Chapter 11: Aggregate Demand & Aggregate Supply Aggregate Demand (AD) – Aggregate Supply (AS) model is a variable price model. AD – AS model provides insights on inflation, unemployment, and economic growth

Aggregate Demand A schedule that shows the various amounts of real domestic output that domestic & foreign buyers will desire to purchase at each possible price level Shows an inverse relationship between price level and domestic output

Price v. Real GDP: Reasons for Inverse Relationship Real Balances Effect: When Price falls, purchasing power of existing financial balances rises  increase spending Interest Rate Effect: A decline in Price means lower interest rates  increase levels of certain types of spending Foreign Purchases Effect: When Price falls, US prices will fall relative to foreign pries  increase spending on US exports, decrease import spending in favor of US products that compete w/ imports

Determinants of Aggregate Demand Real GDP = C + Ig + G + Xn Changes in Consumer Spending Changes in Investment Spending Changes in Governments Spending Changes in Net Exports

Changes in Consumer Spending Consumer Wealth Consumer Expectations Consumer Indebtedness Taxes

Changes in Investment Spending Interest Rates Profit Expectations Business Taxes Technology Amount of Excess Capacity

Change in Government Spending This is Fiscal Policy (Chapter 12)

Changes in Net Exports When unrelated to price level: Income Abroad Exchange Rates Depreciation of $ encourages US exports since US products become less expensive for foreign buyers, who can now obtain $ for their currency Depreciation of $ discourages import buying in the US since it is more expensive for Americans to exchange foreign currency

Aggregate Supply A schedule showing level of Real GDP available at each Price Higher Prices create an incentive for firms to produce & sell more Lower Prices prompt firms to reduce output Direct/Positive relationship between P & Real GDP

Determinants of Aggregate Supply Change in Input Prices Change in Productivity Change in Legal-Institutional Environment

Change in Input Prices Availability of Resources Land, Labor, Capital, & Entrepreneurial Ability Prices of Imported Resources Market Power in Certain Industries

Change in Productivity Productivity = Real Output / Input Changes in Per-unit Production Cost = Total Input Cost / Units of Output If productivity rises, unit production costs fall  Shifts AS to right, lowers Prices If productivity falls, unit production costs rise  Shifts AS to left, increasing Prices

Legal – Institutional Environment Business Taxes Subsidies Government Regulation

Equilibrium: Price v. Real Output Equilibrium Price and Quantity are found where AD and AS curves intersect

Decreases in AD If AD decreases, recession and cyclical unemployment may result Wage contracts are not flexible, business can’t afford to reduce prices Employers are reluctant to cut wages b/c impact on EE effort Minimum Wage Laws keep wages up Menu Costs are difficult to change Fear of price wars keeps prices from being reduced

Why is Unemployment in Europe So High? High minimum wages Generous welfare benefits for unemployed Restrictions against firings discourage employment 30 – 40 days of paid vacation & holidays increase costs of hiring High worker absenteeism reduces productivity Higher employer cost of fringe benefits discourages hiring

Chapter 11 Study Questions 7, 8: Determinants of AD & AS