CHAPTER 12 - Aggregate Demand & Aggregate Supply

What is the AGGREGATE DEMAND-AGGREGATE SUPPLY MODEL (AD-AS)?

A flexible-price model that enables analysis of simultaneous changes of real GDP and the price level.

What is PRODUCTIVITY?

A measure of average output or real output per unit of input. For example, the productivity of labor is determined by dividing real output by hours of work.

What is AGGREGATE SUPPLY?

A schedule or curve showing the total quantity of goods and services at different levels of real GDP.

What is AGGREGATE DEMAND?

A schedule or curve that shows the total quantity of goods and services demanded (purchased) at different price levels.

What are EFFICIENCY WAGES?

A wage that minimizes wage costs per unit of output by encouraging greater effort or reducing turnover.

What is EQUILIBRIUM PRICE LEVEL? What is EQUILIBRIUM REAL OUTPUT LEVEL?

Equilibrium price level is the price level at which the aggregate demand curve intersects the aggregate supply curve. Equilibrium real output level is the gross domestic product at which the total quantity of final goods and services purchased (aggregate expenditures) is equal to the total quantity of final goods and services produced (the real domestic output); the real domestic output at which the aggregate demand curve intersects the aggregate supply curve.

What are the consequences of a shift in the AGGREGATE DEMAND curve to the RIGHT of full-employment output?

Increases in aggregate demand to the right of the full-employment output cause inflation and positive GDP gaps (actual GDP exceeds potential GDP). 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.

What are the results of a leftward shift in the AGGREGATE SUPPLY curve?

Leftward shifts of the aggregate supply curve reflect increases in per-unit production costs and cause cost-push inflation, with accompanying negative GDP gap.

What effect did the rightward shift in AGGREGATE SUPPLY have in U.S. between 199 and 2000?

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.

What are the consequences of a shift in the AGGREGATE DEMAND curve to the LEFT of full-employment output?

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 recession because of downwardly inflexible prices and wages. This inflexibility results from fear of price wars, menu costs, wage contracts, efficiency wages, and minimum wages. When price level is fixed, changes in aggregate demand produce full-strength multiplier effects.

Why is the AGGREGATE DEMAND CURVE downsloping?

The aggregate demand curve is downsloping because of the following: 1.Real-Balances Effect 2. Interest-Rate Effect 3. Foreign Purchases Effect.

What is the AGGREGATE DEMAND CURVE?

The aggregate demand curve shows the level of real output that the economy demand at each price level.

What is the AGGREGATE SUPPLY CURVE? What determines the slope? What are the three time horizons?

The aggregate supply curve shows the levels of real output that businesses will produce at various possible price levels. The slope of the aggregate supply curve depends upon the flexibility of input and output prices. Since flexibility of input and output prices vary, aggregate supply curves are categorized into three time horizons: immediate short-run, short-run, and long-run.

What are the DETERMINANTS OF AGGREGATE DEMAND?

The determinants of aggregate demand consist of spending by domestic consumers (Ca), by businesses (Ig), by government (G) and by foreign buyers (Xn). Changes in these factors alter spending and shift the aggregate demand curve. The extent of the shift is determined by the size of the initial change in spending and the strength of the economy's multiplier.

What are the DETERMINANTS OF AGGREGATE SUPPLY?

The determinants of aggregate supply are: 1. Input Prices 2. Productivity 3. Legal-Institutional Environment A change in any one of these factors will change per-unit production costs at each level of output and therefore will shift the aggregate supply curve.

What is the FULL-EMPLOYMENT RATE OF UNEMPLOYMENT?

The employment rate at which there is no cyclical unemployment of the labor force equal to between 4 and 5 percent in the U.S. because some frictional and structural unemployment is unavoidable.

What is the FOREIGN PURCHASES EFFECT?

The foreign purchases effect suggests that an increase in one country's price level relative to the price levels in other countries reduces the net export component of that nation's aggregate demand.

Describe the IMMEDIATE-SHORT-RUN aggregate supply curve.

The immediate-short-run aggregate supply curve assumes that BOTH input prices and output prices are fixed. With output prices fixed, the aggregate supply curve is a HORIZONTAL line at the current price level.

What is the INTEREST-RATE EFECT?

The interest-rate effect means that, with a specific supply of money, a higher price level increases the demand for money, thereby raising the interest rate and reducing investment pruchases.

Where is EQUILIBRIUM GDP found?

The intersection of the aggregate demand and aggregate supply curves determines an economy's equilibrium price level and real GDP. At the intersection, the quantity of real GDP demanded equals the quantity of real GDP supplied.

Describe the LONG-RUN aggregate supply curve.

The long-run aggregate supply curve 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 level.

What is the REAL-BALANCES EFFECT?

The real-balances effect indicates that inflation reduces the real value or purchasing power of fixed-value financial assets held by households, causing cutbacks in consumer spending.

What are MENU COSTS?

The reluctance of firms to cut prices during recession (that they think will be short-lived) because of the costs of altering and communicating their price reductions; named after the cost associated with printing new menus at restaurants.

Describe the SHORT-RUN aggregate supply curve.

The short-run aggregate supply curve assumes nominal wages and other input prices remain fixed while output prices vary. The aggregate supply curve is generally upsloping because per-unit production costs, and hence the prices that firms must receive, rise as real output expands. The aggregate supply curve is relatively steep to the right of the full-employment output level and relatively flat to the left of it. The only version of aggregate supply that can handle simultaneous changes in the price level and real output, it serves well as the core aggregate supply curve for analyzing the business cycle and economic policy.