Transcript File

Chapter 1
Aggregate Demand
 Relationship between price level and real GDP
demanded
 “schedule or a curve showing the various amounts of
goods and services—the amounts of real output—that
domestic consumers, businesses, government,and
foreign buyers collectively desire to purchase at each
possible price level”
 AD f (C, I, G, X, M)
Why is the Aggregate Demand
Curve downward sloping?
 Real-Balances effect: higher price level reduces real value
of public’s accumulated financial assets
 Interest-Rate effect: as prices rise, assuming money supply
is fixed, interest rates rise because consumers and
businesses need more money to buy goods and pay for
inputs
 Foreign purchases effect: increases in prices reduce our
exports and increase imports
Why is the Aggregate Demand
Curve downward sloping?
NOT Because of:
Income effect: at lower price levels,
less income is likely to be generated
so real income does not necessarily
go up
Substitution effect: most prices are
decreasing so no one set of
goods/services is getting cheaper
Derivation of aggregate demand curve
from aggregate expenditures model
 If price level falls, wealth increases and consumption
expenditures increase; interest rate decreases and
investment increases
1
2
3
GDP 3
GDP 2 GDP 1
GDP
Derivation
of Aggregate
Demand Curve:
3
2
1
GDP 3
GDP 2 GDP 1
GDP
AD
Determinants of Aggregate Demand
 “Increase in aggregate demand” independent of price
changes
 Rightward movement of aggregate demand curve
 Consumer wealth (non-price related): increases in stock
prices, or increases in housing values
 Expect prices to rise in the future
 Household indebtedness low
 Decrease in interest rates (not caused by price level
change) from money supplying increasing
 Higher expected returns on investment projects
Determinants of Aggregate Demand
 “Increase in aggregate demand” independent of
price changes
 Decrease in business taxes
 Improved technology
 A decline in excess capacity
 Increase in government spending (assuming taxes and
price level do not increase as a result)
 Net export spending
 Rising national income abroad
 Dollar depreciates
Shift of AD curve = initial change in spending x
multiplier
Shift in Aggregate
Demand
Increase in AD
Decrease in AD
AD 1
AD
AD 2
Real GDP
Aggregate Supply
 “Schedule or curve showing the level of
real domestic output which will be
produced at each price level”
 Horizontal range: less than full
employment
 Upsloping (intermediate) range: full
employment is not reached
simultaneously in all factor markets
 Vertical range: economy is at full
capacity
Short Run vs. Long Run
 Short Run: period in which nominal wages (and other
resource prices) do not respond to price-level changes
 Long Run: period in which nominal wages (and other
resource prices) match changes in the price level
Long Run AS
 Vertical at economy’s full employment output (potential
output) level
 Assume: $20 profit needed to produce full employment
output of 100 units (price = $1)
 Hires 10 units of labor at $8 wage
 Profit 100-80=$20
 Suppose price level doubles: $200 revenue and wage bill will
double to $160
 Nominal profit = $200-160=40
 Real profit = $40/2 = $20 [price index $2/$1=1]
Short Run AS
 Real Profit = $200 - $80 = $120/2 = $60
 Rise in real profit gives incentive for firm to want to
produce more
Determinants of Aggregate Supply
 What causes the AS to increase (shift to the right)?
 Lower input prices (domestic or imported)
 Increases in resource (factors of production) availability
 Increased productivity
 Market power of input sellers decreases
 Lower business taxes
 Increased subsidies
 Decreased government regulation
Aggregate Supply
Vertical Range
Horizontal Range- Less
than full employment
Intermediate RangeApproaching Full
Employment
Intermediate Range
Horizontal Range
GDP
Vertical Range- Full
employment
Equilibrium
Price
Level
AS
Equilibrium
Pequilibrium
AD
GDP 1
equilibrium
Real GDP
Equilibrium
 Aggregate amount demanded equals aggregate amount
supplied
 “For any increase in aggregate demand, the resulting
increase in real GDP will be smaller the greater the
increase in the price level
 The multiplier is diminished by rising price level
 Ratchet effect: an increase in demand will not lead to the
same equilibrium quantity as the same decrease in
demand since prices and wages are sticky downwards
[see diagram]
Demand Pull Inflation
 AD shifts to the right
Decreases in AD: Recession and
Cyclical Unemployment
 AD shifts to the left, but prices do not easily go down.
Why are prices sticky downwards?
 Wage contracts
 Lower wages decrease morale and
productivity
 Training investments might make it more
costly to lay off more experienced workers
 Minimum wage
 Menu costs: it is expensive to print new
menus
 Fear of price wars
Decreases in AS: Cost-Push
Inflation
 AS shifts to the left
Increases in AS: Full Employment
with Price-Level Stability
Questions
 3, 4, 5, 7, 9, 12