Aggregate Demand and Aggregate Supply

1. Aggregate Demand and Aggregate Supply Chapter 29

2. Aggregate Demand • Aggregate Demand is the relationship between the price level and the real GDP • When the price level goes up, the demand for real GDP goes down PL AD RGDP

3. Aggregate Demand • Why is the curve downward sloping? • Real-Balance Effect—a higher price level reduces the purchase power of households • Interest-Rate Effect—if the demand for money goes up, then interest rates will go up, causing demand for goods/services to go down • Foreign Purchases Effect—If our price level rises, foreigners buy fewer US products and Americans buy more foreign products • All of these price related issues causes us to move along the AD curve

4. Aggregate Demand • Aggregate Demand can shift due to several determinants: • Change in consumer spending: • Wealth effect: People will spend more if their assets become more valuable, spend less if their assets drop in value • Consumer expectations: If consumers expect their income to rise in the future, they will spend more now. If they expect prices/inflation to go up in the future, they will spend more now • Household indebtedness: If people are in too much debt, they will cut spending, if they don’t have a lot of debt, they will increase their spending • Taxes: If taxes go up, people spend less; if taxes go down, people spend more

5. Aggregate Demand • Other determinants of AD: • Investment Spending • Real Interest Rates: If interest rates go up, businesses will purchase less; if rates go down, they purchase more • Expected Returns: If future business is expected to be good, new technology is anticipated, if they are under excess capacity with current equipment/facilities, and if taxes are low businesses will spend more • Government Spending • If the government decides to spend more for whatever reason, AD goes up, if the government slows spending, AD goes down

6. Aggregate Demand • A final determinant of Aggregated Demand is Net Export Spending • There are a few things that can cause our exports to increase: • Our price level goes down • Our national income abroad goes up (thus more foreigners purchase American goods) • Our exchange rate depreciates making the dollar less valuable and thus easier to purchase more American goods

7. Aggregate Demand • The government spends more on military? • The average household debt drops? • Factories are operating well below capacity? • US exchange rate falls? • The stock market crashes? PL AD1 AD2 AD3 RGDP

8. Aggregate Supply • Aggregate Supply shows the relationship between price level and real GDP output • There is a difference between long run (where nominal wages, etc. match changes in price level) and short run (where nominal wages, etc. don’t respond to price level changes)

9. Long Run Aggregate Supply • Long Run AS shows that when a company is running at full employment output will stay the same regardless of price level • This is because in the LR as price goes up, so will the wages that are used to produce it • In the LR changes in price level does not change Real Profit—think inflation PL ASLR RGDP Qr

10. Aggregate Supply Short Run • In the Short Run wages adjust slowly to changes in price level • Until those wages catch up, firms will increase their output level • This is because firms see a higher real profit until wages rise • In other words, if you produce under employment, you are not making as much as you could; if you produce above employment, you are wasting resources (such as man power) PL AS1 Below full employment Above full employment RGDP Qf

11. Aggregate Supply • Usually when we discuss AS we are referring to the SR • Several determinants can shift the AS curve • Changes in input prices (wages, machinery, equipment, land, imports): if prices goes up it goes to the left, prices go down, the curve moves right • Market Power: the ability to set prices above competitive levels (monopolies, etc.) if they can set prices higher, the curve moves left • Change in productivity: If productivity goes down, curve moves left (productivity = total outputs/total inputs) • Legal institutional environment: business tax increase will move curve left whereas an increase in subsidies will move the curve right • Government regulation: Reduction of regulations move the curve to the right (deregulation that results in dishonest business practices or monopolization will move the curve left)

12. Equilibrium and Changes in Equilibrium • The equilibrium price level and equilibrium real output (GDP) show how much aggregate supply and aggregate demand will be created at a given price level

13. Equilibrium and Changes in Equilibrium Do we have a shortage or a surplus? By how much? If we sell at 92 we will see a shortage 514-502 = 12 PL AS 100 Equilibrium Point a b 92 AD 502 510 514 RGDP

14. Equilibrium and Changes in Equilibrium This is referred to as Demand-Pull inflation because an increase in demand will force an increase in Price Level if you move beyond full employment (Qf) Raises in PL diminish the multiplier effect Price goes up, but at least we are producing more too! PL AS P2 P1 AD2 AD1 Qf Q1 Q2 RGDP

15. Equilibrium and Changes in Equilibrium • You typically do not see a decrease in price levels • The reasons: • Wage contracts—suppliers cannot cut cost by cutting wages because their employees are on contracts • Morale, effort, and productivity—It does no good to cut someone’s pay if the result is they are going to produce less due to demotivation—you will still come up with the same profit • Minimum wage—government sets legal bottom to how much you can pay for domestic labor • Menu costs—To change prices of your goods is very expensive (printing fees, new catalogs, etc.) so it’s not worth it to drop price • Fear of price wars—if you drop your price, a competitor may drop theirs lower and so on and so forth until neither of you are turning a profit

16. Equilibrium and Changes in Equilibrium AS2 PL When something causes supply to go down it is exceptionally bad for the economy—prices go up and GDP goes down This is called Cost-Push Inflation AS1 P2 P1 AD1 Q1 Qf RGDP

17. Equilibrium and Changes in Equilibrium • If demand shifts forward (right) without an increase in supply, the price level will go up • If supply shifts right without an increase in demand, the price level will go up • If supply and demand shift right together, the result will be a much smaller rate of inflation and smaller increase in the price level • We saw this “macroeconomic bliss” during 1996-2000 • In March 2000 a major decrease in investment spending sent AS in reverse starting the recession