What is Aggregate Demand?
Aggregate- “added all together.”
When we use aggregates
we combine all prices and all quantities.
Aggregate Demand is all the goods and services
(real GDP) that buyers are willing and able to
purchase at different price levels.
The Demand for everything by everyone in the US.
There is an inverse relationship between
price level and Real GDP.
If the price level:
• Increases (Inflation), then real GDP demanded falls.
• Decreases (deflation), the real GDP demanded increases.
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Why is AD downward sloping?
1. The Wealth Effect• Higher price levels reduce the purchasing
power of money. This decreases the quantity of
expenditures
• Lower price levels increase purchasing power
and increase expenditures
2. Interest-Rate Effect-
• When the price level increases, lenders need to
charge higher interest rates to get a REAL
return on their loans.
• Higher interest rates discourage consumer
spending and business investment.
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Why is AD downward sloping?
3. Foreign Trade Effect• When U.S. price level rises, foreign buyers
purchase fewer U.S. goods and Americans
buy more foreign goods
• Exports fall and imports rise causing real
GDP demanded to fall. (NX Decreases)
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Shifters of
Aggregate Demand
GDP = C + I + G + NX
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Shifters of Aggregate Demand
1. Change in Consumer Spending
Increase in Disposable Income (Higher incomes…)
Consumer Expectations (People fear a recession…)
Household Indebtedness (More consumer debt…)
Taxes (Decrease in income taxes…)
2. Change in Investment Spending
Real Interest Rates (Price of borrowing $)
(If interest rates increase…)
(If interest rates decrease…)
Future Business Expectations (High expectations…)
Productivity and Technology (New robots…)
Business Taxes (Higher corporate taxes means…)
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Shifters of Aggregate Demand
3. Change in Government Spending
Government Expenditures
(Decrease in defense spending…)
(Increase in public works programs…)
4. Change in Net Exports (X-M)
Exchange Rates
(If the us dollar depreciates relative to the euro…)
National Income Compared to Abroad
(If a major importer has a recession…)
(If the US has a recession…)
AD = GDP = C + I + G + Xn
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What is Aggregate Supply?
Aggregate Supply is the amount of goods and
services (real GDP) that firms will produce in an
economy at different price levels.
The supply for everything by all firms.
Aggregate Supply differentiates between short
run and long-run and has two different curves.
Short-run Aggregate Supply
•Wages and Resource Prices will not increase
as price levels increase.
Long-run Aggregate Supply
•Wages and Resource Prices will increase as
price levels increase.
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Short-Run Aggregate Supply
In the Short Run, wages and resource prices will NOT
increase as price levels increase.
Example:
• If a firm currently makes 100 units that are sold for
$1 each. The only cost is $80 of labor.
How much is profit?
• Profit = $100 - $80 = $20
What happens in the SHORT-RUN if price level
doubles?
• Now 100 units sell for $2, TR=$200.
How much is profit?
• Profit = $120
With higher profits, the firm has the incentive to
increase production.
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Long-Run Aggregate Supply
In the Long Run, wages and resource prices
WILL increase as price levels increase.
Same Example:
• The firm has TR of $100 an uses $80 of labor.
• Profit = $20.
What happens in the LONG-RUN if price level
doubles?
• Now TR=$200
•In the LONG RUN workers demand higher wages
to match prices. So labor costs double to $160
• Profit = $40, but REAL profit is unchanged.
If REAL profit doesn’t change
the firm has no incentive to increase output.
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Shifters Aggregate
Supply
R. A. P.
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Shifters of Aggregate Supply
1. Change in Resource Prices
Prices of Domestic and Imported Resources
(Increase in price of Canadian lumber…)
(Decrease in price of Chinese steel…)
Supply Shocks
(Negative Supply shock…)
(Positive Supply shock…)
Inflationary Expectations
(If people expect higher prices in the future…)
If producers expect higher prices in the future,
workers will demand higher wages and costs
will increase. This will decrease AS
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Shifters of Aggregate Supply
2. Change in Actions of the Government
(NOT Government Spending)
Taxes on Producers
(Lower corporate taxes…)
Subsidies for Domestic Producers
(Lower subsidies for domestic farmers…)
Government Regulations
(EPA inspections required to operate a farm…)
3. Change in Productivity
Technology
(Computer virus that destroy half the computers…)
(The advent of a teleportation machine…)
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Shifters of Aggregate Demand
AD = C + I + G + X
Change in Consumer Spending
Change in Investment Spending
Change in Government Spending
Net EXport Spending
Shifters of Aggregate Supply
AS = R + A + P
Change in
Change in
Change in
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Resource Prices
Actions of the Government
Productivity
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Use the AD and AS model to show an
economy at full employment output
Price
Level
LRAS
AS
PLe
AD
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The economy can only be in one of
three places at any time
Capital Goods
Max Capacity
0% Unemployment
Real
GDP
Real
GDP
Consumer Goods
Full Employment
5% Unemployment
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Recessionary Gap
Full Employment
Inflationary Gap
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Inflationary Gap
Output is high and unemployment is less than NRU
LRAS
Price
Level
AS
Actual GDP
above potential
GDP
PL1
AD1
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Recessionary Gap
Output low and unemployment is more than NRU
LRAS
Price
Level
AS
Actual GDP
below potential
GDP
PL1
AD1
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Example: If there is a negative “supply shock”
of oil. What happens to PL and Output?
