD1 Real GDP GDPf ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Decreases in AD Deflation is a rarity in the Canadian economy Real output takes the full brunt of the decline in AD because product prices are “sticky” in the short run wage contracts morale, effort, & productivity minimum wage menu costs fear of price wars ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Decreases in AD prices are sticky downwards Figure 8-8 AS Price level GDP1 AD1 Real GDP GDPf ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Decreases in AS: Cost-Push Inflation effects of a leftward shift in AS are doubly bad output decreases price level increases ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Decreases in AS Figure 8-9 AS2 AS1 GDP2 P2 Price level P1 AD1 Real GDP GDPf ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Increases in AS increases in AD should normally lead to inflation recently, productivity growth has shifted the long-run AS curve to the right ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Increases in AS Figure 8-10 AS1 AD2 AS2 P3 GDP2 Price level P2 GDP3 P1 AD1 Real GDP GDP1 ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Chapter 8 Topics  8.1 Aggregate Demand 8.2 Aggregate Supply 8.3 Equilibrium GDP & Changes in Equilibrium 8.4 From the Short Run to the Long Run 8.5 Equilibrium Versus Full-Employment GDP   ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

From the Short Run to the Long Run nominal wages & other input prices may remain constant in the short run, even though the price level has changed once contracts have expired & nominal wage adjustments have been made, the economy enters the long run ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Short-Run Aggregate Supply Figure 8-11 an increase in price level increases profits & output, moving the economy from a1 to a2 AS1 a2 P2 GDP2 Price level a1 P1 GDPf Real domestic output ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Short-Run Aggregate Supply Figure 8-11 a decrease in price level decreases profits & output, moving the economy from a1 to a3 AS1 Price level a1 P1 a3 P3 GDP3 GDPf Real domestic output ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Long-Run Aggregate Supply Figure 8-11 an increase in price level leads to increases in nominal wages, shifting short-run AS leftward new equilibrium at b1 AS2 ASLR AS1 b1 a2 P2 Price level a1 P1 GDPf GDP2 Real domestic output ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Long-Run Aggregate Supply Figure 8-11 a decrease in price level leads to decreases in nominal wages, shifting short-run AS rightward new equilibrium at c1 ASLR AS1 AS3 Price level a1 P1 a3 P3 c1 GDP3 GDPf GDP2 Real domestic output ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Equilibrium in the Long-Run AD-AS Model Figure 8-12 ASLR AS1 Price level a P1 AD1 GDPf ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Chapter 8 Topics  8.1 Aggregate Demand 8.2 Aggregate Supply 8.3 Equilibrium GDP & Changes in Equilibrium 8.4 From the Short Run to the Long Run 8.5 Equilibrium Versus Full-Employment GDP    ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Equilibrium Versus Full-Employment GDP There is no guarantee, in the short run, that equilibrium GDP will be full-employment GDP ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Recessionary Gap A recessionary gap occurs when AD is too low, and equilibrium GDP is below potential GDP ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Recessionary Gap Figure 8-13 ASLR Potential GDP AS Price level Recessionary Gap = 20 P0 AD1 AD0 P1 490 510 Real GDP ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Inflationary Gap An inflationary gap occurs when AD is too high, and equilibrium GDP is above potential GDP ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Inflationary Gap Figure 8-13 ASLR Potential GDP Inflationary Gap = 20 AS AD2 P1 530 Price level P0 AD0 510 Real GDP ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Chapter 8 Topics  8.1 Aggregate Demand 8.2 Aggregate Supply 8.3 Equilibrium GDP & Changes in Equilibrium 8.4 From the Short Run to the Long Run 8.5 Equilibrium Versus Full-Employment GDP     ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Chapter 8 Appendix The Relationship of the Aggregate Expenditures Model to the AD-AS Model ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Macroeconomics, Chapter 8 Derivation of AD Curve AD can be derived from the Aggregate Expenditures Model illustrated… ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Aggregate expenditures Figure A8 - 1 1 AE 1 at P 1 What if prices go up? Aggregate expenditures (billions of dollars) Real GDP 1' GDP1 Real GDP at price level 1 Price level P1 Real GDP

Aggregate expenditures Figure A8 - 1 AE1 at P 1 1 AE2 at P 2 2 Aggregate expenditures (billions of dollars) What if prices go up again? Real GDP GDP2 GDP1 2' Price level P2 A Lower Real GDP at price level 2 1' P1 Real GDP GDP2 GDP1

Aggregate expenditures Figure A8 - 1 AE1 at P 1 1 AE2 at P 2 AE3 at P 3 2 Aggregate expenditures (billions of dollars) 3 Real GDP GDP3 GDP2 GDP1 3' P3 2' Price level P2 A Still Lower Real GDP Level at price level 3 1' P1 Real GDP GDP3 GDP2 GDP1

Aggregate expenditures Figure A8 - 1 AE1 at P 1 1 AE2 at P 2 AE3 at P 3 2 Aggregate expenditures (billions of dollars) 3 Real GDP GDP3 GDP2 GDP1 3' P3 Aggregate Demand can be derived from AE 2' Price level P2 1' P1 Real GDP GDP3 GDP2 GDP1

Macroeconomics, Chapter 8 Shifts in AD and shifts in Aggregate Expenditure illustrated… ©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8

Aggregate expenditures Figure A8 - 2 AE2 at P 1 An Increase in Aggregate Expenditures AE1 at P 1 GDP2 Aggregate expenditures (billions of dollars) Real GDP GDP1 An Increase in Aggregate Demand AD2 Price level P1 AD1 Real GDP GDP1