1. Chapter 10 Aggregate Demand & Supply
ECON 201
Chapter 10
Aggregate Demand & Supply

2. Review
Chapter 3 talked about Demand & Supply, but it was discussed in terms of the price of one item.
2 items that greatly effected them were the income effect and the substitution effect.
Aggregate Demand & Supply deal with the prices of all products overall.

3. Aggregate demand (AD)-Aggregate Supply (AS) Models
Used in discussion of
Unemployment
Inflation
Economic growth
Determine an economy’s equilibrium price level and level of real GDP
AD-AS model explains periods of demand-pull inflation, cost-push inflation, and recession

4. Aggregate Demand
A schedule or curve that shows the various amounts of real domestic output (GDP) that domestic & foreign buyers will desire to purchase at each possible price level.
Shows an inverse relationship between price level and Real Domestic Output

5. Aggregate Demand Curve
Fig 10.1 on pg 188
Aggregate
Demand
Price Level AD
Real Domestic Output, GDP

6. Specific items that cause the AD curve to slope downward
Real-balances effect: higher price levels reduce the purchasing power of consumers. Which means that higher prices reduce consumption spending
Interest-rate effect: with a fixed supply of money, an increase in the demand for money means that the cost of the money goes up… that cost is the interest rate.

7. Specific items that cause the AD curve to slope downward
Foreign-purchases effect: when prices in the US rise, foreigners buy fewer US goods, and we buy more from foreigners. That means that as prices go up here, we export fewer things and import more things….so we have a bigger trade deficit.

8. Determinates (other things – besides price level that can cause a shift) of Aggregate Demand (AD)
1. Changes in Consumer Spending
Consumer wealth
Consumer Expectations
Household debt
Taxes
Aggregate
Demand
Price Level AD
Real Domestic Output, GDP

9. Determinates of AD 2. Changes in Investment Spending
Interest rates: an increase in real interest rates will lower investment spending & reduce aggre. demand
Expected Returns: if you expect higher returns, the demand for capital will shift the curve to the right.
Aggregate
Demand
Price Level AD
Real Domestic Output, GDP

10. Determinates of AD 3. Changes in Government Spending.
4. Changes in Net Export spending unrelated to price level.
Can be caused by changes in :
National Income
Exchange Rates
Aggregate
Demand
Price Level AD
Real Domestic Output, GDP

11. Aggregate Supply (AS)
Schedule or curve showing the level of real domestic output available at each possible price level.
AS – in the long run
AS – in the short run

12. Aggregate Supply in the Long Run
AS Curve is vertical at the economy’s full-employment output.
Vertical – because in the long run, resources prices adjust to changes in the price-level, leaving no incentive for firms to change their output.
ASLR
Price Level
Long Run
Aggregate
Supply
Real Domestic Output, GDP

13. Aggregate Supply (AS) in the Short Run (Qf – full-employment output)
Price Level Qf
Real Domestic Output, GDP

14. Short Run (references to “aggregate supply” from now on in the chapter refer to short run curve)
To the left of full-employment output, the curve is relatively flat. The relative abundance of idle inputs means that firms can increase output without substantial increases in production costs
To the right of full employment output the curve is relatively steep. Shortages of inputs and production bottlenecks will require substantially higher prices to induce firms to produce.
Aggregate Supply
(Short Run)
Price Level Qf
Real Domestic Output, GDP

15. Determinants of AS
Determinants are the “other things” besides price level that cause changes or shifts in aggregate supply.
1. A change in input prices, which can be caused by changes in several factors:
Domestic resource prices
Prices of imported resources
Market power in certain industries
Aggregate Supply
(Short Run)
Price Level Qf
Real Dom. Output, GDP

16. Determinants of AS
Changes in productivity (productivity = real output / input)
If productivity rises, unit production costs will fall. This can shift aggregate supply to the right and lower prices. The reverse is true when productivity falls. Productivity improvement is very important in business efforts to reduce costs.

17. Productivity Major determinate of Aggregate supply.
Measure of the relationship between a nation’s level of real output and the amount of resources used to produce that output.
Measure of average real output, or of real output per unit of input.

18. Understanding Productivity
Total Output
Total Inputs =
Total Output
Total Inputs = 10 5 2
Per-Unit
Production Cost
Total Input Cost
Units of Output =

19. Other Determinants of AS
Change in legal/institutional environment, which can be caused by changes in other factors.
Business taxes and/or subsidies
Government regulation.

20. Equilibrium: Real Output and the Price Level
Equilibrium price and quantity are found where the aggregate demand and supply curves intersect. AS
Price Level
Equilibrium
100 92 a b AD
502
510
514
Real Domestic Output, GDP
(Billions of Dollars)

21. Increase in AD: Demand Pull Inflation
When the price level is being pulled up by the increase in the demand.
Example: If the government increases their spending beyond what the full-employment level is, this can cause inflation.

22. Real Domestic Output, GDP
Demand Pull Inflation
Increase in Aggregate Demand AS
Demand-Pull
Inflation P2
Price Level P1
AD1 AD Qf Q1 Q2
Real Domestic Output, GDP

23. Decrease in AD: Recession & Cyclical Unempl.
When the price level is being pulled up by the increase in the demand.
Example: If the government increases their spending beyond what the full-employment level is, this can cause inflation.

24. Recession & Cyclical Unempl.
Decrease in Aggregate Demand AS
Price Level b P1 a P2 c
Creates a
Recession
AD1
AD2 Q1 Q2 Qf
Real Domestic Output, GDP

25. Why don’t prices go down?
Fear of price wars: if we lower our prices, others will go even lower.
Menu costs: re-pricing inventory, advertising new prices, printing new catalogs
Wage Contracts: union agreements
Morale & productivity: lowering wages hurts morale and reduces productivity
Minimum wage: we can’t lower wages

26. Decrease in AS: Cost-Push Inflation
When the price level is being pushed up by higher price levels.
Example: a major terrorist attack disrupts the supply of oil to the world. We are very close to this right now.

27. Real Domestic Output, GDP
Cost-Push Inflation
Decrease in Aggregate Supply
AS1 AS
Cost-Push
Inflation b P2
Price Level a P1 AD Q1 Qf
Real Domestic Output, GDP

28. Increase in AS: Full employment & Price Stability
Prices go up, but so does output.
Demand also goes up, so everything is positive!

29. Real Domestic Output, GDP
It’s all good!
AS1
AS2 P3 b P2 c P1 a
Price Level
AD2
AD1 Q1 Q2 Q3
Real Domestic Output, GDP

30. End