CHAPTER TWENTY-NINE

AGGREGATE DEMAND AND AGGREGATE SUPPLY

What you need to know• Define aggregate demand and aggregate supply. • Give three reasons why the aggregate demand curve slopes

downward. • State the determinants of the aggregate demand curve’s location,

and explain how the curve will shift when one of these determinants changes.

• Distinguish between an initial shift in aggregate demand and the full shift after multiplier effects have been incorporated.

• Explain the shape of the short-run aggregate supply curve. • Explain the shape of the long-run aggregate supply curve. • State the determinants of the aggregate supply curve’s location,

and explain how the curve will shift when one of these determinants changes.

• Find an economy’s equilibrium price level and real domestic output using aggregate demand and aggregate supply.

• Explain how the multiplier effect is weakened when demand-pull inflation exists.

• Demonstrate and explain how a decrease in aggregate demand can cause a recession without a drop in the price level.

• Demonstrate and explain the effects of shifts in aggregate supply on the equilibrium price level and real domestic output of an economy.

• Explain how an economy can maintain full employment and stable prices under conditions of rising aggregate demand.

• Explain the impact of oil price fluctuations on the American economy.

• Define and identify terms and concepts at the end of the chapter and appendix.

In this chapter you will learn• About aggregate demand (AD) and the factors

that cause it to change. • About aggregate supply (AS) and the factors that

cause it to change. • How AD and AS determine an economy’s

equilibrium price level and level of real GDP. • How the AD-AS model explains periods of

demand-pull inflation, cost-push inflation, and recession.

• How the aggregate demand curve relates to the aggregate expenditures model.

Aggregate Demand• Aggregate demand is a schedule or curve that shows the amount of

a nation’s output that buyers desire to purchase at each possible price level (Figure 29.1).

• B. The aggregate demand curve shows an inverse relationship between price level and real domestic output, but the explanation for the inverse relationship is not the same as for demand for a single product, which centered on the income and substitution effects. ▫ 1. The income effect doesn’t apply in the aggregate case, because

when consumers pay lower prices, less nominal income flows to resource producers; therefore, people are not left with a higher real income at lower prices.

▫ 2. The substitution effect doesn’t apply within the scope of domestically produced goods, because while consumers may substitute one specific lower-priced product for another, there is no substitute for “everything.”

continued• 3. Three effects explain the inverse relationship between

price level and real output in aggregate demand. ▫ a. Real balances effect—When the price level falls, the

purchasing power of existing financial balances (wealth) rises, which can increase spending.

▫ b. Interest-rate effect—A decline in the price level lowers the demand for borrowed funds, which lowers interest rates. As a result, spending for interest-sensitive purchases can increase.

▫ c. Foreign purchases effect—When the price level falls, other things equal, domestic prices fall relative to foreign prices. So foreigners buy more American exports and Americans decrease import spending, instead buying more American products that compete with imports. Both effects cause an increase in spending for American products.

Changes in Aggregate Demand• A. Determinants of aggregate demand are the

other factors (besides price level) that can cause a shift or change in aggregate demand (Figure 29.2).

• B. Changes in aggregate demand involve two components: ▫1. A change in one of the determinants of aggregate

demand that directly changes the amount of real GDP demanded.

▫2. A multiplier effect that produces a greater ultimate change in aggregate demand than the initial change in spending.

Determinants of Aggregate Demand• Changes in Consumer Spending

▫ a. Consumer wealth (the wealth effect)—An increase in wealth causes consumers to increase spending.

▫ b. Household borrowing—When consumers borrow more money, current spending increases. However, when the debt must be repaid in the future, consumption will decrease.

▫ c. Consumer expectations—If consumers expect their real incomes to increase, or they fear inflation, current spending will increase. If consumers instead fear a recession, current spending will decrease as they increase saving.

▫ d. Personal taxes—Reductions in personal taxes increase real income, allowing consumers to increase spending.

continued• 2. Changes in Investment Spending

▫ a. Interest rates—A decrease in interest rates reduces the cost of buying capital, so firms are more likely to increase investment spending.

▫ b. Expected returns on investment, which are a function of: i. Expectations about future business conditions—Optimism

increases investment. ii. Technology—New developments enhance expected returns on

investment, increasing investment spending. iii. Degree of excess capacity—Firms with a great deal of unused

capital are unlikely to invest in more; as excess capacity diminishes, investment spending increases.

iv. Business taxes—A decrease in business taxes increases the firm’s after-tax profits from capital investment, causing an increase in capital investment.

continued• 3. Changes in Government Spending • 4. Changes in Net Export Spending

▫ a. National income abroad—Rising national incomes allow consumers to buy more products, including American exports, increasing aggregate demand.

