Aggregate Demand and Aggregate Supply - · PDF fileAggregate Demand and Aggregate Supply . Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 17-22 FIGURE 17.1 Aggregate

Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Chapter 17 Aggregate Demand and Aggregate Supply

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 17-2

AS & AD -- Supply and Demand curves for the entire economy.

RGDP (Q)

GDP DEFLATOR (P)

AD

ASP = Price level for the economy as a whole Q = Real GDP (output of goods & services) AD = total quantity of output (of goods and services) demanded by all sectors in the economy at various price levels. AD=C+I+G+X-IM AS = total quantity of output supplied by all producers at various price levels.


AS is production, AD is purchases, equilibrium Real GDP (RGDP) occurs when production is equal to purchases

•  At P>P*, AS > AD (Production is greater than purchases), so Inventories increase, firms lower Q, lower P

•  At P<P*, AD > AS, inventories decrease, firms raise Q, raise P

•  End up at equilibrium Price level and Real GDP

RGDP (Q)

GDP DEFLATOR (P)

AD

AS

P*


Aggregate Demand curve slopes downward because of 3 effects:

1.  Real balance effect: –  Higher prices mean less real wealth for consumers, causing consumers

to spend less. Lower prices increase consumers' purchasing power, leading to increases in spending (AD).

2.  Real interest rate effect: –  Higher prices cause real interest rates to rise –  Firms and individuals need to borrow more money than usual to buy

what they normally buy, increasing Money Demand. –  Less funds in banks results in higher interest rates, which causes a

decreases in spending and AD. 3.  Foreign trade effect:

–  Higher prices on US goods and services makes our goods less competitive (reducing exports) while making imports more attractive to US citizens (increasing imports), decreasing AD.


The Aggregate Demand curve SHIFTS whenever there is a change in one of its components

•  Change in C, I, G, X, or IM from something other than a change in the price level.

•  The magnitude of the shift of the Aggregate Demand curve depends on the initial change in spending and the MULTIPLIER.


Aggregate Supply (AS) curve

•  Slopes upwards because higher prices encourage firms to increase production, increasing Real GDP

•  The Aggregate Supply curve SHIFTS when the following events occur:

1.  input price shocks occur (sharp increases in wages, oil prices, etc.); 2.  the availability of productive resources (land, labor and capital)

changes; 3.  technology & productivity improve.

•  Generally, if costs increase or profitability decreases, the AS curve will shift up & to the left;

–  If costs of production decrease or profitability increases, the AS curve will shift down & to the right.


The SHAPE of the AS curve •  depends on where the economy is relative to its normal

capacity, Potential Real GDP (PRGDP).

AS P

RGDP

PRGDP

• When the economy is well below PRGDP, the AS curve is flat because GDP can increase without increasing prices (unemployment and excess capacity keep wages and input prices low).

• As the economy nears PRGDP, increases in GDP cause some increases in the price level (prices start to increase as firms increase production).


The SHAPE of the AS curve •  depends on where the economy is relative to its normal

capacity, Potential Real GDP (PRGDP).

AS P

RGDP

PRGDP

• Past PRGDP, the economy is overheated and the costs of production increase rapidly as GDP expands (firms must expand plant size to meet demand, train workers for new jobs because not enough skilled labor is available).


Shifts in AD & AS

Examples where only 1 curve shifts. •  Example 1: Consumer confidence declines. •  Example 2: Oil prices increase. •  Example 3: The Fed decreases interest rates. Examples where both AS and AD shift. •  Example 4: Lower wages. •  Example 5: Devaluation of the US $. •  Practice Problems


Analyze what will happen to AD, AS, P & RGDP when The stock market crashes, undermining consumer and investor confidence

Real GDP (Trillions of $)

Price Index (1996=100)

AS

AD

● 118

10

Consumer spending (C) and investment spending (I) will decline, causing a decrease in AD. The price level and Real GDP will decline as a result of the decrease in AD.

