# Aggregate Demand/Aggregate Supply

## Presentation on theme: "Aggregate Demand/Aggregate Supply"— Presentation transcript:

Aggregate Demand/Aggregate Supply
The Alpha and Omega of Macroeconomics Graphs

Production Possibilities Curve/Gross Domestic Product Connection
.A Assume this economy is fully employing all of its resources in the least costly way (Productive Efficiency) and chooses to produce at point “A” (Allocative Efficiency) Assume this economy can produce 5 Capital goods and services And 10 consumption goods and services Assume one capital G/S costs \$5.00 and 1 consumption G/S costs \$1.00 What is this economy’s GDP? Capital 5 Aggregate Demand/Aggregate Supply 10 LRAS Consumption Price Level 5 Capital G/S X \$5.00 = \$25.00 10 Consumption G/S x \$1.00 = \$10.00 GDP - \$35.00 This GDP represents Full-Employment or “Potential GDP”. \$35 FE ***Point “A” on the PPC is the same thing as Full Employment Real GDP Represented by LRAS – only expressed In \$\$\$\$\$\$*** Real GDP

LRAS Price Level Real GDP
Real GDP FE RGDP Between 0 and FE RGDP is a large range of Dollar value of GDP. EVERYONE of these Points to the LEFT of FE RGDP will represent RGDP values that are LESS than our Full-Employment POTENTIAL RGDP.

LRAS Price Level Real GDP
Real GDP FE RGDP REMEMBER: To Calculate RGDP we take Nominal GDP (Price x Quantity) and factor out changes in Price relative to a base year.

This is ACTUAL RGDP This is POTENTIAL RGDP
LRAS Price Level PL1 Real GDP RGDP1 FE RGDP This is ACTUAL RGDP This is POTENTIAL RGDP

LRAS Price Level PL1 Real GDP
RGDP1 FE RGDP If the economy was producing this amount of RGDP relative to the FE RGDP it is in serious trouble. It is way inside its productive capacity. Resource prices (Input prices) and wage rates are going to be low because there is VERY high Unemployment and a high supply of unused resources (Inputs)

LRAS Price Level PL1 Real GDP
RGDP1 RGDP2 FE RGDP If we move to the production of RGDP2 we can see the economy is using MORE of its slack resources to produce RGDP (Inputs AND people) BUT the Price Level is steady…This is because we STILL have relatively HIGH Unemployment and there is still enough slack resources to keep their prices Low.

This will continue over a range of RGDP production…
LRAS Price Level PL1 Real GDP RGDP1 RGDP2 RGDP3 FE RGDP This will continue over a range of RGDP production…

LRAS Price Level PL1 Real GDP
RGDP1 RGDP2 RGDP3 RGDP4 FE RGDP This will continue over a range of RGDP production until we come to this next important point…

LRAS Price Level PL1 Real GDP
RGDP1 RGDP2 RGDP3 RGDP4 RGDP5 FE RGDP What we have constructed so far is a range of production of RGDP that the economy CAN produce, but is not desirable…In the LONG RUN we hope to be at FE RGDP, but because of the current conditions the economy, in the SHORT RUN, can produce any one of these RGDP levels

LRAS Price Level PL1 Real GDP
RGDP1 RGDP2 RGDP3 RGDP4 RGDP5 FE RGDP Hence, we have ONE part of our SHORT RUN AGGREGATE SUPPLY CURVE---The Horizontal, or Keynesian, Range.

This will continue over a range of RGDP production…UNTIL….
LRAS Price Level PL1 Real GDP RGDP1 RGDP2 RGDP3 RGDP4 RGDP5 FE RGDP This will continue over a range of RGDP production…UNTIL….

LRAS Price Level PL2 PL1 Real GDP
RGDP1 RGDP2 RGDP3 RGDP4 RGDP5 RGDP6 FE RGDP …We reach RGDP6…Notice that NOW the Price Level INCREASES to PL2…As we move closer to FE RGDP we are getting to LOWER levels of Unemployment and are using more input resources so now these limited resources are beginning to become MORE scarce. When inputs and wages start to rise, what happens to the Cost of Production?? INCREASES…

LRAS Price Level PL3 PL2 PL1 Real GDP
RGDP1 RGDP2 RGDP3 RGDP4 RGDP5 RGDP6 RGDP7 FE RGDP Producers need to get a higher price to reflect the increasing input costs. The Producers will INCREASE the Quantity Supplied of RGDP when the Price Level INCREASES…

THIS POINT IS VERY IMPORTANT!!!!
LRAS Price Level PL4 PL3 PL2 PL1 Real GDP RGDP1 RGDP2 RGDP3 RGDP4 RGDP5 RGDP6 RGDP7 FE RGDP RGDP8 THIS POINT IS VERY IMPORTANT!!!!