▫ b. Exchange rates—Depreciation of the dollar encourages American exports, because they become less expensive when foreigners can obtain more dollars for their currency. At the same time, dollar depreciation discourages Americans from buying imports because dollars are exchanged for less foreign currency, making imports look more expensive. Therefore, aggregate demand increases for both reasons.

Aggregate Supply• Aggregate supply is a schedule or curve showing the relationship

between a nation’s price level and the amount of real domestic output that firms in the economy produce. This relationship varies depending on how quickly prices for inputs and output can change. ▫ 1. Immediate short run—both input prices and output prices are fixed. ▫ 2. Short run—input prices are fixed, but output prices can vary.

3. Long run—both input prices and output prices can vary. • Aggregate Supply in the Immediate Short Run

▫ 1. Input prices are fixed by contractual agreements, generally labor contracts. Wages and salaries constitute 75 percent of the average firm’s costs.

▫ 2. Output prices are fixed because firms have set a price for customers and agree to supply products at that price (e.g., catalog prices).

▫ 3. The aggregate supply curve is horizontal at a given price level (Figure 29.3).

Aggregate Supply in the Short Run• Input costs are fixed or very inflexible. Labor contract agreements are

generally still in place, and firms may have few choices in finding substitute inputs in the short run.

• Output prices are flexible, as firms can change product prices to respond to changes in some input costs or changes in demand. The lag between changes in resource prices and changes in product prices makes it profitable for firms to increase output when the price level rises.

• The short-run aggregate supply curve is upsloping (Figure 29.4). ▫ a. To the left of full-employment output, the curve is relatively flat. The

relative abundance of idle inputs means that firms can increase output without substantial increases in production costs.

▫ b. To the right of full-employment output, the curve is relatively steep. Shortages of inputs and production bottlenecks will require substantially higher prices to induce firms to produce.

• References to aggregate supply in the remainder of the book apply to the short-run curve, unless otherwise noted.

Aggregate Supply in the Long Run•Both input costs and output prices are

flexible. •The long-run aggregate supply curve is

vertical at the economy’s full-employment output (Figure 29.5).

•The curve is vertical because in the long run, resource prices adjust to changes in the price level, leaving no incentive for firms to change their output.

Changes in Aggregate Supply•Determinants of aggregate supply are the

other factors (besides price level) that can cause a change or shift in aggregate supply (Figure 29.6).

•The determinants cause changes in per-unit production costs and profit at each level of output, which leads firms to change output at each price level.

Determinants of Aggregate Supply• Changes in Input Prices

▫ Domestic resource prices—Decreases in resource prices lower per-unit production costs, increasing aggregate supply.

▫ Prices of imported resources—Decreases in the price of imported resources, whether due to changes in supply or demand for the resource or changes in exchange rates, also lower per-unit production costs, increasing aggregate supply.

• Changes in Productivity ▫ Changes in productivity (total output / total input) can cause changes

in per-unit production costs (total input cost / units of output). ▫ If productivity rises, unit production costs will fall, shifting aggregate

supply to the right and lowering prices. ▫ Productivity improvement primarily results from improved technology,

but also comes from a better-educated workforce, improved forms of business enterprises, and reallocation of labor resources to higher-productivity uses.

Change in the Legal-Institutional Environment• Business taxes and subsidies—Increases in subsidies or

reductions in business taxes lower the per-unit cost of production, increasing the aggregate supply.

• Government regulation—Reductions in the amount of regulation may lower per-unit production costs, increasing aggregate supply. ▫ Supply-side economists argue that reducing government

regulation will significantly reduce production costs and increase aggregate supply, promoting economic growth.

▫ Other economists argue that deregulation results in accounting manipulations, monopolization, and business failures, which are actually more likely to shift aggregate supply to the left, rather than to the right.

Equilibrium and Changes in Equilibrium• Equilibrium price and quantity are found where the aggregate

demand and aggregate supply curves intersect (Key Graph 29.7). • Increases in aggregate demand cause demand-pull inflation (Figure

29.8). ▫ Increases in aggregate demand increase real output and create upward

pressure on prices, especially when the economy operates at or above its full-employment level of output.

▫ An inflationary gap develops, as actual GDP exceeds potential GDP. ▫ The multiplier effect weakens as the aggregate demand curve moves

further right along the aggregate supply curve. More of the increase in spending is absorbed into price increases instead of generating greater real output. For any initial increase in aggregate demand, the greater the increase in price level, the less the increase in real output.

▫ In the 1960s and 1970s, significant increases in government spending for the war in Vietnam caused aggregate demand to increase, causing an increase in output and the price level.

• Decreases in aggregate demand cause recession and cyclical unemployment (Figure 29.9). ▫ Reductions in aggregate demand reduce real output and a recessionary gap

develops, as actual GDP is less than potential GDP. • Deflation is unusual in the American economy because of “sticky prices.”

