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Aggregate Demand and Aggregate Supply
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Aggregate Demand andAggregateSupply
Chapter ObjectivesChapter Objectives Aggregate Demand and the Factors That Aggregate Demand and the Factors That
Cause it to ChangeCause it to Change Aggregate Supply and the Factors That Cause Aggregate Supply and the Factors That Cause
it to Changeit to Change How AD and AS Determine an Economy’s How AD and AS Determine an Economy’s
Equilibrium Price Level and the Level of Real Equilibrium Price Level and the Level of Real GDPGDP
How the AD-AS Model Explains Periods of How the AD-AS Model Explains Periods of Demand-Pull Inflation, Cost-Push Inflation, Demand-Pull Inflation, Cost-Push Inflation, and Recessionand Recession
AD – AS ModelAD – AS Model Aggregate DemandAggregate Demand
AD is a schedule, graphically AD is a schedule, graphically represented as a curve, which represented as a curve, which shows the various amounts of shows the various amounts of goods and services – the amount of goods and services – the amount of real domestic output – which real domestic output – which domestic consumers, businesses, domestic consumers, businesses, government and foreign buyers government and foreign buyers collectively will desire to purchase collectively will desire to purchase at each possible price level.at each possible price level.
AGGREGATE DEMAND CURVE
Pri
ce le
vel
Real domestic output, GDP
AD
AD – AS ModelAD – AS Model Why the Downward Slope?Why the Downward Slope?
Real-Balances EffectReal-Balances Effect Interest-Rate EffectInterest-Rate Effect Foreign Purchases EffectForeign Purchases Effect
Why the Downward Slope?Why the Downward Slope?
Real-Balances Effect / Wealth Real-Balances Effect / Wealth EffectEffect A higher price level will reduce A higher price level will reduce
the real value or purchasing the real value or purchasing power of the public’s power of the public’s accumulated financial assetsaccumulated financial assets
Why the Downward Slope?Why the Downward Slope?
Interest-Rate EffectInterest-Rate Effect A higher price level – by A higher price level – by
increasing the demand for money increasing the demand for money and the interest rate – reduces the and the interest rate – reduces the amount of real output demanded.amount of real output demanded.
The AD curve assumes that the The AD curve assumes that the supply of money in the economy supply of money in the economy is fixed.is fixed.
Why the Downward Slope?Why the Downward Slope? Foreign Purchases EffectForeign Purchases Effect
The volume of imports and exports The volume of imports and exports depend on, among other things, relative depend on, among other things, relative price level in the country and abroad.price level in the country and abroad.
Thus if the price level rises in Pakistan Thus if the price level rises in Pakistan relative to foreign countries, Pakistani relative to foreign countries, Pakistani buyers will buy more imports at the buyers will buy more imports at the expense of domestic goods. Similarly, expense of domestic goods. Similarly, foreigners will buy fewer Pakistani foreigners will buy fewer Pakistani goods, reducing Pakistan’s exportsgoods, reducing Pakistan’s exports
Changes in Aggregate DemandChanges in Aggregate Demand
Law of DemandLaw of Demand An increase in the price level, An increase in the price level,
other things being equalother things being equal, will , will decrease the quantity of real decrease the quantity of real output demanded. output demanded.
Determinants of Aggregate Determinants of Aggregate Demand (Other Things)Demand (Other Things)
Determinants of Aggregate Determinants of Aggregate DemandDemand
Changes in:Changes in: Consumer SpendingConsumer Spending
Consumer WealthConsumer Wealth Consumer ExpectationsConsumer Expectations Household DebtHousehold Debt Personal TaxesPersonal Taxes
Investment SpendingInvestment Spending Real Interest RatesReal Interest Rates
Changes in Aggregate DemandChanges in Aggregate DemandExpected ReturnsExpected Returns
About Future Business About Future Business ConditionsConditions
TechnologyTechnology Degree of Excess CapacityDegree of Excess Capacity Business TaxesBusiness Taxes
Government SpendingGovernment Spending Net Export SpendingNet Export Spending
National Income AbroadNational Income AbroadExchange RatesExchange Rates
Changes in Aggregate DemandChanges in Aggregate Demand
Real Domestic Output, GDP
Pri
ce L
evel
AD1
Increase inAggregateDemand
AD3
AD2Decrease inAggregateDemand
AGGREGATE SUPPLY
•Levels of Real Domestic Output•At Each Possible Price Level•Long-run Supply Curve
•Wages and Resource Prices Match Price Level
•Short-run Supply Curve•Wages and Resource Prices Do Not Match Price Level
Pric
e le
vel
Real domestic output, GDPQ
PLong Run
ASLR
Long-runAggregate
Supply
Qf
Full-Employment
AGGREGATE SUPPLY
Pric
e le
vel
Real domestic output, GDPQ
PShort Run
ASAggregate
SupplyShort-run
Qf
Full-Employment
AGGREGATE SUPPLY
Pric
e le
vel
Real domestic output, GDPQ
P AS3
AS1
AS2
Increase InAggregate
Supply
Decrease InAggregate
Supply
Changes in Aggregate Supply
DETERMINANTS OF AGGREGATE SUPPLY
Input Prices
Domestic Resource Prices•Labor•Land•Capital
Prices of Imported Goods
Market Power
DETERMINANTS OF AGGREGATE SUPPLY
Productivity
Productivity =Total Output
Total Inputs
Legal-Institutional Environment
• Business Taxes and Subsidies
• Government Regulation
Equilibrium and Changes in Equilibrium and Changes in EquilibriumEquilibrium
The equilibrium price level and The equilibrium price level and amount of real domestic output are amount of real domestic output are determined at the intersection of the determined at the intersection of the AD and AS curves.AD and AS curves.
