1 Ch. 7: Aggregate Demand and Aggregate Supply James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts University ©2005 Thomson Business & Professional Publishing, A Division of Thomson Learning

2 Aggregate Demand Aggregate Demand: the quantity demanded of all goods and services (Real GDP) at various price levels, ceteris paribus. Aggregate Demand: the quantity demanded of all goods and services (Real GDP) at various price levels, ceteris paribus. Aggregate Demand (AD) Curve: a curve that shows the quantity demanded of all goods and services (Real GDP) at various price levels, ceteris paribus. Aggregate Demand (AD) Curve: a curve that shows the quantity demanded of all goods and services (Real GDP) at various price levels, ceteris paribus.

3 Exhibit 1: The Aggregate Demand Curve

4 Aggregate Demand Monetary Wealth: the value of a person’s monetary assets. Monetary Wealth: the value of a person’s monetary assets. Purchasing Power: the quantity of goods and services that can be purchased with a unit of money. Purchasing power and the price level are inversely related. Purchasing Power: the quantity of goods and services that can be purchased with a unit of money. Purchasing power and the price level are inversely related.

5 Why Does the Aggregate Demand Curve Slope Downward? Real Balance Effect: the change in the purchasing power of dollar-denominated assets that result from a change in the price level. Real Balance Effect: the change in the purchasing power of dollar-denominated assets that result from a change in the price level. Interest Rate Effect: the changes in household and business buying as the interest rate changes. Interest Rate Effect: the changes in household and business buying as the interest rate changes. International Trade Effect: the change in foreign sector spending as the price level changes. International Trade Effect: the change in foreign sector spending as the price level changes.

6 Exhibit 2: Why the Aggregate Demand Curve is Downward-Sloping?

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9 Exhibit 3: A Change in the Quantity Demanded of Real GDP versus a Change in Aggregate Demand

10 How Spending Components Affect Aggregate Demand Components of Spending: Components of Spending: –Consumption –Investment –Government Purchases –Net Exports A change in any of these components will affect aggregate demand. A change in any of these components will affect aggregate demand.

11 Changes in Aggregate Demand If at a given price level, Consumption, Investment, Government Purchases, or Net Exports increase, then Aggregate Demand will increase. If at a given price level, Consumption, Investment, Government Purchases, or Net Exports increase, then Aggregate Demand will increase. If at a given price level, Consumption, Investment, Government Purchases, or Net Exports decrease, the Aggregate Demand will decrease. If at a given price level, Consumption, Investment, Government Purchases, or Net Exports decrease, the Aggregate Demand will decrease.

12 Exhibit 4: Changes in Aggregate Demand

13 What Causes Consumption to Change? Wealth Wealth Expectations about future prices and Income Expectations about future prices and Income Interest rate Interest rate Income taxes Income taxes

14 What Causes Investment to Change? The interest rate The interest rate Expectations about future sales Expectations about future sales Business taxes Business taxes

15 What Would Change Net Exports? Foreign real national income Foreign real national income Exchange rate Exchange rate

16 Exhibit 5: Factors That Change Aggregate Demand

17 The Interest Rate and the Loanable Funds Market Interest rates can change consumption and investment. Interest rates can change consumption and investment. Interest rates are market determined in the loanable funds market. Interest rates are market determined in the loanable funds market.

18 Exhibit 6: The Loanable Funds Market

19 The Loanable Funds Market Demand shifters are anything that will cause one or more of the four sectors (C,I,G,NX) to borrow more will shift demand. Demand shifters are anything that will cause one or more of the four sectors (C,I,G,NX) to borrow more will shift demand. Supply shifters are anything that prompts one or more of the four sectors (C,I,G,NX) to loan more funds. Supply shifters are anything that prompts one or more of the four sectors (C,I,G,NX) to loan more funds.

