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Aggregate Demand and Aggregate Supply

10. Aggregate Demand and Aggregate Supply. Chapter Objectives. Aggregate Demand and the Factors That Cause it to Change Aggregate Supply and the Factors That Cause it to Change How AD and AS Determine an Economy’s Equilibrium Price Level and the Level of Real GDP

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Aggregate Demand and Aggregate Supply

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  1. 10 Aggregate Demand and Aggregate Supply

  2. Chapter Objectives • Aggregate Demand and the Factors That Cause it to Change • Aggregate Supply and the Factors That Cause it to Change • How AD and AS Determine an Economy’s Equilibrium Price Level and the Level of Real GDP • How the AD-AS Model Explains Periods of Demand-Pull Inflation, Cost-Push Inflation, and Recession

  3. O 10.1 AD – AS Model • Aggregate Demand-Aggregate Supply Model (AD-AS Model) • Aggregate Demand • Why the Downward Slope? • Real-Balances Effect • Interest-Rate Effect • Foreign Purchases Effect

  4. Aggregate Demand • Schedule or curve that shows the amounts of real output (real GDP) that buyers collectively desire to purchase at each psb price level • Relationship b/w price level and amount of real GDP demanded is inverse • When price rises, quantity of real GDP demanded decreases, and vice versa

  5. Aggregate Demand Curve • AD curve is downward sloping • Why? • 1. real-balances effect • 2. interest-rate effect • 3. foreign purchases effect

  6. Real Balances Effect • Produced by a change in price level • Higher price levels reduce real value (purchasing power) of public’s savings balances. Because of this, households will reduce spending

  7. Interest-Rate Effect • Assume money supply is fixed • When prices rise, consumers and businesses need more money • Higher price level increases the demand for money • This will cause interest rates to rise • Higher interest rates discourage spending and consumption spending • by increasing the demand for money and consequently the interest rate, a higher price reduces real output demanded

  8. Foreign Purchases Effect • When U.S. price level rises relative to foreign price levels, foreigners will buy less U.S. goods, and vice versa • Leads to a reduction in net exports

  9. AD – AS Model Aggregate Demand Curve Aggregate Demand Price Level AD Real Domestic Output, GDP Click to Link to Appendix 10: Relationship of AD to the AE Model

  10. Changes in Aggregate Demand • Determinants of Aggregate Demand and Multiplier Effect • Changes in: • Consumer Spending • Consumer Wealth • Consumer Expectations • Household Debt • Personal Taxes • Investment Spending • Real Interest Rates

  11. Changes in Aggregate Demand • Expected Returns • About Future Business Conditions • Technology • Degree of Excess Capacity • Business Taxes • Government Spending • Net Export Spending • National Income Abroad • Exchange Rates

  12. Changes in Aggregate Demand Changes in Aggregate Demand Curve Increase in Aggregate Demand Price Level Decrease in Aggregate Demand AD2 AD1 AD3 Real Domestic Output, GDP

  13. Changes in Aggregate Demand • Determinants of aggregate demand – aggregate demand shifters – factors that will cause the entire AD curve to shift • Inc in AD, shift right • Dec in AD, shift left • 2 components: • 1. change in one of the determinants of AD changes the amount of real GDP demanded • 2. multiplier effect that produces a greater ultimate change in AD than the initiating change in spending • See Figure 10.2

  14. Determinants of AD • 1. consumer spending – factors such as real consumer wealth, expectations, debt, and taxes can affect consumer spending

  15. 2. Investment Spending • Purchase of capital goods • Increase in real interest rates will lower investment spending and dec. AD, and vice versa • Higher expected returns will increase I spending and inc AD, and vice versa

  16. 3. Government Spending • Inc in gov purchases will inc AD, vice versa

  17. 4. Net Export Spending • Higher exports, inc in AD, and vice versa • Increases or decreases in national income abroad affect export spending • Exchange rates affect export spending • Dollar depreciation increases exports, AD

  18. Aggregate Supply • Schedule or curve showing the level or real GDP that firms will produce at each price level • Differ in long run and short run • Long run – period in which nominal wages and other resource prices match changes in the price level • Short run – period in which nominal wages do not respond to price –level changes

  19. Long Run Aggregate Supply • LRAS curve is vertical at the economy’s full employment output -when changes in wages respond completely to changes in the price level, those changes do not alter the amount of real GDP produced and offered for sale

  20. Aggregate Supply Aggregate Supply in the Long Run ASLR Price Level Long Run Aggregate Supply Real Domestic Output, GDP

  21. Short-Run Aggregate Supply • In reality nominal wages do not automatically adjust to price level changes • Direct relationship b/w price level and output • SRAS is upsloping • Per-unit costs underlie SRAS curve - per-unit production cost = total input cost/units of output • This establishes output’s price level

  22. Total Input Cost Per-Unit Production Cost = Units of Output W 10.1 Aggregate Supply Aggregate Supply in the Short Run Aggregate Supply (Short Run) Price Level 0 Qf Real Domestic Output, GDP

  23. Changes in Aggregate Supply • Determinants of Aggregate Supply • Changes in: • Input Prices • Domestic Resource Prices • Prices of Imported Resources • Market Power • Productivity • Legal-Institutional Environment • Business Taxes and Subsidies • Government Regulation

  24. Changes in SRAS • When SRAS increases, shift curve right • When SRAS decreases, shift curve left • Determinants of aggregate supply – supply shifters – changes in these determinants raise or lower per-unit production costs at each price level

  25. Determinants of Aggregate Supply • 1. Input prices – domestic or imported resources • Domestic resource prices – labor, price of machinery, land • Imported resource prices also affect AS • Market power – change in the degree of market power a resource supplier has effect on AS (ex. OPEC)

