1. Aggregate Demand (AD) and Aggregate Supply (AS)
Chapter 29
Aggregate Demand (AD) and Aggregate Supply (AS)

2. Learning objectives AD and the factors that cause it to change
AS and the factors that cause it to change
How AD and AS determine an economy’s equilibrium price level and level of real GDP
How the AD-AS model explains periods of demand-pull inflation, cost-push inflation, and recession
GUARANTEED TO BE A MAJOR EMPHASIS ON THE AP MACRO EXAM!

3. First, Let’s look at a couple of multipliers: The Tax Multiplier
Simply: -MPC/MPS (ex: -.8/.2 = tax multiplier of -4)
If MPC=.8 and Lump-Sum Tax increase = $10 billion, then RGDP declines by $40 bil = ($10 bil x -4)
Rationale: C is reduced by the lump-sum tax amount multiplied by the MPC, not by full multiplier (of 5 in the example…why? Because a portion of the tax is “paid for” by a reduction in S.)
If MPC = .8 and lump-sum tax = $10 billion,
C is reduced by ($10 billion X .8) = $8 billion.
S is reduced by $2 billion.
so, -$8 X multiplier of 5 = -$40 bil RGDP
Change in C = MPC x lump sum tax amount

4. The Balanced Budget Multiplier
Equal increases in G and T (to maintain a balanced budget) will increase GDP by the amount of the increase in G (or T.)
For example: +10 G and +10 T, GDP +10
Rationale: Government spending has a direct impact on AE while taxes affect AE indirectly by changing DI.
Convince yourself: work out the change in GDP given MPC = .75 and G and T both increasing by $20 billion.
The balanced budget multiplier = 1

5. Aggregate Demand (AD)
A schedule or curve showing various amounts of g/s that domestic consumers, businesses, government and foreign buyers collectively desire to purchase at each price level (PL).
Why does it slope downward?
Wealth Effect (Real-Balances Effect)—higher price level reduces purchasing power of the public’s accumulated financial assets.
Interest Rate Effect—As prices increase, so does the price of money, interest rates.
Foreign Purchases Effect—an increase in a nation’s price level reduces its net export level.
Explains movement along the AD curve…price level changes change output demanded!

6. Determinants of AD— “shifters”
1. Consumer Spending, even at constant prices, consumers sometimes alter their spending.
Consumer wealth
Consumer expectations
Household indebtedness
Taxes
2. Investment Spending
Interest rates
Expected returns on investment projects
Business taxes
Technology
Degree of excess capacity

7. 3. Government Spending (assume no changes in T or RIR)
4. Net Export Spending
National income abroad—rising NI levels in foreign nations increase foreign demand for U.S. goods.
Exchange rates
Preferences
Don’t forget: Any spending shift is subject to multiplier effect…(to some extent at least…more analysis required once we’re done with the model!)
Shift in AD = change in spending X multiplier

8. Aggregate Supply (AS)
A schedule or curve showing the level of real domestic output (GDP) that will be produced at each price level. There is a direct relationship between the price level and the amount of real output businesses offer for sale.
The AS curve reflects what happens to per unit production costs as GDP expands.
The AS curve has three ranges…

9. Intermediate (Upsloping) Range – SRAS
Horizontal Range
Implies recession and idle resources—output can be increased without pushing up prices because per unit production costs do not increase.
Real output and employment may fall, but prices and wages stay constant (prices and wages are inflexible downward.)
Intermediate (Upsloping) Range – SRAS
An expansion of output is accompanied by an increase in prices (per unit production costs are increasing.)
Some industries are at capacity while others are not.
Vertical Range – LRAS
The economy is at full capacity. Price increases will not increase output.
Attempts to increase production cause resource prices to be “bid up” and transferred from one producer to another.

10. Determinants of AS (“shifters”)
Each determinant change will affect per unit production costs at each price level.
Input Prices (resource prices)
Domestic resource availability—supply increase drops resource prices, AS shifts to the right.
Land
Labor
Capital
Entrepreneurial ability
Prices of imported resources, exchange rates
Market power of resource suppliers
Labor unions
OPEC

11. Legal-Institutional Environment
Productivity—by reducing per unit production cost, an increase in productivity shifts the AS curve rightward. Increases in productivity allow an economy to expand output without increasing prices (1990’s expansion!)
Example…
Legal-Institutional Environment
Business Taxes and Subsidies
Government Regulation/Deregulation
Study & bookmark pages to review AD/AS determinants!

12. Equilibrium: real output and the price level
Shifts of the AD curve—three possible intersection points:
In the horizontal range, only output changes
In the intermediate range, both price and real output change
In the vertical range, only price changes
Increases in AD in the intermediate and vertical range represent demand-pull inflation

13. Shifting of AS
Decrease in AS leads to cost-push inflation and lower employment
Increase in AS leads to lower prices and increased employment.

14. Multiplier with price level changes
If the economy is in the horizontal range, any initial change in spending transmits fully into a change in real GDP and employment. The full strength multiplier works.
If the economy is in either the intermediate or vertical range, part or all of any initial increase in spending (AD) will be dissipated by inflation. Inflation reduces the multiplier.
For any initial increase in AD, the resulting increase in real GDP will be smaller the greater the increase in the price level. (reduced by inflation)

15. Ratchet effect
Assumption: All prices (both product and resource prices) are inflexible downwards.
Graph…
Causes of downward price level inflexibility:
Wage contracts
Morale, effort and productivity (“efficiency wages”—that elicit maximum output and minimize labor costs per unit of output.)
“menu” costs
Minimum wage laws
Fear of price wars