Aggregate Demand Aggregate demand is the total demand in an economy for all the goods and services produced. The aggregate demand schedule is a schedule relating the total demand for all the goods and services produced in an economy to the price level. The aggregate demand curve slopes down.

Aggregate Demand AD P Y P2P2 Y 1 Y 2 P1P1 Note that at P 2, the higher price level, aggregate demand equals Y 1, but at P 1, the lower price level, aggregate demand equals Y 2. 0

Aggregate Demand Aggregate demand slopes down because: –As the price level increases, the purchasing power of real wealth decreases, resulting in less spending and lower Y. –As the price level increases, the real money supply decreases, pushing up interest rates. –As the domestic price level increases, foreigners buy less of our goods and services.

Aggregate Demand AE 2 (P 1 ) AE 1 (P 2 ) AE Y Y P1P1 P2P2 P Y 1 Y 2 A B AS AD We begin at point A where income is Y 1 and the price level is P 2. Y 1 and P 2 comprise one point on the aggregate demand curve, AD. We let the price level fall to P 1. At the lower price level, purchasing power increases, causing aggregate expenditures to shift up from AE 1 to AE 2. At P 1, equilibrium income is Y 2. Y 2 and P 1 comprise another point on aggregate demand curve, AD. A B 0 0

Changes in Aggregate Demand Aggregate demand increases when people want to buy more goods and services and decreases when people want to buy less. There are two types of aggregate demand change that can occur –A change in aggregate demand caused by a change in the price level. –A changes in aggregate demand caused by events not related to a change in the price level.

Moving along the AD Curve Changes in aggregate demand caused by a change in the price level are shown by a movement along the aggregate demand schedule. –Increases in the price level decrease aggregate demand –Decreases in the price level increase aggregate demand.

Moving along the AD Curve AD P Y P2P2 Y 1 Y 2 P1P1 Note that at P 2, the higher price level, aggregate demand equals Y 1, but as the price level falls to P 1, the lower price level, aggregate demand rises to Y 2. 0

Shifting the AD Curve A change in any of the variables in the AE/AS model except the price level shifts AD. Examples: –An increase or decrease in investment –An increase or decrease in consumption –An increase or decrease in taxes –An increase or decrease in government spending. –An increase or decrease in the money supply

Shifting the AD Curve Y P AD1 AD2 Y 1 Y 2 P1P1 Increases in AD are shown by shifting the AD curve from AD 1 to AD 2. Note that at the price level P 1, aggregate demand on AD 2 is greater than on AD 1. Decreases in AD are shown by shifting the AD curve from AD 2 to AD 1. Note that at the price level P 1, aggregate demand on AD 1 is less than on AD 2. 0

Shifting Aggregate Demand AE 2 (P 1 ) AE 1 (P 1 ) AE Y Y P1P1 P Y 1 Y 2 AS AD 1 AD 2 An increase in spending that is NOT caused by a change in the price level causes the aggregate demand curve to shift. Increases in spending shift aggregate expenditures from AE 1 to AE 2. Increases in spending shift aggregate demand from AD 1 to AD 2. Decreases in spending shift aggregate expenditures from AE 2 to AE 1. Decreases in spending shift aggregate demand from AD 2 to AD 1. A A B B 0 0

Aggregate Demand and the Multiplier AE 2 (P 1 ) AE 1 (P 1 ) AE Y Y P1P1 P Y 1 Y 2 A B AS AD 1 D AD 2 C When aggregate expenditures rise, income increases by more than the increase in expenditures. A change in spending that is not caused by a change in the price level shifts the aggregate demand curve. Note that the price level is P 1 at both Y 1 and Y 2. The distance Y 1 Y 2 = CD reflects the impact of the multiplier effect in the aggregate demand model. 0 0

Practice How does a lower price level change aggregate demand? Is this a shift in AD or a movement along the AD schedule? What will cause the AD schedule to shift up? List three real world examples of such an AD shift. What will cause the AD schedule to shift down? List three real world examples of such an AD shift.

Aggregate Supply Aggregate supply is the total quantity of goods and services produced in an economy. The aggregate supply schedule is a schedule relating the total supply of all the goods and services produced in an economy to the price level.

