Aggregate Supply – Aggregate Demand

GDP 2007 to 2010

What is Aggregate Demand? A schedule or curve showing amounts of

real output that buyers collectively desire to purchase at each possible price level.

Think: Why does AD slope downward?

Why does AD slope downward?

Real domestic output, GDP

AD

Price

level

Vertical axis representsPrice level for ALL final goodsAnd services

The aggregate price levelIs measured by either GDPDeflator or CPI

The horizontal axis representsthe real quantity of all G&Spurchased as measured by thelevel of REAL GDP

Inverse Relationship

Vertical and Horizontal Axis

Horizontal axis = GDPVertical axis = GDP deflator (includes C+I+G)or CPI…. Government uses the deflator* so it get a lower number.

*A broader measure of price level… includes airplanes, dentistVisits, pizzas, new shopping centers, etc.

ASSUMPTION for Aggregate demand IS: If Price level is decreasing, so are incomes.

Economy moves down its AD curve

Moves to lower price level

*remember circular flow model- (when consumers pay lower prices for goods and services – Less nominal income flows to resource suppliers .

There are 3 Reasons that cause the Aggregate

Demand Curve to be downward sloping.

Real Balance Effect (Wealth effect)Interest Rate Effect

International Trade Effect

Real Balance Effect Price level falls- causes purchasing power

to rise… translates into more money to spend or monetary wealth improves.

1) Real Balance Effect (or Wealth Effect) – Higher price level means less consumption spending.

Real Balance EffectHigher price level reduces real value of purchasing power of public’s accumulated savingsThe change in the purchasing power of dollar-

Relates to assets that result from a change in the price level

Interest Rate Effect Inverse relationship between price level

and quantity demanded of GDP – because households and businesses adjust to interest rates for those interest-sensitive purchases.

Price level falls (bundle of goods costs less) rest of money into savings, more money available for borrowing interest rate down.

Think of money as stationary… demand drives up price of money.

Interest Rate continued Now if bundle of goods increases… want to

purchase interest sensitive good, cost to borrow is up.

An increase in money demand will drive up the price paid for its use

… use of money = interest rate As price level rises, houses and firms

require more money to handle transactions…

International Trade Effect (Open Economy Effect) FYI: An open economy is global, a closed economy

is domestic.The Open Economy Effect

Higher price levels result in foreigners’ desiring to buy fewer American-made goods while Americans desire more foreign-made goods (i.e., net exports fall).

Equivalent to a reduction in the amount of real goods and services purchased in the U.S.

When Demand for exports decreases, this is an unfavorable balance of trade (imports exceed exports)

Effect on AD

Why an Increase in Price Level Reduces Quantity of

Real GDP Demanded

Why a Decrease in Price Level Raises Quantity of

Real GDP Demanded

Wealth

When P rises, consumers are poorer in real terms. This primarily decreases the demand for consumption goods.

When P falls, consumers are wealthier in real terms. This primarily increases the demand for consumption goods.

Interest Rate

When P rises, individuals save less, which increases the equilibrium interest rate. Higher interest rates reduce the quantity demanded of investment goods.

When P falls, individuals can afford to save more, which decreases the equilibrium interest rate. Lower interest rates increase the quantity demanded of investment goods.

International Trade

When P rises in the United States, all else equal, goods and services produced elsewhere are less expensive. Imports rise and exports fall so that net exports fall.

When P falls in the United States, all else equal, goods and services produced elsewhere are more expensive. Imports fall and exports rise so net exports fall.

Movement on the Curve

These 3 cause movement on the curve:

Wealth Effect (or Real Balance Effect)Interest Rate EffectInternational Trade Effect

Difference between D and AD

If price of one item falls- quantity demanded tends to rise. (bread goes down, we buy more.) This is Law of Demand

If price level falls (any parts of C + I + G) consumers pay lower prices. But less nominal income flows to suppliers. This is Aggregate Demand

Difference between Quantity of AD and Change of ADQAD = movement up or down as result of

price level changing (ONLY)

Change in AD =Change in any of the component parts of AD (C + I + G + Net Exports)

Shifts of Aggregate Demand

Curve shifts right or left according to stimuli.

These shifts come from any or all components of GDP (C, I, G, X-M)

DETERMINANTS OF AGGREGATE DEMAND

Change in Consumer Spending

•Consumer Wealth (people’s houses fell in value)

•Consumer Expectations (expect higher prices)• Interest rate (interest sensitive durables)

• Taxes

Think in aggregate terms

Changes in Investment Spending Real Interest Rates (rates high- not much I

taking place)

Expected Future Sales (health of economy- confidence is big)

Business Taxes (higher taxes less profit)

Government SpendingThis will be discussed further, but anytime

government spends, it has an affect on GDP.Infrastructure – Health CareSupplies for militaryEducationEtc.

Net Export Spending

National Income Abroad-(when foreign nations do well, their incomes are higher- can buy more U.S. goods and services. – U.S. exports rise)

Exchange Rates- Price of one nation’s currency in terms of another. Dollar vs EuroOur currency appreciates if it takes more foreign $ to buy it.. (depreciates if it takes more of ours to buy theirs.) $1.00 to $1.25 Euro.Depreciation of nation’s currency makes foreign goods more expensive (but attracts foreigners to buy our goods.) Our exports rise. *this is why the Fed has not worried about our low dollar valuation.

