Aggregate DemandChapter 9
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Principles of Economics:Macroeconomics - Econ101
9-2
Aggregate Demand• Aggregate demand: The total
quantity of output (real GDP) demanded at alternative price levels in a given time period, ceteris paribus
• The aggregate demand curve illustrates how the real value of purchases varies with the average level of prices
• The downward slope suggests that with a given (constant) income, at lower price levels people will buy more goods and services
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Three Reasons for the Downward SlopeWealth Effect:The change in the purchasing power of dollar-denominated assets that results from a change in the price level.
International Trade Effect:The change in foreign sector spending as the price level changes.
Interest Rate Effect:Changes in household and business buying as the interest rate changes.
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Components of Aggregate Demand
• The four components of aggregate demand are– Consumption (C)– Investment (I)– Government spending (G)– Net exports (X – M)
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Determinants of AD on (C)
Wealth ↓ → C ↓ → AD ↓
1. Wealth - The value of all assets owned, bothmonetary and non- monetary
Expect higher future prices → C↑ → AD↑
Expect lower future prices → C↓ → AD↓
2. Expected Future Prices
Wealth ↑ → C ↑ → AD ↑
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Determinants of AD on (C)
Expect lower future income → C↓ → AD↓
Expect higher future income → C ↑ →A D↑
3. Expected Future Income
Interest Rate ↑ → C↓ → AD↓
Interest Rate ↓ → C ↑ → AD↑
4. Interest Rates
Income taxes ↑ → C↓ → AD↓
Income taxes ↓ → C ↑ → AD↑
5. Income Taxes
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Determinants of AD on (I)
Interest rates ↑ → I↓ → AD↓
Interest rates ↓ → I ↑ → AD↑
1. Interest Rates
Pessimistic about future sales → I↓ → AD↓
Optimistic about future sales → I ↑ → AD↑
2. Expected Future Sales
Business taxes↑ → I↓ → AD↓
Business taxes↓ → I↑ → AD↑
3. Business Taxes
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Determinants of AD on (NE)
Foreign real national income ↓ → EX↓ → NX↓ →AD↓
Foreign real national income ↑ → EX↑ → NX↑ →AD↑
US $ appreciates → EX↓ and IM ↑ → NX↓ →AD↓
US $ depreciates → EX↑ and IM ↓ → NX↑ →AD↑
2. Exchange Rates
1. Foreign Income
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Aggregate Supply• Aggregate supply: The
total quantity of output (real GDP) producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus
• Two reasons for upward sloping curve:– The profit effect– The cost effect
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The Short-Run Aggregate Supply Curve (SRAS) Slopes Upward…………..
….because over the short-run, as the price level increases, the quantity of goods and services firms are willing to supply will
increase.
As prices of final goods & services rise, prices of inputs, such as the wages of workers or the price of a natural resources, rise
more slowly. Profits rise when the prices of the goods & services firms sell rise more rapidly than the prices they pay for
inputs.
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Factors that Shift the Short-Run Aggregate Supply Curve (SRAS)
Wage rates
Productivity
Supply shocks Adverse Beneficial
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Macro Equilibrium• Aggregate supply and
demand curves summarize the market activity of the whole (macro) economy
• Equilibrium (macro): The combination of price level and real output that is compatible with both aggregate demand and aggregate supply
PR
ICE
LE
VE
L
REAL OUTPUT
QE
PE
Aggregatedemand
Aggregatesupply
E
D1 S1
P1
Macro equilibrium
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Competing Theories of Short-Run Instability
• Macro controversies focus on the shape of aggregate supply and demand curves and the potential to shift them
• Demand-side theories, such as Keynesian and Monetary, emphasize aggregate-demand shifts
• Supply-side theories center on shifts in supply
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Keynesian Theory
• Keynes argued that a deficiency of spending tends to depress an economy and cause persistently high unemployment
• Advocated increasing government spending – a rightward AD shift – to move the economy toward full employment
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Monetary Theories
• Monetary Theories emphasize the role of money in financing aggregate demand
• Money and credit affect ability and willingness to buy goods and services
• If credit isn’t available or is too expensive consumers reduce spending and businesses curtail investment
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Supply-Side Theories
• Inadequate supply can keep the economy below its full-employment potential and cause prices to rise as well
• Increases in aggregate supply move us closer to goals of price stability and full employment
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Long-Run Self Adjustment
• Some economists argue that the long-run trend of the economy is what really matters, not short-run fluctuations
• They assert a long-run aggregate supply curve anchored at the natural rate of output (QN)– Flexible prices (and wages) enable the economy to
maintain the natural rate of output QN
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REAL OUTPUT
PRIC
E LE
VEL
The “Natural” Rate of Output
QN
AS
AD2
AD1
P2
P1
Fluctuations in aggregate demand affect the price level but not real output.
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Short vs. Long-run Perspectives
• The long-run aggregate supply curve is likely to be vertical at QN
• The short-run aggregate supply curve is likely to be upward-sloping
• Both aggregate supply and aggregate demand influence short-run macro outcomes
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Policy Strategies
• Shift the aggregate demand curve: Use policy tools that affect total spending
• Shift the aggregate supply curve: Implement policy levers that influence the costs of production or otherwise affect output
• Laissez-faire: Don’t interfere with the market; let markets self adjust
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Selecting Policy Tools
• There are a host of tools available:– Classical laissez faire– Fiscal policy– Monetary policy– Supply-side policy– Trade policy
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Policy Tools
• The laissez-faire approach requires no tools, as the economy naturally self-adjusts to full employment
• Fiscal policy: The use of government taxes and spending to alter macroeconomic outcomes
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Policy Tools
• Monetary policy: The use of money and credit controls to influence macroeconomic outcomes
• Supply-side policy: The use of tax incentives, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services
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Policy Tools
• Trade policy can be used to affect international trade and money flows and shift the aggregate demand and/or the aggregate supply curve
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