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Chapter 25 Aggregate Demand and Aggregate Supply.

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1 Chapter 25 Aggregate Demand and Aggregate Supply

2 The Aggregate Demand Curve
When price level rises, money demand curve shifts rightward Consequently, interest rate is higher, given money supply is fixed Then, aggregate expenditure decreases (AE line shifts downward) As a result, the equilibrium GDP becomes lower So, a rise in price level causes a decrease in equilibrium GDP. The aggregate demand curve shows the negative relationship between price levels and equilibrium real GDP

3 Figure 2: Deriving the Aggregate Demand Curve

4 Understanding the AD Curve
Each point on the AD curve represents a short-run equilibrium in economy The AD curve is different from a demand curve for one particular product

5 Movements of the AD Curve
Moving along the AD curve whenever price level changes When anything other than price level cause equilibrium GDP to change, the AD curve shifts Government purchasing Taxes Autonomous consumption spending Investment spending Net exports Money supply Expectations

6 Figure 3: A Spending Shock Shifts the AD Curve

7 Costs and Prices To understand how macroeconomic events affect the price level, we assume A firm sets price of its products as a markup over cost per unit So, in the short-run, price level rises when there is an economy-wide increase in unit costs Labor costs Costs of natural resources How an increase in output level raises the price level? As output increases, demand for inputs rises As unit cost increases, price level ( assumed as a markup over unit cost) rises

8 Figure 5: The Aggregate Supply Curve

9 Movements of the AS Curve
When price level changes due to a change in real GDP, the change happens along the AS curve When the change of price level is caused by any factor other than real GDP, the AS curve shifts Oil prices Weather Technological change Nominal wage

10 Figure 6: Shifts of the Aggregate Supply Curve
Price Level Real GDP ($ Trillions) 100 AS 1 10 A AS 2 140 L

11 Figure 8: Short-Run Macroeconomic Equilibrium

12 Figure 9: The Effect of a Demand Shock
Price Level Real GDP ($ Trillions) AS 10 E AD 1 H 12 130 13.5 100 J AD 2

13 An Increase in Government Purchases
When G , AD curve shifts rightward. As a result, real GDP , given price level is fixed However, when real GDP , unit cost , so price level Furthermore, as price level , Md and interest rate , which causes aggregate expenditure to decrease In the end, real GDP increases by less than horizontal shift in AD curve

14 An Increase in the Money Supply
Can you demonstrate how an increase in the money supply affects the real equilibrium GDP?

15 Demand Shocks A positive demand shock—shifts AD curve rightward
Increases both real GDP and price level in short-run A negative demand shock—shifts AD curve leftward Reduces both real GDP and price level in short-run

16 Examples The Great Depression 1929 – 1933
Negative demand shocks Oil Crisis 1973 (began on October 17) Negative supply shocks

17 Demand Shocks: Adjusting to the Long-Run
In short-run, wage rate is treated as given But in long-run, wage rate can change When output is above full employment, wage rate will rise, shifting AS curve upward When output is below full employment, wage rate will fall, shifting AS curve downward

18 Figure 10: The Long-Run Adjustment Process After A Positive Demand Shock
Price Level Long-Run AS Curve Real GDP P 1 Y FE E AS AD AS 2 P 4 K 2 AD Y P H Y 3 P J

19 Figure 11: Long-Run Adjustment After A Negative Demand Shock

20 Figure 13: The Effect of a Supply Shock

21 More examples 1990-91 recession 2001 recession
Oil supplies and price of oil 2001 recession Money supply and interest rate

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