Price
Level
LRAS
AS1
AS
Stagflation
PL1
Stagnate Economy
+ Inflation
PLe
Still considered
recessionary gap
AD
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What Happens In
the Long-Run?
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If consumer spending increases, what will
happen in the short-run and in the long-run?
In the long-run, wages and costs increase
LRAS
AS1
Real
GDP
Price
Level
AS
PL2
Real
GDP
PL1
PLe
AD AD1
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If consumer spending decreases, what will
happen in the short-run and in the long-run?
In the long-run, wages & costs eventually decrease
LRAS
Price
Level
AS
Real
GDP
AS2
PLe
PL1
Real
GDP
PL2
AD2 AD
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The first situation is when an economy experiences a short-run
increase in aggregate demand. This occurs anytime that the
components of consumer spending, investment spending,
government spending, and net exports increase, causing GDP to
increase. When there is a short-run increase in AD, the price level
and real GDP increase. Since wages and prices are flexible in the
long-run, we will see an increase in both of these after this change in
AD. An increase in wages means resource costs are increasing, which
makes it more expensive for firms to produce their goods. As a result,
we will see a decrease in SRAS. This is the economy self-correcting
itself back to potential output. We will have a higher price level , but
our real GDP will return to potential output.
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An example of this could be that businesses decide to spend money
to improve their factories. This will cause an increase in aggregate
demand which leads to an inflationary gap in the short run. Since
wages and resource prices are sticky, we know that eventually, they
will rise in the long run. This will lead to production costs increasing
for firms and as a result, they will decrease their supply which is
shown by a decrease in short-run aggregate supply.
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The second situation is when an economy experiences a short-run
decrease in aggregate demand. This involves anytime that the
components of consumer spending, investment spending, government
spending, and net exports decrease causing GDP to increase. When there
is a short-run decrease in AD, the price level and real GDP decrease.
Since wages and prices are flexible in the long-run, we will see a
decrease in both of these after this change in AD. A decrease in wages
means resource costs are decreasing, making it less expensive for firms
to produce their goods. As a result, we will see an increase in SRAS.
This is the economy self-correcting itself back to potential output. We
will have a lower price level but our real GDP will return to potential
output.
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An example of this could be if consumers are worried about the health
of the economy and so they cut back on their spending which causes
the decrease in aggregate demand in the short run. As wages and
resources prices adjust in the long run, we will see a decrease in these.
Once wages and resource prices decrease than businesses will have
lower production costs which will lead to an increase in short run
aggregate supply.
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The third situation is when the economy experiences a short-run
decrease in aggregate supply (SRAS). This causes inflation and leads
to a recessionary gap (negative output gap).
Again, since prices and wages are flexible, this will result in worker's
wages decreasing because the economy is experiencing a recessionary
gap. The movement from SRAS to SRAS1 shows this. Since the
worker's wages are decreasing, there is a decrease in production costs
for firms. This will cause the economy to self-correct by moving from
SRAS1 back to SRAS.
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The fourth situation is when the economy experiences a short-run
increase in aggregate supply. This leads to deflation and causes an
inflationary gap (positive output gap).
When there is a short-run increase in aggregate supply, it causes an
inflationary gap (move from SRAS to SRAS1). This causes an increase
in output. Worker's wages are going to increase due to the increase in
production. This increase in wages will then cause production costs to
increase for firms. This will then cause a decrease in aggregate supply
(SRAS1 to SRAS) bringing the economy back to long-run equilibrium.
This is how the economy self corrects itself after a short-run increase in
aggregate supply.
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If investment increases, what happens in the
short-run and long-run?
Capital Stock- Machinery and tools purchased by
businesses that increase their output
LRAS LRAS1
AS AS1
PL1
PLe
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Capital Goods
Price
Level
The PPC shifts outward since
producers can make more
Consumer Goods
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An increase in consumption or government
spending doesn’t cause economic growth.
Only Investment causes growth since firms
increase their capital stock
LRAS1
AS1
Capital Goods
Price
Level
PLe
AD1
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Consumer Goods
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