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Aggregate Demand andAggregateSupply
Chapter 29
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
29-2
Chapter Objectives
• Aggregate demand (AD)• Aggregate supply (AS)• How AD and AS determine
equilibrium price and real GDP• The AD-AS model
29-3
Aggregate Demand
• Amount of real GDP purchased at each price level
• Why the downward slope?– No income or substitution effect– Real-balances effect: purchasing power
of held assets (C)– Interest-rate effect: demand for $ (I)– Foreign purchases effect (X)
• Consumption, investment, and net exports
29-5
Aggregate Demand
• Determinants of aggregate demand– Fixed variables along the demand curve
• Change in fixed variable (C I G X)• Multiplier effect• Consumer spending variables:
– Consumer wealth: value of assets
– Consumer expectations: income and prices
– Household borrowing: borrowing vs. repaying
– Personal taxes
29-6
Aggregate Demand
• Investment spending variables –Real interest rates (related to
money supply)–Expected returns on investment
• Future business conditions• Technology• Degree of excess capacity• Business taxes
– r = i
29-7
Aggregate Demand
• Government spending• Remember - Non-transfers only
• Net export spending variables• National income abroad• Exchange rates
–UK vs. US
29-8
Changes in Aggregate Demand
Real Domestic Output, GDP
Pri
ce L
evel
AD1
Increase inAggregateDemand
AD3
AD2
Decrease in AggregateDemand
29-9
• Amount real GDP produced at each price level
• Three time horizons• Immediate short run
–Few days to a few months–Sticky prices and wages
• All prices fixed (input and output)• Implicit price agreements (output)• Contractual agreements (input)
Aggregate Supply
29-10
Aggregate Supply
Real Domestic Output, GDP
Pri
ce L
evel ASISR
Immediate-short-run Aggregate
Supply
Qf
29-12
• Short run– Input prices fixed, Output prices variable
• In the Short Run, do firms prefer increase or decrease in Price Level?
– Increase! – Fixed input contracts– Real profit changes
• Long run– All prices variable – inputs and outputs– Full employment GDP– All prices adjust
Aggregate Supply
29-13Real Domestic Output, GDP
Pri
ce L
evel
0 Qf
Aggregate Supply(Short Run)
Slope not constant: per unit production cost and firm capacity
Aggregate Supply
Competition for resources hikes ATC
Plentiful resources limit growth of ATC
29-15
• Determinants of aggregate supply• Change in input price (land, labor, capital)
– Domestic resource prices– Prices of imported resources
• Change in productivity• Change in legal-institutional
environment– Business taxes and subsidies– Government regulation
Aggregate Supply
Determinants of Aggregate Supply
• RPG– RResource Prices– PProductivity– GGovernment taxes, subsidies, regulation
29-16
29-17Real Domestic Output, GDP
Pri
ce L
evel
AS1
Increase inAggregate
Supply
AS3
AS2
Decrease inAggregate
Supply
Aggregate Supply
29-18
Equilibrium
Real OutputDemanded(Billions)
Price Level(Index Number)
Real OutputSupplied(Billions)
$506
508
510
512
514
108
104
100
96
92
$513
512
510
507
502Equilibrium Price Level and
Equilibrium Real GDP
29-19
Real Domestic Output, GDP(Billions of Dollars)
Pri
ce L
evel
100
92
502 510 514
a b
AD
AS
Equilibrium
Equilibrium
29-20
Changes in Equilibrium
Real Domestic Output, GDP
Pri
ce L
evel
AD
AS
P1
P2
Q2Q1Qf
AD1
Increase in Aggregate Demand
Demand-PullInflation
**increase in price level diminishes the multiplier effect
Positive (Inflationary) GDP gap
29-21
Changes in Equilibrium
Real Domestic Output, GDP
Pri
ce L
evel
AD1
AS
P1
P2
Q1Q2 Qf
AD2
Decrease in Aggregate Demand
Creates aRecession
a
c
b
**No change in price level protects full multiplier effect
Negative (recessionary) GDP gap
29-22
• Decrease in aggregate demand– Recession and cyclical unemployment– Deflation?
• Downward price inflexibility:– Fear of price wars– Menu costs– Wage contracts– Morale, effort, and productivity
• Efficiency wages: output per hour of input
– Minimum Wage
Changes in Equilibrium
29-23
Real Domestic Output, GDP
Pri
ce L
evel
AD
AS1
P1
P2
Q1 Qf
Decrease in Aggregate Supply
Cost-PushInflation
AS2
a
b
Changes in Equilibrium
29-24Real Domestic Output, GDP
Pri
ce L
evel
AD1
AS2
P1
P2
Q2Q1
Increases in Aggregate Supply – Full-Employment With Price-Level Stability
AS1
b
AD2
c
P3
Q3
a
Changes in Equilibrium
29-25
Impact of Oil Prices
• Aggregate supply shocks• Cost push inflation• Oil prices affected core inflation prior
to 1980• Core inflation unaffected post 1980
– Energy efficiency– Composition of GDP– Fed vigilance
29-26
Key Terms
• aggregate demand-aggregate supply (AD-AS) model
• aggregate demand• real-balances effect• interest-rate effect• foreign purchases effect• determinants of
aggregate demand• aggregate supply• immediate-short-run
aggregate supply curve
• short-run aggregate supply curve
• long-run aggregate supply curve
• determinants of aggregate supply
• productivity• equilibrium price level• equilibrium real output• menu costs• efficiency wages