1. Aggregate Supply – Aggregate Demand

2. GDP 2007 to 2010

3. What is Aggregate Demand?
A schedule or curve showing amounts of real output that buyers collectively desire to purchase at each possible price level.
Think: Why does AD slope downward?

4. Why does AD slope downward?
Vertical axis represents
Price level for ALL final goods
And services
The aggregate price level
Is measured by either GDP
Deflator or CPI
Price level
The horizontal axis represents
the real quantity of all G&S
purchased as measured by the
level of REAL GDP AD
Real domestic output, GDP
Inverse Relationship

5. Vertical and Horizontal Axis
Horizontal axis = GDP
Vertical axis = GDP deflator (includes C+I+G)
or CPI…. Government uses the deflator* so it
get a lower number.
*A broader measure of price level… includes airplanes, dentist
Visits, pizzas, new shopping centers, etc.

6. ASSUMPTION for Aggregate demand IS: If Price level is decreasing, so are incomes.
Economy moves down its AD curve
Moves to lower price level
*remember circular flow model- (when consumers pay lower prices for goods and services – Less nominal income flows to
resource suppliers .

7. There are 3 Reasons that cause the Aggregate
Demand Curve to be downward sloping.
Real Balance Effect (Wealth effect)
Interest Rate Effect
International Trade Effect

8. Real Balance Effect
Price level falls- causes purchasing power to rise… translates into more money to spend or monetary wealth improves.
Real Balance Effect (or Wealth Effect) – Higher price level means less consumption spending.

9. Real Balance Effect Higher price level reduces real value of purchasing power of public’s accumulated savings
The change in the purchasing power of dollar-
Relates to assets that result from a change in the price level

10. Interest Rate Effect
Inverse relationship between price level and quantity demanded of GDP – because households and businesses adjust to interest rates for those interest-sensitive purchases.
Price level falls (bundle of goods costs less) rest of money into savings, more money available for borrowing interest rate down.
Think of money as stationary… demand drives up price of money.

11. Interest Rate continued
Now if bundle of goods increases… want to purchase interest sensitive good, cost to borrow is up.
An increase in money demand will drive up the price paid for its use
… use of money = interest rate
As price level rises, houses and firms require more money to handle transactions…

12. International Trade Effect (Open Economy Effect)
FYI: An open economy is global, a closed economy is domestic.
The Open Economy Effect
Higher price levels result in foreigners’ desiring to buy fewer American-made goods while Americans desire more foreign-made goods (i.e., net exports fall).
Equivalent to a reduction in the amount of real goods and services purchased in the U.S.
When Demand for exports decreases, this is an unfavorable balance of trade (imports exceed exports) 25 12

13. Why an Increase in Price Level Reduces Quantity of Real GDP Demanded
Effect on AD
Why an Increase in Price Level Reduces Quantity of Real GDP Demanded
Why a Decrease in Price Level Raises Quantity of Real GDP Demanded
Wealth
When P rises, consumers are poorer in real terms. This primarily decreases the demand for consumption goods.
When P falls, consumers are wealthier in real terms. This primarily increases the demand for consumption goods.
Interest Rate
When P rises, individuals save less, which increases the equilibrium interest rate. Higher interest rates reduce the quantity demanded of investment goods.
When P falls, individuals can afford to save more, which decreases the equilibrium interest rate. Lower interest rates increase the quantity demanded of investment goods.
International Trade
When P rises in the United States, all else equal, goods and services produced elsewhere are less expensive. Imports rise and exports fall so that net exports fall.
When P falls in the United States, all else equal, goods and services produced elsewhere are more expensive. Imports fall and exports rise so net exports fall.
Lecture Tip:
Note that the variables C, I, and NX are discussed in the table. These are the terms from the GDP equation.

