Chapter 08 Aggregate Demand and Aggregate Supply

Chapter Outline Aggregate Demand Aggregate Supply Shifts in Aggregate Demand and Aggregate Supply Causes of Inflation Supply-Side Economics How the Government Can Influence (but probably not control) the Economy

Aggregate Demand Aggregate Demand: the amounts of real domestic output which domestic consumers, businesses, governments, and foreign buyers collectively will desire to purchase at each possible price level

Figure 1 Aggregate Demand RGDP PI AD

Why Aggregate Demand is Downward Sloping Real Balances Effect Because higher prices reduce real spending power, prices and output are negatively related. Foreign Purchases Effect When domestic prices are high, we will export less to foreign buyers and we will import more from foreign producers. Therefore higher prices leads to less domestic output. Interest Rate Effect higher prices lead to inflation which leads to less borrowing and a lowering of RGDP

Aggregate Supply Aggregate Supply: the level of real domestic output available at each possible price level

Figure 2 The Aggregate Supply Curve AS RGDP PI Classical Range Intermediate Range Keynesian Range

The Ranges of AS Keynesian Range Classical Range Intermediate Range Large amounts of unemployment make it so that increases in aggregate demand have no affect on wages or prices. Classical Range Full employment makes it so that increases in aggregate demand only increase wages or prices. Intermediate Range Some sectors of the economy reach full employment more quickly than others.

Variables that Shift Aggregate Demand Taxes Interest Rates Confidence Strength of the Dollar Government Spending

Determinants of AD Variable GDP Component C,I,G,X Effect of an increase on AD Effect of a decrease on AD Taxes C,I Decrease so AD <= Increase so AD => Interest Rates Confidence Strength of the Dollar X (exports-imports) Government Spending G

Figure 3 AD Increases AS AD RGDP PI AD’ PI’ RGDP’ PI* RGDP*

Figure 4 AD Decreases AS AD RGDP PI AD’ PI* RGDP* PI’ RGDP’

Variables that Shift AS Input Prices Productivity Government Regulation

Determinants of AS Variable Input Prices Decrease so AS Increase so Effect of an Increase on AS Effect of an Decrease on AS Input Prices Decrease so AS Increase so Productivity Government Regulation

Figure 5 Increase in AS AS AD RGDP PI AS’ PI* RGDP* PI’ RGDP’

Figure 6 Decrease in AS RGDP AS AD PI AS’ PI’ RGDP’ PI* RGDP*

Causes of Inflation Demand Pull Inflation: inflation caused by an increase in aggregate demand Cost Push Inflation: inflation caused by a decrease in aggregate supply

Government Influence: Aggregate Demand Government can influence economic activity with aggregate demand side policies affecting: Taxes Government Spending Interest Rates

Government Influence: Aggregate Supply Government can influence economic activity with aggregate supply side policies affecting input costs (labor and wage) reducing regulation Increase incentives to Work Take Risks The actions are call Supply Side Economics