Aggregate Demand and Aggregate Supply

AP Econ. - Leader

Aggregate Demand

• Aggregate Demand refers to the quantity demanded of goods and services, or the quantity demanded of the Real GDP, at various price levels.

Aggregate Demand

• The sum of all expenditure in the economy over a period of time

• Macro concept – WHOLE economy• Formula:

AD = C+I+G+(X-M)– C= Consumption Spending– I = Investment Spending– G = Government Spending– (X-M) = difference between spending on imports and

receipts from exports (Balance of Payments)

Aggregate Demand Curve

• The curve is downward sloping, indicating an inverse relationship between the price level and the quantity demanded of Real GDP: as the price level rises, the quantity demanded of Real GDP falls, and as the price level falls, the quantity of GDP demanded of Real GDP rises.

Why the Aggregate Demand Curve Slopes Downwards

• The Real BalanceReal Balance effect states that the inverse relationship between the price level and the quantity demanded of Real GDP is established through changes in the value of monetary wealth.

• A fall in the price level causes purchasing power to rise, which increases a person’s Monetary Monetary WealthWealth. As people become wealthier, the quantity demanded from the GDP rises.

• A rise in the price level causes Purchasing PowerPurchasing Power to fall which decreases a person’s monetary wealth.

Why the Aggregate Demand Curve Slopes Downwards Cont.

• The Interest Rate EffectInterest Rate Effect states that the inverse relationship between the price level and the quantity demanded of Real GDP is established through changes in household and business spending that is sensitive to changes in interest rates.

A Change in the Quantity Demanded of Real GDP versus a

Change in Aggregate Demand• A Change in the quantity demanded of Real GDP

is brought about by a change in the price level. This would cause a shift down the Aggregate Demand Curve, but would not move the curve.

• A Change in Aggregate Demand is a shift in the Aggregate Demand Curve. An increase is a right shift of the curve, while a decrease in Aggregate Demand would cause a left shift to the curve.

A Shift in the Aggregate Demand Curve

Changes in Aggregate Demand

• If at a given price level, Consumption, Investment, Government Purchases, or Net Exports INCREASE, then Aggregate Demand will INCREASE as well.

• If at a given price level, Consumption, Investment , Government Purchases, or Net Exports DECREASE, the Aggregate Demand will DECREASE as well.

How Spending Can Affect Aggregate Demand

• Components of Spending: – Consumption– Investment– Government Purchases– Net Exports

• A change in some or all of these components can affect aggregate demand.

What Causes Consumption to Increase?

– Tax rates (Fiscal Policy)

– Incomes – short term and expected income over lifetime

– Wage Increases

– Credit

– Interest Rates (Monetary Policy)

– Wealth

• Property

• Shares

• Savings

• Bonds

What Causes Investment to Increase?

• Spending on:– Machinery

– Equipment

– Buildings

– Infrastructure

• Influenced by:– Expected rates of return

– Interest rates

– Expectations of future sales

– Existing Stock / Physical Capital

Increase Government Spending?• Healthcare• Social Welfare• Education• Foreign Aid• Regions• Industry• Law and Order• National Def.

What Would Increase Net Exports?

• Foreign Real National Income: As exports rise, net exports rise, and so does the Real GDP. They can afford to buy more from us.

• Exchange Rate: whether or how far a different monetary unit has appreciated or depreciated when compared to your own monetary units.

Short Run Aggregate Supply

• The quantity supplied of all goods and services in an economy at different price levels.

• The Short Run Aggregate Supply Curve is upward sloping.

Production Capacity of the Economy

• Costs of Production• Technology• Education and Training• Incentives• Taxes• Capital Stock• Worker Productivity

Short-Run Aggregate Supply Curve

Short-Run Aggregate Supply Curve:

• “Sticky” Wages: Some economists believe that wages are sticky or inflexible. Wages may also become sticky because of certain social conventions or perceived notion of fairness. (Nominal Wages – Past Contracts)

• Most individuals are willing to work, and current workers are willing to work more, at higher than at lower real wages.

Short-Run Aggregate Supply Curve Cont.:

• Prices are also sometimes “sticky”: some prices adjust quickly in an economy, others do not.

• Some prices are sticky because there are costs to changing prices, called Menu Costs.

• If some prices are sticky, a decline in the price level is linked with a decrease in output, which is illustrative of an upward-sloping SRAS curve.

Short-Run Aggregate Supply Curve and the Producer:

• Producer Misperceptions: Economists generally agree that producers will produce more output as their relative price of their good rises and produce less output as the relative price of their good falls.

• If producers misperceive relative price changes, then a higher price level will bring about an increase in output, which is illustrative of an upward-sloping SRAS curve.

Shifts in the Aggregate Supply Curve • Wage Rate: a rise

in equilibrium wage rates leads to a leftward shift in the aggregate supply curve.

• Price of Nonlabor units: An increase in the amount nonlabor input shifts the ASC leftward. (PPI)

• A decrease in the amount nonlabor input shifts the ASC rightward.

Shifts in the Aggregate Supply Curve

• Supply Shocks: Major natural or institutional changes on the supply side of the economy that affect aggregate supply are referred to as supply shocks.

• A Supply shock might include a drought in the Midwest, or finding even more oil in the middle east.

How Short-Run Equilibrium In The Economy Is Achieved

• Aggregate demand and short-run aggregate supply determine the price level, Real GDP, and the unemployment rate in the short run.

• In instances of both surplus and shortage, economic forces are moving the economy toward the short-run equilibrium point, where the quantity demanded of Real GDP is equal to the short-run quantity supplied of Real GDP.

• An increase in the short-run aggregate supply lowers the equilibrium price level and raises Real GDP.

The Unemployment Rate In The Short Run

• All other things held constant, we expect a higher Real GDP level to be associated with a lower unemployment rate and a lower Real GDP level to be associated with a higher unemployment rate.

• Since more workers are needed to produce more output (more Real GDP), fewer people remain unemployed and the unemployment rate drops.

• Since fewer workers are needed to produce less output, more people are unemployed and the employment rate rises.

Q & A: Identify what will happen to the price level and Real GDP when

each of the following occurs:• Short-Run Aggregate

Supply rises• Short-Run Aggregate

Supply falls• Aggregate Demand

rises• Aggregate Demand

falls

• Aggregate Demand rises by more than the Short-Run Aggregate Supply rises

• Aggregate Demand falls by less than the Short-Run Aggregate Supply falls

Long Run Aggregate Supply

• Short-Run equilibrium identifies the Real GDP the economy produces when any of these conditions are held: sticky wages, sticky prices, producers’ misperceptions, workers’ misperceptions.

• Wages and prices eventually become unstuck and misperceptions will turn to accurate perceptions: when this happens the economy is said to be in The Long Run. (All prices are flexible.)

• The LRAS curve is graphed as a vertical line because price has no impact on output.

Long Run Aggregate Supply Shifts

• The position of the LRAS curve shows the potential output of an economy. (A shift right increases potential output and a shift left decreases potential output.

• What could cause a shift:*A change in the quantity of resources.*A change in the quality of resources.

(A more well educated work force.)

*A change in technology.

Equilibrium in Aggregate Demand and Aggregate Supply

*Show and explain short run aggregate supply and demand equilibrium.

(Demand Shock / Supply Shock)

*Show and explain SRAS / LRAS / and AD all in equilibrium.

(Long-Run Macroeconomic Equilibrium)