Aggregate Demand and Aggregate Supply: The Basic Model

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Chapter 10

• Aggregate Demand and Aggregate Supply The Basic
  Model

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The Basics of Aggregate Demand

• Aggregate demand refers the real value of all
  new, final, domestically produced goods and
  services that households, firms, governments, and
  the foreign sector are willing and able to
  purchase at a given set of price levels, ceteris
  paribus.

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The Basics of Aggregate Demand (contd)

• AD equals
• Consumption Spending by Households, plus
• Investment Expenditures by Firms, plus
• Government Expenditures, plus
• Net Exports

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The Price Level and Aggregate Demand

• The overall price level is the major determinant
  of total spending in the economy.
• Aggregate demand curve shows relationship between
  the price level and total spending
• What is the relationship??

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Figure 10.1 The Aggregate Demand Curve
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Why the Aggregate Demand Curve Slopes Downward

• There are three basic reasons
• The Wealth Effect
• As prices decrease you feel wealthier because you
  can buy more
• The Interest Rate Effect
• As prices fall ?dont have to spend as much ?
  save more ?interest rates fall ?encourage
  borrowing ?changes AD
• The International Trade Effect
• As prices fall ?buy more US good ?imports fall ?
  other countries see that our goods are cheaper
  ?exports increase

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Basic Movements in Aggregate Demand

• Change in aggregate quantity demanded
• Caused by a change in the overall price level.
• Shown by a movement along the aggregate demand
  curve

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Basic Movements in Aggregate Demand (contd)

• A change in aggregate demand is caused by changes
  in forces other than the price level
• Macroeconomic policy influences
• Changing interest rates, changing taxes, changes
  in government spending
• Expectations
• Consumer confidence
• Global influences
• Purchasing power of the dollar
• Represented by a shift of the aggregate demand
  curve

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Table 10.1 Key Influences on Changes in
Aggregate Demand
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Figure 10.2 Change in Aggregate Demand
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Can we do it??

• Lets try number 2
• How will the following actions of macroeconomic
  policy affect the US aggregate demand curve?
• Social Security taxes are increased to extend the
  life of the Social Security system
• AD shift to the left
• The federal government expends its spending on
  prescription drug benefits under Medicare
• AD shift to the right
• Consumers expect more disposal income in the
  future as temporary tax cuts are made permanent
• AD shift to the right

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The Basics of Aggregate Supply

• Aggregate supply is the real value of all final,
  domestically produced goods and services that
  firms are willing to offer for sale at various
  price levels, ceteris paribus.
• There are two different aggregate supply curves
• The Short-Run AS Curve
• The Long-Run AS Curve

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Aggregate Supply in the Short Run

• The short run is a period of time that is too
  short for firms to adjust fully to changes in the
  price level.
• Workers face sticky wages.
• Cant change nominal wages easily when prices
  change
• Firms face sticky prices.
• Cant always increase the price of your product
• Firms and workers may have mistaken estimates of
  nominal prices.
• May not have all the information right ? OOPS

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The Price Level and Short-Run Aggregate Supply

• In the short run, a higher price level will cause
  firms to produce more goods and services.
• The short-run aggregate supply curve is
  upward-sloping.

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Why the Short-Run Aggregate Supply Curve Slopes
Upward

• A higher price level provides an incentive for
  firms to increase output.
• Based on the process of profit maximization
• Note If price rises faster than costs,
  profitability increases.

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Why the Short-Run Aggregate Supply Curve Slopes
Upward (contd)

• Resource prices (such as nominal wages) are
  sticky.
• They change more slowly than output prices.
• As price levels rise faster than production
  costs, profit per unit increases, and firms have
  an incentive to increase output.

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Basic Movements in Short-Run Aggregate Supply
(contd)

• A change in the price level is represented by a
  movement along a short-run aggregate supply
  curve.
• This is called a change in aggregate quantity
  supplied.

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Figure 10.3 The Short-Run Aggregate Supply Curve
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Changes in Short-Run Aggregate Supply

• Changes in other factors other than price can
  affect profitability at a given price level
• Nominal resource prices, especially nominal wages
• Wages account for 2/3 of total production costs
• Productivity
• Workers become more efficient and produce more
• Producers expectations
• What do firms think will happen in the future?
• These changes will shift the entire aggregate
  supply curve.

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Figure 10.4 Change in Short-Run Aggregate Supply
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Can we do it??

• Lets try number 6
• For a given industry, let the product price per
  unit 5 and the production cost per unit 3
• Based on this information, what is the profit per
  unit for this producer?
• 2 number of units sold
• Now let the product price increase to 6 per
  unit, and the production cost per unit increase
  to 3.50 per unit. What is the profit per unit
  now for this producer?
• 2.50 number of units sold
• How should this producer change his production
  plans in the face of the changing profit per
  unit?
• Should increase production
• If many producers faced the same situation, how
  would this affect the AS curve?
• Because it is a PRICE change AS will not shift ?
  change in Aggregate Quantity Supplied