Factors That Change Aggregate Demand & Consumption/Interest Rates

Interest Rate ↑ → C↓ → AD↓ Interest Rate ↓ → C ↑ → AD↑

Factors That Change Aggregate Demand & Investment/ Interest Rates

Interest rates ↑ → I↓ → AD↓

Interest rates ↓ → I ↑ → AD↑

Factors That Change Aggregate Demand & Investment/ Business Taxes

Business taxes↑ → I↓ → AD↓

Business taxes↓ → I↑ → AD↑

Long-Run Equilibrium and the Price LevelFor the economy as a whole, long-run

equilibrium occurs at the price level where the aggregate demand curve (AD) crosses the long-run aggregate supply curve (LRAS).

Figure 10-5 Long-Run Economywide Equilibrium

OK… One more time…..Component parts of GDP?

C + I + G + (X-M) = GDP

Long-Run Aggregate Supply Curve (LRAS) A vertical line representing the real output of goods and

services after full adjustment has occurred

It represents the real GDP of the economy under conditions of full employment; the economy is on its production possibilities curve

The Production Possibilities and the Economy’s Long-Run Aggregate Supply Curve

Output Growth and the Long-Run Aggregate Supply Curve (cont'd) LRAS is vertical

Input prices fully adjust to changes in output prices

Suppliers have no incentive to increase output

Unemployment is at the natural rate

Determined by endowments and technology (or existing resources)

Output Growth and the Long-Run Aggregate Supply Curve (cont'd) Growth is shown by outward shifts of

either the production possibilities curve or the LRAS curve caused by

Growth of population and the labor-force participation rate

Capital accumulation

Improvements in technology

What does Long Run Equilibrium Mean? Economy is a full employment Any additional production would be

difficult to achieve. Economy operating at natural rate of

unemployment (anyone wanting job=have it.)

Equate the LRAS curve with bowed line on PPC.

To extend either would be to discover new resources – R&D

Full Employment

The condition that exists when the unemployment rate is equal to the natural unemployment rate.

Full productive capacity has been

Reached.

Image Cylinder= Economy…

Businesses, factories, economynot working at full capacity

Full Employment

AS AD

LRAS

SRAS (short run aggregate supply) Period where adjustment occurs.

Direct relationship

As the output increases that puts upward pressure on price.

Movement on the curve denotes the relationship between price level and real output.

SRAS………….Shift Shift in the curve denotes determinates

that affect more or less real output production at various price levels.

Determinants:Change in input prices (steel, plastic, wool change in resource availability )

Change in productivity (+ = Shift right; - = Shift left) (more for less is the object)

Change in legal environment (contracts, taxes, subsidies)

AD and SRAS

LRAS = long-run aggregate supply

LRAS is a vertical line reflecting that LR Aggregate Supply is not affected by changes in PL.

The LRAS is labeled as the natural level of real GDP

The natural level of real GDP is defined as the level of real GDP that arises when the economy is fully employing all of its available input resources ( We are in agreement that it hovers around 5%)

Long Run Aggregate Supply

Pric

e le

vel

Real domestic output, GDPQ

P LRASLR

Long-runAggregate

Supply

Qf

Full-Employment

RealRateOfInterest

Money Supply

D1

D2

Can a Change in Money Supply Change AD?Probably… but it is a chain of events.MS changes, then Interest Rates, then change in consumptionand investment. Then Change in AD

Equilibrium States of the Economy

During the time an economy moves from one equilibrium to another, it is said to be in disequilibrium.

LRAS

Goods & Services(real GDP)

Price level

P 100

YF

SRAS1

AD1

Unanticipated Increase in Aggregate Demand

In response to an unanticipated increase in AD for goods & services (shift from AD1 to AD2), prices will rise to P105 and output will temporarily exceed full-employment capacity (increases to Y2).

P 105

Y2

AD2

Short-run effects of an unanticipated increase in AD

LRAS1

Goods & Services(real GDP)

Price level

YF

AD

P 1

SRAS1

YF1

SRAS2

YF2

LRAS2

YF2 Here we illustrate the impact of economic growth due to

capital formation or a technological advancement, for example.

Both LRAS and SRAS increase (to LRAS2 and SRAS2); the full employment output of the economy expands from YF1 to YF2.

P 2

Growth in Aggregate Supply

A sustainable, higher level of real output and real income is the result. ***If the money supply is held constant, a new long-run equilibrium will emerge at a larger output rate (YF2) and lower price level (P2).

LRAS

Goods & Services(real GDP)

Price level

AD

YF

P 100

SRAS1 (Pr1)

AP 110

Y2 The higher resource prices shift the SRAS curve to the left; in

the short-run, the price level rises to P110 and output falls to Y2. What happens in the long-run depends on whether the

reduction in the supply of resources is temporary or permanent.

Effects of Adverse Supply Shock

If temporary, resource prices fall in the future, permitting the economy to return to its original equilibrium (A).

If permanent, the productive potential of the economy will shrink (LRAS shifts to the left) and (B) will become the long-run equilibrium.

SRAS2 (Pr2)

B

Pric

e Le

vel

Real Domestic Output, GDP

Q

P ASAD1

INCREASES IN AD: DEMAND-PULL INFLATION

P2

P1

AD2

Qf Q1 Q2

Pric

e Le

vel

Real Domestic Output, GDP

Q

P AS1

AD1

DECREASES IN AS: COST-PUSH INFLATION

P2

QfQ1

a

b

AS2

P1

Long run growth

P

Y

xP1

Yf 1

AD1

Yf 2

LRAS1

AS1

AS2

AD2LRAS2

P2

Consumergoods

Capitalgoods

PPC shif ts out andLRAS shif ts right.

Non-governmental actions that shift AS Shift AS left:

Raw materials cost rise Wages rise faster than productivity Worker productivity decreases Obsolescence Wars Natural disasters

Fiscal Policy Governmental actions that shift AD Shift AD right:

Govt spending increases Taxes decreases Money Supply increases

Shift AD left: G decreases T increases MS decreases