1 Aggregate Demand and Supply Key Concepts Key Concepts Summary ©2005 South-Western College Publishing

2 What is the purpose of this chapter? In this chapter, you will use aggregate demand and supply analysis to study the business cycle and will be provided the basic tools with which to organize your thinking about the macro economy.

3 What is the aggregate demand curve? The curve shows the level of real GDP purchased by households, businesses, government, and foreigners at different price levels during a time period, ceteris paribus

4 What does the horizontal axis measure? The value of final goods and services included in real GDP measured in base year dollars

5 What does the vertical axis measure? It is an index of the overall price level, such as the GDP deflator or the CPI

6 Why does the aggregate demand curve slope downward to the right? Real balance wealth effect Interest rate effect Net exports effect

7 What is the real balance effect? Consumers spend more on goods and services because lower prices make their dollars more valuable

8 What is the interest rate effect? Assuming fixed credit, an increase in the price level translates through higher interest rates into a lower real GDP

9 What is the net exports effect? A higher domestic price level makes U.S. goods more expensive compared to foreign goods, exports decrease, imports increase, decreasing real GDP

10 $200 $150 $100 $ B A AD Price Level Real GDP The Aggregate Demand Curve

11 What can cause a shift in the aggregate demand curve? Consumption, investments, government spending and net exports can change

BA Real GDP AD 2 AD 1 Price Level (CPI) A Shift in the Aggregate Demand Curve

13 What is the aggregate supply curve? The curve that shows the level of real GDP produced at different price levels during a time period, ceteris paribus

14 Why did Keynes assume fixed product prices and wages? During a deep recession or depression, there are many idle resources in the economy

15 Why do idle resources mean fixed prices? Producers are willing to sell additional output at current prices because there is plenty of resources to go around for everyone who wants them

16 Why do idle resources mean fixed wages? The supply of unemployed workers willing to work for the prevailing wage rate diminishes the power of workers to increase their wages

17 What kind of supply curve would explain fixed prices and wages? A horizontal supply curve

E2E2 E1E1 Real GDP Price Level (CPI) AS AD 2 AD 1 The Keynesian Horizontal Aggregate Supply Curve

19 Government spending (G) increases Aggregate demand increases and the economy moves from E 1 to E 2 Price level remains constant, while real GDP and employment rise

20 According to Keynes, what will a shift in aggregate demand do? It will restore a depressed economy to full employment

E2E2 E1E1 Real GDP Price Level (CPI) AS AD 2 AD 1 The Keynesian Horizontal Aggregate Supply Curve full employment

22 What is the Classical view of the aggregate supply curve? It is a vertical line at the full employment output

23 According to the Classical economists, where does the economy normally operate? The economy normally operates at its full employment level

24 How do the Classical economists view prices and costs? The price level of products and production costs change by the same percentage in order to maintain full employment

AD 2 E2E2 E1E1 AD Real GDP Full employment The Classical Aggregate Supply Curve AS Price Level (CPI) 17 Surplus E

26 YKYK Real GDP Keynesian Range Three Ranges of the Aggregate Supply Curve AS Price Level Intermediate Range Classical Range YFYF Full Employment

AS Full Employment Price Level AD 1 AD 2 AD 3 AD 4 AD 6 AD 5 Real GDP Increasing Demand

28 What factors can cause a shift in the aggregate supply curve? A change in resource prices technology taxes subsidies regulations

full employment A Rightward Shift in the Aggregate Supply Curve AS 1 Price Level 17 AD E1E1 E2E2 AS 2 Real GDP

30 Change in one or more nonprice- level determinants: resource prices, technological change, taxes, subsidies, and regulations Increase in the aggregate supply curve

31 What are the two types of inflation? Cost push Demand pull

32 What is cost push inflation? A rise in the general price level resulting from an increase in the cost of production

33 What is stagflation? The condition that occurs when an economy experiences the twin maladies of high unemployment and rapid inflation simultaneously

full employment Cost Push Inflation Price Level 17 AD E1E1 E2E2 AS 1 Real GDP AS 2