20 Can a Change in the Money Supply Change Aggregate Demand? Yes. We’ll discuss in detail in later chapters.

21 Self-Test Explain the real balance effect. Explain the real balance effect. Explain what happens to the AD curve if the dollar appreciates relative to other currencies. Explain what happens to the AD curve if the dollar appreciates relative to other currencies. Explain what happens to the AD curve if personal income taxes decline. Explain what happens to the AD curve if personal income taxes decline. What happens to the demand for loanable funds and the interest rate if the budget deficit becomes smaller (but not zero)? Explain. What happens to the demand for loanable funds and the interest rate if the budget deficit becomes smaller (but not zero)? Explain.

22 Short-Run Aggregate Supply Aggregate Supply: the quantity supplied of all goods and services (Real GDP) at different price levels, ceteris paribus. Aggregate Supply: the quantity supplied of all goods and services (Real GDP) at different price levels, ceteris paribus. The Short-Run Aggregate Supply Curve (SRAS) is upward sloping. The Short-Run Aggregate Supply Curve (SRAS) is upward sloping.

23 Exhibit 7: The Short-Run Aggregate Supply Curve

24 Short-Run Aggregate Supply Curve: What it is and Why is it Upward- Sloping? Short-Run Aggregate Supply Curve (SRAS): a curve that shows the quantity supplied of all goods and services (Real GDP) at different price levels, ceteris paribus. Short-Run Aggregate Supply Curve (SRAS): a curve that shows the quantity supplied of all goods and services (Real GDP) at different price levels, ceteris paribus. Why is it upward-sloping? Why is it upward-sloping? –Sticky Wages –Sticky Prices –Menu Costs –Producer Misperceptions –Worker Misperceptions

25 The Difference Between Short- Run And Long-Run Aggregate Supply Curve The Following Will Change Over Time: Sticky Wages Sticky Wages Sticky Prices Sticky Prices Producer Misperceptions Producer Misperceptions Worker Misperceptions Worker Misperceptions

26 Shifts in the Aggregate Supply Curve Wage Rates Wage Rates Prices of Nonlabor Inputs Prices of Nonlabor Inputs Productivity Productivity Supply Shocks Supply Shocks

27 Exhibit 8: Wage Rates and a Shift in the Short-Run Aggregate Supply Curve (same applies to changes in prices of other non-labor inputs)

28 Shifts in the Short-Run Aggregate Supply Curve Productivity: describes the output produced per unit of input employed over some time. Productivity: describes the output produced per unit of input employed over some time. An increase in productivity causes the SRAS to shift rightward. A decrease in productivity causes the SRAS to shift to the left. An increase in productivity causes the SRAS to shift rightward. A decrease in productivity causes the SRAS to shift to the left.

29 Shifts in the Aggregate Supply Curve Supply Shocks: major natural or institutional changes on the supply side of the economy that affect aggregate supply. Supply Shocks: major natural or institutional changes on the supply side of the economy that affect aggregate supply. A supply shock might include a drought in the Midwest, or finding more oil in the middle east. A supply shock might include a drought in the Midwest, or finding more oil in the middle east.

30 Exhibit 9: Changes in Short-Run Aggregate Supply

31 Self-Test If wage rates decline, explain what happens to the short-run aggregate supply (SRAS) curve? If wage rates decline, explain what happens to the short-run aggregate supply (SRAS) curve? Give an example of an increase in labor productivity. Give an example of an increase in labor productivity. What are menu costs and what role do they play in the sticky-price explanation for an upward-sloping SRAS curve? What are menu costs and what role do they play in the sticky-price explanation for an upward-sloping SRAS curve?

32 How Short-Run Equilibrium In The Economy Is Achieved AD and SRAS determine the price level, real GDP, and the unemployment rate in the short run. AD and SRAS determine the price level, real GDP, and the unemployment rate in the short run. In instances of both surplus and shortage, economic forces are moving the economy toward the short-run equilibrium point. In instances of both surplus and shortage, economic forces are moving the economy toward the short-run equilibrium point. Ceteris paribus, we expect a higher real GDP level to be associated with a lower unemployment rate and a lower real GDP level to be associated with a higher unemployment rate. Ceteris paribus, we expect a higher real GDP level to be associated with a lower unemployment rate and a lower real GDP level to be associated with a higher unemployment rate.

