Chapter 32: Aggregate Demand and Aggregate Supply

Increases in AD: Demand-Pull Inflation

When an increase in demand pulls the price level up

Aggregate Demand Curve

A downward-sloping curve showing the relationship between the price level and the quantity of domestically produced goods and services all households, business firms, governments, and foreigners (net exports) are willing to purchase.

Real-Balances Effect

A higher price level reduces the real value or purchasing power of the public's accumulated savings balances For example: A house- hold might buy a new car or a plasma TV if the purchasing power of its financial asset balances is, say, $50,000. But if inflation erodes the purchasing power of its asset balances to $30,000, the household may defer its purchase. So a higher price level means less consumption spending.

Input Prices

A key determinant in aggregate supply. Domestic Resource Prices:decreases in wages reduce per-unit production costs Prices of Imported Resources: A decrease in the price of imported sources increases US aggregate supply, while an increase in their price reduces US aggregate supply

Personal Taxes

A reduction in personal income tax rates raises take-home income and increases consumer purchases at each possible price level. Tax cuts shift the aggregate demand curve to the right. Tax increases reduce consumption spending and shift the curve to the left

Define aggregate demand (AD) and explain how its downward slope is the result of the real-balances effect, the interest-rate effect, and the foreign purchases effect.

Aggregate demand is when the price level rises, the quantity of real GDP demanded decreases; when the price level falls, the quantity of real GDP demanded increases. The downward slope is the result of the real-balances effect (a higher price level means less consumption of spending), the interest-rate effect (increases in the demand for money= increase of interest rate. Higher interests rates may sway the consumer into not buying the item), and the foreign purchases effect (when the US price level rises relative to foreign price levels, foreigners buy fewer US goods and Americans buy more foreign goods.)

Real Interest Rates

An increase in real interest rates will raise borrowing costs, lower investment spending, and reduce aggregate demand. An increase in the money supply lowers the interest rate, thereby increasing investment and aggregate demand. A decrease in the money supply raises the interest rate, reducing investment and decreasing aggregate demand.

Explain the factors that cause changes (shifts) in AD.

Changes in aggregate demand involve two components: ∙ A change in one of the determinants of aggregate demand that directly changes the amount of real GDP demanded. ∙ A multiplier effect that produces a greater ultimate change in aggregate demand than the initiating change in spending.

Legal-Institutional Environment

Changes in the legal-institutional setting in which businesses operate are the final determinant of aggregate supply. Changes of this type: -Changes in taxes and subsidies -Changes in the extent of regulation

Consumer Wealth

Consumer wealth is the total dollar value of all assets owned by consumers in the economy less the dollar value of the liabilities (debts). The resulting increase in consumer spending--the so-called wealth effect-- shifts the aggregate demand curve to the right.

Household Borrowing

Consumers can increase their consumption spending by borrowing. Doing so shifts the aggregate demand curve to the right. By contrast, a decrease in borrowing shifts the aggregate demand curve to the left. The aggregate demand curve will also shift to the left if consumers increase their savings rates to pay off their debts.

Interest-Rate Effect

Firms that expect a 6 percent rate of return on a purchase will find that a 5 percent interest rate is profitable while a 7 percent interest rate is unprofitable. Since consumers may decide to not purchase if the interest rate goes up. So, by increasing the demand for money and consequently the interest rate, a higher price level reduces the amount of real output demanded

Decreases in AD: Recession and Cyclical Unemployment

For example, in 2008 investment spending in the United States greatly declined because of sharply lower expected returns on investment. These lower expectations resulted from the prospects of poor future business conditions and high degrees of current unused production capacity.

Government Spending

Government purchases are the third determinant of aggregate demand. Increase=shifts curve to the right Reduction=shifts curve to the left

Net Export Spending

Higher US exports mean an increased foreign demand for US goods. The final determinant of aggregate demand is net export spending.

Expected Returns

Higher expected returns on investment projects will increase the demand for capital goods and shift the aggregate demand curve to the right. Declines in expected returns will decrease investment and shift the curve to the left. Expected returns are influenced by: -Expectations about future business conditions -Technology -Degree of excess capacity -Business taxes

Long Run

Input prices and output prices can vary

Investment Spending

Investment spending (the purchase of capital goods) is a second major determinant of aggregate demand. A decline in investment spending at each price level will shift the aggregate demand curve to the left. An increase in investment spending will shift it to the right.

Determinants of Aggregate Demand/ Aggregate demand shifters

Movements along a fixed aggregate demand curve represent these changes in real GDP. However, if one or more of those "other things" change, the entire aggregate demand curve will shift. These "other things" are known as determinants of aggregate demand or aggregate demand shifters

Decreases in AS: Cost-Push Inflation

Suppose that a major terrorist attack on oil facilities severely disrupts world oil supplies and drives up oil prices by, say, 300 percent. Higher energy prices would spread through the economy, driving up production and distribution costs on a wide variety of goods.

Aggregate Demand-Aggregate Supply Model (AD-AS Model)

The AD-AS model is a "variable price-variable output" model that allows both the price level and level of real GDP to change. It can also show both longer time horizons, distinguishing between the immediate short run, the short run, and the long run.

Increases in AS: Full Employment with Price-Level Stability

The aggregate supply curve suggests that increases in aggregate demand that are sufficient for over-full employ- ment will raise the price level (see Figure 32.8). Higher infla- tion, so it would seem, is the inevitable price paid for expanding output beyond the full-employment level.

Productivity

The second major determinant of aggregate supply is productivity. Productivity is a measure of the relationship between a nation's level of real output and the number of resources used to produce that output. Per-Unit production cost=Total input cost divided by total output

Consumer Expectations

When people expect their future real incomes to rise, they tend to spend more of their current incomes. Thus, current consumption spending increases (current saving falls), and the aggregate demand curve shifts to the right. If inflation is expected in the near future increase in aggregate demand will occur because consumers will want to buy the product before the prices skyrocket. However, a decrease in income or lower future prices may reduce current consumption and shift the aggregate demand curve to the left.

Aggregate Supply

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

Immediate Short Run

both input prices and output prices are fixed

Short Run

input prices are fixed, but output prices can vary

Aggregate Demand

is a 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. When the price level rises, the quantity of real GDP demanded decreases; when the price level falls, the quantity of real GDP demanded increases.

Foreign Purchases Effect

when the US price level rises relative to foreign price levels, foreigners buy fewer US goods and Americans buy more foreign goods