Chapter 11: Aggregate Demand

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Chapter 11 Aggregate Demand Aggregate Supply

• Aggregate Demand (AD) Aggregate Supply (AS)
  model is a variable price model.
• AD AS model provides insights on inflation,
  unemployment, and economic growth

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Aggregate Demand

• A schedule that shows the various amounts of real
  domestic output that domestic foreign buyers
  will desire to purchase at each possible price
  level
• Shows an inverse relationship between price level
  and domestic output

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Price v. Real GDP Reasons for Inverse
Relationship

• Real Balances Effect When Price falls,
  purchasing power of existing financial balances
  rises ? increase spending
• Interest Rate Effect A decline in Price means
  lower interest rates ? increase levels of certain
  types of spending
• Foreign Purchases Effect When Price falls, US
  prices will fall relative to foreign pries ?
  increase spending on US exports, decrease import
  spending in favor of US products that compete w/
  imports

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Determinants of Aggregate Demand

• Real GDP C Ig G Xn
• Changes in Consumer Spending
• Changes in Investment Spending
• Changes in Governments Spending
• Changes in Net Exports

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Changes in Consumer Spending

• Consumer Wealth
• Consumer Expectations
• Consumer Indebtedness
• Taxes

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Changes in Investment Spending

• Interest Rates
• Profit Expectations
• Business Taxes
• Technology
• Amount of Excess Capacity

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Change in Government Spending

• This is Fiscal Policy (Chapter 12)

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Changes in Net Exports

• When unrelated to price level
• Income Abroad
• Exchange Rates
• Depreciation of encourages US exports since US
  products become less expensive for foreign
  buyers, who can now obtain for their currency
• Depreciation of discourages import buying in
  the US since it is more expensive for Americans
  to exchange foreign currency

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Aggregate Supply

• A schedule showing level of Real GDP available at
  each Price
• Higher Prices create an incentive for firms to
  produce sell more
• Lower Prices prompt firms to reduce output
• Direct/Positive relationship between P Real GDP

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Determinants of Aggregate Supply

• Change in Input Prices
• Change in Productivity
• Change in Legal-Institutional Environment

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Change in Input Prices

• Availability of Resources
• Land, Labor, Capital, Entrepreneurial Ability
• Prices of Imported Resources
• Market Power in Certain Industries

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Change in Productivity

• Productivity Real Output / Input
• Changes in Per-unit Production Cost Total Input
  Cost / Units of Output
• If productivity rises, unit production costs fall
  ? Shifts AS to right, lowers Prices
• If productivity falls, unit production costs rise
  ? Shifts AS to left, increasing Prices

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Legal Institutional Environment

• Business Taxes
• Subsidies
• Government Regulation

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Equilibrium Price v. Real Output

• Equilibrium Price and Quantity are found where AD
  and AS curves intersect

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Decreases in AD

• If AD decreases, recession and cyclical
  unemployment may result
• Wage contracts are not flexible, business cant
  afford to reduce prices
• Employers are reluctant to cut wages b/c impact
  on EE effort
• Minimum Wage Laws keep wages up
• Menu Costs are difficult to change
• Fear of price wars keeps prices from being reduced

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Why is Unemployment in Europe So High?

• High minimum wages
• Generous welfare benefits for unemployed
• Restrictions against firings discourage
  employment
• 30 40 days of paid vacation holidays increase
  costs of hiring
• High worker absenteeism reduces productivity
• Higher employer cost of fringe benefits
  discourages hiring

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Chapter 11 Study Questions

• 7, 8 Determinants of AD AS