Aggregate Demand

1. Aggregate Demand • A schedule or curve that shows the amounts of real output (GDP) at various price levels • Price level is measured with the GDP price index: • Definition—a price index for all goods and services that make up Gross Domestic Product

2. Aggregate Demand Curve PL PL1 PL2 AD Y2 Y1 Real GDP

3. Why the downward slope? • For individual products the reasons are: • Income effect—as price falls, the consumer’s income allows for larger purchases of the product • Substitution effect—as price falls, the product becomes relatively less expensive than other substitutes • The income effect and substitution effect do not apply to aggregate demand. Why?

4. Why the downward slope? • The income effect does not apply because as the PL falls, less $ goes to resource suppliers in the form of wages, rents, interest, profits, etc. • The substitution effect does not apply because there are no substitutes for all goods and services • So, once again, why the downward slope?

5. Aggregate Demand and the downward slope explained (finally!) • Real-Balances Effect--higher prices means our assets have less value so people are poorer and consume less • Interest-rate effect—higher prices drive up the demand for money and so drive up interest rates, at higher interest rates, investment falls (more later)

6. Aggregate Demand and the downward slope explained (cont.) • Foreign-purchases effect—at higher prices, foreign goods are cheaper, so net exports falls (more later)

7. Changes in AD: Determinants(factors other than Price level) • Change in consumer spending (C): • Consumer Wealth • Think of appreciating/depreciating assets like stocks, bonds, real-estate, and land • Not income (remember, the income effect does not apply to aggregate demand) • Consumer expectations—about prices, income, etc. • Household debt—Think borrowing • Taxes

8. Changes in AD: Determinants(factors other than Price level) • Change in investment spending (I): • Interest rates—remember the investment demand curve? • Expected Returns • Expected future business conditions • Technology • Degree of excess capacity—stock of capital goods • Business taxes

9. Changes in AD: Determinants(factors other than Price level) • Change in government spending (G) • Change in net export spending (Xn): • Rising income in foreign countries • Exchange rates (more later)

10. Initial increase in Aggregate demand PL AD1 Real GDP

11. Increase in aggregate demand after multiplier effect takes hold PL AD2 AD1 Real GDP

12. Initial decrease in aggregate demand PL AD1 Real GDP

13. Decrease in aggregate demand after multiplier effect takes hold PL AD1 AD3 Real GDP

14. PL AD2 AD1 AD3 Real GDP

15. Aggregate Supply • The level of Real Output (GDP) that firms will produce at each price level • Aggregate supply has two distinct curves: • Long Run Aggregate Supply (LRAS) • Short Run Aggregate Supply (SRAS) • Let’s start with LRAS

16. Long Run Aggregate Supply PL LRAS Qf Real GDP

17. LRAS RGDP Qf LRAS • The LRAS represents the level of output at full-employment • This is the level of sustainable production in the long run given efficient use of available resources • Think PPF PL

18. LRAS PL RGDP Qf LRAS • LRAS does not change as the price level changes • Only changes technology or in the factors of production will cause the LRAS to shift left or right

19. LRAS1 PL Qf RGDP LRAS • What would happen if the labor force increased?

20. LRAS1 LRAS2 PL Qf Qf RGDP LRAS • What is possible to produce in the long run has increased due to the increase in one of the factors of production

21. PL SRAS PL1 PL2 Real GDP Q2 Q1 Short Run Aggregate Supply NOTE:You can use Y to show the level of output

22. Determinants for Short-Run Aggregate Supply • Input prices: • Wages make up about 75% of all business costs • Domestic resource prices • Prices of imported resources • Supply shocks due to market power—ex. OPEC • Changes in productivity: • usually a result of new technology, better organization of resources, and job training/education • Taxes, subsidies, and regulation

23. PL SRAS1 SRAS2 PL1 Real GDP Q1 Q2 Shifts in Short Run Aggregate Supply

24. What is the difference between the long-run and the short-run? • In the short-run, the prices of inputs like labor and raw materials cannot adjust to increases in the price level • As households see an increase in overall prices, they will demand higher prices for their resources (i.e. labor, land) to maintain their standard of living • The long-run has been reached once wages and cost of inputs have adjusted to the new higher price level

25. SRAS1 PL AD1 Q1 Real GDP AD/AS Equilibrium • The intersection of AD and SRAS establishes the equilibrium price level and RGDP • This is the current level of productivity PL1

26. SRAS1 PL PL2 PL1 AD1 Q2 Q1 RGDP Shifts in AD/AS • Increase in aggregate demand • A.K.A. Demand-Pull Inflation AD2

27. SRAS2 PL SRAS1 PL2 PL1 Q2 Q1 RGDP Shifts in AD/AS • Decrease in aggregate supply • A.K.A. Cost-Push Inflation AD1

28. Downward Inflexibility of Prices • While decreases in AD will theoretically cause the price level to drop, this usually does not happen in reality. Why? • Fears of price wars (gas stations in the 50’s) • Menu Costs • Wage Contracts • Morale (state workers) • Minimum Wage • A reduction in AD might slow inflation, but the price level rarely goes backwards • One major exception was The Great Depression

29. LRAS SRAS1 PL AD1 Qf Real GDP AD/AS and LRAS • The economy is operating at full employment if AD and SRAS intersect at LRAS • The goal for policy makers is to craft fiscal and monetary policy that targets the LRAS PL1

30. LRAS PL SRAS1 AD1 Q1 Qf Real GDP AD/AS and LRAS • If the AD/AS equilibrium is to the left of the LRAS, the economy is in recession PL1

31. LRAS PL SRAS1 PL1 AD1 Qf Q1 AD/AS and LRAS • If the AD/AS equilibrium is to the right of the LRAS, the economy is in an inflationary period • How can we produce beyond the LRAS? • Only for short periods of time Real GDP

32. Different types of AD/AS graphs • http://apecon.us/aggregatesupplykeynesianclassical2.swf