Chapter 11 Aggregate Demand and Supply

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.11-2 Learning Objectives Explain how the aggregate demand curve differs from the individual demand curve. List and explain two reasons why the aggregate demand curve slopes down. Define the aggregate supply curve. Explain why the aggregate supply curve slopes up.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.11-3 Economic Models Business fluctuations—recessions and expansions—are an important aspect of macroeconomics. Indeed, much of macroeconomics is concerned with how to predict and prevent recessions. In order to make such predictions, economists and government policy makers have to use a model of the macroeconomy.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.11-4 Economic Models (cont.) In this chapter we examine two models: –The simplest model of the circular flow of income and product within our economy. –The aggregate demand and aggregate supply model.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.11-5 The Two Principles of the Circular Flow of Income The concept of a circular flow of income (ignoring taxes) involves two principles: 1.In every economic exchange, the seller receives exactly the same amount that the buyer spends. 2.Goods and services flow in one direction and money payments flow in the other.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.11-6 Figure 11-1: The Circular Flow of Income and Product

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.11-7 Distinguishing Between Product and Factor Markets Product Markets: Transactions in which households buy goods take place in the product markets—that’s where households are the buyers and businesses are the sellers of consumer goods.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.11-8 Distinguishing Between Product and Factor Markets (cont.) Factor Markets: In these markets, households are the sellers of resources such as labor, land, capital, and entrepreneurial ability. Businesses are the buyers in factor markets; business expenditures constitute income for households.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.11-9 Expanding the Circular Flow Model We can think of the top part of the circular flow model with government and the foreign sector added as a representation of gross domestic product, or GDP.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Expanding the Circular Flow Model (cont.) The Government Sector: Its participation involves government spending on goods and services, government spending on wages and salaries for its workers and payments to welfare recipients and farm owners, plus many other types of outlays. The government also collects revenues from taxes.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Expanding the Circular Flow Model (cont.) The Foreign Sector: Americans purchase goods and services from foreigners, called imports. Foreigners purchase goods and services from us, called exports. When we purchase more from foreigners than they do from us, we have to talk in terms of negative net exports.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Putting It All Together You now have all of the elements of gross domestic product, or GDP = C + I + G + X. In this formula, –C equals consumer spending; –I equals mainly business spending on investment (capital goods); –G is government spending; and –X is net exports.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Aggregate Demand Aggregate demand is the total dollar value of all planned expenditures in the economy. It consist of spending by consumers on goods and services, spending by businesses on investment, spending by the government, and net exports.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved The Aggregate Demand Curve When talking about aggregate demand, we examine the relationship between aggregate quantity demanded and the overall price level. The aggregate demand curve gives the total amount of output that will be purchased at each price level.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Figure 11-2: The Aggregate Demand Curve

Copyright © 2005 Pearson Addison-Wesley. All rights reserved What Happens When the Price Level Rises? If the average price of goods and services rises, then consumers will be buying fewer of these goods and services. Hence, the aggregate demand curve is downward sloping. There are economy-wide factors that explain why the aggregate demand curve slopes downward. Two of them are: the real-balance effect, and the open economy effect.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved The Real-Balance Effect If the price level goes up while you hold cash, the real value of that cash goes down, just as if a pickpocket stole some cash out of your wallet. Hence, you buy fewer goods and services.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved The Open Economy Effect Given any set of exchange rates between the U.S. dollar and other currencies, an increase in the price level in the United States makes U.S. goods more expensive for foreigners. Relatively cheaper prices for foreign goods cause U.S. residents to want to buy more foreign goods, and lowers their demand for domestically produced goods and services.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Shifts in the Aggregate Demand Curve Any change in a variable that increases the amount of output people want to buy at a given price level is said to cause an increase in aggregate demand. Graphically this is known as a shift to the right of the aggregate demand curve.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Table 11-1: Determinants of Aggregate Demand

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Aggregate Supply Aggregate supply is the total of all planned production for the entire economy, usually over a year period. In the short run, the overall price level is related to the output of final goods and services in the economy.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Aggregate Supply (cont.) If the price level goes up and wages do not, overall profits will rise. Producers will want to supply more to the marketplace—they offer more output as the price level increases. This positive relationship is called aggregate supply.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Figure 11-3: The Aggregate Supply Curve in the Short Run

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Table 11-2: Determinants of Aggregate Supply

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Putting Aggregate Demand and Aggregate Supply Together When we combine the aggregate demand curve with the aggregate supply curve, we find equilibrium at their intersection. In equilibrium, when the aggregate quantity demanded equals aggregate quantity supplied, the equilibrium price level is determined as well as the equilibrium level of real GDP per year.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Figure 11-4: Equilibrium Price Level and Output

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Looking at the National Economy Using the AD-AS Model Changes in Federal Taxes: In general, a decrease in taxes will cause the aggregate demand curve to shift outward to the right. Consider the Bush tax cuts that started to go into effect in the early 2000s, as seen in Figure 11-5, next.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Figure 11-5: Effects of the Bush Tax Cuts

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Looking at the National Economy Using the AD-AS Model (cont.) Immigration: Increased immigration over time leads to a larger supply of labor. While there are many who believe that immigration hurts America, at least in the short run and certainly in the long run immigration causes the aggregate supply curve to increase—shift outward to the right.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Key Terms and Concepts aggregate demand aggregate demand curve aggregate supply aggregate supply curve cash balance circular flow of income exports imports net exports open economy effect real-balance effect