Wiki: Chapter 10 Aggregate Demand & Aggregate SupplyThis is a featured page

Aggregate Demand:
  • Aggregate Demand represents the real GDP (real, total, output) that consumers are willing to purchase at any given price level. As price levels rise, the amount of GDP that consumers are willing to purchase drops. Conversely, the amount they are willing to purchase rises as price levels fall.
  • This relationship is shown by an Aggregate Demand Curve, such as the one shown below.
  • In essence, this curve represents the Demand Curve for every good or service produced by a nation, rather than just one. As such, some factors of demand, such as substitute goods, are ignored.
Relationship between PL & RGDP
  • Real Balance Effect- Produced by a change in the price level. Basically, a high price level will mean less consumption spending.
  • Interest Rate Effect- A higher price level will increase the demand for money.
  • Foreign Purchases Effect- when the US PL rises relative to foreign PLs, then foreigners buy less American goods and Americans buy more foreign goods--this reduces quantity of US net exports. And vice versa, if PL falls relative to foreign PLs, then there is an increase in US exports, and a decrease in US imports, in the US's favor.
Determinants of Aggregate Demand
  • Consumer Spending-Domestic consumers may shift their purchases of U.S. goods, even when the overall price levels are constant. If they purchase more, the demand curve will shift to the right, if they purchase less, it will shift to the left.
a) Consumer wealth-Both investments like stocks as well as property.
b)Consumer expectations-Expectations about the future (both prices and incomes) can alter consumer spending habits.
c)Household debt-An overall raise in the household debt consumers have will increase AD. A decrease in household debt will decrease AD.
d)personal Taxe- A reduction in income taxes increases consumer spending.
  • Investment Spending - Decline in investment spending will shift curve to left - Increase to right
a) real interest rates
b)expected returns
    i) expected future business conditions ii) technology iii) degree of excess capacity iv) business taxes
    • Government Spending - An increase in government purchases will shift curve to the right as long as tax collections and interest rates do not change. Opposite happens when there is a reduction in government spending.
    • Net Export Spending - Rise in exports-shifts demand to the right. Decrease in exports- Shifts to left.
    a) national income abroad - Rising national income abroad encouraged foreigners to buy more products so net exports rise. Vice versa.
    b)exchange rate - A drop in the valueof the dollar makes other countries think that goods are less expensive, so more goods are bought. Vice Versa.

    Aggregate Demand Curve
    AD Graph

    Consumption as a component of AD

    Aggregate Demand Determinants
    Determinants of AD

    Aggregate Supply Curve
    Aggregate Supply

    Aggregate Supply:
    • Aggregate supply is a schedule, or curve, showing the level or real domestic output that firms will produce at each price level.
    • These production responses of firms to changes in the price level differ in the long run, which is a period in which nominal wages match changes in the price level, and the short run, a period in which nominal wages do not respond to price level changes.
    Determinants of Aggregate Supply: (Factors that shift the aggregate supply curve)
    • Changes in output prices
      • Domestic resource prices
      • Prices of imported resources
      • Market power
    • Change in productivity: An increase in productivity reduces per-unit cost of production of a good and causes aggregate supply to shift to the right. A decrease in productivity, which is rare, makes the aggregate supply curve shift to the left.
      Productivity=total output/total inputs; Per-unit production cost=total input cost/total output
    • Change in legal-institutional environment
      • Business taxes and subsidies
      • Government regulations - government regulations tend to cost businesses more, which will result in a higher per-unit production cost, shifting the aggregate supply graph to the left.

    Aggregate Supply Determinants
    Aggregate Supply Determinants

    AD-AS Equilibrium

    AD-AS Model

    AD-LRAS Graph

    Equilibrium and Changes in Equilibrium:
    • Equilibrium Price Level and Equilibrium Real Output are shown by the intersection of the aggregate demand curve, and the aggregate supply curve. Basically, together these curves determine price level and real GDP.

    Demand Pull Inflation: Demand-pull inflation arises when aggregate demand in an economy outpaces aggregate supply.

    AD-AS LRAS Graph1

    In this kind of inflation, real output usually declines the most in aggregate demand because the price level never really goes down. The reasons for this are:
    • Fear of Price Wars - firms worry that if they reduce prices, competing companies will retaliate by lowering prices even further. In order to prevent this, employers usually just reduce production of the number of employees.
    • Menu costs - this is seen when companies think that a recession will be short so they don't want to cut prices. The common example, menus at a restaurant, shows that some costs rise from lowering others. These are:
      • estimating length/severity of a shift in demand and determining whether prices should be lowered
      • changing inventory prices
      • making and shipping new catalogs
      • advertising about new prices
    • Wage contracts - it is very hard for businesses to profit from cutting product prices without cutting wages. However, many workers take part in unions and have contracts that prevent wage cuts. Nonunion workers usually only have their wages adjusted annually.
    • Morale, effort, and productivity - many employers don't wish to cut wages. When a certain wage level produces maximum work effort and minimizes labor costs, it is called an efficiency wage. If productivity is constant, lower wages benefit the company. But if they decrease morale, it can decrease productivity. In these situations, employers try not to cut wages.
    • Minimum wage - this puts a legal floor under the pay grade of unskilled workers. Businesses cannot pay the worker lower than that when aggregate demand lowers.

    Cost Push Inflation: A sustained rise in prices caused by businesses passing on increases in costs, especially labor/production costs, to purchasers.

    AD-AS LRAS Graph2

    Efficiency Wage- A wage that minimizes wage costs per unit of output by encouraging greater effort or reducing turnover.

    Full Employment with Price-Level Stability

    Between 1996 and 2000, the United States broke the laws of the AD-AS graph and saw "full employment", "strong econmoic growth" and "very low inflation." Employment fell to 4 percent and real GDP grew 4 percent annually. Increase in productivity exploded due to the burst of new technology. Real output increased and thus price barely rose at all. The United States was pushing towards a new era, but then faced reality and found a drop in investment spending by March 2001. Our economy, while still facing the new era stage, is incredibly "roller-coaster" like in nature.

    Decrease in Aggregate Demand
    Decreases in aggregate deman describe the opposite end fo the business cycle: recession and cyclical unemployment.

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