Chapter 30 - Aggregate Demand and Aggregate Supply

Legal-Institutional Environment (determinant of AS)

- Changes in Taxes and Subsidies: higher business taxes such as sales, excise, and payroll taxes, increase per unit costs and reduce short run AS; a business subsidy (tax break) lowers production costs and increases short run AS - Government Regulation: more regulation tends to increase per unit production costs and shift AS curve to left

Why is the long run aggregate supply curve vertical?

- when companies try to produce more, demand for more inputs goes up --> the unemployment rate is already much below the NRU at this point, so since there is more demand for a limited number of available workers, nominal wage prices go up --> cost of production increased --> motive to keep producing beyond the full employment output level decreases --> [what goes next??? ask question]

Why is the aggregate supply curve flatter before the full employment output point (in the short run)?

- when economy is operating below full employment, large amounts of equipment and workers are idle --> less pressure to employ these resources, as there will not be lot of shortage of production inputs --> demand for inputs won't be greatly increasing --> per unit production cost doesn't rise as suddenly - only slow increases in price

Why is the aggregate supply curve steeper beyond the full employment output point (in the short run)?

- when vast majority of resources are already employed, adding more workers to already congested workplace reduces efficiency - when companies have try to produce more, demand for more inputs goes up --> the unemployment rate is already much below the NRU at this point, so since there is more demand for a limited number of available workers, nominal wage prices go up --> cost of production increased --> producers have to charge customers more to cover these higher costs of production as the short run supply curve transitions into the long run supply curve

How does the economy produce more goods (GDP increases) without the price level increasing and causing inflation (usually when the AD curve moves rightward, it increases production, but also inflation)?

aggregate demand did increase, however, aggregate supply also increased --> more produced, but as aggregate supply shifts "down" (rightward), it intersects AD curve at a lower price point

ratchet effect

AD will increase but in times of recession, wages and per unit cost of production cannot decrease, so the output price will not be lowered - that would decrease profits or even make the company lose money with each sale

Determinants of Aggregate Demand

CHANGE IN CONSUMER SPENDING - consumer wealth - household borrowing - consumer expectations - personal taxes CHANGE IN INVESTMENT SPENDING - real interest rates - expected returns *expected future business conditions * technology * degree of excess capacity * business taxes CHANGE IN GOV'T SPENDING CHANGE IN NET EXPORT SPENDING - national income abroad - exchange rates

Determinants of Aggregate Supply

CHANGE IN INPUT PRICES - domestic resource prices - prices of imported resources CHANGE IN PRODUCTIVITY CHANGE IN LEGAL-INSTITUTIONAL ENVIRONMENT - business taxes and subsidies - government regulations

Net Export Spending (determinant of aggregate demand curve)

higher exports mean higher demand for US goods --> rise in net exports will shift AD curve to right - National Income Abroad: rising national income abroad encourages foreigners to buy more products, some which are made in US --> US net exports rise --> AD curve shifts right - Exchange Rates: if value of US dollar depreciates in terms of the Euro, European companies will buy more goods from USA b/c it takes fewer Euros to do so; it takes more US dollars to purchase European goods tho --> more net exports --> AD curve shifts right

What happens when you produce more than the full employment level?

higher inflation

Government Spending (determinant of aggregate demand curve)

increase in gov't purchases will move AD curve to right

Change in price affects aggregate demand curve how?

it will change amount of aggregate spending --> will change real amount of GDP demanded

Aggregate Supply

schedule or curve showing relationship between nation's price level and amount of real domestic output that firms in the economy produce

Aggregate Demand

schedule or curve that shows the amount of a nation's output (real GDP) that buyers collectively desire to purchase at each possible price level

What do shifts in the aggregate supply curves do to per unit production costs?

they raise or lower the per unit production costs at each price level or each level of output - movement to the right reduces per unit production costs - movement to the left increases per unit production costs

Change in Consumer Spending (determinant of aggregate demand)

- Consumer Wealth) total dollar value of all assets owned by consumers in economy (such as assets in real estate, stocks, etc.) minus the value of their liabilities (mortgages, loans, etc); can change suddenly and increase in wealth will increase consumer spending - Household Borrowing) consumers can increase consumption by borrowing; AD curve can shift left if consumers save money to pay off debts - Consumer Expectations) when people expect their incomes to rise, they spend more of their current incomes; likewise, if consumers expect a big inflation in the future, they might buy more goods before the inflation hits - Personal Taxes) tax cuts allow more spending --> shifts AD curve to right