LRAS Price Level PL4 PL3 PL2 PL1 Real GDP
RGDP1 RGDP2 RGDP3 RGDP4 RGDP5 RGDP6 RGDP7 FE RGDP RGDP8 At this point, ACTUAL RGDP is EQUAL to POTENTIAL RGDP…This economy’s ability to Produce RGDP in the SHORT RUN is now EQUAL to the Economy’s ability to Product RGDP in the LONG-RUN…

LRAS Price Level PL5 PL4 PL3 PL2 PL1 Real GDP RGDP1 RGDP2 RGDP3 RGDP4 RGDP5 RGDP6 RGDP7 FE RGDP RGDP9 RGDP8 What about this NEXT point? Can our economy produce at this point?

LRAS Price Level PL5 PL4 PL3 PL2 PL1 Real GDP
RGDP1 RGDP2 RGDP3 RGDP4 RGDP5 RGDP6 RGDP7 FE RGDP RGDP9 IN THE SHORT RUN it can, but it will NOT be sustainable…Now Unemployment is BELOW the Natural Rate of Unemployment and Inputs are very scarce. The pressure on wages will INCREASE. The economy is up against a wall. There will not be any increase in Quantity Supplied at this point. RGDP8

LRAS Price Level PL5 PL4 PL3 PL2 PL1 Real GDP
RGDP1 RGDP2 RGDP3 RGDP4 RGDP5 RGDP6 RGDP7 FE RGDP RGDP9 RGDP8 This Range of the SHORT RUN AGGREGATE SUPPLY CURVE is called the INTERMEDIATE RANGE…

LRAS Price Level PL6 PL5 PL4 PL3 PL2 PL1 Real GDP
RGDP1 RGDP2 RGDP3 RGDP4 RGDP5 RGDP6 RGDP7 FE RGDP RGDP9 RGDP8 We have reach the END of this economy’s ability to Produce RGDP….The SHORT RUN AGGREGATE SUPPLY CURVE Becomes VERTICAL and Parallels the LRAS CURVE…

Classical and Keynesian Range mean later….
LRAS Price Level PL7 SRAS Classical Range PL6 PL5 PL4 PL3 PL2 PL1 Real GDP RGDP1 RGDP2 RGDP3 RGDP4 RGDP5 RGDP6 RGDP7 FE RGDP RGDP9 RGDP8 The VERTICAL RANGE of the SRAS Curve is called the Classical Range…More on what the Classical and Keynesian Range mean later….

Classical Range LRAS Price Level PL7 SRAS PL6 PL5 PL4 PL3 PL2 PL1
Real GDP RGDP1 RGDP2 RGDP3 RGDP4 RGDP5 RGDP6 RGDP7 FE RGDP RGDP9 RGDP8 Let’s take away all the “stuff” and see what we are left with….

LRAS Price Level SRAS Real GDP
FE RGDP This is how I like to represent the “SUPPLY-SIDE” of the Economy. There are 3 distinct sections to the SRAS curve and it extends beyond the LRAS curve and then becomes vertical again….This just shows that an economy CAN produce beyond it productive capacity, but does so at it’s peril…Now we will insert an Aggregate Demand Curve and start with serious analysis on the economy.

Aggregate Supply (AS) Shifters Changes in spending not caused by Price Level
Changes in INPUT prices for land, labor, capital, and entrepreneurship THE FACTORS OF PRODUCTION 1. Before the Change 2. The change 3. After the change Change in Market Power (unions, presence of monopolies) Change in Productivity Change in Government policies – business taxes, subsudies, regulations Change in value of currency (AS) Price Level GDP (AS) Price Level GDP (AS) Price Level GDP (AS) Price Level GDP

Aggregate Demand /Aggregate Supply
Price Level SRAS SRAS1 Real GDP Unions grow more aggressive; wage rate increases.

Aggregate Demand /Aggregate Supply
Price Level SRAS SRAS1 Real GDP OPEC successfully increases oil price

Aggregate Demand /Aggregate Supply
Price Level SRAS SRAS1 Real GDP Labor productivity increases dramatically

Aggregate Demand /Aggregate Supply
Price Level SRAS SRAS1 Real GDP Giant natural gas discovery decreases energy prices.

