1. Aggregate Demand and Aggregate Supply Chapter 29 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 29-2 Chapter Objectives Aggregate demand (AD) Aggregate supply (AS) How AD and AS determine equilibrium price and real GDP The AD-AS model

3. 29-3 Aggregate Demand Amount of real GDP purchased at each price level Why the downward slope? –Real-balances effect –Interest-rate effect –Foreign purchases effect Consumption, investment, and net exports

4. 29-4 Aggregate Demand Curve Real Domestic Output, GDP Price Level AD Aggregate Demand

5. 29-5 Aggregate Demand Determinants of aggregate demand –Fixed variables along the demand curve Change in fixed variable Multiplier effect Consumer spending variables: –Consumer wealth –Consumer expectations –Household borrowing –Personal taxes

6. 29-6 Aggregate Demand Investment spending variables –Real interest rates –Expected returns Future business conditions Technology Degree of excess capacity Business taxes

7. 29-7 Aggregate Demand Government spending Net export spending variables National income abroad Exchange rates

8. 29-8 Changes in Aggregate Demand Real Domestic Output, GDP Price Level AD 1 Increase in Aggregate Demand AD 3 AD 2 Decrease in Aggregate Demand

9. 29-9 Amount real GDP produced at each price level Three time horizons Immediate short run –Few days to a few months –All prices fixed –Implicit price agreements –Contractual agreements Aggregate Supply

10. 29-10 Aggregate Supply Real Domestic Output, GDP Price Level AS ISR Immediate-short- run Aggregate Supply QfQf

11. 29-11 Short run –Input prices fixed –Output prices variable –Real profit changes Long run –All prices variable –Full employment GDP –All prices adjust Aggregate Supply

12. 29-12 Real Domestic Output, GDP Price Level 0 QfQf Aggregate Supply (Short Run) Slope not constant: per unit production cost and firm capacity Aggregate Supply

13. 29-13 Aggregate Supply Real Domestic Output, GDP Price Level AS LR Long-run Aggregate Supply QfQf

14. 29-14 Determinants of aggregate supply Change in input price –Domestic resource prices –Prices of imported resources Change in productivity Change in legal-institutional environment –Business taxes and subsidies –Government regulation Aggregate Supply

15. 29-15 Real Domestic Output, GDP Price Level AS 1 Increase in Aggregate Supply AS 3 AS 2 Decrease in Aggregate Supply Aggregate Supply

16. 29-16 Equilibrium Real Output Demanded (Billions) Price Level (Index Number) Real Output Supplied (Billions) $506 508 510 512 514 108 104 100 96 92 $513 512 510 507 502 Equilibrium Price Level and Equilibrium Real GDP

17. 29-17 Real Domestic Output, GDP (Billions of Dollars) Price Level 100 92 502510514 a b AD AS Equilibrium

18. 29-18 Changes in Equilibrium Real Domestic Output, GDP Price Level AD AS P1P1 P2P2 Q2Q2 Q1Q1 QfQf AD 1 Increase in Aggregate Demand Demand-Pull Inflation

19. 29-19 Changes in Equilibrium Real Domestic Output, GDP Price Level AD 1 AS P1P1 P2P2 Q1Q1 Q2Q2 QfQf AD 2 Decrease in Aggregate Demand Creates a Recession a c b

20. 29-20 Decrease in aggregate demand –Recession and cyclical unemployment –Deflation? Downward price inflexibility: –Fear of price wars –Menu costs –Wage contracts –Morale, effort, and productivity Efficiency wages –Minimum Wage Changes in Equilibrium

21. 29-21 Real Domestic Output, GDP Price Level AD AS 1 P1P1 P2P2 Q1Q1 QfQf Decrease in Aggregate Supply Cost-Push Inflation AS 2 a b Changes in Equilibrium

22. 29-22 Real Domestic Output, GDP Price Level AD 1 AS 2 P1P1 P2P2 Q2Q2 Q1Q1 Increases in Aggregate Supply – Full-Employment With Price-Level Stability AS 1 b AD 2 c P3P3 Q3Q3 a Changes in Equilibrium

23. 29-23 Impact of Oil Prices Aggregate supply shocks Cost push inflation Oil prices affected core inflation prior to 1980 Core inflation unaffected post 1980 –Energy efficiency –Composition of GDP –Fed vigilance

24. 29-24 Key Terms aggregate demand- aggregate supply (AD- AS) model aggregate demand real-balances effect interest-rate effect foreign purchases effect determinants of aggregate demand aggregate supply immediate-short-run aggregate supply curve short-run aggregate supply curve long-run aggregate supply curve determinants of aggregate supply productivity equilibrium price level equilibrium real output menu costs efficiency wages

25. 29-25 Next Chapter Preview… Fiscal Policy, Deficits, and Debt

26. The Relationship of the Aggregate Demand Curve to the Aggregate Expenditures Model Appendix

27. 29-27 Deriving the AD Curve Price Level Aggregate Expenditures (billions of dollars) 45° AE 2 (at P 2 ) AE 3 (at P 3 ) AE 1 (at P 1 ) Q1Q1 Q2Q2 Q3Q3 Real Domestic Product, GDP AD P3P3 P2P2 P1P1 As Price Levels Increase… Real GDP Declines

28. 29-28 Deriving the AD Curve Price Level Aggregate Expenditures 45° Real Domestic Product, GDP AE 2 (at P 1 ) AE 1 (at P 1 ) Q1Q1 Q2Q2 AD 1 P1P1 Increase in Aggregate Expenditures Increase in Aggregate Demand AD 2

29. 29-29 Deriving the AD Curve Price Level Aggregate Expenditures 45° Real Domestic Product, GDP AE 2 (at P 1 ) AE 1 (at P 1 ) Q1Q1 Q2Q2 AD 1 P1P1 AD 2 The Shift in the Aggregate Demand Curve is a Multiple of the initial Change in Aggregate Expenditures