Aggregate Demand and Aggregate Supply

12

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Aggregate Demand

• Real GDP desired at each price level• Inverse relationship

• Real balances effect

• Interest effect

• Foreign purchases effect

LO1 12-2

Aggregate Demand

Real domestic output, GDP

Pri

ce l

evel

AD

LO1

0

12-3

Changes in Aggregate Demand

• Determinants of aggregate demand

• Shift factors affecting C, I, G, Xn

• 2 components involved

• Change in one of the determinants

• Multiplier effect

LO1 12-4

Changes in Aggregate Demand

Real domestic output, GDP

Pri

ce l

evel

AD1AD3

AD2

LO1

0

12-5

Consumer Spending

• Consumer wealth• Household borrowing• Consumer expectations• Personal taxes

LO1 12-6

Investment Spending

• Real interest rates• Expected returns

• Expectations about future business conditions

• Technology

• Degree of excess capacity

• Business taxes

LO1 12-7

Government Spending

• Government spending increases

• Aggregate demand increases (as long as interest rates and tax rates do not change)

• More transportation projects• Government spending decreases

• Aggregate demand decreases

• Less military spending

LO1 12-8

Net Export Spending

• National income abroad• Exchange rates

• Dollar depreciation

• Dollar appreciation

LO1 12-9

Aggregate Supply

• Total real output produced at each price level

• Relationship depends on time horizon

• Immediate short run

• Short run

• Long run

LO2 12-10

AS: Immediate Short Run

Real domestic output, GDP

Pri

ce l

evel

ASISR

Qf

Immediate-short-runaggregate supply

P1

0

LO2 12-11

Aggregate Supply: Short Run

Real domestic output, GDP

Pri

ce l

evel

0 Qf

AS

Aggregate supply(short run)

LO2 12-12

Aggregate Supply: Long Run

Real domestic output, GDP

Pri

ce l

evel

ASLR

Qf0

Long-runaggregatesupply

LO2 12-13

Changes in Aggregate Supply

• Determinants of aggregate supply

• Shift factors• Collectively position the AS curve• Changes raise or lower per-unit

production costs

LO2 12-14

Changes in Aggregate Supply

Real domestic output, GDP

Pri

ce l

evel

AS1

AS3

AS2

0

LO2 12-15

Input Prices

• Domestic resource prices

• Labor

• Capital

• Land• Prices of imported resources

• Imported oil

• Exchange rates

LO2 12-16

Productivity

• Real output per unit of input

• Increases in productivity reduce costs

• Decreases in productivity increase costs

LO2

Per-unit production cost =total input cost

total output

Productivity =total output

total inputs

12-17

Legal-Institutional Environment

• Legal changes alter per-unit costs of output

• Taxes and subsidies

• Extent of government regulation

LO2 12-18

Equilibrium

Real domestic output, GDP(billions of dollars)

Pri

ce le

vel (

ind

ex n

um

ber

s)

100

92

502 510 514

ab

AD

ASReal Output Demanded(Billions)

Price Level(Index Number)

Real OutputSupplied(Billions)

$506 108 $513

508 104 512

510 100 510

512 96 507

514 92 502

0

LO3 12-19

AD Increases: Demand-Pull Inflation

Real domestic output, GDP

Pri

ce le

vel

AD1

AS

P1

P2

Q2Q1Qf

AD2

0

LO4 12-20

Decreases in AD: Recession

Real domestic output, GDP

Pri

ce le

vel

AD1

AS

P1

P2

Q1 Q2 Qf

AD2

c

ab

0

LO4 12-21

Decreases in AD: Recession

• Prices are downwardly inflexible

• Fear of price wars

• Menu costs

• Wage contracts

• Efficiency wages

• Minimum wage law

LO4 12-22

Decreases in AS: Cost-Push Inflation

Real domestic output, GDP

Pri

ce le

vel

AD

AS1

P1

P2

Q1 Qf

AS2

a

b

0

LO4 12-23

Increases in AS: Full-Employment

Real domestic output, GDP

Pri

ce le

vel

AD1

AS2

P1

P2

Q2Q1

AS1

b

AD2

c

P3

Q3

a

0

LO4 12-24

Impact of Oil Prices Diminished?

• 1970’s

• Reduced AS and negative GDP gap

• Cost-push inflation

• Rising unemployment• 2000’s

• Core inflation steady

• Use 50% less oil and gas today

• Federal Reserve more vigilant

12-25

Stagflation is a combination of

recession (falling real GDP) and inflation. Now

we will show how stagflation could be

produced by a supply shock

Stagflation

Inflation-Unemployment pairs for the U.S., 1960-89

Unemployment Rate

109876543

Inflati

on

Rate

16

14

12

10

8

6

4

2

0

8988

87

86

8584

83

82

81

80

79

78

7776

75

74

73

72

71

7069

68

6766

65

646362

6160

www.bls.gov

Price per barrel of 320 crude oilDate Price ($)

Jan. 1972 1.79Dec. 1973 4.68Jan. 1974 10.84

April 1979 14.55June 1979 18.00

Nov 1979 24.00

Aug. 1980 30.00Oct. 1981 34.00

Source: Petroleum Economist

• Anchovies• Grain failures

Stagflation due to oil price shock

10.09.75

AS0

AD

AS1

110

115

Real GDP0

Price LevelStory of Joseph Buffer Stock

program