Aggregate Demand /Aggregate Supply
Price Level SRAS SRAS1 Real GDP Computer technology brings new levels of efficiency to industry.

Aggregate Demand /Aggregate Supply
Price Level SRAS SRAS1 Real GDP Research shows that improved schools have increased the skills of American workers and managers.

Aggregate Demand /Aggregate Supply
Price Level SRAS SRAS1 Real GDP Government increases regulation of industry to address pollution problem

Aggregate Demand /Aggregate Supply
Price Level SRAS SRAS1 Real GDP The dollar depreciates in foreign exchange markets

Aggregate Demand /Aggregate Supply
Price Level SRAS SRAS1 Real GDP President announces cuts in farm and business subsidies.

Aggregate Demand /Aggregate Supply
Price Level SRAS SRAS1 Real GDP Business taxes fall.

Aggregate Demand /Aggregate Supply
Price Level SRAS SRAS1 Real GDP New low-cost means of extracting oil from shale is discovered

Introduction to Aggregate Demand

Why is Aggregate Demand Curve Downward Sloping
AD GDP Price Level According to the AD curve, what is the relationship between Price Level and Real GDP? There is an inverse relationship; the lower the price level, the higher the Real GDP or real output.

Why is Aggregate Demand Curve Downward Sloping
AD GDP Price Level Explain how each of the following effects helps explain why the AD curve is downward sloping? Interest Rate Effect A lower price level decreases the demand for money, which decreases the interest rate and increases investment and interest sensitive components of consumption and, therefore, Real GDP or real output.

Why is Aggregate Demand Curve Downward Sloping
AD GDP Price Level Wealth Effect or Real Balance Effect As the price level falls, cash balances will buy more so people will spend more, thus increasing Real GDP or Real Output.

Why is Aggregate Demand Curve Downward Sloping
AD GDP Price Level Net Export or International Trade Effect A lower U.S. price level means prices for goods produced in the U.S. are lower relative to the prices in foreign countries. Thus people will buy more U.S. produced goods and fewer foreign produced goods. This increases net exports, a component of GDP

Aggregate Demand (AD) Shifters Changes in spending not caused by Price Level
1. Before the Change 2. The change 3. After the change Change in Net Exports (Nx) caused by a change in national income abroad, or exchange rate of money Change in Government (G) spending Change in Investment (I) caused by a change in interest rates, profit expectations, business taxes, technology, or excess capacity Change in consumer spending (C) caused by a change in wealth, expectations, indebtedness, personal taxes Pl Pl Price Level Price Level (AD) (AD) GDP GDP Price Level (AD) GDP Price Level (AD) GDP Price Level (AD) GDP

Bottom Line of Aggregate Demand (AD)
Aggregate Demand is driven by the Components of GDP AD = C + I + G + N(x) When one of these variables change, either positively or negatively (increase or decrease), AD curve will move right or left

Aggregate Demand Shifts
In the slides that follow, read the situation and determine if it causes an increase, decrease or no change in AD. DO NOT CLICK ON THE YELLOW BARS. They are hot linked and will take you to a different part of the PPT. Just choose in your mind the direction you think AD will shift

Situation: Congress cuts taxes.

Situation: Investment spending decreases.

Situation: Government spending increases; President promises no tax increases.

Situation: Survey shows consumer confidence jumps.

Situation: Stock market collapses; investors lose billions.

Situation: Productivity rises for the fourth straight year.

Situation: President/Congress cut defense spending by 20 percent; no increase in domestic spending.

Situation: Consumer indebtedness rises.

Situation: Dollar appreciates in foreign exchange markets.

Situation: The price of imported resources skyrockets.

Situation: Consumers expect the price level to rise.

Situation: Consumer wealth plummets as stock prices fall.

Situation: Excess plant capacity decreases significantly.

Situation: Interest rates rise.

Situation: Foreign incomes fall.

Situation: Dollar value depreciates in foreign exchange markets.

PL1 LRAS SRAS Price Level Real GDP Unemployment Rate 15%(?)
This AD/AS Model of the Economy shows an economy in TROUBLE…Aggregate Demand is intersecting Aggregate Supply on the HORIZONTAL section of SRAS...This economy is in a SEVERE RECESSON boardering on a DEPRESSION. PL1 AD1 FE RGDP RGDP1 Real GDP Unemployment Rate 15%(?)

