29 Aggregate Demand Aggregate Supply Mc GrawHillIrwin Copyright

29 Aggregate Demand Aggregate Supply Mc. Graw-Hill/Irwin Copyright © 2012 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Aggregate Demand • • LO 1 Real GDP desired at each price level Inverse relationship § Real balances effect-change in the price level. An increase in the price level reduces the real value of purchasing power which leads to less CONSUMPTION. § Interest effect-if we assume the supply of money to be fixed, higher prices lead to a shortfall of dollars. Thus the demand for money rises, increasing the interest rate. This leads to less C and Ig. § Foreign purchases effect-when the U. S. price level rises, foreigners will buy____goods and Americans will buy _____ foreign goods. 29 -2

Price level Aggregate Demand AD 0 LO 1 Real domestic output, GDP 29 -3

Price level Changes in Aggregate Demand AD 2 0 AD 3 AD 1 Real domestic output, GDP LO 1 29 -4

Consumer Spending • • LO 1 Consumer wealth-assets minus liabilities • More wealth =____. Household borrowing Consumer expectations • if we expect our future incomes to rise we will spend more now. • If we expect prices to rise in the future we may also spend now. Personal taxes 29 -5

Investment Spending • • LO 1 Real interest rates-an increase raises borrowing costs. Expected returns • Expectations about future business conditions • If businesses think the economy will be better in the future they will forecast higher rates of return. • Technology • Degree of excess capacity-TOO much excess capacity gives businesses little incentive to INVEST more. • Business taxes 29 -6

Government Spending • Government spending increases • Aggregate demand increases (as • LO 1 long as interest rates and tax rates do not change) • More transportation projects Government spending decreases • Aggregate demand decreases • Less military spending, less unemployment 29 -7

Net Export Spending • National income abroad • Exchange rates • Dollar depreciation-? ? ? • Dollar appreciation-? ? ? LO 1 29 -8

Aggregate Supply • Total real output produced at each • LO 2 price level Relationship depends on time horizon • Immediate short run • Short run-flat up to full emp. then rises quickly. WHY? • Long run- Why is it vertical? 29 -9

AS: Immediate Short Run Price level Immediate-short-run aggregate supply P 1 0 ASISR Qf Real domestic output, GDP LO 2 29 -10

Aggregate Supply: Short Run AS Price level Aggregate supply (short run) 0 Qf Real domestic output, GDP LO 2 29 -11

Aggregate Supply: Long Run Price level ASLR Long-run aggregate supply 0 Qf Real domestic output, GDP LO 2 29 -12

Changes in Aggregate Supply • Determinants of aggregate supply • Shift factors • Changes raise or lower per-unit production costs LO 2 29 -13

Changes in Aggregate Supply AS 3 AS 1 Price level AS 2 0 Real domestic output, GDP LO 2 29 -14

Input Prices • Domestic resource prices • Labor • Capital • Land • Prices of imported resources • Imported oil • Exchange rates LO 2 29 -15

Productivity • Real output per unit of input • Increases in productivity reduce costs • Decreases in productivity increase costs Productivity = Per-unit production cost LO 2 total output total inputs = total input cost total output 29 -16

Legal-Institutional Environment • LO 2 Legal changes alter per-unit costs of output • Taxes and subsidies • Extent of government regulation • More could lead to less agg. supply, however, if deregulation leads to unfair and unsafe business practices, it could move the other direction. • Also, if agg. demand is strong enough, would businesses really cut back? 29 -17

Price level (index numbers) Equilibrium AS 100 a 92 b Real Output Demanded (Billions) Price Level (Index Number) Real Output Supplied (Billions) $506 108 $513 508 104 512 510 100 512 96 507 514 92 502 AD 0 502 510 514 Real domestic output, GDP (billions of dollars) LO 3 29 -18

Increases in AD: Demand-Pull Inflation Price level AS P 2 P 1 AD 2 AD 1 0 Qf Q 1 Q 2 Real domestic output, GDP LO 4 29 -19

Why? • Firms boost investment spending because they anticipate higher future profits from investments in new capital. • Government increases spending for such programs as national defense.

Decreases in AD: Recession Price level AS P 1 P 2 b a c AD 1 AD 2 0 Q 1 Q 2 Qf Real domestic output, GDP LO 4 29 -21

Prices? • Sticky prices • Costs do not necessarily change-menu costs, minimum wage, wage contracts • Morale, productivity-wage inflexibility • Price wars

Decreases in AS: Cost-Push Inflation Price level AS 2 P 1 AS 1 b a AD 0 Q 1 Qf Real domestic output, GDP LO 4 29 -23

Increases in AS: Full-Employment Price level AS 1 P 3 P 2 P 1 AS 2 b a c AD 2 AD 1 0 Q 1 Q 2 Q 3 Real domestic output, GDP LO 4 29 -24