35 What is demand pull inflation? A rise in the general price level resulting from an excess of total spending

full employment Demand Pull Inflation Price Level 17 AD 1 E1E1 E2E2 AS Real GDP AD 2

37 What determines the business cycle? Shifts in the aggregate demand and aggregate supply curves

38 What happens when both curves increase? That depends on how much each increases

Price Level 17 AD 1 AS 1 Real GDP AD 2 AS 2

40 Key Concepts

41 What is the aggregate demand curve? Why does the aggregate demand curve slope downward to the right?Why does the aggregate demand curve slope downward to the right? What can cause a shift in the aggregate demand curve?What can cause a shift in the aggregate demand curve? What is the aggregate supply curve? Why did Keynes assume fixed product prices and wages?Why did Keynes assume fixed product prices and wages? What kind of supply curve would explain fixed prices and wages?What kind of supply curve would explain fixed prices and wages?

42 According to Keynes, what will a shift in aggregate demand do?According to Keynes, what will a shift in aggregate demand do? What is the Classical view of the aggregate supply curve?What is the Classical view of the aggregate supply curve? According to the Classical economists, where does the economy normally operate?According to the Classical economists, where does the economy normally operate? What factors can cause a shift in the aggregate supply curve?What factors can cause a shift in the aggregate supply curve? What are the two types of inflation?

43 Summary

44 The aggregate demand curve shows the level of real GDP purchased in the economy at different price levels during a period of time.

45 Reasons why the aggregate demand curve is downward- sloping include the following three effects:

46 (1) The real balances or wealth effect is the impact on real GDP caused by the inverse relationship between the purchasing power of fixed value financial assets and inflation, which causes a shift in the consumption schedule.

47 (2) The interest-rate effect assumes a fixed money supply, and, therefore, inflation increases the demand for money. As the demand for money increases, the interest rate rises, causing consumption and investment spending to fall.

48 (3) The net exports effect is the impact on real GDP caused by the inverse relationship between net exports and inflation. An increase in the U.S. price level tends to reduce U.S. exports and increase imports, and vice versa.

BA Real GDP AD 2 AD 1 Price Level (CPI) A Shift in the Aggregate Demand Curve

50 The aggregate supply curve shows the level of real GDP that the economy will produce at different possible price levels.

51 The shape of the aggregate supply curve depends on the flexibility of prices and wages as real GDP expands and contracts. The aggregate supply curve has three ranges:

52 (1) The Keynesian range of the curve is horizontal because neither the price level nor production costs will increase when there is substantial unemployment in the economy.

53 (2) In the intermediate range, both prices and costs rise as real GDP rises toward full employment. Prices and production costs rise because of bottlenecks, the stronger bargaining power of labor, and the utilization of less productive workers and capital

54 (3) The classical range is the vertical segment of the aggregate supply curve. It coincides with the full-employment output. Because output is at its maximum, increases in aggregate demand will only cause a rise in the price level.

55 YKYK Real GDP Keynesian Range Three Ranges of the Aggregate Supply Curve AS Price Level Intermediate Range Classical Range YFYF Full Employment

56 Aggregate demand and aggregate supply analysis determines the equilibrium price level and the equilibrium real GDP by the intersection of the aggregate demand and the aggregate supply curves.

57 Stagflation exists when an economy experiences inflation and unemployment simultaneously. Holding aggregate demand constant, a decrease in aggregate supply results in the unhealthy condition of a rise in the price level and a fall in real GDP and employment.

58 Cost-push inflation is inflation that results from a decrease in the aggregate supply curve while the aggregate demand curve remains fixed.

59 Cost-push inflation is undesirable because it is accompanied by declines in both real GDP and employment.

Cost Push Inflation Price Level 17 AD E2E2 AS 1 Real GDP full employment E1E1 AS 2

61 Demand-pull inflation is inflation that results from an increase in the aggregate demand curve in both the classical and the intermediate ranges of the aggregate supply curve while the aggregate supply curve is fixed.

Demand Pull Inflation Price Level 17 AD 1 E1E1 E2E2 AS Real GDP AD 2 full employment

63 END