Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-1 Chapter 7 Aggregate demand and aggregate supply

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-2 Learning objectives Introduce the concepts of aggregate demand and aggregate supply Distinguish between short-run and long-run aggregate supply Explain the shapes of the aggregate demand and aggregate supply curves Discuss the relationship that exists between the aggregate expenditures model and the aggregate demand curve

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-3 Learning objectives (cont.) Discuss the non price-level factors that cause the aggregate demand and aggregate supply curves to shift Combine the aggregate demand and aggregate supply curves to provide a model of macroeconomic equilibrium Discuss how the aggregate demand–aggregate supply model may be used to analyse the circumstances outlined in Chapter 5

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-4 Learning objectives (cont.) Contrast demand-pull and cost-push inflation Discuss the reasons why the general level of prices is downwards ‘sticky’— the ratchet effect Explain the impact of price-level changes on the size of the multiplier

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-5 Aggregate demand (AD) Represents the amount of goods and services that consumers, businesses, government and foreign buyers are willing and able to buy at various price levels

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-6 AD curve The AD curve slopes downwards to the right due to: Interest-rate effect Real-balances effect (wealth effect) Foreign-purchases effect

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-7 Aggregate demand curve 0 Price level Real gross domestic output AD

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-8 Interest-rate effect Rising price level causes higher nominal interest rates, which causes reduction in certain kinds of consumption and investment spending — most importantly, investment spending

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-9 Real-balances effect Also known as ‘wealth effect’ At a higher price level, the real value or purchasing power of the accumulated financial assets held by the public falls (real wealth falls), leading to a fall in consumption spending

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-10 Foreign-purchases effect Higher domestic prices cause the relative price of foreign goods (local goods) to decrease (increase) This causes increased imports and decreased exports, resulting in a fall in net exports

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-11 Deriving the AD curve Aggregate expenditure model –Drawn at a constant price level Aggregate demand model –Real GDP at various price levels

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-12 (C + I + G + NX) 2 at P 2 (C + I + G + NX) 2 at P 3 The aggregate demand can be constructed Deriving the AD curve (cont.) Spending (billions of dollars) 0 0 Price level Real GDP P1P1 (C + I + G + NX) 1 at P 1 1′1′ 1 GDP 1 P2P2 GDP 2 2 2′2′ 3 P3P3 GDP 3 3′3′

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-13 Non-price determinants of aggregate demand Results in shift in the AD curve Changes in consumer spending –Consumer wealth –Consumer expectations –Consumer indebtedness –Taxes

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-14 Non-price determinants of aggregate demand (cont.) Changes in investment spending –Interest rates –Profit expectation on investment projects –Business taxes –Technology –Degree of excess capacity Changes in government spending

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-15 Non-price determinants of aggregate demand (cont.) Changes in net export spending Growth in foreign GDP The level of the exchange rates

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-16 Changes in aggregate demand 0 Price level Real gross domestic output AD 1 AD 3 AD 2 Increase in AD Decrease in AD

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-17 Aggregate expenditure shifts & aggregate expenditures Shifts in the aggregate expenditure curve caused by changes in the non-price determinants of consumption, investment, and exports will shift the entire aggregate demand curves rightwards or leftwards Degree of shift affected by the multiplier Shift in AD = change in spending times the multiplier

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-18 Shifts in AD and AE 0 Spending (billions of dollars) 0 Price level P1P1 AD 1 GDP 1 GDP 2 AD 2 Real GDP GDP 1 (C + I + G + NX) 1 at P 1 GDP 2 (C + I + X + G) 2 at P 1 AS Real GDP GDP 1 (C + I + G + NX) 1 at P 1 GDP 2 (C + I + X + G) 2 at P 1 AS Real GDP Spending (billions of dollars) 0 Price level P1P1 AD 1 GDP 1 GDP 2 AD 2 Real GDP GDP 1 (C + I + G + NX) 1 at P 1 GDP 2 (C + I + X + G) 2 at P 1 AS Real GDP Spending (billions of dollars) 0 Price level P1P1 AD 1 GDP 1 GDP 2 AD 2 Real GDP Spending (billions of dollars) 0 Price level P1P1 AD 1 GDP 1 GDP 2 AD 2 Real GDP Spending (billions of dollars) 0 Price level P1P1 AD 1 GDP 1 GDP 2 AD 2 Real GDP

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-19 Aggregate supply (AS) Indicates the level of real GDP that will be produced at each possible price level There is a direct or positive relationship between the price level and real GDP

