Transcript Aggregate Demand

Aggregate Demand
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A schedule or curve that shows the
amounts of real output (GDP) at
various price levels
Price level is measured with the GDP
price index:
• Definition—a price index for all goods
and services that make up Gross
Domestic Product
Aggregate Demand Curve
PL
PL1
PL2
AD
Y1
Y2
Real GDP
Why the downward slope?
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For individual products the reasons are:
• Income effect—as price falls, the consumer’s
income allows for larger purchases of the
product
• Substitution effect—as price falls, the product
becomes relatively less expensive than other
substitutes
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The income effect and substitution effect
do not apply to aggregate demand. Why?
Why the downward slope?
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The income effect does not apply
because as the PL falls, less $ goes
to resource suppliers in the form of
wages, rents, interest, profits, etc.
The substitution effect does not
apply because there are no
substitutes for all goods and services
So, once again, why the downward
slope?
Aggregate Demand and the
downward slope explained (finally!)
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Real-Balances Effect-- higher
prices means our assets have less
value so people are poorer and
consume less
Interest-rate effect—higher prices
drive up the demand for money and
so drive up interest rates, at higher
interest rates, investment falls (more
later)
Aggregate Demand and the
downward slope explained (cont.)
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Foreign-purchases effect—at
higher prices, foreign goods are
cheaper, so net exports falls (more
later)
Changes in AD: Determinants
(factors other than Price level)
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Change in consumer spending (C):
• Consumer Wealth
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Think of appreciating/depreciating assets
like stocks, bonds, real-estate, and land
Not income (remember, the income effect
does not apply to aggregate demand)
• Consumer expectations—about prices,
income, etc.
• Household debt—Think borrowing
• Taxes
Changes in AD: Determinants
(factors other than Price level)
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Change in investment spending (I):
• Interest rates—remember the
investment demand curve?
• Expected Returns
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Expected future business conditions
Technology
Degree of excess capacity—stock of capital
goods
Business taxes
Changes in AD: Determinants
(factors other than Price level)
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Change in government spending (G)
Change in net export spending (Xn):
• Rising income in foreign countries
• Exchange rates (more later)
PL
Initial increase in
Aggregate demand
AD1
Real GDP
PL
Increase in aggregate
demand after multiplier
effect takes hold
AD2
AD1
Real GDP
PL
Initial decrease in
aggregate demand
AD1
Real GDP
PL
Decrease in aggregate
demand after multiplier
effect takes hold
AD1
AD3
Real GDP
PL
AD2
AD1
AD3
Real GDP
Aggregate Supply
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The level of Real Output (GDP) that
firms will produce at each price level
Aggregate supply has two distinct
curves:
• Long Run Aggregate Supply (LRAS)
• Short Run Aggregate Supply (SRAS)
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Let’s start with LRAS
PL
Long Run Aggregate Supply
LRAS
Qf
Real GDP
LRAS
PL
LRAS
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Qf
RGDP
The LRAS represents
the level of output at
full-employment
This is the level of
sustainable
production in the long
run given efficient
use of available
resources
Think PPF
LRAS
PL
LRAS
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Qf
RGDP
LRAS does not
change as the
price level
changes
Only changes
technology or
in the factors
of production
will cause the
LRAS to shift
left or right
LRAS
PL
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LRAS1
Qf
RGDP
What would
happen if the
labor force
increased?
LRAS
PL
LRAS1
LRAS2
Qf
Qf
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RGDP
What is possible
to produce in the
long run has
increased due to
the increase in
one of the
factors of
production
Short Run Aggregate Supply
PL
SRAS
PL1
PL2
NOTE: You can use
Y to show the level
of output
Q2
Q1
Real GDP
Determinants for Short-Run
Aggregate Supply
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Input prices:
• Wages make up about 75% of all business
costs
• Domestic resource prices
• Prices of imported resources
• Supply shocks due to market power—ex. OPEC
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Changes in productivity:
• usually a result of new technology, better
organization of resources, and job
training/education
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Taxes, subsidies, and regulation
Shifts in Short Run Aggregate
Supply
PL
SRAS1
SRAS2
PL1
Q1
Q2
Real GDP
What is the difference between the
long-run and the short-run?
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In the short-run, the prices of inputs like
labor and raw materials cannot adjust to
increases in the price level
As households see an increase in overall
prices, they will demand higher prices for
their resources (i.e. labor, land) to
maintain their standard of living
The long-run has been reached once
wages and cost of inputs have adjusted to
the new higher price level
AD/AS Equilibrium
SRAS1
PL
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PL1
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AD1
Q1
Real GDP
The intersection
of AD and SRAS
establishes the
equilibrium price
level and RGDP
This is the
current level of
productivity
Shifts in AD/AS
SRAS1
PL
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PL2
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PL1
AD2
AD1
Q1
Q2
RGDP
Increase in
aggregate
demand
A.K.A.
Demand-Pull
Inflation
Shifts in AD/AS
PL
SRAS2
SRAS1
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PL2
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PL1
AD1
Q2
Q1
RGDP
Decrease in
aggregate
supply
A.K.A. CostPush Inflation
Downward Inflexibility of Prices
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While decreases in AD will theoretically
cause the price level to drop, this usually
does not happen in reality. Why?
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Fears of price wars (gas stations in the 50’s)
Menu Costs
Wage Contracts
Morale (state workers)
Minimum Wage
A reduction in AD might slow inflation, but
the price level rarely goes backwards
One major exception was The Great
Depression
AD/AS and LRAS
PL
LRAS
SRAS1
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PL1
AD1
Qf
Real GDP
The economy is
operating at full
employment if AD
and SRAS intersect
at LRAS
The goal for policy
makers is to craft
fiscal and
monetary policy
that targets the
LRAS
AD/AS and LRAS
LRAS
PL
SRAS1
PL1
AD1
Q1
Qf
Real GDP
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If the AD/AS
equilibrium is
to the left of
the LRAS, the
economy is in
recession
AD/AS and LRAS
PL
LRAS
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SRAS1
PL1
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AD1
Qf
Q1
Real GDP
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If the AD/AS
equilibrium is to
the right of the
LRAS, the
economy is in
an inflationary
period
How can we
produce beyond
the LRAS?
Only for short
periods of time
Different types of AD/AS graphs
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http://apecon.us/aggregatesupplyke
ynesianclassical2.swf