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Chapter 8 Aggregate Demand and Aggregate Supply McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Outline • Aggregate Demand • Aggregate Supply • Shifts in Aggregate Demand and Aggregate Supply • Causes of Inflation • Supply-Side Economics • How the Government can Influence (but probably not control) the economy McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Aggregate Demand • Aggregate Demand: the amounts of real domestic output which domestic consumers, businesses, governments, and foreign buyers collectively will desire to purchase at each possible price level McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 1 Aggregate Demand PI AD RGDP McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Aggregate Demand is Downward Sloping • Real Balances Effect – Because higher prices reduce real spending power, prices and output are negatively related. • Foreign Purchases Effect – When domestic prices are high, we will export less to foreign buyers and we will import more from foreign producers. Therefore higher prices leads to less domestic output. • Interest Rate Effect – higher prices lead to inflation which leads to less borrowing and a lowering of RGDP McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Aggregate Supply • Aggregate Supply: the level of real domestic output available at each possible price level McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 2 The Aggregate Supply Curve AS PI Classical Range Intermediate Range Keynesian Range RGDP McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Ranges of AS • Keynesian Range – Large amounts of unemployment make it so that increases in aggregate demand have no affect on wages or prices. • Classical Range – Full employment makes it so that increases in aggregate demand only increase wages or prices. • Intermediate Range – Some sectors of the economy reach full employment more quickly than others. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Variables that Shift Aggregate Demand • • • • • Taxes Interest Rates Confidence Strength of the Dollar Government Spending McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Determinants of AD Variable GDP Component Affected C,I,G,X Effect of an increase on AD Effect of a decrease on AD Taxes C,I Decrease so Increase so AD <= AD => Interest Rates C,I Decrease so Increase so AD <= AD => Confidence C,I Increase so AD => Strength of the Dollar Government Spending McGraw-Hill/Irwin Decrease so AD <= X Decrease so Increase so (exports-imports) AD <= AD => G Increase so AD => Decrease so AD <= © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 3 AD Increases PI AS PI’ PI* AD’ AD RGDP* McGraw-Hill/Irwin RGDP’ RGDP © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 4 AD Decreases PI AS PI* PI’ AD AD’ RGDP’ McGraw-Hill/Irwin RGDP* RGDP © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Variables that Shift AS • Input Prices • Productivity • Government Regulation McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Determinants of AS Variable Effect of an Increase on AS Effect of an Decrease on AS Input Prices Decrease so AS Increase so AS Decrease so AS Increase so AS Decrease so AS Increase so AS Productivity Government Regulation McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 5 Increase in AS PI AS AS’ PI* PI’ AD RGDP* McGraw-Hill/Irwin RGDP’ RGDP © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 6 Decrease in AS PI AS’ AS PI’ PI* AD RGDP’ McGraw-Hill/Irwin RGDP* RGDP © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Causes of Inflation • Demand Pull Inflation: inflation caused by an increase in aggregate demand • Cost Push Inflation: inflation caused by a decrease in aggregate supply McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Influence: Aggregate Demand • Government can influence economic activity with aggregate demand side policies affecting: – Taxes – Government Spending – Interest Rates McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Influence: Aggregate Supply • Government can influence economic activity with aggregate supply side policies affecting – input costs (labor and wage) – reducing regulation • The actions are call Supply Side Economics McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.