14. Movement on the Curve
These 3 cause movement on the curve: Wealth Effect (or Real Balance Effect) Interest Rate Effect International Trade Effect

15. Difference between D and AD
If price of one item falls- quantity demanded tends to rise. (bread goes down, we buy more.) This is Law of Demand If price level falls (any parts of C + I + G) consumers pay lower prices. But less nominal income flows to suppliers. This is Aggregate Demand

16. Difference between Quantity of AD and Change of AD
QAD = movement up or down as result of price level changing (ONLY)
Change in AD =
Change in any of the component parts of AD (C + I + G + Net Exports)

17. Shifts of Aggregate Demand
Curve shifts right or left according to stimuli. These shifts come from any or all components of GDP (C, I, G, X-M)

18. Change in Consumer Spending
DETERMINANTS OF AGGREGATE DEMAND
Change in Consumer Spending
Consumer Wealth (people’s houses fell in value)
Consumer Expectations (expect higher prices)
Interest rate (interest sensitive durables)
Taxes
Think in aggregate terms

19. Changes in Investment Spending
Real Interest Rates (rates high- not much I taking place)
Expected Future Sales (health of economy- confidence is big)
Business Taxes (higher taxes less profit)

20. Government Spending
This will be discussed further, but anytime government spends, it has an affect on GDP.
Infrastructure – Health Care Supplies for military
Education
Etc.

21. Net Export Spending
National Income Abroad-(when foreign nations do well, their incomes are higher- can buy more U.S. goods and services. – U.S. exports rise)
Exchange Rates- Price of one nation’s currency in terms of another. Dollar vs Euro
Our currency appreciates if it takes more foreign $ to buy it.. (depreciates if it takes more of ours to buy theirs.) $1.00 to $1.25 Euro.
Depreciation of nation’s currency makes foreign goods more expensive (but attracts foreigners to buy our goods.) Our exports rise. *this is why the Fed has not worried about our low dollar valuation.

22. Factors That Change Aggregate Demand & Consumption/Interest Rates
Interest Rate ↑ → C↓ → AD↓
Interest Rate ↓ → C ↑ → AD↑

23. Factors That Change Aggregate Demand & Investment/ Interest Rates
Interest rates ↑ → I↓ → AD↓
Interest rates ↓ → I ↑ → AD↑

24. Factors That Change Aggregate Demand & Investment/ Business Taxes
Business taxes↓ → I↑ → AD↑
Business taxes↑ → I↓ → AD↓

25. Long-Run Equilibrium and the Price Level
For the economy as a whole, long-run equilibrium occurs at the price level where the aggregate demand curve (AD) crosses the long-run aggregate supply curve (LRAS). 37 25

26. Figure 10-5 Long-Run Economywide Equilibrium26

27. OK… One more time….. Component parts of GDP? C + I + G + (X-M) = GDP
Long-Run Aggregate Supply Curve (LRAS)
A vertical line representing the real output of goods and services after full adjustment has occurred
It represents the real GDP of the economy under conditions of full employment; the economy is on its production possibilities curve

28. The Production Possibilities and the Economy’s Long-Run Aggregate Supply Curve28

29. Output Growth and the Long-Run Aggregate Supply Curve (cont'd)
LRAS is vertical
Input prices fully adjust to changes in output prices
Suppliers have no incentive to increase output
Unemployment is at the natural rate
Determined by endowments and technology (or existing resources) 10 29

30. Output Growth and the Long-Run Aggregate Supply Curve (cont'd)
Growth is shown by outward shifts of either the production possibilities curve or the LRAS curve caused by
Growth of population and the labor-force participation rate
Capital accumulation
Improvements in technology 11 30

31. What does Long Run Equilibrium Mean?
Economy is a full employment
Any additional production would be difficult to achieve.
Economy operating at natural rate of unemployment (anyone wanting job=have it.)
Equate the LRAS curve with bowed line on PPC.
To extend either would be to discover new resources – R&D

32. Full Employment
The condition that exists when the unemployment rate is equal to the natural unemployment rate.
Full productive capacity has been
Reached.