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-20 Short-run period ‘Short run’ is a period in which input prices, particularly nominal wages, remain fixed while other prices change Input prices are fixed due to –Workers not being aware of higher or lower prices –The existence of fixed wage contracts

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-21 Long-run period This is a period in which input prices (wages etc.) are fully responsive to changes in the price level Workers are freed from existing wage contracts and can negotiate new nominal wages and salaries

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-22 Short-run aggregate supply curve Upward sloping and is constructed on the basis of two assumptions: –A given price level –Nominal wages have been established and remain constant on the expectations that the given price level will persist

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-23 Long-run aggregate supply The long-run aggregate supply curve is vertical at the level potential output consistent with the economy’s natural rate of unemployment

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-24 Short-run AS AS 1 Price level Real gross domestic output 0 P1P1 A1A1 QPQP P3P3 A3A3 Q3Q3 P2P2 A2A2 Q2Q2 AS 1 P2P2 A2A2 Q2Q2

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-25 Long-run AS Price level Real gross domestic output, GDP 0 P3P3 P1P1 P2P2 A1A1 C1C1 B1B1 AS LS QPQP AS 3 AS 1 AS 2 A3A3 A2A2

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-26 Determinants of AS Changes in input prices –Domestic resource availability  Land  Labour  Capital  Entrepreneurial ability –Prices of imported resources –Market power

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-27 Non-price determinants of AS (cont.) Changes in productivity: –Productivity = real output/input Changes in the legal and institutional environment –Business taxes and subsidies –Government regulation Changes in these determinants shift the AS curve

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-28 Changes in short-run AS Real gross domestic output 0 AS 1 AS 2 Price level Decrease in Short-run AS AS 3 Increase in Short-run AS

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-29 Changes in long-run AS 0 Price level Real gross domestic output AS LS1 QPQP AS LS2 QPQP Decrease in long-run AS

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-30 Changes in long-run AS Price level Real gross domestic output, GDP 0 QPQP QPQP AS LS3 Increase in long-run AS

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-31 Equilibrium Intersection of AS and AD determines equilibrium real GDP and the price level At all other points there will be pressure on real GDP and/or prices to change

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-32 AS LS QpQp AS Equilibrium real GDP and equilibrium price level Price level Real domestic output AD QeQe PePe Q1Q1 P3P3 Q2 Q2 P2P2

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-33 Shift in aggregate demand and the price level The effects of an increase in aggregate demand on the price level depend upon the position of the short-run aggregate supply in which it occurs Demand-pull inflation is a situation of rising prices due to shift in AD

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-34 Effects of an increase in AD AD 2 AD 3 AS LS QpQp AD 1 AS Q2Q2 Real gross domestic output Q1Q1 Q2Q2 P1P1 Price level P2P2 P3P3 Low employment and the price level

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-35 Effects of an increase in AD AS LS QpQp Price level Real gross domestic output AD 3 High employment and the price level Q3Q3 P3P3

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-36 Ratchet effect The result of the tendency for prices of both products and resources to be individually ‘sticky’ or inflexible in a downward direction, leading to a loss in downward flexibility of the general level of prices

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-37 Downward price inflexibility Causes Wage inflexibility Employers’ interests Monopoly power Menu costs

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-38 Shift in aggregate supply and the price level Causes Higher production costs shift the AS leftwards, resulting in higher prices and lower real GDP Leads to cost-push inflation Adverse shifts in the aggregate supply result in stagflation, a situation of simultaneous higher prices and higher unemployment

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-39 Effects of a decrease in AS AS LS QpQp Price level Real domestic product AS 1 AD Q1Q1 Q2Q2 P1P1 P2P2 AS 2

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-40 Effects of an increase in AS AS LS QpQp Price level Real domestic output, GDP AS 1 AD QeQe P1P1 P3P3 Q3Q3 AS 3

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-41 Price-level changes and the multiplier Shifts of AD in the –Horizontal range = Full multiplier effect –Intermediate range = Reduced multiplier effect –Vertical = No multiplier effect

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-42 Multiplier and the price level Real gross domestic product Q1Q1 P1P1 P3P3 } Full multiplier Q2Q2 Price level AS AD 2 AD 1

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 7-43 Multiplier and the price level Price level Q1Q1 Q2Q2 AD 2 P1P1 P3P3 Q3Q3 Real domestic output, GDP AD 3 AS } Reduced multiplier Q4Q4