Chapter 30: Aggregate Demand and Aggregate Supply

Determinants of Aggregate Demand: Investment Spending

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. Factors the change investment spending are real interest rates and expected returns.

Interest-Rate Effect

A higher price level increases the demand for money. So, given a fixed supply of money, an increase in money demand will drive up the price paid for its use, the interest rate. This decreases investment spending and thus decreases aggregate demand.

Real-Balances Effect

A higher price level reduces the purchasing power of the Public's accumulated savings balances. In particular, the real value of assets we fix money values, such as savings accounts, diminishes. As a result, the public is poor in real terms and will reduce its spending, therefore decreasing aggregate demand.

Determinants of Aggregate Supply: Productivity

A measure of real output per unit of input. When this increases, per-unit production costs decrease, shifting the aggregate supply curve to the right.

Determinants of Aggregate Demand: Consumer Spending: 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.

Determinants of Aggregate Demand: Net Export Spending

A rise in US net exports shifts the aggregate demand curve to the right. In contrast, a decrease in US net exports shifts the aggregate demand curve leftward. Note that these changes net exports are not those prompted by a change in the US price level, those associated with the foreign purchases effect. The changes there are movement along the aggregate demand curve, not shifts of the curve. Rather, national income abroad and exchange rates cause net exports to change and the aggregate demand curve to shift.

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.

Aggregate Demand

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.

Determinants of Aggregate Supply: Input Prices: Prices of Imported Resources

Added supplies of resources, whether domestic or imported, typically reduce per-unit production costs. A decrease in the price of imported resources increases us aggregate supply, while an increase in their price reduces us aggregate supply. Also, appreciation of the dollar causes firms to face a lower dollar price of imported resources, prompting them to increase their imports, lowering their per-unit production costs at each level of output. This shifts the aggregate supply curve to the right. Depreciation of the dollar will have the opposite set of effects and will shift the aggregate supply curve to the left.

Increases in Aggregate Demand: Demand-Pull Inflation

An increase in aggregate demand beyond the full-employment output causes demand-pull inflation. The difference between the new output level and the full-employment output level is an inflationary GDP gap. Note that, for any initial increase in aggregate demand, the resulting increase in real output will be smaller the greater is the increase in the price level. Price-level flexibility weakens the realized multiplier effect, as part of the increase in aggregate demand is absorbed as inflation.

Determinants of Aggregate Demand: Government Spending

An increase in government purchases will shift the aggregate demand curve to the right, as long as tax collections and interest rates do not change as a result. In contrast, a reduction in government spending will shift the curve to the left.

Aggregate Demand and Multiplier Effect

An increase in spending increases aggregate demand by that amount times the multiplier. The opposite applies for a decrease in spending.

Determinants of Aggregate Supply: Legal-Institutional Environment

Changes in taxes and subsidies and changes in the extent of regulation may alter the per-unit costs of output and, if so, shift the aggregate supply curve.

Determinants of Aggregate Demand: Consumer Spending: Household Borrowing

Consumers can increase their consumptions spending by borrowing, Shifting the aggregate demand curve to the right. by contrast, a decrease in borrowing for consumption purposes 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.

Determinants of Aggregate Demand: Net Export Spending: Exchange Rates

Depreciation of the dollar causes US net exports to increase, shifting the aggregate demand curve to the right. Appreciation of the dollar causes us net exports to decrease, shifting the aggregate demand curve to the left.

Demand Curve vs. Aggregate Demand Curve

The downward slope of the demand curve was explained by the income effect and the substitution effect. With the aggregate demand curve, however, the income effect does not apply because when consumers pay lower prices for goods and services, West nominal income flows to Resource suppliers in the form of wages, rents, interest, and profits. As a result, a decline in the price level does not necessarily mean an increase in the nominal income of the economy as a whole. Also, the substitution effect does not apply because there is no substitute (cheaper alternative) for all goods and services produced (no overall effect).

Determinants of Aggregate Demand

Factors that shift the aggregate demand curve when they change. Include consumer spending, investment spending, government spending, and net exports spending.

