10/22/20141 Aggregate Demand & Aggregate Supply Chapter 07

2 Outline Aggregate Demand (AD) Aggregate Demand (AD) Aggregate Supply (AS) Aggregate Supply (AS) Equilibrium Price Level (Pe) and Real GDP (Qe= Ye) Equilibrium Price Level (Pe) and Real GDP (Qe= Ye)

10/22/20143 AD-AS Model AD-AS model is the macroeconomic model that uses AD and AS to determine and explain the price level (P) and the level of real domestic output (Q = Y). AD-AS model is the macroeconomic model that uses AD and AS to determine and explain the price level (P) and the level of real domestic output (Q = Y).

10/22/20144 Aggregate Demand (AD) AD is a schedule or curve that shows the total quantity of goods and services demanded (purchased) at different price levels (P). AD is a schedule or curve that shows the total quantity of goods and services demanded (purchased) at different price levels (P).

10/22/20145 The AD Curve Price Level GDP Deflator (P) Real GDP (Q = Y) Aggregate Demand (AD) P1P1 Q1Q1 A At the price level P 1, the economy purchases Q 1.At the price level P 2, the economy purchases Q 2. P2P2 Q2Q2 B Lower price levels increase the quantity of real GDP demanded, and vice versa.

10/22/20146 Changes in AD Price Level GDP Deflator (P) Real GDP (Q = Y) AD 1 P1P1 Q1Q1 A1A1 A rightward shift from AD 1 to AD 2 represents an increase in AD. P stays unchanged, but Q rises. AD 2 AD 3 A2A2 A3A3 Q3Q3 Q2Q2 A leftward shift from AD 1 to AD 3 represents a decrease in AD. P stays unchanged, but Q falls.

10/22/20147 Changes in AD GDP = Q = C + I + G + NX If P is unchanged; any change in C, or I, or G, or NX changes AD. Changes in consumer spending (C) and AD Up – rightward shift Down – leftward shift Household borrowing More borrowing/less saving Less borrowing/more saving Up (Wealth effect) Down (Reverse wealth effect) increases decreases ADConsumer wealthC Up – rightward shift Down – leftward shift increases decreases ADC

10/22/20148 Changes in AD GDP = Q = C + I + G + NX If P is unchanged; any change in C, or I, or G, or NX changes AD. Changes in consumer spending (C) and AD Up – rightward shift Down – leftward shift Personal income taxes Tax reductions Tax increases Positive Negative increases decreases ADConsumer expectationsC Up – rightward shift Down – leftward shift increases decreases ADC

10/22/20149 Changes in AD GDP = Q = C + I + G + NX If P is unchanged; any change in C, or I, or G, or NX changes AD. Changes in investment spending (I) and AD Up – rightward shift Down – leftward shift Expected returns Higher Lower Declines Increases increases decreases ADReal interest rateI Up – rightward shift Down – leftward shift increases decreases ADI

10/22/ Changes in AD GDP = Q = C + I + G + NX If P is unchanged; any change in C, or I, or G, or NX changes AD. Changes in investment spending (I) and AD Up – rightward shift Future business conditions Optimisticincreases AD Expected returns I Down – leftward shiftPessimisticdecreases Up – rightward shift Technology New and improvedincreases AD Expected returns I

10/22/ Changes in AD GDP = Q = C + I + G + NX If P is unchanged; any change in C, or I, or G, or NX changes AD. Changes in investment spending (I) and AD Up – rightward shift Excess capacity Declinesincreases AD Expected returns I Down – leftward shiftIncreasesdecreases Up – rightward shift Business taxes Decreasesincreases AD Expected returns I Down – leftward shiftIncreasesdecreases

10/22/ Changes in AD GDP = Q = C + I + G + NX If P is unchanged; any change in C, or I, or G, or NX changes AD. Changes in government spending (G) and AD Up – rightward shift Down – leftward shift increases decreases ADG

10/22/ Changes in AD GDP = Q = C + I + G + NX If P is unchanged; any change in C, or I, or G, or NX changes AD. Changes in net export spending (NX) and AD Up – rightward shift Down – leftward shift increases decreases ADNX

10/22/ Changes in AD GDP = Q = C + I + G + NX If P is unchanged; any change in C, or I, or G, or NX changes AD. Changes in net export spending (NX) and AD Up – rightward shiftIncreasesincreases ADNational income abroadNX Down – leftward shiftDecreasesdecreases Up – rightward shiftDollar depreciationincreases ADExchange ratesNX Down – leftward shiftDollar appreciationdecreases

10/22/ Changes in AD GDP = Q = C + I + G + NX If P is unchanged; any change in C, or I, or G, or NX changes AD. Summary Up – rightward shiftincreases ADC, or I, or G, or NX when Consumer wealth increases Consumer borrowing increases Consumer expectations are positive Personal income taxes reduce Real interest rates falls Expected returns are higher Government purchases increase National income abroad increases Domestic currency (dollar) depreciates

10/22/ Aggregate Supply (AS) AS is a schedule or curve that shows the total quantity of goods and services supplied (produced) at different price levels. AS is a schedule or curve that shows the total quantity of goods and services supplied (produced) at different price levels.

