Chapter 10

Aggregate Demand and Aggregate Supply: The Basic Model

The Basics of Aggregate Demand

• Aggregate demand refers the real value of all new, final, domestically produced goods and services that households, firms, governments, and the foreign sector are willing and able to purchase at a given set of price levels, ceteris paribus.

The Basics of Aggregate Demand (cont’d)

• AD equals: Consumption Spending by Households, plus

Investment Expenditures by Firms, plus

Government Expenditures, plus

Net Exports

• ADC I G (X M )

The Price Level and Aggregate Demand

• The overall price level is the major determinant of total spending in the economy.

• Aggregate demand curve shows relationship between the price level and total spending What is the relationship??

Figure 10.1 The Aggregate Demand Curve

Why the Aggregate Demand Curve Slopes Downward

• There are three basic reasons: The Wealth Effect

• As prices decrease you feel wealthier because you can buy more

The Interest Rate Effect

• As prices fall don’t have to spend as much save more interest rates fall encourage borrowing changes AD

The International Trade Effect

• As prices fall buy more US good imports fall other countries see that our goods are cheaper exports increase

Basic Movements in Aggregate Demand

• Change in aggregate quantity demanded Caused by a change in the overall price level.

Shown by a movement along the aggregate demand curve

Basic Movements in Aggregate Demand (cont’d)

• A change in aggregate demand is caused by changes in forces other than the price level: Macroeconomic policy influences

• Changing interest rates, changing taxes, changes in government spending

Expectations• Consumer confidence

Global influences • Purchasing power of the dollar

• Represented by a shift of the aggregate demand curve

Table 10.1 Key Influences on Changes in Aggregate Demand

Figure 10.2 Change in Aggregate Demand

Can we do it??

• Let’s try number 2…• How will the following actions of

macroeconomic policy affect the US aggregate demand curve? Social Security taxes are increased to extend the life

of the Social Security system• AD shift to the left

The federal government expends its spending on prescription drug benefits under Medicare• AD shift to the right

Consumers expect more disposal income in the future as temporary tax cuts are made permanent• AD shift to the right

The Basics of Aggregate Supply

• Aggregate supply is the real value of all final, domestically produced goods and services that firms are willing to offer for sale at various price levels, ceteris paribus.

• There are two different aggregate supply curves: The Short-Run AS Curve The Long-Run AS Curve

Aggregate Supply in the Short Run

• The short run is a period of time that is too short for firms to adjust fully to changes in the price level. Workers face sticky wages.

• Can’t change nominal wages easily when prices change

Firms face sticky prices.

• Can’t always increase the price of your product

Firms and workers may have mistaken estimates of nominal prices.

• May not have all the information right OOPS

The Price Level and Short-Run Aggregate Supply

• In the short run, a higher price level will cause firms to produce more goods and services. The short-run aggregate supply curve is

upward-sloping.

• A higher price level provides an incentive for firms to increase output. Based on the process of profit maximization

Note: If price rises faster than costs, profitability increases.

Why the Short-Run Aggregate Supply Curve Slopes Upward

Profit per Unitof Output

ProductPrice

Production Costper Unit of Output

Why the Short-Run Aggregate Supply Curve Slopes Upward (cont’d)

• Resource prices (such as nominal wages)

are sticky. They change more slowly than output prices.

• As price levels rise faster than production costs, profit per unit increases, and firms have an incentive to increase output.

Basic Movements in Short-Run Aggregate Supply (cont’d)

• A change in the price level is represented by a movement along a short-run aggregate supply curve. This is called a change in aggregate quantity

supplied.

Figure 10.3 The Short-Run Aggregate Supply Curve

Changes in Short-Run Aggregate Supply

• Changes in other factors other than price can affect profitability at a given price level: Nominal resource prices, especially nominal wages

• Wages account for 2/3 of total production costs

Productivity• Workers become more efficient and produce more

Producers’ expectations• What do firms think will happen in the future?

These changes will shift the entire aggregate supply curve.

Figure 10.4 Change in Short-Run Aggregate Supply

Can we do it??

• Let’s try number 6…• For a given industry, let the product price per unit = $5 and the

production cost per unit = $3 Based on this information, what is the profit per unit for this producer?

• $2 * number of units sold Now let the product price increase to $6 per unit, and the production

cost per unit increase to $3.50 per unit. What is the profit per unit now for this producer?• $2.50 * number of units sold

How should this producer change his production plans in the face of the changing profit per unit?• Should increase production

If many producers faced the same situation, how would this affect the AS curve?• Because it is a PRICE change AS will not shift change in Aggregate

Quantity Supplied