Aggregate Demand and Aggregate Supply Chapter Objectives Aggregate Demand and the Factors That Cause it to Change Aggregate Demand and the Factors That.

Aggregate Demand andAggregateSupply

Chapter ObjectivesChapter Objectives Aggregate Demand and the Factors That Aggregate Demand and the Factors That

Cause it to ChangeCause it to Change Aggregate Supply and the Factors That Cause Aggregate Supply and the Factors That Cause

it to Changeit to Change How AD and AS Determine an Economy’s How AD and AS Determine an Economy’s

Equilibrium Price Level and the Level of Real Equilibrium Price Level and the Level of Real GDPGDP

How the AD-AS Model Explains Periods of How the AD-AS Model Explains Periods of Demand-Pull Inflation, Cost-Push Inflation, Demand-Pull Inflation, Cost-Push Inflation, and Recessionand Recession

AD – AS ModelAD – AS Model Aggregate DemandAggregate Demand

AD is a schedule, graphically AD is a schedule, graphically represented as a curve, which represented as a curve, which shows the various amounts of shows the various amounts of goods and services – the amount of goods and services – the amount of real domestic output – which real domestic output – which domestic consumers, businesses, domestic consumers, businesses, government and foreign buyers government and foreign buyers collectively will desire to purchase collectively will desire to purchase at each possible price level.at each possible price level.

AGGREGATE DEMAND CURVE

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Real domestic output, GDP

AD

AD – AS ModelAD – AS Model Why the Downward Slope?Why the Downward Slope?

Real-Balances EffectReal-Balances Effect Interest-Rate EffectInterest-Rate Effect Foreign Purchases EffectForeign Purchases Effect

Why the Downward Slope?Why the Downward Slope?

Real-Balances Effect / Wealth Real-Balances Effect / Wealth EffectEffect A higher price level will reduce A higher price level will reduce

the real value or purchasing the real value or purchasing power of the public’s power of the public’s accumulated financial assetsaccumulated financial assets

Why the Downward Slope?Why the Downward Slope?

Interest-Rate EffectInterest-Rate Effect A higher price level – by A higher price level – by

increasing the demand for money increasing the demand for money and the interest rate – reduces the and the interest rate – reduces the amount of real output demanded.amount of real output demanded.

The AD curve assumes that the The AD curve assumes that the supply of money in the economy supply of money in the economy is fixed.is fixed.

Why the Downward Slope?Why the Downward Slope? Foreign Purchases EffectForeign Purchases Effect

The volume of imports and exports The volume of imports and exports depend on, among other things, relative depend on, among other things, relative price level in the country and abroad.price level in the country and abroad.

Thus if the price level rises in Pakistan Thus if the price level rises in Pakistan relative to foreign countries, Pakistani relative to foreign countries, Pakistani buyers will buy more imports at the buyers will buy more imports at the expense of domestic goods. Similarly, expense of domestic goods. Similarly, foreigners will buy fewer Pakistani foreigners will buy fewer Pakistani goods, reducing Pakistan’s exportsgoods, reducing Pakistan’s exports

Changes in Aggregate DemandChanges in Aggregate Demand

Law of DemandLaw of Demand An increase in the price level, An increase in the price level,

other things being equalother things being equal, will , will decrease the quantity of real decrease the quantity of real output demanded. output demanded.

Determinants of Aggregate Determinants of Aggregate Demand (Other Things)Demand (Other Things)

Determinants of Aggregate Determinants of Aggregate DemandDemand

Changes in:Changes in: Consumer SpendingConsumer Spending

Consumer WealthConsumer Wealth Consumer ExpectationsConsumer Expectations Household DebtHousehold Debt Personal TaxesPersonal Taxes

Investment SpendingInvestment Spending Real Interest RatesReal Interest Rates

Changes in Aggregate DemandChanges in Aggregate DemandExpected ReturnsExpected Returns

About Future Business About Future Business ConditionsConditions

TechnologyTechnology Degree of Excess CapacityDegree of Excess Capacity Business TaxesBusiness Taxes

Government SpendingGovernment Spending Net Export SpendingNet Export Spending

National Income AbroadNational Income AbroadExchange RatesExchange Rates

Changes in Aggregate DemandChanges in Aggregate Demand

Real Domestic Output, GDP

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AD1

Increase inAggregateDemand

AD3

AD2Decrease inAggregateDemand

AGGREGATE SUPPLY

•Levels of Real Domestic Output•At Each Possible Price Level•Long-run Supply Curve