Determinants of Aggregate Supply

Factors that shift the aggregate supply curve when they change. Changes in these factors raise or lower per unit production costs at each price level, thereby affecting profits and leading firms to alter the amount of output they are willing to produce at each price level. These factors include input prices, productivity, and the legal-institutional environment.

Decreases in Aggregate Demand: Recession and Cyclical Unemployment: Downward Price Stickiness: Minimum Wage

The minimum wage imposes a legal for under the wages of the least-skilled workers. Firms paying those wages cannot reduce that wage rate when aggregate demand declines.

Decreases in Aggregate Demand: Recession and Cyclical Unemployment: Downward Price Stickiness: Menu Costs

Firms often do not want to lower their prices due to the costs of lowering prices through actions such as changing menu prices, calculating proper price cuts, repricing items in inventory, or communicating new prices to customers.

Decreases in Aggregate Demand: Recession and Cyclical Unemployment: Downward Price Stickiness: Wage Contracts

Firms rarely profit from cutting their product prices if they cannot also cut their wage rates. Wages are usually in flexible downward because large parts of the labor force work on the contracts prohibiting wage cuts for the duration of the contract.

Determinants of Aggregate Supply: Legal-Institutional Environment: Business Taxes and Subsidies

Higher business taxes increase per-unit production costs and shift the aggregate supply curve to the left. Business subsidies lower per-unit production costs and shift the aggregate supply curve to the right.

Determinants of Aggregate Demand: Investment 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. Alternatively, declined and 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 (amount of unused capital), and business taxes.

Increases in Aggregate Supply: Full Employment with Price-Level Stability

If both aggregate supply and aggregate demand increase (shift to the right), the economy can operate above the full-employment output level without extreme inflation, if any. However, aggregate demand and/or aggregate supply will inevitably fall, and the economy will once again operate at full-employment output.

Determinants of Aggregate Demand: Consumer Spending

If consumers decide to buy more output at each price level, the aggregate demand curve will shift to the right. Several factors other than a change in the price level may change consumer spending and therefore shift the aggregate demand curve. These factors are real consumer wealth, consumer expectations, household debt, and taxes.

Focusing on the Short-Run Aggregate Supply Curve

In most economic models in discussions, the short run aggregate supply curve is the only aggregate supply curve considered. This is because real-world economy's typically manifest simultaneous changes in both their price levels and the levels of real output. The upsloping short-run aggregate supply curve is the only version of aggregate supply that can handle simultaneous movements in both of these variables.

Aggregate Supply in the Immediate Short Run

Input prices are fixed, mostly due to wage and salary contracts. Output prices are also fixed due to firms setting fixed prices for their customers for a certain amount of time. This means that firms must supply whatever quantity demanded results at their fixed output prices. Therefore, the aggregate supply curve is horizontal.

Aggregate Supply in the Short Run

Input prices are fixed, mostly due to wage and salary contracts. Output prices are now flexible. The aggregate supply curve slopes upward because changes in the price level will raise or lower real firm profits. When the price level rises, real profits rise, prompting firms to increase real output. When the price level falls, real profits fall, prompting firms to decrease real output. The concavity of the curve is due to per-unit production costs.

Aggregate Supply in the Long Run

Input prices as will as output prices are now flexible. The aggregate supply curve is vertical at the economy's full-employment output, meaning that the economy will produce the full-employment output level no matter what the price level is. This is due to input prices rising when output prices rise. For example, if firms produce beyond the full employment output level, a great deal of demand is created for the commies limited supply of productive resources, such as labor. This increased demand causes input prices to increase, decreasing real firm profits and prompting a decrease in output to the full-employment level.

Equilibrium Real Output

The output level (real GDP) at which the aggregate demand curve and the aggregate supply curve intersect. Occurs at full-employment GDP.

Equilibrium Price Level

The price level at which the aggregate demand curve and the aggregate supply curve intersect. Occurs at full-employment GDP.

Determinants of Aggregate Demand: Consumer Spending: Consumer Wealth

The total dollar value of all assets owned by consumers in the economy less the dollar value of their debts. Consumer well sometimes changes suddenly and unexpectedly due to surprising changes in asset values. An unforeseen increase in the stock market is an example. The increase in wealth prompts consumers to save less and buy more out of their current incomes than they had previously been planning. This so-called wealth effect shifts the aggregate demand curve to the right. In contrast, an unexpected decline in asset values will cause a "reverse wealth effect" to occur.