Change in input prices (determinant of AS)

- Domestic Resource Prices: wages and salaries make up 75% of all business's costs; changes in wages and salaries shift the AS curve; AS curve shifts when the prices of land and capital inputs change - Prices of imported resources: added supplies of resources, whether domestic or imported, reduce per unit production cost; exchange rate fluctuations are another factor that may alter price of imported goods - appreciation of US dollar will allow for more imports with paying less money --> lowering per unit production costs and shifting aggregate supply to left

When (short term) aggregate demand declines during a recession, why might businesses not drop the prices of their goods? Why does deflation, or the drop in prices, not occur?

- Fear of Price Wars - Menu Costs: firms don't know how long the recession will last so they don't reprice their items bc it will cost extra money to (1) estimate the magnitude and duration of the recession (2) reprice items in inventory (3) print and mail new catalogs (4) communicate new prices to customers - Wage Contracts: firms don't profit from cutting prices without cutting wages; they can't cut wages in short term AS b/c of wage contracts - Morale, Effort, and Productivity: lower wages might impair worker morale and work effort --> lower productivity raises labor costs per unit - Minimum Wage: firms cannot cut prices without cutting wages - minimum wage doesn't allow firms to cut already low wages

Why is the aggregate demand curve downward sloping?

- REAL BALANCES EFFECT) higher price level reduces the real value or purchasing power of the public's accumulated savings balances - INTEREST RATE EFFECT) as the price of goods increase, the demand for money (to buy those goods) increases, driving up the price paid for the use of that money (interest rate); when people have to pay a higher interest rate, they might not buy the goods and services - FOREIGN PURCHASES EFFECT) rise in the price level (of American goods) causes Americans to buy more foreign goods and foreigners to buy more foreign goods --> reduces the quantity of US goods demanded as net exports

Change in Investment Spending (determinant of AD curve)

- Real Interest Rates) increase in interest rates will raise borrowing costs, lower investment spending, and reduce AD - Expected Returns) higher investment returns will shift AD curve to right *Expectations about future business conditions - if firms are optimistic about future business conditions, they will invest more *Technology - improved tech enhances expected returns on investment --> increases AD *Degree of excess capacity - rise in unused capital will reduce expected return and decrease AD *Business taxes - increase in business taxes will reduce after tax profits from investment --> reduces AD

Aggregate demand curve vs demand curve

- aggregate demand curve shows that as price level decreases, the GDP increases - it's more general and not based off of the sale of a single product

Aggregate Supply in the long run

- all output and input prices are fully flexible - vertical curve means that in the long run the economy will produce the full employment output level no matter what the price is; when input and output levels are flexible, profit levels will always adjust to give firms exactly the right profit incentive to produce exactly the full-employment output level (Qf)

Change in aggregate demand involves 2 components ...

- change in one of the determinants of aggregate demand that directly changes the amount of real GDP demanded - multiplier effect that produces a greater ultimate change in aggregate demand than initiating change in spending

3 time horizons of aggregate supply

- in the immediate short run, both input (such as labor contracts) prices and output prices are fixed (horizontal straight line) - in the short run, input prices are fixed, but output prices can vary - in the long run, input prices, as well as output prices, can vary (vertical straight line)

Aggregate Supply in the immediate short run

- lasts as long as both input prices and output prices stay fixed - input prices are fixed in both the immediate short run and short run by contractual agreements - 75% of the average firm's costs are wages and salaries, so they're fixed for a longer time than output prices are - with output prices fixed and firms selling however much customers want to purchase at those fixed prices, the ISR AS curve is a horizontal line

Aggregate supply in the short run

- period where output prices are flexible, but input prices are either totally fixed or highly inflexible - When firms increase (output) price in the short run, they get a much larger profit -keeping in mind that input prices such as wages remain the same- so there is more incentive to produce more goods and services - Conversely, declines in the price level reduce profit and cause firms to produce less - Direct relationship between price level and real output ex) wages (firm's largest input cost) at UPS are set by five year labor contracts, but gasoline is a flexible input --> input prices are really inflexible, but output prices can be changed

Productivity (determinant of AS)

- productivity is a measure of the relationship between a nation's level of real output and amount of resources used to produce that output - productivity = total output/total inputs - increased productivity lowers per unit production costs --> AS curve shifts right