10/22/ The AS Curve Price Level GDP Deflator (P) Real GDP (Q = Y) AS ISR A The immediate short-run AS is horizontal, as both input and output prices stay fixed. P1P1 QfQf AS SR AS LR The short-run AS is upward-sloping. With input prices fixed, changes in P will raise or lower real firm profits. The long-run AS is vertical. The economy will produce full-employment output level Qf no matter what P is.

10/22/ Aggregate Supply (AS) Name AS in the immediate short-run Label AS ISR Shape horizontal Input and output prices stay fixed. Firms supply G&S at fixed prices. Explanation Input prices stay sticky, but output are flexible. Firms supply more when prices rise and less when prices fall. upward- sloping AS in the short-run AS SR Input prices change to match changes in the price level. Firms have no incentive to alter their output. vertical AS in the long-run AS LR

10/22/ The Short-Run AS Curve Price Level GDP Deflator (P) Real GDP (Q = Y) AS SR P1P1 Q1Q1 A At the price level P 1, the economy supplies Q 1.At the price level P 2, the economy supplies Q 2. P2P2 Q2Q2 B Higher price levels increase the quantity of real GDP supplied, and vice versa.

10/22/ Changes in AS Price Level GDP Deflator (P) Real GDP (Q = Y) AS 1 P1P1 Q1Q1 A1A1 A rightward shift from AS 1 to AS 2 represents an increase in AS. P stays unchanged, but Q rises. AS 2 AS 3 A2A2 A3A3 Q3Q3 Q2Q2 A leftward shift from AS 1 to AS 3 represents a decrease in AS. P stays unchanged, but Q falls.

10/22/ Changes in AS GDP = Q = A F (L, K, H, N) If P is unchanged; any change in L, or K, or H, N, or A changes AS. Changes in input prices and AS Domestic resources Labor/wages; land/rent; capital/interest ASInputs/PricesInput prices Up – rightward shift Down – leftward shift decreases increases ASInput prices Per-unit production cost = Total input costs / Units of output Imported resources $ appreciates $ depreciates Exchange rates Up – rightward shift Down – leftward shift decreases increases

10/22/ Changes in AS GDP = Q = A F (L, K, H, N) If P is unchanged; any change in L, or K, or H, N, or A changes AS. Changes in input prices and AS Up – rightward shift Down – leftward shift increases decreases ASProductivity Per-unit production cost = Total input costs / Units of output

10/22/ Changes in AS GDP = Q = A F (L, K, H, N) If P is unchanged; any change in L, or K, or H, N, or A changes AS. Changes in input prices and AS Legal-institution environment Up – rightward shift Down – leftward shift Lower Higher ASBusiness taxes Per-unit production cost = Total input costs / Units of output Up – rightward shift Down – leftward shift Fewer More ASRegulations

10/22/ Equilibrium Price Level (P) and Real GDP (Qe = Ye = AEe) Pe and Qe Pe and Qe Changes in the price level and real GDP Changes in the price level and real GDP –Demand-pull inflation –Cost-push inflation

10/22/ Macroeconomic Equilibrium P Real GDP (Q = Y) AS SR P1P1 PePe QeQe E The economy is illustrated by the AD and AS curves below. AD Shortage P2P2 Surplus The intersection point between AD and AS curves determines the economy’s equilibrium price level Pe, and real GDP Qe. At P 1 < Pe, there is a shortage of G&S, which will cause the price level to increase to Pe. At P 2 > Pe, there is a surplus of G&S, which will cause the price level to fall to Pe.

10/22/ Demand-Pull Inflation P Real GDP (Q = Y) AS SR PePe QfQf E1E1 The economy is illustrated by the AD and AS curves below. AD 1 P2P2 An increase in AD causes a demand-pull inflation and a positive GDP gap (Q 1 – Q f ). AD 2 E2E2 Q2Q2

10/22/ Cost-Push Inflation P Real GDP (Q = Y) AS 1 PePe QfQf E1E1 The economy is illustrated by the AD and AS curves below. AD P2P2 Q2Q2 E2E2 AS 2 A leftward shift of the AS causes a cost-push inflation and a negative GDP gap. AS 2

10/22/ Equilibrium Price Level (P) and Real GDP (Qe = Ye = AEe) Downward price level inflexibility Downward price level inflexibility –Fear of price wars –Menu costs –Wage contracts –Morale, effort, and productivity –Minimum wage –The ratchet effect –Recession and cyclical unemployment

10/22/ Recession and Cyclical Unemployment P Real GDP (Q = Y) AS SR P2P2 Q2Q2 E2E2 The economy is illustrated by the AD and AS curves below. AD 2 P1P1 A decrease in AD causes a recession. There is deflation and a negative GDP gap. AD 1 E1E1 QfQf

10/22/ Equilibrium Price Level (P) and Real GDP (Qe = Ye = AEe) The multiplier effect The multiplier effect – The multiplier is the ratio of a change in GDP to an initial change in government spending (G) – Multiplier = Change in real GDP / Initial change in G – Change in real GDP = multiplier x Initial change in G

10/22/ Equilibrium Price Level (P) and Real GDP (Qe = Ye = AEe) Self-correction? Self-correction? – In theory, price and wage flexibility would allow the economy to automatically self- correct from a recession. – In reality, downward price and wage flexibility make the process slow and uncertain. – The government and the Fed often intervene to increase AD.

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