Chapter 12, Aggregate Demand and Aggregate Supply

Foreign Purchases Effect (as price level rises)

A higher price level decreases net export spending...which decreases spending on U.S. exports and increases spending on U.S. imports ...which decreases real GDP

Interest-rate Effect (as price level rises)

A higher price level increases the nominal interest rate...which decreases consumer spending on interest-sensitive products (e.g., autos) and also business investment...which decreases real GDP

Aggregate Demand (AD)

shows the amount of goods and services which will be purchased at each possible price level

Assume the prices are fully flexible in an economy. If aggregate demand increased and aggregate supply decreased, what will happen to the price level and real output?

the affect on the real output will be uncertain but the price level will increase, An increase in aggregate demand and an increase in aggregate supply are certain to increase the price level, but the effect on real GDP will be uncertain based on the size of the shifts in AD and AS.

AggregateSupply in the Immediate Short Run

The aggregate supply curve is horizontal at a given price level due to the rigidity of prices

would most likely lead to an increase in aggregate demand?

The government passes legislation that sharply increases spending for national defense and roads, an increase in government spending increases AD

would most likely increase aggregate demand?

a depreciation in the value of the U.S. dollar, A depreciation of the U.S. dollar means that U.S. exports are less expensive for foreigner to buy and that U.S. imports are now more expensive. Net export therefore will increase and increase aggregate demand.

A decline in the amount of government regulation is most likely to

increase aggregate supply, A decline in government regulation reduces the cost of production and thus increases

In the context of aggregate supply, the basic difference between the immediate short run and the short run is that in the immediate short run

input prices and output prices are fixed, while in the short run input prices are fixed but output prices are flexible, in the immediate short run, both input prices as well as output prices are fixed. In the short run, input prices are fixed but output prices can vary.

The aggregate demand curve slopes downward due to the

inverse relationship between the price level and real GDP

Aggregate supply

is a schedule or curve showing the level of real domestic output available at each possible price level.

is a major reason why prices and wages tend to be inflexible downward

menu costs, Businesses do not like to lower prices because it can reduce profits, be costly due to menu costs, and lead to price wars. Businesses also do not like to reduce wages because it hurts work morale and work effort

Assume that it takes 100 units of input to produce 300 units of output in an economy. Then because of an improvement in technology, it requires only 75 units of input to produce the same level of output

productivity in the economy increased from 3 to 4, Productivity is measured by dividing total output by total input. So productivity changes from 300/100 =3 to 300/75 = 4

If AD decreases

recession and cyclical unemployment may result

efficiency wages

wages that maximize work effort and productivity, minimizing cost.

The multiplier effect

weakens the further right the aggregate demand curve moves along the aggregate supply curve.More of the increase in spending is absorbed into price increases instead of generating greater real output.

Real-balances Effect (as price level rises)

A higher decreases the real value of financial assets ...which decreases household wealth and consumer spending ...which decreases real GDP

A rise in the interest rate for business loans

AD decreases, AS remains the same, Price level decreases, Quantity decreases

An increase in business taxes

AD decreases, AS remains the same, Price level decreases, Quantity decreases

Balancing the federal budget cuts government spending

AD decreases, AS remains the same, Price level decreases, Quantity decreases

An improvement in consumer and business confidence.

AD increases, AS remains the same, Price level increases, Quantity decreases

A rise in the national incomes of our trading partners

AD increases, AS remains the same, Price level increases, Quantity increases

Consumer income rise as the economy moves out of a recession

AD increases, AS remains the same, Price level increases, Quantity increases

There is a depreciation in the value of the United States Dollar

AD increases, AS remains the same, Price level increases, Quantity increases

The price of oil on the world market rises to a high level

AD remains the same, AS decreases, Price level increases, Quantity decreases

A rise in the price of imported chemicals

AD remains the same, AS decreases, Price level remains the same, Quantity decreases

An increase in labor productivity

AD remains the same, AS increases, Price level decreases, Quantity increases

Changes in Aggregate Demand

Consumer wealth Household borrowing Consumer expectations Personal taxes Real interest rates Expected returns, which are a function of: Expected future business conditions Technology Degree of excess capacity Business taxes

Aggregate Demand Decrease results

Price level decrease and Quantity decrease.

Aggregate Supply Increase results

Price level decrease and Quantity increase

Aggregate Demand decrease and Aggregate Supply Increase results

Price level decrease and Quantity is uncertain

Aggregate Supply Decrease results

Price level increase and Quantity decrease

Aggregate Demand Increase results

Price level increase and Quantity increase.

Aggregate Demand Increase and Aggregate Supply Decrease results

Price level increase and Quantity is uncertain

Aggregate Demand Decrease and Aggregate Supply Decrease results

Price level is uncertain and Quantity decrease

Aggregate Demand Increase and Aggregate Supply Increase results

Price level is uncertain and Quantity increase

Aggregate Supply in the Short Run

The short run aggregate supply curve is upward sloping.

Cost-push inflation occurs because

aggregate supply decreases, Cost-push inflation occurs because of a decrease in aggregate supply that "pushes" up the price level

change would be associated most closely with an increase in economic growth in an economy

an increase in aggregate supply, An increase in aggregate supply will increase real output that is associated with economic growth

most likely increase aggregate demand?

an increase in consumer wealth, increase in consumer spending is known as the wealth effect and shifts the AD curve to the right

most likely decrease aggregate demand?

an increase in real interest rates, Rising real interest rates makes it more expensive to borrow money and this will decrease investment spending

Increases in aggregate demand

cause demand-pull inflation

Aggregate supply in the Long Run

curve is vertical at the economy's full-employment output. The curve is vertical because in the long-run resources prices adjust to changes in the price level, leaving no incentive for firms to change their output.

A decrease in aggregate demand in the short-run when the price level is flexible will

decrease real output and decrease the price level, With flexible prices, a decrease in aggregate demand will reduce the price level and real output

If aggregate demand increases, this situation is most likely to lead to

demand-pull inflation