PL1 LRAS SRAS Price Level
This means it is currently producing a RGDP that is WAY inside its ability to produce RGDP . PL1 AD1 FE RGDP RGDP1 Real GDP A VERY large Recessionary Gap Unemployment Rate 15%(?)

PL1 LRAS SRAS Price Level Real GDP
AD1 AD2 PL1 FE RGDP RGDP1 RGDP2 Real GDP Aggregate Demand INCREASES from AD1 to AD2 Still a LARGE Recessionary Gap But not a large as before Unemployment Rate 10%(?)

PL1 LRAS SRAS Price Level Real GDP

PL1 LRAS SRAS Price Level

PL1 LRAS SRAS Price Level
Between RGDP1 and RGDP3 there are lots of under-employed resources ( excess inventories) AND PEOPLE---Unemployment is very high..When unemployment and Inventories are high there is little to NO pressure on prices to increase because there is plenty of “slack resources”. Even though RGDP is Increasing the is no upward pressure on the Price Level over this range of RGDP. AD3 AD1 AD2 PL1 FE RGDP RGDP1 RGDP2 RGDP3 Real GDP Aggregate Demand INCREASES from AD2 to AD3 The Recessionary Gap Is shrinking…

PL1 LRAS SRAS Price Level
BUT….the story changes as the economy moves to AD4 . RGDP INCREASES but so does the PRICE LEVEL….As we approach Full-Employment (closer to where SRAS intersects LRAS) the economy has FEWER slack resources (inventories are decreasing) AND Unemployment is DECREASING more rapidly…There is INCREASING pressure on the PRICE LEVEL to INCREASE… AD3 AD1 AD2 PL2 PL1 AD4 RGDP4 FE RGDP RGDP1 RGDP2 Real GDP RGDP3 Recessionary Gap Unemployment Rate 7%(?)

PL1 LRAS SRAS Price Level
This is NOT dangerous for the Economy at this point…Actually it can be quite healthy…Increasing prices are GOOD for Business and Increasing wages are GOOD for Workers… AD3 AD1 AD2 PL2 PL1 AD4 RGDP4 FE RGDP RGDP1 RGDP2 Real GDP RGDP3 Recessionary Gap

PL1 LRAS SRAS Price Level
As a matter of fact, when AD5 intersects SRAS and LRAS the Economy is considered to be at FULL-EMPLOYMENT---The Sweet Spot for this economy…The total demand for goods and services EQUALS the economy’s ability to produce those goods and services in the Short Run (SRAS) AND the Long Run (LRAS) AD3 PL3 AD1 AD2 PL2 PL1 AD5 AD4 RGDP4 FE RGDP RGDP1 RGDP2 Real GDP RGDP3 RGDP5 Unemployment Rate 5%(?)=NRU

PL1 LRAS SRAS Price Level
At FULL-EMPLOYMENT we have eliminated the Recessionary Gap. A couple of KEY points about this Equilibrium: The economy is at its Natural Rate of Unemployment (Frictional + Structural) with NO cyclical unemployment AD3 PL3 AD1 AD2 PL2 PL1 AD5 AD4 RGDP4 FE RGDP RGDP1 RGDP2 Real GDP RGDP3 RGDP5

“NON-ACCCELERATING INFLATION RATE OF UNEMPLOYMENT
LRAS SRAS At FULL-EMPLOYMENT we have eliminated the Recessionary Gap. A couple of KEY points about this Equilibrium: 2. The Economy is at its: “NON-ACCCELERATING INFLATION RATE OF UNEMPLOYMENT (NAIRU) Fancy way of saying we are “Inflation Neutral” at the Natural Rate of Unemployment (NRU) Price Level AD3 PL3 AD1 AD2 PL2 PL1 AD5 AD4 RGDP4 FE RGDP RGDP1 RGDP2 Real GDP RGDP3 RGDP5

PL1 LRAS SRAS Price Level
If the AD shifts to AD6 the economy has now gone beyond FULL-EMPLOYMENT and is now producing RGDP6 . The unemployment rate is now something LESS than the NRU (wages will start to increase faster)…The Economy is starting to overheat !(Demand for goods and services is GREATER than the economy’s ability to produce goods and services!... PL4 Inflationary Gap AD3 PL3 AD1 AD2 AD6 PL2 PL1 AD5 AD4 RGDP4 FE RGDP RGDP6 RGDP1 RGDP2 Real GDP RGDP3 RGDP5 Unemployment Rate 3%-- less than theNRU

