Aggregate Demand and Aggregate Supply

Chapter Objectives Aggregate Demand and the Factors That Cause it to Change Aggregate Supply and the Factors That Cause it to Change How AD and AS Determine an Economy’s Equilibrium Price Level and the Level of Real GDP How the AD-AS Model Explains Periods of Demand-Pull Inflation, Cost-Push Inflation, and Recession

AD – AS Model Aggregate Demand AD is a schedule, graphically represented as a curve, which shows the various amounts of goods and services – the amount of real domestic output – which domestic consumers, businesses, government and foreign buyers collectively will desire to purchase at each possible price level.

AGGREGATE DEMAND CURVE Price level AD Real domestic output, GDP

AD – AS Model Why the Downward Slope? Real-Balances Effect Interest-Rate Effect Foreign Purchases Effect

Why the Downward Slope? Real-Balances Effect / Wealth Effect A higher price level will reduce the real value or purchasing power of the public’s accumulated financial assets

Why the Downward Slope? Interest-Rate Effect A higher price level – by increasing the demand for money and the interest rate – reduces the amount of real output demanded. The AD curve assumes that the supply of money in the economy is fixed.

Why the Downward Slope? Foreign Purchases Effect The volume of imports and exports depend on, among other things, relative price level in the country and abroad. Thus if the price level rises in Pakistan relative to foreign countries, Pakistani buyers will buy more imports at the expense of domestic goods. Similarly, foreigners will buy fewer Pakistani goods, reducing Pakistan’s exports

Changes in Aggregate Demand Law of Demand An increase in the price level, other things being equal, will decrease the quantity of real output demanded. Determinants of Aggregate Demand (Other Things)

Determinants of Aggregate Demand Changes in: Consumer Spending Consumer Wealth Consumer Expectations Household Debt Personal Taxes Investment Spending Real Interest Rates

Changes in Aggregate Demand Expected Returns About Future Business Conditions Technology Degree of Excess Capacity Business Taxes Government Spending Net Export Spending National Income Abroad Exchange Rates

Changes in Aggregate Demand Increase in Aggregate Demand Price Level Decrease in Aggregate Demand AD2 AD1 AD3 Real Domestic Output, GDP

AGGREGATE SUPPLY Levels of Real Domestic Output At Each Possible Price Level Long-run Supply Curve Wages and Resource Prices Match Price Level Short-run Supply Curve Wages and Resource Prices Do Not Match Price Level

Long Run P ASLR Q Price level Long-run Aggregate Supply Full-Employment Qf Q Real domestic output, GDP

AGGREGATE SUPPLY Short Run P AS Q Aggregate Supply Short-run Price level Full- Employment Q Qf Real domestic output, GDP

AGGREGATE SUPPLY Changes in Aggregate Supply P Q Decrease In Aggregate Price level Increase In Aggregate Supply Q Real domestic output, GDP

Input Prices Domestic Resource Prices Labor Land Capital DETERMINANTS OF AGGREGATE SUPPLY Input Prices Domestic Resource Prices Labor Land Capital Prices of Imported Goods Market Power

Legal-Institutional Environment DETERMINANTS OF AGGREGATE SUPPLY Productivity Productivity = Total Output Total Inputs Legal-Institutional Environment Business Taxes and Subsidies Government Regulation

Equilibrium and Changes in Equilibrium The equilibrium price level and amount of real domestic output are determined at the intersection of the AD and AS curves.

Equilibrium Price Level and Equilibrium Price Level Real Output Demanded (Billions) Real Output Supplied (Billions) Price Level (Index Number) $506 508 510 512 514 108 104 100 96 92 $513 512 510 507 502 Equilibrium Price Level and Equilibrium Price Level

Equilibrium and Changes in Equilibrium AS Price Level Equilibrium 100 92 a b AD 502 510 514 Real Domestic Output, GDP (Billions of Dollars)

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

DECREASES IN AD: RECESSION & CYCLICAL UNEMPLOYMENT b a P1 Price Level c Q Q1 Qf Real Domestic Output, GDP

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

Aggregate Demand Curve Aggregate Expenditures Model Derivation of the Aggregate Demand Curve from the Aggregate Expenditures Model …

Aggregate expenditures DERIVATION OF THE AGGREGATE DEMAND CURVE AE1 at P 1 1 AE2 at P 2 AE3 at P 3 Aggregate expenditures (billions of dollars) 2 3 Q3 Q2 Q1 3’ P3 The Aggregate Demand Can Be Constructed Price level 2’ P2 1’ P1 AD Q3 Q2 Q1 Real Domestic Output

Increase in Aggregate Expenditures Increase in Aggregate Demand SHIFTS IN THE AGGREGATE EXPENDITURES SCHEDULE & THE AGGREGATE DEMAND CURVE AE2 at P 1 AE1 at P 1 Aggregate expenditures (billions of dollars) Increase in Aggregate Expenditures Q1 Q2 Increase in Aggregate Demand Price level P1 AD2 AD1 Q1 Q2 Real Domestic Output

SUMMARY AD reflects an inverse relationship between the price level and the amount of real domestic output demanded. Changes in the price level produce wealth, interest rate, and foreign purchases effects which explain the downward slope of the AD curve. Changes in one or more of the determinants of AD alter the amounts of real domestic output demanded at each price level; they shift the AD curve. An increase in AD is shown as a rightward shift of the AD curve; a decrease entails a leftward shift of the curve.

Quick Review The equilibrium price level and amount of real domestic output are determined at the intersection of the AD and AS curves. Increase in the AD in upsloping and vertical ranges of AS cause Demand Pull Inflation. Decrease in AS curve cause Cost push inflation. Increase in AS expand real domestic output; they result in economic growth.