Chapter 11: Aggregate Demand & Aggregate Supply

1. Chapter 11: Aggregate Demand & Aggregate Supply • Aggregate Demand (AD) – Aggregate Supply (AS) model is a variable price model. • AD – AS model provides insights on inflation, unemployment, and economic growth

2. Aggregate Demand • A schedule that shows the various amounts of real domestic output that domestic & foreign buyers will desire to purchase at each possible price level • Shows an inverse relationship between price level and domestic output

3. Price v. Real GDP: Reasons for Inverse Relationship • Real Balances Effect: When Price falls, purchasing power of existing financial balances rises  increase spending • Interest Rate Effect: A decline in Price means lower interest rates  increase levels of certain types of spending • Foreign Purchases Effect: When Price falls, US prices will fall relative to foreign pries  increase spending on US exports, decrease import spending in favor of US products that compete w/ imports

4. Determinants of Aggregate Demand Real GDP = C + Ig + G + Xn • Changes in Consumer Spending • Changes in Investment Spending • Changes in Governments Spending • Changes in Net Exports

5. Changes in Consumer Spending • Consumer Wealth • Consumer Expectations • Consumer Indebtedness • Taxes

6. Changes in Investment Spending • Interest Rates • Profit Expectations • Business Taxes • Technology • Amount of Excess Capacity

7. Change in Government Spending • This is Fiscal Policy (Chapter 12)

8. Changes in Net Exports When unrelated to price level: • Income Abroad • Exchange Rates • Depreciation of $ encourages US exports since US products become less expensive for foreign buyers, who can now obtain $ for their currency • Depreciation of $ discourages import buying in the US since it is more expensive for Americans to exchange foreign currency

9. Aggregate Supply • A schedule showing level of Real GDP available at each Price • Higher Prices create an incentive for firms to produce & sell more • Lower Prices prompt firms to reduce output • Direct/Positive relationship between P & Real GDP

10. Determinants of Aggregate Supply • Change in Input Prices • Change in Productivity • Change in Legal-Institutional Environment

11. Change in Input Prices • Availability of Resources • Land, Labor, Capital, & Entrepreneurial Ability • Prices of Imported Resources • Market Power in Certain Industries

12. Change in Productivity • Productivity = Real Output / Input • Changes in Per-unit Production Cost = Total Input Cost / Units of Output • If productivity rises, unit production costs fall  Shifts AS to right, lowers Prices • If productivity falls, unit production costs rise  Shifts AS to left, increasing Prices

13. Legal – Institutional Environment • Business Taxes • Subsidies • Government Regulation

14. Equilibrium: Price v. Real Output • Equilibrium Price and Quantity are found where AD and AS curves intersect

15. Decreases in AD • If AD decreases, recession and cyclical unemployment may result • Wage contracts are not flexible, business can’t afford to reduce prices • Employers are reluctant to cut wages b/c impact on EE effort • Minimum Wage Laws keep wages up • Menu Costs are difficult to change • Fear of price wars keeps prices from being reduced

16. Why is Unemployment in Europe So High? • High minimum wages • Generous welfare benefits for unemployed • Restrictions against firings discourage employment • 30 – 40 days of paid vacation & holidays increase costs of hiring • High worker absenteeism reduces productivity • Higher employer cost of fringe benefits discourages hiring

17. Chapter 11 Study Questions • 7, 8: Determinants of AD & AS