Chapter 29
 Aggregate Demand is the
relationship between the
price level and the real
GDP
PL
 When the price level
goes up, the demand for
real GDP goes down
AD
RGDP
 Why is the curve downward sloping?
 Real-Balance Effect—a higher price level reduces the
purchase power of households
 Interest-Rate Effect—if the demand for money goes up,
then interest rates will go up, causing demand for
goods/services to go down
 Foreign Purchases Effect—If our price level rises,
foreigners buy fewer US products and Americans buy
more foreign products
 All of these price related issues causes us to move
along the AD curve
 Aggregate Demand can shift due to several
determinants:
 Change in consumer spending:
 Wealth effect: People will spend more if their assets become
more valuable, spend less if their assets drop in value
 Consumer expectations: If consumers expect their income to
rise in the future, they will spend more now. If they expect
prices/inflation to go up in the future, they will spend more
now
 Household indebtedness: If people are in too much debt,
they will cut spending, if they don’t have a lot of debt, they
will increase their spending
 Taxes: If taxes go up, people spend less; if taxes go down,
people spend more
 Other determinants of AD:
 Investment Spending
 Real Interest Rates: If interest rates go up, businesses will
purchase less; if rates go down, they purchase more
 Expected Returns: If future business is expected to be good,
new technology is anticipated, if they are under excess
capacity with current equipment/facilities, and if taxes are
low businesses will spend more
 Government Spending
 If the government decides to spend more for whatever
reason, AD goes up, if the government slows spending, AD
goes down
 A final determinant of Aggregated Demand is Net
Export Spending
 There are a few things that can cause our exports to
increase:
 Our price level goes down
 Our national income abroad goes up (thus more foreigners
purchase American goods)
 Our exchange rate depreciates making the dollar less valuable
and thus easier to purchase more American goods
1.
2.
3.
4.
5.
The government
spends more on
military?
The average household
debt drops?
Factories are operating
well below capacity?
US exchange rate falls?
The stock market
crashes?
PL
AD2
AD1
AD3
RGDP
 Aggregate Supply shows the relationship between
price level and real GDP output
 There is a difference between long run (where nominal
wages, etc. match changes in price level) and short run
(where nominal wages, etc. don’t respond to price level
changes)
 Long Run AS shows that
when a company is running
at full employment output
will stay the same
regardless of price level
PL
ASLR
 This is because in the LR
as price goes up, so will the
wages that are used to
produce it
 In the LR changes in price
level does not change Real
Profit—think inflation
Qr
RGDP
 In the Short Run wages adjust
slowly to changes in price
level
 Until those wages catch up,
firms will increase their
output level
 This is because firms see a
higher real profit until wages
rise
 In other words, if you produce
under employment, you are
not making as much as you
could; if you produce above
employment, you are wasting
resources (such as man
power)
PL
AS1
Below full
employment
Above full
employment
Qf
RGDP
 Usually when we discuss AS we are referring to the SR
 Several determinants can shift the AS curve
 Changes in input prices (wages, machinery, equipment, land,




imports): if prices goes up it goes to the left, prices go down,
the curve moves right
Market Power: the ability to set prices above competitive
levels (monopolies, etc.) if they can set prices higher, the
curve moves left
Change in productivity: If productivity goes down, curve
moves left (productivity = total outputs/total inputs)
Legal institutional environment: business tax increase will
move curve left whereas an increase in subsidies will move the
curve right
Government regulation: Reduction of regulations move the
curve to the right (deregulation that results in dishonest
business practices or monopolization will move the curve left)
 The equilibrium price level and equilibrium real
output (GDP) show how much aggregate supply and
aggregate demand will be created at a given price level
PL
AS
Do we have a
shortage or a
surplus?
By how much?
If we sell at 92 we
will see a shortage
514-502 = 12
100
92
a
Equilibrium
Point
b
AD
502
510 514
RGDP
PL
This is referred to as
Demand-Pull
inflation because an
increase in demand
will force an increase
in Price Level if you
move beyond full
employment (Qf )
AS
P2
Raises in PL diminish
the multiplier effect
P1
AD1
Qf
Q1 Q 2
AD2 Price goes up, but at
least we are
producing more too!
RGDP
 You typically do not see a decrease in price levels
 The reasons:
 Wage contracts—suppliers cannot cut cost by cutting wages
because their employees are on contracts
 Morale, effort, and productivity—It does no good to cut someone’s
pay if the result is they are going to produce less due to
demotivation—you will still come up with the same profit
 Minimum wage—government sets legal bottom to how much you
can pay for domestic labor
 Menu costs—To change prices of your goods is very expensive
(printing fees, new catalogs, etc.) so it’s not worth it to drop price
 Fear of price wars—if you drop your price, a competitor may drop
theirs lower and so on and so forth until neither of you are turning a
profit
AS2
PL
AS1
P2
When something
causes supply to go
down it is
exceptionally bad for
the economy—prices
go up and GDP goes
down
This is called CostPush Inflation
P1
AD1
Q1 Qf
RGDP
 If demand shifts forward (right) without an increase in
supply, the price level will go up
 If supply shifts right without an increase in demand,
the price level will go up
 If supply and demand shift right together, the result
will be a much smaller rate of inflation and smaller
increase in the price level
 We saw this “macroeconomic bliss” during 1996-2000
 In March 2000 a major decrease in investment spending
sent AS in reverse starting the recession