•Wages and Resource Prices Match Price Level

•Short-run Supply Curve•Wages and Resource Prices Do Not Match Price Level

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Real domestic output, GDPQ

PLong Run

ASLR

Long-runAggregate

Supply

Qf

Full-Employment

AGGREGATE SUPPLY

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Real domestic output, GDPQ

PShort Run

ASAggregate

SupplyShort-run

Qf

Full-Employment

AGGREGATE SUPPLY

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Real domestic output, GDPQ

P AS3

AS1

AS2

Increase InAggregate

Supply

Decrease InAggregate

Supply

Changes in Aggregate Supply

DETERMINANTS OF AGGREGATE SUPPLY

Input Prices

Domestic Resource Prices•Labor•Land•Capital

Prices of Imported Goods

Market Power

DETERMINANTS OF AGGREGATE SUPPLY

Productivity

Productivity =Total Output

Total Inputs

Legal-Institutional Environment

• Business Taxes and Subsidies

• Government Regulation

Equilibrium and Changes in Equilibrium and Changes in EquilibriumEquilibrium

The equilibrium price level and The equilibrium price level and amount of real domestic output are amount of real domestic output are determined at the intersection of the determined at the intersection of the AD and AS curves.AD and AS curves.

Real OutputDemanded(Billions)

Price Level(Index Number)

Real OutputSupplied(Billions)

$506

508

510

512

514

108

104

100

96

92

$513

512

510

507

502Equilibrium Price Level and

Equilibrium Price Level

Equilibrium and Changes Equilibrium and Changes in Equilibriumin Equilibrium

Real Domestic Output, GDP(Billions of Dollars)

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100

92

502 510 514

a b

AD

AS

Equilibrium

Equilibrium and Changes Equilibrium and Changes in Equilibriumin Equilibrium

Real Domestic Output, GDP

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AD

AS

P1

P2

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AD1

Increase in Aggregate Demand

Demand-PullInflation

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Real Domestic Output, GDP

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P ASAD1

DECREASES IN AD: RECESSION & CYCLICAL UNEMPLOYMENT

P1

AD2

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c

b

Equilibrium and Changes Equilibrium and Changes in Equilibriumin Equilibrium

Real Domestic Output, GDP

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AD

AS

P1

P2

Q1 Qf

Decrease in Aggregate Supply

Cost-PushInflation

AS1

a

b

Derivation of theAggregate Demand Curve

from the Aggregate Expenditures Model

…

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P1

AE1 at P 1

1

1’

P2

AE2 at P 2

2

2’

AE3 at P 3

3

P3

3’

The Aggregate DemandCan Be Constructed

DERIVATION OF THE AGGREGATE DEMAND CURVE

Q3 Q2

Q1Q3 Q2

AD

Real Domestic Output

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P1

AE1 at P 1

SHIFTS IN THE AGGREGATE EXPENDITURESSCHEDULE & THE AGGREGATE DEMAND CURVE

Q1

Q2Q1

AD1

AD2

Increase inAggregate

Expenditures

Increase inAggregateDemand

Real Domestic Output

SUMMARYSUMMARY AD reflects an inverse relationship between the AD reflects an inverse relationship between the

price level and the amount of real domestic price level and the amount of real domestic output demanded.output demanded.

Changes in the price level produce wealth, Changes in the price level produce wealth, interest rate, and foreign purchases effects which interest rate, and foreign purchases effects which explain the downward slope of the AD curve.explain the downward slope of the AD curve.

Changes in one or more of the determinants of Changes in one or more of the determinants of AD alter the amounts of real domestic output AD alter the amounts of real domestic output demanded at each price level; they shift the AD demanded at each price level; they shift the AD curve.curve.

An increase in AD is shown as a rightward shift of An increase in AD is shown as a rightward shift of the AD curve; a decrease entails a leftward shift the AD curve; a decrease entails a leftward shift of the curve.of the curve.

Quick ReviewQuick Review

The equilibrium price level and amount of The equilibrium price level and amount of real domestic output are determined at real domestic output are determined at the intersection of the AD and AS curves.the intersection of the AD and AS curves.

Increase in the AD in upsloping and Increase in the AD in upsloping and vertical ranges of AS cause Demand Pull vertical ranges of AS cause Demand Pull Inflation.Inflation.

Decrease in AS curve cause Cost push Decrease in AS curve cause Cost push inflation.inflation.

Increase in AS expand real domestic Increase in AS expand real domestic output; they result in economic growth.output; they result in economic growth.