AD2


What will happen to AD, AS, P and RGDP when Interest rates decrease?



AS

AD

● 118

10

Consumers and investors will borrow more money to spend (C) and invest (I), increasing AD. The price index and Real GDP will increase as a result.

AD2


What will happen to AD, AS, P and RGDP when energy costs increase



AS

AD

● 118

10

Higher costs of production will cause AS to decrease. The price index will increase and Real GDP will decrease as a result.

AS2


What will happen to AD, AS, P and RGDP when wages decrease



AS

AD

● 118

10

Lower costs will cause AS to increase. Lower income will cause AD to decrease. The result will be a decline in the price index but little or no change in Real GDP.

AS2

AD2

●


What will happen to AD, AS, P and RGDP when the dollar depreciates in value



AS

AD

● 118

10

Foreign goods become more expensive. The increases US exports and reduces US imports, increasing AD. But foreign inputs become more expensive, causing a small decrease in AS. The price index increases and RGDP increases slightly.

AD2

AS2

●


More details on Aggregate Demand Shifts

•  In the next slides, we go through in more detail the factors that affect each component of aggregate demand


Consumption (C) changes as a result of changes in:

1.  Income –  Disposable Income = Total Income (RGDP) - Net Taxes (T) –  Disposable Income (DI) is either consumed (C) or saved (S):

DI = C + S –  Marginal Propensity to Consume: mpc=ΔC/ΔDI –  Marginal Propensity to Save: mps=ΔS/ΔDI –  mpc+mps=1 (disposable income is either consumed or saved)

2.  Wealth and Debt (Assets), interest rates 3.  Expectations 4.  Taxes (any reduction in taxes increases DI, which will then

increase C & S) 5.  Preferences for current consumption


Investment (I) changes as a result of changes in:

1.  expectations about AD (sales) 2.  interest rates 3.  expectations about input/output prices &

profitability 4.  capacity utilization 5.  technology 6.  taxes


Government Spending

•  Government Spending (G) generally depends on politics and does not always change in a systematic manner.

•  Except for Automatic Stabilizers – Which increase G in recessions and increase T

during expansions.


Net Exports (Exports - Imports) change as a result of changes in:

1.  US income (we buy more imports when our income is higher)

2.  Foreign income (they buy more of our goods when their income is higher)

3.  Relative prices of foreign and domestic goods 4.  Exchange rates 5.  Taxes and tariffs


General Rule for Shifts in AD:

•  Changes in any one of the components of AD will shift the AD curve, unless the change occurs as a result of a change in the price level. Price level changes are already built into the slope of the AD curve.


FIGURE 17.BP.1 Aggregate Demand and Aggregate Supply


FIGURE 17.1 Aggregate Demand and Aggregate Supply


FIGURE 17.2 Aggregate Demand


FIGURE 17.3 Money Demand with a Price Increase


FIGURE 17.4 Demand for Investment Funds


FIGURE 17.5 Movement Along the Aggregate Demand Curve


FIGURE 17.6 Shifts in the Aggregate Demand Curve


TABLE 17.1 Effects of Monetary and Fiscal Policy on Aggregate Demand


FIGURE 17.7 Short-Run Aggregate Supply


FIGURE 17.8 A Supply Shock


FIGURE 17.9 Equilibrium with Aggregate Demand and Long-Run and Short-Run Aggregate Supply


FIGURE 17.10 Impact of Productivity Increases on Long-Run Aggregate Supply


TABLE 17.2 Growth of U.S. Output per Person-Hour Worked, 1973–2007


FIGURE 17.11 Output per Manufacturing Employee in Selected Countries


FIGURE 17.12 Economic Growth in the United States, 1895–2005


FIGURE 17.BP.2 Construction of the Aggregate Demand–Aggregate Supply Model


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Aggregate Demand and Aggregate Supply - · PDF fileAggregate Demand and Aggregate Supply . Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 17-22 FIGURE 17.1 Aggregate