33. Image Cylinder= Economy…
Businesses, factories, economy not working at full capacity

34. Full Employment AD AS
LRAS

35. SRAS (short run aggregate supply)
Period where adjustment occurs.
Direct relationship
As the output increases that puts upward pressure on price.
Movement on the curve denotes the relationship between price level and real output.

36. SRAS………….Shift
Shift in the curve denotes determinates that affect more or less real output production at various price levels.
Determinants:
Change in input prices (steel, plastic, wool change in resource availability )
Change in productivity (+ = Shift right; - = Shift left) (more for less is the object)
Change in legal environment (contracts, taxes, subsidies)

37. AD and SRAS

38. LRAS = long-run aggregate supply
LRAS is a vertical line reflecting that LR Aggregate Supply is not affected by changes in PL.
The LRAS is labeled as the natural level of real GDP
The natural level of real GDP is defined as the level of real GDP that arises when the economy is fully employing all of its available input resources ( We are in agreement that it hovers around 5%)

39. Long Run Aggregate Supply
LRASLR
Price level
Long-run
Aggregate
Supply
Full-Employment Qf Q
Real domestic output, GDP

40. Can a Change in Money Supply Change AD?
Real
Rate Of
Interest D2 D1
Money Supply
Can a Change in Money Supply Change AD?
Probably… but it is a chain of events. MS changes, then Interest Rates, then change in consumption
and investment. Then Change in AD

41. Equilibrium States of the Economy
During the time an economy moves from one equilibrium to another, it is said to be in disequilibrium.

42. Unanticipated Increase in Aggregate Demand
LRAS
Goods & Services (real GDP)
Price level P
100 Y F
SRAS1
AD1
AD2
Short-run effects of an unanticipated increase in AD P
105 Y 2
In response to an unanticipated increase in AD for goods & services (shift from AD1 to AD2), prices will rise to P105 and output will temporarily exceed full-employment capacity (increases to Y2).

43. Growth in Aggregate SupplyF2
LRAS2
LRAS1
Goods & Services (real GDP)
Price level Y F AD P 1
SRAS1 F1
SRAS2 P 2 Y F2
Here we illustrate the impact of economic growth due to capital formation or a technological advancement, for example.
Both LRAS and SRAS increase (to LRAS2 and SRAS2); the full employment output of the economy expands from YF1 to YF2.
A sustainable, higher level of real output and real income is the result. ***If the money supply is held constant, a new long-run equilibrium will emerge at a larger output rate (YF2) and lower price level (P2).

44. Effects of Adverse Supply Shock
LRAS
Goods & Services (real GDP)
Price level AD Y F P
100
SRAS1 (Pr1) A
SRAS2 (Pr2) B P
110 Y 2
The higher resource prices shift the SRAS curve to the left; in the short-run, the price level rises to P110 and output falls to Y2.
What happens in the long-run depends on whether the reduction in the supply of resources is temporary or permanent.
If temporary, resource prices fall in the future, permitting the economy to return to its original equilibrium (A).
If permanent, the productive potential of the economy will shrink (LRAS shifts to the left) and (B) will become the long-run equilibrium.

45. DEMAND-PULL INFLATION
INCREASES IN AD:
DEMAND-PULL INFLATION P
AD1
AD2 AS P2
Price Level P1 Q Qf Q1 Q2
Real Domestic Output, GDP

46. DECREASES IN AS: COST-PUSH INFLATIONb
Price Level a P1
AD1 Q Q1 Qf
Real Domestic Output, GDP

48. Non-governmental actions that shift AS Shift AS left:
Raw materials cost rise
Wages rise faster than productivity
Worker productivity decreases
Obsolescence
Wars
Natural disasters

49. Fiscal Policy Governmental actions that shift AD Shift AD right:
Govt spending increases
Taxes decreases
Money Supply increases
Shift AD left:
G decreases
T increases
MS decreases

50. KILEY SAYS THAT'S ALL!