33 Exhibit 10: Short-Run Equilibrium

34 Exhibit 11: Changes in Short-Run Equilibrium in the Economy

35 Ceteris Paribus Makes All The Difference in the Relationship between Real GDP and the Unemployment Rate If other things change, it may appear as if the inverse relationship between the unemployment rate and Real GDP doesn’t hold. If other things change, it may appear as if the inverse relationship between the unemployment rate and Real GDP doesn’t hold. Economics is about establishing a connection or link between an effect and a correct cause. Economics is about establishing a connection or link between an effect and a correct cause.

36 Exhibit 12: How a Factor Affects the Price Level, Real GDP, and the Unemployment Rate in the Short Run

37 Exhibit 13: A Summary Exhibit of AD and SRAS

38 Q & A: Identify what will happen to the price level and Real GDP when each of the following occurs: Short-Run Aggregate Supply rises Short-Run Aggregate Supply rises Short-Run Aggregate Supply falls Short-Run Aggregate Supply falls Aggregate Demand rises Aggregate Demand rises Aggregate Demand falls Aggregate Demand falls Aggregate Demand rises by more than the Short-Run Aggregate Supply rises Aggregate Demand rises by more than the Short-Run Aggregate Supply rises Aggregate Demand falls by less than the Short-Run Aggregate Supply falls Aggregate Demand falls by less than the Short-Run Aggregate Supply falls

39 Long Run Aggregate Supply Short-Run equilibrium identifies the Real GDP the economy produces when any of these conditions hold: sticky wages, sticky prices, producers’ misperceptions, workers’ misperceptions. Short-Run equilibrium identifies the Real GDP the economy produces when any of these conditions hold: sticky wages, sticky prices, producers’ misperceptions, workers’ misperceptions. Wages and prices eventually become unstuck and misperceptions will turn to accurate perceptions: when this happens the economy is said to be in The Long Run. Wages and prices eventually become unstuck and misperceptions will turn to accurate perceptions: when this happens the economy is said to be in The Long Run.

40 Exhibit 14: Long-Run Aggregate Supply (LRAS) Curve

41 Exhibit 15: Equilibrium States of the Economy

42 Questions Economists Ask What can cause the economy to move from one short-run equilibrium position to another short- run equilibrium position? What can cause the economy to move from one short-run equilibrium position to another short- run equilibrium position?

43 Questions Economists Ask What happens to certain economic variables such as the price level and Real GDP, as the economy moves from one short-run equilibrium to another short-run equilibrium? What happens to certain economic variables such as the price level and Real GDP, as the economy moves from one short-run equilibrium to another short-run equilibrium? If the economy is in the short-run equilibrium, what path does it travel to long-run equilibrium? If the economy is in the short-run equilibrium, what path does it travel to long-run equilibrium? How long does it take the economy to move from short-run equilibrium to long-run equilibrium? How long does it take the economy to move from short-run equilibrium to long-run equilibrium?

44 Questions Economists Ask If the economy is in long-run equilibrium, what must happen to move it to another long-run equilibrium? If the economy is in long-run equilibrium, what must happen to move it to another long-run equilibrium? How long does it take to move from one long-run equilibrium position to another long-run equilibrium position? How long does it take to move from one long-run equilibrium position to another long-run equilibrium position?

45 Questions Economists Ask Are some of the states of an economy better than other states? Are some of the states of an economy better than other states? If some states of the economy are better than others, is there anything that government can do to move the economy from one state to another? If some states of the economy are better than others, is there anything that government can do to move the economy from one state to another?

46 Exhibit 16: Different States of the Economy

47 Coming Up (Ch. 8): The Self-Regulating Economy