AGGREGATE DEMAND – is a schedule or curve that shows amounts of real output that buyers collectively desire to purchase at each possible price level.
- Aggregate Demand Curve
The aggregate demand curve slopes downward as does the demand curve for an individual product.
- Reasons Why ADC Slopes Downward
· Real-balances effect – indicates that the inflation reduces the real value or purchasing power of fixed-value financial assets held by households, causing cutbacks in consumer spending.
· Interest-rate effect – means that, with a specific supply of money, a higher price level increases the demand for money, thereby causing to raise the interest rate and reducing investment purchases.
· Foreign purchases effect – suggests that an increase in the country’s price level relative to the price levels in other countries reduces the net export component of that nation’s aggregate demand.
- Determinants of Aggregate Demand
Changes in aggregate demand involves two components:
-A change in one of the determinants of demand that directly changes the amount of real GDP.
-A multiplier effect that produces a greater ultimate change in aggregate demand than the initiating change in spending.
· Consumer Spending
Factors that change consumer spending:
-Consumer wealth – includes both financial assets such as stocks and bonds and physical assets such as houses and land.
-Consumer expectations – when people expect their future real incomes to rise, they tend to spend more of their current incomes.
-Household indebtedness – households finance some of their spending by borrowing.
-Taxes – a reduction in personal income tax rates raises take-home income and increases consumer purchases at each possible price level.
· Investment Spending
Factors that change investment spending:
-Real interest rates – an increase in interest rates will lower investment spending and reduce aggregate demand.
-Expected returns – higher expected returns on investment projects will increase the demand for capital goods and shift the aggregate demand curve to the right.
Factors that influence expected returns:
-Expectations about future business conditions
-Technology
-Degree of excess capacity
-Business taxes
· Government Spending
· Net Export Spending
Factors that change net export spending:
-National Income Abroad – Rising national income abroad encourages foreigners to buy more products, some of which are made in the U.S.
AGGREGATE SUPPLY – is a schedule or curve showing the level of real domestic output that firms will produce at each price level.
- Aggregate supply in the long run – assumes that nominal wages and other input prices fully match any change in the price level. The curve is vertical at the full-employment output.
- Aggregate supply in the short run – assumes nominal wages and other input prices do not respond to the price-level changes. It is generally upsloping because per-unit production costs, and hence the prices that firms must receive, rise as real output expands.
- Determinants of Aggregate Supply
· Input or Resource Prices – are a major ingredient of per-unit production costs. These resources can either be:
-Domestic resource prices
-Prices of imported resources
-Market power
· Productivity – is a measure of the relationship between a nation’s level of real output and the amount of resources used to produce that output.
Productivity = total output/ total inputs
Per-unit production cost = total input cost/ total output
· Legal-Institutional Environment
Two changes of this type are:
-Businesses taxes and subsidies
-Government regulation
EQUILIBRIUM AND CHANGES IN EQUILIBRIUM
- Increases in AD: Demand –Pull Inflation
Increases in aggregate demand to the right of full-employment output cause inflation and positive GDP gaps. An upsloping aggregate supply curve weakens the multiplier effect of an increase in aggregate demand because a portion of the increase in aggregate demand is dissipated in inflation.
- Decreases in AD: Recession and Cyclical Unemployment
Shifts of the aggregate demand curve to the left of the full-employment output cause recession, negative GDP gaps and cyclical unemployment. The price level may not fall during recessions because of downwardly inflexible prices and wages. This inflexibility results from wage contracts, efficiency wages, menu costs, minimum wages, and fear of price wars. When the price level is fixed, full multiplier effects, occur along what, in essence, is a horizontal portion of the aggregate supply curve.
- Decreases in AS: Cost-Push Inflation
Leftward shifts of the aggregate supply curve reflects increases in per-unit production costs and cause cost-push inflation, with accompanying negative GDP gaps.
- Increase in AS: Full-Employment with Price-Level Stability
Rightward shifts of the aggregate supply curve, caused by large improvements in productivity, help explain the simultaneous achievement of full-employment, economic growth and price stability that occurred in the United States between 1996 and 2000.
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