Short-Run Aggregate Supply Curve The short run aggregate supply curve shows how aggregate supply increases as the price level rises but factor costs do not change. –The short run is defined as that period of time over which nominal factor costs do not change. Nominal factor costs include wages, interest paid on loans, and the cost of plant and equipment. The short run aggregate supply curve may be flat or upward sloping.

Short Run Aggregate Supply Curve Y P AS Aggregate supply is drawn as a horizontal line over the range of output that is far below the economy’s full capacity. Over this range, 0Y 1, there is no shortage of inputs and the economy can expand without a price level increase. As the economy approaches full capacity, Y f e, employers have difficulty finding skilled workers and must hire less productive employees. The price level rises due to diminishing returns. This is reflected in an upward sloping AS curve. At Y fe, we have full employment of all resources. Output is fixed. Y 1 Y fe 0

Aggregate Supply and the Price Level Y P AS Y fe 0 A fall in the price level from P 2 to P 1 causes a decrease in profits, given fixed resource costs. Lower profits are an incentive for lower levels of production and output. A rise in the price level from P 1 to P 2 results in an increase in profits, given fixed resource costs. Higher profits are an incentive for higher levels of production and output. P2P2 P1P1 Y1Y1

Shifting the Aggregate Supply Curve Y P AS 1 0 AS 2 AS 3 A shift in the aggregate supply curve represents any change in aggregate supply that is not caused by a change in the price level. Shifts in aggregate supply are caused by events such as a change in the overall level of resource productivity and changes in resource availability. Tax policy also can affect AS. Increases in AS are shown by a shift of the curve to the right. Decreases in AS are shown by a shift of the curve to the left.

Practice How does a lower price level change aggregate supply? Is this a shift in AS or a movement along the AS schedule? What will cause the AS schedule to shift up? List three real world examples of such an AS shift. What will cause the AS schedule to shift down? List three real world examples of such an AS shift.

Equilibrium in the AD/AS Model Equilibrium in the AD/AS model occurs where aggregate demand just equals aggregate supply. It is a stable equilibrium. –If AD>AS, the price level rises and Y falls –If AD<AS, the price level falls and Y rises.

Equilibrium in the AD/AS Model Y P AS Y 1 Y fe 0 AD P1P1 E Equilibrium occurs at the point E where the price level is P 1 and output is Y 1. At this point, aggregate demand is just equal to aggregate supply. All the goods and services produced are demanded by the members of the economy. The equilibrium is stable. If the economy is not at equilibrium, there are forces that push AD and AS towards equilibrium.

Equilibrium in the AD/AS Model Y P AS Ye 0 AD Pe E Equilibrium occurs at point E, where the price level is Pe and output is Ye. At price levels above Pe, AS >AD by the amount AB. Firms will not be able to sell all the goods they produce, resulting in an increase in inventories and a decline in both production and the price level. At price levels below Pe, AD>AS by the amount CD. Firms will not be able to meet demand with current production levels, resulting in a decline in inventories and a rise in both production and the price level. C B D A Deflationary Gap Inflationary Gap

Changes in Aggregate Demand Y P AS Y 1 Y 2 0 AD 1 P1P1 B A AD 2 P2P2 Increases in aggregate demand shift the AD curve to the right. Both income and the price level rise. Decreases in aggregate demand shift the AD curve to the left. Both income and the price level fall.

Changes in Aggregate Supply Y P AS 2 Y 1 Y 2 0 AD P1P1 P2P2 B A Increases in aggregate supply shift the AS curve to the right. Income rises and the price level falls. We move from point A to point B. Decreases in aggregate supply shift the AS curve to the left. Income falls and the price level rises.. We move from point B to point A. AS 1

Practice Assume the economy is at full employment and increase AD. What happens to P and Y? Now assume the economy is at full employment and increase AS. What happens to P and Y? If you were in charge of increasing Y while avoiding inflation, which curve would you want to shift? How would you do it?

Practice Explain and show graphically what will happen to P and Y under the following circumstances: (Assume the economy is neither in a recession or at full employment) –Taxes on consumers fall –Taxes on businesses fall –Interest rates rise –Business optimism falls –Oil prices double –People begin to save more at every rate of interest

Practice In the Great Depression, the price level and GDP fell. What shift or combination of shifts in AD and AS would best describe the Great Depression? Currently, we are in an economic expansion. Is our expansion caused by changes in AD or AS? Explain your answer.