Real OutputDemanded(Billions)
Price Level(Index Number)
Real OutputSupplied(Billions)
$506
508
510
512
514
108
104
100
96
92
$513
512
510
507
502Equilibrium Price Level and
Equilibrium Price Level
Equilibrium and Changes Equilibrium and Changes in Equilibriumin Equilibrium
Real Domestic Output, GDP(Billions of Dollars)
Pri
ce L
evel
100
92
502 510 514
a b
AD
AS
Equilibrium
Equilibrium and Changes Equilibrium and Changes in Equilibriumin Equilibrium
Real Domestic Output, GDP
Pri
ce L
evel
AD
AS
P1
P2
Q2Q1Qf
AD1
Increase in Aggregate Demand
Demand-PullInflation
Pric
e Le
vel
Real Domestic Output, GDP
Q
P ASAD1
DECREASES IN AD: RECESSION & CYCLICAL UNEMPLOYMENT
P1
AD2
QfQ1
a
c
b
Equilibrium and Changes Equilibrium and Changes in Equilibriumin Equilibrium
Real Domestic Output, GDP
Pri
ce L
evel
AD
AS
P1
P2
Q1 Qf
Decrease in Aggregate Supply
Cost-PushInflation
AS1
a
b
Derivation of theAggregate Demand Curve
from the Aggregate Expenditures Model
…
Agg
rega
te e
xpen
ditu
res
(bill
ions
of
dolla
rs)
0
0
Pric
e le
vel
Q1
P1
AE1 at P 1
1
1’
P2
AE2 at P 2
2
2’
AE3 at P 3
3
P3
3’
The Aggregate DemandCan Be Constructed
DERIVATION OF THE AGGREGATE DEMAND CURVE
Q3 Q2
Q1Q3 Q2
AD
Real Domestic Output
Agg
rega
te e
xpen
ditu
res
(bill
ions
of
dolla
rs)
0
0
Pric
e le
vel
Q2
AE2 at P 1
P1
AE1 at P 1
SHIFTS IN THE AGGREGATE EXPENDITURESSCHEDULE & THE AGGREGATE DEMAND CURVE
Q1
Q2Q1
AD1
AD2
Increase inAggregate
Expenditures
Increase inAggregateDemand
Real Domestic Output
SUMMARYSUMMARY AD reflects an inverse relationship between the AD reflects an inverse relationship between the
price level and the amount of real domestic price level and the amount of real domestic output demanded.output demanded.
Changes in the price level produce wealth, Changes in the price level produce wealth, interest rate, and foreign purchases effects which interest rate, and foreign purchases effects which explain the downward slope of the AD curve.explain the downward slope of the AD curve.
Changes in one or more of the determinants of Changes in one or more of the determinants of AD alter the amounts of real domestic output AD alter the amounts of real domestic output demanded at each price level; they shift the AD demanded at each price level; they shift the AD curve.curve.
An increase in AD is shown as a rightward shift of An increase in AD is shown as a rightward shift of the AD curve; a decrease entails a leftward shift the AD curve; a decrease entails a leftward shift of the curve.of the curve.
Quick ReviewQuick Review
The equilibrium price level and amount of The equilibrium price level and amount of real domestic output are determined at real domestic output are determined at the intersection of the AD and AS curves.the intersection of the AD and AS curves.
Increase in the AD in upsloping and Increase in the AD in upsloping and vertical ranges of AS cause Demand Pull vertical ranges of AS cause Demand Pull Inflation.Inflation.
Decrease in AS curve cause Cost push Decrease in AS curve cause Cost push inflation.inflation.
Increase in AS expand real domestic Increase in AS expand real domestic output; they result in economic growth.output; they result in economic growth.
