Aggregate Demand andAggregateSupply

Chapter 29

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

29-2

Chapter Objectives

• Aggregate demand (AD)• Aggregate supply (AS)• How AD and AS determine

equilibrium price and real GDP• The AD-AS model

29-3

Aggregate Demand

• Amount of real GDP purchased at each price level

• Why the downward slope?– No income or substitution effect– Real-balances effect: purchasing power

of held assets (C)– Interest-rate effect: demand for $ (I)– Foreign purchases effect (X)

• Consumption, investment, and net exports

29-4

Aggregate Demand Curve

Real Domestic Output, GDP

Pri

ce L

evel

AD

AggregateDemand

29-5

Aggregate Demand

• Determinants of aggregate demand– Fixed variables along the demand curve

• Change in fixed variable (C I G X)• Multiplier effect• Consumer spending variables:

– Consumer wealth: value of assets

– Consumer expectations: income and prices

– Household borrowing: borrowing vs. repaying

– Personal taxes

29-6

Aggregate Demand

• Investment spending variables –Real interest rates (related to

money supply)–Expected returns on investment

• Future business conditions• Technology• Degree of excess capacity• Business taxes

– r = i

29-7

Aggregate Demand

• Government spending• Remember - Non-transfers only

• Net export spending variables• National income abroad• Exchange rates

–UK vs. US

29-8

Changes in Aggregate Demand

Real Domestic Output, GDP

Pri

ce L

evel

AD1

Increase inAggregateDemand

AD3

AD2

Decrease in AggregateDemand

29-9

• Amount real GDP produced at each price level

• Three time horizons• Immediate short run

–Few days to a few months–Sticky prices and wages

• All prices fixed (input and output)• Implicit price agreements (output)• Contractual agreements (input)

Aggregate Supply

29-10

Aggregate Supply

Real Domestic Output, GDP

Pri

ce L

evel ASISR

Immediate-short-run Aggregate

Supply

Qf

Aggregate Supply

29-11

29-12

• Short run– Input prices fixed, Output prices variable

• In the Short Run, do firms prefer increase or decrease in Price Level?

– Increase! – Fixed input contracts– Real profit changes

• Long run– All prices variable – inputs and outputs– Full employment GDP– All prices adjust

Aggregate Supply

29-13Real Domestic Output, GDP

Pri

ce L

evel

0 Qf

Aggregate Supply(Short Run)

Slope not constant: per unit production cost and firm capacity

Aggregate Supply

Competition for resources hikes ATC

Plentiful resources limit growth of ATC

29-14

Aggregate Supply

Real Domestic Output, GDP

Pri

ce L

evel

ASLR

Long-runAggregate

Supply

Qf

29-15

• Determinants of aggregate supply• Change in input price (land, labor, capital)

– Domestic resource prices– Prices of imported resources

• Change in productivity• Change in legal-institutional

environment– Business taxes and subsidies– Government regulation

Aggregate Supply

Determinants of Aggregate Supply

• RPG– RResource Prices– PProductivity– GGovernment taxes, subsidies, regulation

29-16

29-17Real Domestic Output, GDP

Pri

ce L

evel

AS1

Increase inAggregate

Supply

AS3

AS2

Decrease inAggregate

Supply

Aggregate Supply

29-18

Equilibrium

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 Real GDP

29-19

Real Domestic Output, GDP(Billions of Dollars)

Pri

ce L

evel

100

92

502 510 514

a b

AD

AS

Equilibrium

Equilibrium

29-20

Changes in Equilibrium

Real Domestic Output, GDP

Pri

ce L

evel

AD

AS

P1

P2

Q2Q1Qf

AD1

Increase in Aggregate Demand

Demand-PullInflation

**increase in price level diminishes the multiplier effect

Positive (Inflationary) GDP gap

29-21

Changes in Equilibrium

Real Domestic Output, GDP

Pri

ce L

evel

AD1

AS

P1

P2

Q1Q2 Qf

AD2

Decrease in Aggregate Demand

Creates aRecession

a

c

b

**No change in price level protects full multiplier effect

Negative (recessionary) GDP gap

29-22

• Decrease in aggregate demand– Recession and cyclical unemployment– Deflation?

• Downward price inflexibility:– Fear of price wars– Menu costs– Wage contracts– Morale, effort, and productivity

• Efficiency wages: output per hour of input

– Minimum Wage

Changes in Equilibrium

29-23

Real Domestic Output, GDP

Pri

ce L

evel

AD

AS1

P1

P2

Q1 Qf

Decrease in Aggregate Supply

Cost-PushInflation

AS2

a

b

Changes in Equilibrium

29-24Real Domestic Output, GDP

Pri

ce L

evel

AD1

AS2

P1

P2

Q2Q1

Increases in Aggregate Supply – Full-Employment With Price-Level Stability

AS1

b

AD2

c

P3

Q3

a

Changes in Equilibrium

29-25

Impact of Oil Prices

• Aggregate supply shocks• Cost push inflation• Oil prices affected core inflation prior

to 1980• Core inflation unaffected post 1980

– Energy efficiency– Composition of GDP– Fed vigilance

29-26

Key Terms

• aggregate demand-aggregate supply (AD-AS) model

• aggregate demand• real-balances effect• interest-rate effect• foreign purchases effect• determinants of

aggregate demand• aggregate supply• immediate-short-run

aggregate supply curve

• short-run aggregate supply curve

• long-run aggregate supply curve

• determinants of aggregate supply

• productivity• equilibrium price level• equilibrium real output• menu costs• efficiency wages

29-27

Next Chapter Preview…

Fiscal Policy,Deficits, and Debt