LRAS SRAS If AD increases to AD7 then we have a LARGE increase in PRICE LEVEL with NO increase in RGDP (RGDP7 = RGDP6 ) This economy is in TROUBLE---INFLATION Is the Problem of the Day…. Price Level PL5 Inflationary Gap PL4 AD7 AD3 PL3 AD1 AD2 AD6 PL2 PL1 AD5 AD4 RGDP4 FE RGDP RGDP6 RGDP1 RGDP2 Real GDP RGDP3 RGDP5 RGDP7

Aggregate Demand /Aggregate Supply
Price Level LRAS SRAS What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL1 PL* AD1 AD Fe RGDP RGDP1 Real GDP

Aggregate Demand /Aggregate Supply
Price Level LRAS SRAS What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL* PL1 AD AD1 RGDP1 Fe RGDP Real GDP

STAGFLATION Aggregate Demand /Aggregate Supply Price Level LRAS SRAS
What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL1 PL* STAGFLATION AD RGDP1 Fe RGDP Real GDP

Aggregate Demand /Aggregate Supply
Price Level LRAS SRAS SRAS1 What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL* PL1 AD Fe RGDP RGDP1 Real GDP

Directions for the next set of slides: Analyze the situation or event and determine the effect on AD or short run AS. Shift the appropriate curve and determine change in PL, Real GDP and Unemployment.

Aggregate Demand /Aggregate Supply
Price Level LRAS SRAS What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL1 PL* AD1 AD Fe RGDP RGDP1 Real GDP Congress passes a tax cut for the middle class, and the president signs it.

Aggregate Demand /Aggregate Supply
Price Level LRAS SRAS SRAS1 What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL* PL1 AD Fe RGDP RGDP1 Real GDP New oil discoveries cause large decreases in oil prices

Aggregate Demand /Aggregate Supply
Price Level LRAS SRAS What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL1 PL* AD1 AD Fe RGDP RGDP1 Real GDP The government increases spending on schools, highways, and other public works

STAGFLATION Aggregate Demand /Aggregate Supply Price Level LRAS SRAS
What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL1 PL* STAGFLATION AD RGDP1 Fe RGDP Real GDP Production costs increase nationwide

Aggregate Demand /Aggregate Supply
Price Level LRAS SRAS SRAS1 What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL* PL1 AD Fe RGDP RGDP1 Real GDP New technology and better education increase productivity.

Aggregate Demand /Aggregate Supply
Price Level LRAS SRAS What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL1 PL* AD1 AD Fe RGDP RGDP1 Real GDP A new president makes consumers and businesses more confident about the future economy

Aggregate Demand /Aggregate Supply
Price Level LRAS SRAS What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL1 PL* AD1 AD Fe RGDP RGDP1 Real GDP With the unemployment rate at five percent, the federal government reduces personal taxes and increases spending

Aggregate Demand /Aggregate Supply
Price Level LRAS SRAS What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL1 PL* AD1 AD Fe RGDP RGDP1 Real GDP Foreign incomes increase

Aggregate Demand /Aggregate Supply
Price Level LRAS SRAS What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL* PL1 AD AD1 RGDP1 Fe RGDP Real GDP Excess plant capacity increases.

Aggregate Demand /Aggregate Supply
Price Level LRAS SRAS SRAS1 What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL* PL1 AD Fe RGDP RGDP1 Real GDP Dollar appreciates; relative prices of imported resources fall.

Aggregate Demand /Aggregate Supply
Price Level LRAS SRAS What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL* PL1 AD AD1 RGDP1 Fe RGDP Real GDP Consumer indebtedness increases; consumption falls

Aggregate Demand /Aggregate Supply
Price Level LRAS SRAS What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL* PL1 AD AD1 RGDP1 Fe RGDP Real GDP Interest rates rise; business investment falls.

Aggregate Demand /Aggregate Supply
Price Level LRAS SRAS SRAS1 What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL* PL1 AD Fe RGDP RGDP1 Real GDP A new administration increases subsidies to businesses.

Aggregate Demand /Aggregate Supply
Price Level LRAS SRAS What happened to: Price Level INC DEC RGDP INC DEC Unemployment INC DEC PL1 PL* AD1 AD Fe RGDP RGDP1 Real GDP Promising research increases business profit expectations.