Decreases in Aggregate Demand: Recession and Cyclical Unemployment: Downward Price Stickiness: Morale, Effort, and Productivity

Wage inflexibility downward is reinforced by the reluctance of money employers to reduce wage rates. Some current wages may be efficiency wages. Therefore, lowering wages might impair worker morale and work effort, thereby reducing productivity.

Efficiency Wages

Wages that elicit maximum work effort and thus minimize labor costs per unit of output.

Determinants of Aggregate Demand: Consumer Spending: Consumer Expectations

When people expect the real future incomes to rise, they tend to spend more of their current incomes. Thus, current consumption spending increases and the aggregate demand curve shifts to the right. This could also be caused by a widely-held expectation of surging inflation in the near future, as consumers will want to buy products before their prices escalate. Conversely, expectations of lower future income or lower future prices may reduce current consumption and shift the aggregate demand curve to the left.

Foreign Purchases Effect

When the US price level rises relative to foreign price levels, US exports decrease and imports increase, causing a decrease in net exports and thus a decrease in aggregate demand.

Decreases in Aggregate Supply: Cost-Push Inflation

When the aggregate supply curve shifts leftward, the price level rises (cost-push inflation) and real output declines. Therefore, a recession (negative GDP gap) occurs.

Aggregate Supply in the Short Run: Concavity

When the economy is operating below its full-employment output, it has large amounts of unused machinery and equipment and large numbers of unemployed workers. Firms can put these resources back to work with little upward pressure on per-unit production costs. Therefore, the slope of the short run aggregate supply curve is less than 1 at output levels below the full-employment output level. On the other hand, when the economy is operating beyond its full employment output level, the vast majority of its available resources are already employed. Adding more workers, capital, or land resources would cause total input costs to rise more rapidly than total output, as efficiency of resources would decrease. Therefore, the slope of the short run aggregate supply curve is greater than 1 at output levels above the full-employment output level.

Determinants of Aggregate Supply: Legal-Institutional Environment: Government Regulation

It is usually costly is usually costly for businesses to comply with government regulations. More regulation therefore tends to increase per-unit production costs and shift the aggregate supply curve to the left.

Decreases in Aggregate Demand: Recession and Cyclical Unemployment

Many important prices in the US economy are downwardly inflexible such that the price level is sticky downward even when aggregate demand substantially declines. Therefore, when aggregate demand declines, and price level does not change, the multiplier is at full strength and output decreases more than if the price level would change. The difference between the new output level and the full-employment output level is a recessionary GDP gap.

Determinants of Aggregate Demand: Investment Spending: Real Interest Rates

Other things equal, an increase in real interest rates will raise borrowing costs, lower investment spending, and reduce aggregate demand. This can be caused by a decrease in a nation's money supply. The opposite can also occur, with a decrease in real interest rates.

Determinants of Aggregate Supply: Input Prices: Domestic Resource Prices

Other things equal, decreases in wages reduce per-unit production costs. So when wages fall, the aggregate supply curve shifts to the right. Increases and wages shift the curve to the left. Similarly, the aggregate supply curve shifts when the prices of land and capital inputs change.

Determinants of Aggregate Supply: Input Prices

Resource prices (not to be confused with output prices that make up the price level) are a major ingredient of per-unit production costs and therefore a key determinant of aggregate supply. These resources can be either domestic or imported.

Determinants of Aggregate Demand: Net Export Spending: National Income Abroad

Rising national income abroad encourages foreigners to buy more products, some of which are made in the US. US net exports Buss rise, and the US aggregate demand curve shifts to the right. Declines in national income abroad do the opposite.

Decreases in Aggregate Demand: Recession and Cyclical Unemployment: Downward Price Stickiness: Fear of Price Wars

Some large firms may be concerned that if they reduce their prices, a price war will occur, in which all involved firms end up with significant profit loss. For this reason, firms may resist making price cuts, choosing instead to reduce production and lay off workers.