  26. 2. Productivity • Measure of the relationship b/w a nation’s level of real output and the amount of resources used to produce the output • Productivity = total output/total inputs • Increase in productivity, increase in SRAS and vice versa

  27. Total Output = Productivity Total Inputs Total Output 10 = = 2 Total Inputs 5 G 10.1 Changes in Aggregate Supply Understanding Productivity

  28. 3. Legal-Institutional Environment • 1. business taxes and subsidies – higher business taxes increase per-unit costs and decrease SRAS, subsidies decrease per-unit costs • 2. Government regulation – more regulations will increase per-unit costs and decrease SRAS

  29. Changes in Aggregate Supply Changes in Aggregate Demand Curve AS3 AS1 Decrease in Aggregate Supply AS2 Price Level Increase in Aggregate Supply Real Domestic Output, GDP

  30. Equilibrium and Changes in Equilibrium • Intersection of AS and AD curve est. equilibrium price level and equilibrium real output

  31. Equilibrium and Changes in Equilibrium Tabular View… Real Output Demanded (Billions) Real Output Supplied (Billions) Price Level (Index Number) $506 508 510 512 514 108 104 100 96 92 $513 512 510 507 502 Equilibrium Price Level and Equilibrium Price Level

  32. Equilibrium and Changes in Equilibrium AS Price Level Equilibrium 100 92 b a AD 502 510 514 Real Domestic Output, GDP (Billions of Dollars)

  33. Increase in AD: Demand-Pull Inflation • Increase in AD beyond the full-employment level of output will cause inflation • Will cause demand-pull inflation b/c price level is being pulled up by inc in AD

  34. Equilibrium and Changes in Equilibrium Increase in Aggregate Demand AS Demand-Pull Inflation P2 Price Level P1 AD1 AD Qf Q1 Q2 Real Domestic Output, GDP

  35. Decreases in AD: Recession and Cyclical Unemployment • Decreases in AD will cause recession and unemployment • Decreases in AD rarely cause deflation • Real output declines but price has remained relatively inflexible in recent recessions • Why?

  36. Why? • 1. fear of price wars - b/w competing firms • 2. menu costs – firms that think a recession may be fairly short may be reluctant to cut prices • 3. wage contracts – may prohibit wage cuts • 4. morale, effort, and productivity • 5. minimum wage – price floor on labor

  37. Equilibrium and Changes in Equilibrium Decrease in Aggregate Demand AS Price Level b a P1 c P2 Creates a Recession AD1 AD2 Q1 Q2 Qf Real Domestic Output, GDP

  38. O 10.2 Equilibrium and Changes in Equilibrium • Recession and Cyclical Unemployment • Deflation • Downward Price Inflexibility Due to: • Fear of Price Wars • Menu Costs • Wage Contracts • Morale, Effort, and Productivity • Efficiency Wages • Minimum Wage

  39. Decrease in AS: Cost-Push Inflation • SRAS shifts left, cost-push inflation arises • Can be caused by aggregate supply shocks

  40. Equilibrium and Changes in Equilibrium Decrease in Aggregate Supply AS1 AS Cost-Push Inflation b P2 Price Level a P1 AD Q1 Qf Real Domestic Output, GDP

  41. Increase in AS: Full Employment with Price-Level Stability • Inc in AS curve leads to growth, full employment and relative price stability

  42. Equilibrium and Changes in Equilibrium Increases in Aggregate Supply – Full-Employment With Price-Level Stability AS1 AS2 P3 b c P2 a P1 Price Level AD2 AD1 Q1 Q2 Q3 Real Domestic Output, GDP

  43. Has the Impact of Oil Prices Diminished? Last Word • Several Aggregate Supply Shocks • Shifts in Aggregate Supply • Significant Changes in Oil Prices Brought Rapid Cost-Push Inflation • Rising Unemployment • Recent Fears of Reoccurrence • Core Inflation Rate Remaining Steady

  44. Has the Impact of Oil Prices Diminished? Last Word • Lower Production Costs and High Productivity are Compensating for Oil Prices • Aggregate Supply Did Not Decline • Productivity Impact: • 14,000 Btus per $1 of GDP in 1970 • 7,000 Btus per $1 of GDP in 2005 • Result is 33% Less Sensitive to Oil Price Fluctuations • Federal Reserve Vigilance in Managing Price Stability

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

  46. Next Chapter Preview… Fiscal Policy, Deficits, and Debt Chapter 11! Click to Link to Appendix 10: Relationship of AD to the AE Model

  47. Return to Chapter 10 10 Appendix The Relationship of the Aggregate Demand Curve to the Aggregate Expenditures Model

  48. Return to Chapter 10 Deriving the AD Curve AE1 (at P1 ) AE2 (at P2 ) AE3 (at P3 ) As Price Levels Increase… Aggregate Expenditures (billions of dollars) 45° P3 Real GDP Declines Price Level P2 P1 AD Q1 Q2 Q3 Real Domestic Product, GDP

  49. Aggregate Expenditures 45° Price Level Real Domestic Product, GDP Return to Chapter 10 Deriving the AD Curve AE2 (at P1 ) AE1 (at P1 ) Increase in Aggregate Expenditures Increase in Aggregate Demand P1 AD2 AD1 Q1 Q2

  50. Aggregate Expenditures 45° Price Level Real Domestic Product, GDP Return to Chapter 10 Deriving the AD Curve AE2 (at P1 ) AE1 (at P1 ) The Shift in the Aggregate Demand Curve is a Multiple of the initial Change in Aggregate Expenditures P1 AD2 AD1 Q1 Q2

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