January 12, 2011
Aggregate
Demand and
Aggregate
Supply
Aggregate Demand
• Amount of real GDP purchased at
each price level
• Why the downward slope?
–Real-balances effect
–Interest-rate effect
–Foreign purchases effect
• Consumption, investment, and
net exports
2
Price Level
Aggregate Demand Curve
Aggregate
Demand
AD
Real Domestic Output, GDP
3
Aggregate Demand
• Determinants of aggregate demand
– Fixed variables along the demand curve
• Change in fixed variable
• Multiplier effect
• Consumer spending variables:
– Consumer wealth
– Consumer expectations
– Household borrowing
– Personal taxes
4
Aggregate Demand
• Investment spending variables
–Real interest rates
–Expected returns
• Future business conditions
• Technology
• Degree of excess capacity
• Business taxes
5
Aggregate Demand
• Government spending
• Net export spending variables
• National income abroad
• Exchange rates
6
Changes in Aggregate Demand
Price Level
Increase in
Aggregate
Demand
Decrease in
Aggregate
Demand
AD2
AD1
AD3
Real Domestic Output, GDP
7
Aggregate Supply
• Amount real GDP produced at
each price level
• Three time horizons
• Immediate short run
–Few days to a few months
–All prices fixed
–Implicit price agreements
–Contractual agreements
8
Price Level
Aggregate Supply
ASISR
Immediate-shortrun Aggregate
Supply
Qf
Real Domestic Output, GDP
9
Aggregate Supply
• Short run
–Input prices fixed
–Output prices variable
–Real profit changes
• Long run
–All prices variable
–Full employment GDP
–All prices adjust
10
Aggregate Supply
Slope not constant: per unit production cost
and firm capacity
Price Level
Aggregate Supply
(Short Run)
0
Qf
Real Domestic Output, GDP
11
Aggregate Supply
Price Level
ASLR
Long-run
Aggregate
Supply
Qf
Real Domestic Output, GDP
12
Aggregate Supply
• Determinants of aggregate supply
• Change in input price
– Domestic resource prices
– Prices of imported resources
• Change in productivity
• Change in legal-institutional
environment
– Business taxes and subsidies
– Government regulation
13
Aggregate Supply
AS3
AS1
AS2
Price Level
Decrease in
Aggregate
Supply
Increase in
Aggregate
Supply
Real Domestic Output, GDP
14
Equilibrium
Real Output
Demanded
(Billions)
Price Level
(Index Number)
Real Output
Supplied
(Billions)
$506
108
$513
508
104
512
510
100
510
512
96
507
514
92
502
Equilibrium Price Level and
Equilibrium Real GDP
15
Equilibrium
Price Level
AS
Equilibrium
100
92
a
b
AD
502
510 514
Real Domestic Output, GDP
(Billions of Dollars)
16
Changes in Equilibrium
Increase in Aggregate Demand
Price Level
AS
Demand-Pull
Inflation
P2
P1
AD1
AD
Qf
Q1 Q2
Real Domestic Output, GDP
17
Changes in Equilibrium
Decrease in Aggregate Demand
Price Level
AS
b
P1
a
c
P2
Creates a
Recession
AD1
AD2
Q1 Q2 Q f
Real Domestic Output, GDP
18
Changes in Equilibrium
• 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
– Minimum Wage
19
Changes in Equilibrium
Decrease in Aggregate Supply
Price Level
AS2
Cost-Push
Inflation
P2
P1
AS1
b
a
AD
Q1 Q f
Real Domestic Output, GDP
20
Changes in Equilibrium
Increases in Aggregate Supply –
Full-Employment With Price-Level Stability
Price Level
AS1
P3
P2
P1
AS2
b
c
a
AD2
AD1
Q1
Q2Q3
Real Domestic Output, GDP
21