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Aggregate Demand and Aggregate Supply.

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Presentation on theme: "Aggregate Demand and Aggregate Supply."— Presentation transcript:

1 Aggregate Demand and Aggregate Supply

2 I. AD/AS Model To Analyze changes in real GDP & price level simultaneously Provides insights on inflation, unemployment, & economic growth Aggregate Demand Amounts of real output Buyers collectively desire At each possible price level Aggregate Supply Levels of real domestic output firms will produce

3 II. Aggregate Demand Curve
Income & substitution effects do not apply AD Curve – negative slope Real-Balances effect Higher price level means real value of savings decreases Thus lowering consumption Interest-rate effect High demand for $ leads to high interest rates High interest rates limit investment spending Thus leads to less real output Foreign purchases effect US price level up then foreigners buy less US goods

Price level AD Real domestic output, GDP

Can Increase Price level AD2 AD1 Real domestic output, GDP

Can Increase …or Decrease Price level AD1 AD3 Real domestic output, GDP

7 Determinants of AD Change in consumer spending (C)
Wealth effect Consumer expectations Household indebtedness Personal income taxes Change in investment spending (Ig) Real interest rates Expected returns Future business conditions Technology Degree of excess capacity Business taxes Change in government spending (G) Net export spending (Xn) National income abroad Exchange rates

8 III. Aggregate Supply Long-run AS curve Short-run AS curve
Vertical at full-employment level of real GDP Resource prices adjust to changes in PL – no incentive for firms to change output Short-run AS curve Upward sloping Rise in price level increases real output Lag between product prices & resource prices make it profitable for firms to increase output when PL rises

9 AGGREGATE SUPPLY Short Run AS Aggregate Supply Short-run Price level
Full- Employment Qf Real domestic output, GDP

10 AGGREGATE SUPPLY Changes in Aggregate Supply Decrease In Aggregate
Price level Increase In Aggregate Supply Real GDP

11 AGGREGATE SUPPLY Long Run ASLR Price level Long-run Aggregate Supply
Full-Employment Qf Real GDP

12 Three Segmented AS Curve [16]
AS - amount of real output firms will produce at each PL. Higher price levels provide an incentive to produce more. AS has three ranges: 1. Horizontal (Keynesian) 2. Intermediate 3. Vertical (Classical) Three Segmented AS Curve [16] AS Vertical [Classical] Range Horizontal [Keynesian] Range Price level Upsloping or Intermediate Range Q Real domestic output, GDP

13 IV. Determinants of AS Input prices Domestic
Land Labor Capital Prices of imported resources Market power (OPEC)

14 Productivity = Total output/total inputs
Legal-institutional environment Business taxes and subsidies Government regulation

P AS Price Level Equilibrium Real Output 100 a b 92 AD Q 502 510 514 Real Domestic Output, GDP

Price Level P1 Q Qf Q1 Q2 Real Domestic Output, GDP [“Good News” – more jobs; “Bad News” – higher prices]

b a P1 Price Level c Q Q1 Qf Real Domestic Output, GDP [“Good News”–lower prices; “Bad News”–job losses]

18 [“bad news” – job losses; “bad news” – inflation]
DECREASES IN AS: COST-PUSH INFLATION AS2 P AS1 P2 b Price Level a P1 AD1 Q Q1 Qf Real Domestic Output, GDP [“bad news” – job losses; “bad news” – inflation]

19 V. “Sticky Prices” – prices inflexible (rigid) in a downward direction
Wage Prices Morale, effort, productivity Minimum wage Menu costs Fear of price wars

20 Bath Tub Approach to Economics
Consumption Investment Gov. Spending Exports Full Employment [Frictional & structural] Injections Income Employment Output *Classicals – “A leakage down the drain of saving is returned thru the spigot of investment.” Saving Taxes Imports Leakages An economy in equilibrium at FE

21 Review of the Marginal Propensities
If consumption increases from 465 to 480 and disposable income increases from 490 to 510. What is the marginal propensity to consume? If the marginal propensity to consume is 0.8 then what is the marginal propensity to save? Why will the MPC + MPS always equal 1? 15/20 = .75 MPS = 0.2 Consuming or saving is an either-or proposition

22 Aggregate Expenditures Model
Keynesian Cross Model

23 Building “Mult” = 4 [C + Ig] Private-closed [C + Ig + Xn] Private-open
[Simple [Basic] economy to Complex economy] [C + Ig] Private - closed Private-closed [C + Ig + Xn] Private-open Private-open [C+Ig+G+Xn] Mixed - open Mixed-open AE3 (C+Ig+G+Xn) (Complex Economy) [Mixed-open] (AE3)630 AE2 (C+Ig+Xn) (Private-open) [X(40)-M(20)] (AE2)550 +20 G AE1(C+Ig)[Basic Economy][Private(no G)-Closed(no X or M)] +20 Xn (AE1)470 Consumption AE(C+Ig+G) +20 Ig AE(C+Ig1) C=390 AE(C+Ig+G) +80 +80 +80 10 G Real GDP Real GDP “Mult” = 4 YR Y*

24 I. AE Model / Keynesian Cross Model
Aggregate Expenditures means total spending When AE fall – Total output & employment decrease When AE rise – Total output & employment increase

25 II. Mixed Economy AE = C + Ig + G + Xn
Increase in public spending shifts AE upward & produces higher equilibrium GDP In a mixed economy the Savings (Leakages) = planned investment (Injections) Sa + M + T = Ig + X + G Lump-sum tax (constant at each level of GDP) – Reduces C & S Proposed balanced budget requirement (G spending = G revenue) would eliminate discretionary fiscal policy Balance budget multiplier = 1 (equal increases in G & T) AE shift is equal to change in G or T

26 FULL-EMPLOYMENT GDP Recessionary Gap Recessionary Gap = $5 Billion
AE0 530 510 490 AE1 Recessionary Gap = $5 Billion Aggregate Expenditures (billions of dollars) Full Employment 45 o o Real domestic product, GDP (billions of dollars)

27 FULL-EMPLOYMENT GDP Inflationary Gap Inflationary Gap = $5 Billion
AE2 Inflationary Gap = $5 Billion AE0 530 510 490 Aggregate Expenditures (billions of dollars) Full Employment 45 o o Real domestic product, GDP (billions of dollars)

28 III. Limitations No price-level changes
Ignores premature demand-pull inflation Limits real GDP to the full-employment level of output Ignores cost-push inflation Does not allow for self-correction

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