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Chapter 14 Aggregate Demand and Supply

Chapter 14 Aggregate Demand and Supply. Survey of Economics Irvin B. Tucker. Lecture Slides. What will I learn in this chapter?. How to use an aggregate demand and supply model to explain the business cycle. What is the aggregate demand curve (AD)?.

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Chapter 14 Aggregate Demand and Supply

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  1. Chapter 14Aggregate Demand and Supply Survey of EconomicsIrvin B. Tucker Lecture Slides

  2. What will I learn in this chapter? • How to use an aggregate demand and supply model to explain the business cycle

  3. What is the aggregate demand curve (AD)? • The curve shows the level of real GDP purchased by consumers, businesses, government, and foreigners (net exports) at different possible price levels during a time period, ceteris paribus

  4. The vertical axis measures the average price of goods and services in the economy using the CPI • The horizontal axis measures the value of final goods and services included in real GDP measured in base year dollars

  5. Decrease in the real GDP demanded Increase in the real GDP demanded Increase in the price level Decrease in the price level

  6. Exhibit 14.1 The Aggregate Demand Curve 400 300 A Price Level (CPI) B 200 AD 100 0 8 16 12 20 4 Real GDP (trillions of dollars per year)

  7. Why does the aggregate demand curve slope downward to the right? • Real balances effect • Interest-rate effect • Net exports effect

  8. What is thereal balances effect? • Consumers spend more on goods and services because lower prices make their dollars more valuable

  9. What is theinterest-rate effect? • Assuming a fixed money supply, an increase in the price level increases borrowing demand and in turn higher interest rates, which discourages consumer spending.

  10. What is thenet exports effect? • A higher domestic price level makes U.S. goods more expensive compared to foreign goods. As a result, exports (x) decrease and imports (m) increase, which decreases real GDP through the net exports component (x - m).

  11. What can cause a shift in the aggregate demand curve? • Any of the components of GDP: Consumption ( ), investments (I), government spending (G), or net exports (X-M) can change and shift the AD curve C

  12. Increase in the aggregate demand curve Decrease in the aggregate demand curve Decrease in C,I, G, (X-M) Increase in C,I, G, (X-M)

  13. Exhibit 14.3 An increase in the Aggregate Demand Curve 400 300 Price Level (CPI) A B 200 AD2 100 AD1 0 4 8 12 20 16 Real GDP (trillions of dollars per year)

  14. What is the aggregate supply curve (AS)? • The curve that shows the level of real GDP produced at different price levels during a time period, ceteris paribus • There are two opposing theories for the shape of the AS curve: (1) Keynesian view and (2) Classical view

  15. Who is John Maynard Keynes? • Keynes was a famous Cambridge University economist who wrote The General Theory of Employment, Interest, and Money published in 1936.

  16. What is the Keynesian view of the AS curve? • When there is a severe recession, Keynes argued that a horizontal (flat) supply curve exists because product prices and wages are fixed or rigid

  17. Why did Keynes assume fixed product prices and wages? • During a deep recession or depression, there are many idle resources in the economy

  18. Why do idle resources cause fixed prices? • Firms are willing to sell products at current prices because there are no shortages to put upward pressure on prices

  19. Why do idle resources result in fixed wages? • Unemployed workers willing to work for the prevailing wage diminish the power of employed workers to increase their wages • Union contracts prevent business from lowering wage rates

  20. According to Keynes, government spending must be used to increase aggregate demand and restore a depressed economy to full employment

  21. Price level remains constant, while real GDP and employment rise Aggregate demand increases and the economy moves from E1 to E2 Government spending (G) increases

  22. Exhibit 14.4 The Keynesian Horizontal Aggregate Supply Curve 400 300 E2 E1 Price Level (CPI) AS 200 AD2 100 AD1 Full employment 0 8 4 16 12 20 Real GDP 23 (trillions of dollars per year)

  23. What is the classical view of the aggregate supply curve? • A vertical line at the full-employment real GDP

  24. According to the classical economists, where does the economy normally operate? • The economy normally operates at full- employment real GDP because markets will adjust in a short period of time without government intervention

  25. Unlike Keynes, Classical economists believed in flexible prices and wages. • A decrease in the AD curve creates a surplus of unsold goods. Firms cut prices and layoff workers. • Competition from unemployed workers reduces the wage rate • As prices fall, consumers increase their spending downward along the AD curve according to the real balances effect

