Chapter 20: Aggregate Demand and Supply

Aggregate Supply Curve

A curve that shows the quantity of goods and services that firms choose to produce and sell at each price level. In the long run, the aggregate supply curve is vertical, whereas, in the short run, the aggregate-supply curve slopes upward.

Aggregate Demand Curve Shifts

- Changes in consumption - Changes in investment - Changes in government purchases - Changes in net exports

Long Run Aggregate Supply Curve Shifts

- Changes in labor - Changes in capital - Changes in natural resources - Changes in technological knowledge

Short Run Aggregate Supply Curve Shifts

- Changes in labor - Changes in capital - Changes in natural resources - Changes in technological knowledge - Changes in the expected price level

Why the Short Run Aggregate Supply Curve Slopes Upward

- Sticky Wage Theory - Sticky Price Theory - Misperceptions Theory

The Wealth Effect

A decrease in the price level raises the real value of money and makes consumers wealthier, which in turn encourages them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded. Conversely, an increase in the price level reduces the real value of money and makes consumers poorer, which in turn reduces consumer spending and the quantity of goods and services demanded.

Aggregate Demand Curve

A downward sloping curve that shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level. A decrease in the economy's overall level of prices raises the quantity of goods and services demanded, while an increase in the price level reduces the quantity of goods and service demanded.

The Interest Rate Effect

A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded. Conversely, a higher price level raises the interest rate, discourages investment spending, and decreases the quantity of goods and services demanded.

Recession

A period of declining real incomes and rising unemployment.

Stagflation

A period of falling output and rising prices.

Depression

A severe recession

Misperceptions Theory

An unexpectedly low price level leads some suppliers to think their relative prices have fallen, which induces a fall in production.

Sticky Price Theory

An unexpectedly low price level leaves some firms with higher than desired prices, which depresses their sales and leads them to cut back production.

Sticky Wage Theory

An unexpectedly low price level raises the real wage, which causes firms to hire fewer workers and produce a smaller quantity of goods and services.

Classical Macroeconomic Theory

Changes in the money supply affect prices and other nominal variables but do not affect real variables (real GDP, unemployment, etc).

Three Key Factors of Economic Fluctuations

Economic fluctuations are irregular and unpredictable. Most macroeconomic quantities fluctuate together. As output falls, unemployment rises.

Aggregate Demand and Aggregate Supply

Economists use the model of aggregate demand and aggregate supply to analyze economic fluctuations. On the vertical axis is the overall level of prices. On the horizontal axis is the economy's total output of goods and services. Output and the price level adjust to the point at which the aggregate-supply and aggregate-demand curves intersect.

What determines the quantity of goods and services supplied in the long run?

In the long run, an economy's production of goods and services (its real GDP) depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services.

Long Run Aggregate Supply Curve

In the long run, the quantity of output supplied depends on the economy's quantities of labor, capital, and natural resources and on the technology for turning these inputs into output. Because the quantity supplied does not depend on the overall price level, the long-run aggregate-supply curve is vertical at the natural level of output.

Short Run Aggregate Supply Curve

In the short run, a fall in the price level reduces the quantity of output supplied. This positive relationship could be due to sticky wages, sticky prices, or misperceptions. Over time, wages, prices, and perceptions adjust, so this positive relationship is only temporary.

The Effects of a Shift in Aggregate Demand

In the short run, shifts in aggregate demand cause fluctuations in the economy's output of goods and services. In the long run, shifts in aggregate demand affect the overall price level but do not affect output. Because policymakers influence aggregate demand, they can potentially mitigate the severity of economic fluctuations.

Do the assumptions of classical macroeconomic theory apply to the world in which we live?

Most economists believe that classical theory describes the world in the long run but not in the short run.

Two Causes of Economic Fluctuation

Shifts in aggregate demand and shifts in aggregate supply.

The Effects of a Shift in Aggregate Supply

Shifts in aggregate supply can cause stagflation—a combination of recession (falling output) and inflation (rising prices). Policymakers who can influence aggregate demand can potentially mitigate the adverse impact on output but only at the cost of exacerbating the problem of inflation.

Aggregate Supply and Demand: Long Run Equilibrium

The long-run equilibrium of the economy is found where the aggregate-demand curve crosses the long-run aggregate-supply curve (point A). When the economy reaches this long-run equilibrium, the expected price level will have adjusted to equal the actual price level. As a result, the short-run aggregate-supply curve crosses this point as well.

Model of Aggregate Demand and Supply

The model that most economists use to explain short-run fluctuations in economic activity by explaining the relationship between inflation, unemployment, and GDP. Analyses two variables: Real GDP and CPI. This measures both real and nominal variables so it contradicts the classical assumption of macroeconomic theory.

Natural level of Output

The production of goods and services that an economy achieves in the long run when unemployment is at its normal rate. Any changes shift the long run aggregate supply curve.

Neutrality of Money

The proposition that in the long run, changes in the quantity of money affect nominal variables, but do not affect any real variables.

Classical Dichotomy

The separation of variables into real variables (those that measure quantities or relative prices) and nominal variables (those measured in terms of money).

Real GDP

The variable most commonly used to monitor short-run changes in the economy because it is the most comprehensive measure of economic activity. Real GDP measures the value of all final goods and services produced within a given period of time. It also measures the total income (adjusted for inflation) of everyone in the economy. Y = C + I + G + NX

Why the Aggregate Demand Curve Slopes Downward

Wealth Effect: Consumers are wealthier, which stimulates the demand for consumption goods. Interest Rate Effect: Interest rates fall, which stimulates the demand for investment goods. Exchange Rate Effect: The currency depreciates, which stimulates the demand for net exports.

The Exchange Rate Effect

When a fall in the U.S. price level causes U.S. interest rates to fall, the real value of the dollar declines in foreign exchange markets. This depreciation stimulates U.S. net exports and thereby increases the quantity of goods and services demanded. Conversely, when the U.S. price level rises and causes U.S. interest rates to rise, the real value of the dollar increases, and this appreciation reduces U.S. net exports and the quantity of goods and services demanded.