While disinflation (a reduction in the rate of inflation) occurs, actual deflation (a lowering of prices) generally does not. ▫ Fear of price wars—If rivals retaliate by making deeper cuts in prices, the firm

may become unprofitable. ▫ Menu costs—Firms incur costs by changing prices frequently, so they tend to

“wait out” recessions to see if long-term cuts in prices will be necessary. ▫ Wage contracts—Wages are not flexible in the short run, so businesses can’t

afford to reduce prices. ▫ Morale, effort, and efficiency—Employers seek to pay efficiency wages—wages

that maximize work effort and productivity, minimizing cost. If lower wages reduce morale and productivity, firms will incur higher—not lower—per-unit costs.

▫ Minimum wage—By law, employers cannot pay a lower wage, even if aggregate demand declines.

continued• In the Great Recession of 2007-2009, failure of the

financial sector caused a reverse wealth effect, triggering a decrease in aggregate demand and significant cyclical unemployment, as well as a significant reduction in the inflation rate.

• Consider This … Ratchet Effect—Increases in aggregate demand ratchet the American price level upward, and the higher price level tends to remain even when aggregate demand falls.▫Why?▫Short run impact?▫Long run impact?”

Decreases in aggregate supply cause cost-push inflation (Figure 29.10).•The decrease in aggregate supply causes a

recessionary gap, while at the same time, the price level increases.

• In the 1970s, the oil crisis caused a significant increase in the price of oil, increasing production costs for firms and reducing aggregate supply, which caused cyclical unemployment and inflation simultaneously.▫Prior to the crisis I was paying $.25 (Yes, a

quarter) a gallon for Texaco High Test

Increases in aggregate supply cause full employment with price level stability (Figure 29.11).• An increase in aggregate supply alone would

cause an increase in output with a decrease in prices. Because aggregate demand is generally increasing, causing demand-pull inflation, a simultaneous increase in aggregate supply can limit the increases in prices.

• In the late 1990s, despite strong increases in aggregate demand, prices remained relatively stable (low inflation) as breakthroughs in technology increased productivity gains, causing aggregate supply to shift to the right.

Has the Impact of Oil Prices Diminished?• In the mid- to late 1970s, oil price shocks caused cost-

push inflation, rising unemployment, and a negative GDP gap (stagflation).

• In the late 1980s and through most of the 1990s, oil prices fell, causing an increase in aggregate supply.

• In the mid- to late 2000s, the continuing conflict in Iraq, the rising demand for oil in India and China, increasing economic growth in several industrial nations, and supply disruptions due to hurricanes combined to significantly increase the cost of oil. While economists were concerned that these events would cause severe cost-push inflation, core inflation (inflation rate minus price changes in food and energy) remained steady.

continued• Two reasons explain why oil price shocks have had

less of an impact in recent years: ▫Oil prices are a less significant factor in the American

economy than they were in the 1970s. The amount of gas and oil used to produce each dollar of output has declined significantly since the 1970s. In addition, American production has shifted away from larger, heavier items that require more energy to make and transport, toward smaller and lighter items and services.

▫Federal Reserve monetary policy helped to keep prices stable, preventing oil price increases from becoming generalized into core inflation.

From the Appendix• Derivation of the Aggregate Demand Curve from the Aggregate

Expenditures Model• The aggregate demand curve can be connected to the aggregate expenditures

model by relating possible price levels to corresponding equilibrium GDPs (Appendix Figure 1). ▫ Both models measure real GDP on horizontal axis. ▫ Suppose the initial price level is P1, aggregate expenditures are AE1, and

equilibrium real domestic output is Q1. Point 1 is the corresponding point on the aggregate demand curve.

▫ If the price level rises to P2, aggregate expenditures fall to AE2 because the purchasing power of wealth falls, interest rates may rise, and net exports fall. The new equilibrium is at Q2. That generates Point 2, up and to the left of Point 1 on the aggregate demand curve.

▫ If the price rises to P3, real asset balance value falls, interest rates rise again, and net exports fall so the equilibrium is at Q3. Point 3 is upward and to the left of Point 2.

• The aggregate demand curve is found by drawing a line through Points 1, 2, & 3

Aggregate Demand Shifts and the Aggregate Expenditures Model•When one of the determinants of

aggregate demand schedule shifts up or down (Appendix Figure 2a).

•The change in aggregate expenditures is multiplied, and aggregate demand shifts more than the initial change in spending (Appendix Figure 2b).

•Shift of AD curve = initial change in spending multiplier

•McConnell, Campbell R., Stanley L. Brue, and Sean M. Flynn, eds. Economics. 19thth ed. New York City: McGraw-Hill Irwin, 2012. N. pag. Print.