  26. The economy moves to a level of full employment Unemployment causes a decrease in prices Aggregate demand decreases at full employment

  27. Exhibit 14.5 The Classical Aggregate Supply Curve AS 400 Surplus E1 300 E' Price Level (CPI) E2 200 AD1 AD2 100 Full employment 0 8 16 4 12 20 Real GDP (trillions of dollars per year) 28

  28. Why is the AS curve upward-sloping in the intermediate range? • Bottlenecks (obstacles to output flows) develop because firms can not fill orders and raise their prices • Labor shortages make wage increase demands difficult to reject • Production costs rise as firms use less skilled labor and machinery to fill orders

  29. Exhibit 14.6 Three Ranges of the Aggregate Supply Curve AS ClassicalRange Price Level (CPI) Intermediate Range Full employment Keynesian Range YK YF Real GDP

  30. How is macro equilibrium determined? • Equilibrium occurs where the aggregate demand curve equals the aggregate supply curve

  31. Exhibit 14.7 The Aggregate Demand and Aggregate Supply Model AS 500 400 300 Price level (CPI) E 200 AD 100 - GDP gap Full employment 0 4 12 20 24 8 16 Real GDP (trillions of dollars per year)

  32. How do increases in the AD curve affect the price level and real GDP? • Along the Keynesian range, real GDP increases while the price level remains constant • Along the intermediate range, both real GDP and the price level increase • Along the classical range, the price level rises while real GDP remains at the full- employment level

  33. Exhibit 14.8 Effects of Increases in Aggregate Demand AS E5 400 E4 AD5 300 E3 Price Level(CPI) E1 E2 AD4 200 AD3 AD2 100 AD1 Full employment 8 0 4 12 16 20 Real GDP (trillions of dollars per year)

  34. Exhibit 9Effect of Decreases in Aggregate Demand During the Recession of 2008-2009 (actual data) AS E1 219 Price level (CPI) E2 E3 212 AD1 Q3 2008 AD3 AD2 Q4 2008 Q2 2009 12.9 13.1 13.3 13.4 Real GDP (trillions of dollars per year)

  35. What are some examples of factors that would cause a rightward shift in the AS curve? • Lower labor costs • Lower oil prices • Lower taxes • Reduced government regulations

  36. Exhibit 14.10 A Rightward Shift in the Aggregate Supply Curve 250 AS1 AS2 200 E1 175 E2 150 Price Level (CPI) 100 AD 50 Full employment 10 0 20 8 4 12 16 Real GDP 37 (trillions of dollars per year)

  37. What are the two types of inflation? • Cost push • Demand pull

  38. What iscost-push inflation? • A rise in the general price level resulting from an increase in the cost of production that causes the AS curve to shift leftward

  39. Exhibit 14.11 Summary of the Nonprice – Level Determinants of Aggregate Demand and Aggregate Supply Nonprice-Level Determinants of Aggregate Demand (total spending) Nonprice-Level Determinants of Aggregate Supply 1. Consumption (c) 1. Resource prices (domestic and imported) 2. Investment (I) 2. Taxes 3. Government spending (G) 3. Technological change 4. Net exports (X – M) 4. Subsidies 5. Regulation

  40. Exhibit 14.12(a) Cost - Push Inflation AS74 AS73 E2 49.3 PriceLevel(CPI) E1 44.4 AD Full employment 4,319 4,341 Real GDP 41 (billions of dollars per year)

  41. What is stagflation? • High unemployment and rapid inflation exist simultaneously

  42. What isdemand-pull inflation? • A rise in the general price level resulting from an excess of total spending caused by a rightward shift in the AD curve.

  43. Exhibit 14.12(b) Demand- Pull Inflation AS Price Level (CPI) E2 32.4 AD66 31.5 AD65 E1 Full Employment 3,191 3,399 Real GDP (billions of dollars per year) 44

  44. What determines the business cycle? • Shifts in the aggregate demand and aggregate supply curves

  45. What happens when both curves increase? • That depends on how much each increases

  46. Increase in price level Increase in real GDP Increase in aggregate demand and supply

  47. Exhibit 14.13 Rightward Shift in Aggregate Demand and Supply Curves AS95 AS00 E2 Price Level (CPI) 172 E1 152 AD00 AD95 8,031 9,817 Real GDP (billions of dollars per year)

  48. END

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