7 Aggregate Demand Aggregate Supply Mc GrawHillIrwin Copyright

#7 Aggregate Demand Aggregate Supply Mc. Graw-Hill/Irwin Copyright © 2013 by The Mc. Graw-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 LO 1 7 -2

Price level Aggregate Demand AD 0 LO 1 Real domestic output, GDP 7 -3

Changes in Aggregate Demand • Determinants of aggregate demand • Change in consumer spending • Change in investment spending • Change in government spending • Change in export spending LO 1 7 -4

Price level Changes in Aggregate Demand AD 2 0 AD 3 AD 1 Real domestic output, GDP LO 1 7 -5

Consumer Spending • Consumer wealth • Household borrowing • Consumer expectations • Personal taxes LO 1 7 -6

Investment Spending • Real interest rates • Expected returns • Expectations about future business conditions • Technology • Degree of excess capacity • Business taxes LO 1 7 -7

Investment Spending LO 1 7 -8

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 7 -9

Net Export Spending • National income abroad • Exchange rates • Dollar depreciation • Dollar appreciation LO 1 7 -10

Net Export Spending LO 1 7 -11

Aggregate Supply • Total real output produced at each • LO 2 price level Relationship depends on time horizon • Immediate short run • Short run • Long run 7 -12

AS: Immediate Short Run Price level Immediate-short-run aggregate supply P 1 0 ASISR Qf Real domestic output, GDP LO 2 7 -13

Aggregate Supply: Short Run AS Price level Aggregate supply (short run) 0 Qf Real domestic output, GDP LO 2 7 -14

Aggregate Supply: Long Run Price level ASLR Long-run aggregate supply 0 Qf Real domestic output, GDP LO 2 7 -15

Changes in Aggregate Supply • Determinants of aggregate supply • Change in input prices • Change in productivity • Change in legal-institutional • • LO 2 environment Collectively position the AS curve Changes raise or lower per-unit production costs 7 -16

Changes in Aggregate Supply AS 3 AS 1 Price level AS 2 0 Real domestic output, GDP LO 2 7 -17

Input Prices • Domestic resource prices • Labor • Capital • Land • Prices of imported resources • Imported oil • Exchange rates LO 2 7 -18

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 7 -19

Legal-Institutional Environment • Legal changes alter per-unit costs of output • Taxes and subsidies • Extent of government regulation LO 2 7 -20

Price level (index numbers) Equilibrium AS 100 a 92 b AD 0 502 Real Output Demanded (billions) Price Level (index number) Real Output Supplied (billions) $506 108 $513 508 104 512 510 100 512 96 507 514 92 502 510 514 Real domestic output, GDP (billions of dollars) LO 3 7 -21

AD Increases: 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 7 -22

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 7 -23

Downward Price-Level Inflexibility • Prices are downwardly inflexible • Fear of price wars • Menu costs • Wage contracts • Efficiency wages • Minimum wage law LO 4 7 -24

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 7 -25

The Multiplier Effect • Shifts in AD embody an “initial • change” in spending Price levels and average wage levels are becoming more flexible downward Multiplier = LO 4 Change in real GDP Initial change in spending 7 -26