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CHAPTER 29: AGGREGATE DEMAND AND AGGREGATE SUPPLY Introduction The aggregate demand-aggregate supply (AD-AS) model provides the primary graphic d~piction of changes in the macroeconomy. Shifts in aggregate supply and aggregate dema~d explam changes in real output, employment, and price levels in the economy. Chapter 29 mtroduces the AD-AS model, bringing together the concepts of GDP, inflation, unemployment, and . recessionary and inflationary gaps that have been introduced throughout the macroec~nomlcs . chapters. Material from Chapter 29 is very likely to appear in a large number of multlple-c~OIce questions and appears as part of a free-response question on nearly every AP macroeconomICS exam. Aggregate Demand Aggregate demand is a curve showing the amount of GOP (output) demanded at each price level. When the price level rises, fewer products are purchased; when the price level falls, more products are purchased. Therefore, aggregate demand is a downward-sloping curve, with the negative slope resulting from three effects: the real balances effect, the interest rate effect, and the foreign purchases effect. The real balances effect focuses on the value of consumers' wealth. At a higher price level, the real value of a consumer's savings (homes, stocks, savings accounts) falls. With less wealth in real terms. consumers in the economy are Jess likely to buy products. At lower price levels, consumers buy more because they have more real wealth. The second reason for the downward slope of the aggregate demand curve is the interest rate effect. When prices rise, consumers and firms must borrow more money to make the same purchases. That increased demand for money pushes up the interest rate (the price of borrowing money), which discourages consumer borrowing to buy products. It also causes firms to reduce spending for capital, because the higher interest rate can exceed the expected return on the investment. At lower prices, less borrowing is necessary, so interest rates fall and the quantity of products demanded in the economy increases. i Taking the KEK! Out of Economics Although the curves look similar, it is important to recognize the differences between the demand curve for a specific product and the aggregate demand curve for the macroeconomy. Notice the differences in the axis labels. For individual product demand, the label for the vertical axis is price; for aggregate demand, the label is price level. This is because, when we're dealing with the demand for alJ of the products in the economy, there is no one "price" for everything-······and an "average" price makes little sense if we're talking about the average price of a home and a toothpick. So instead we talk about a price level, which can show us increases and decreases in prices, but not precise prices for products. The horizontal axis. which is labeled "quantity" for the individual product, is labeled "real GOP" or "real output" for macroeconomic analysis, because we're looking at aU of the spending in the economy together. So while the demand curve for sp~cific products could help us to identify the specific price of the product and the specific quantIty sold, the aggregate demand curve shows much more general information about the economic performance of the entire economy. ......................- - - - - - - - - - - -_ _ _ _ _--1 ~~~~~~~~ The third cause of the downward slope in aggregate demand is the foreign purchases effect When the U.S. price level increases and if exchange rates do not change, Americans buy m~re 200 Chapter 29: Aggregate Demand and Aggregate Supply imports and foreigners buy fewer U.S. exports. As a result, quantity demanded for U.S. goods falls at higher prices, and at lower prices, the quantity demanded is higher. Bear in Mind The aggregate demand-aggregate supply model is part of a free-response question on almost every AP macroeconomics exam. As part of the question, you are asked to draw a correctly labeled graph. It is very important that you use the correct labeling to distinguish macroeconomic graphs from microeconomic graphs. Price is not sufficient; the label must be "price level." Rather than "quantity," the label should be "real output" or HGDP." "Supply" and "demand" curve labels are not enough; they must be "aggregate supply" and "aggregate demand." Careful labeling will help you earn the points you deserve. Changes in Aggregate Demand While the real balances, interest rate, and foreign purchases effects can cause movement along the aggregate demand curve, a number of factors can actually cause the aggregate demand curve to shift. As was true for the individual product demand curve, increases in aggregate demand shift the curve to the right, while decreases shift it to the left. Changes in aggregate demand can result from changes in all four sectors in the macroeconomy. Consumer sector demand can shift due to changes in wealth, borrowing, expectations, and taxes. If consumer wealth significantly rises, such as by receiving an inheritance or from increasing stock values, consumers gain confidence and increase their demand for products at all prices. If consumers borrow money, their demand for products increases. If consumers expect their real future incomes to increase, or if they fear inflation in the near future, they increase demand for products ahead of the price increase. And if personal taxes decline, consumers have more disposable income to spend, so aggregate demand increases. If consumer wealth falls, consumers borrow less, they are concerned about a decrease in real income, or their personal taxes increase, aggregate demand falls. The investment sector's investment spending for capital goods depends on the interest rate and expected return on investment. If interest rates fall, aggregate demand increases because costs are now lower than expected return on the investment. Firms also increase investment if the expected returns increase due to optimism about future business conditions, improvements in technology, production at capacity, or a reduction in business taxes. Higher interest rates or lower expected returns on investment reduce aggregate demand through investment. Because interest rates and expectations can change so quickly and often, the investment sector is the most volatile of the four sectors. The third sector, government spending, is straightforward. If government spending increases (and taxes and interest rates do not change), aggregate demand increases. Decreases in government spending reduce aggregate demand. Finally, changes in net exports can also change aggregate demand. If exports increase due to higher foreign incomes, U.S. aggregate demand increases and the curve shifts to the right. If the value of the U.S. dollar depreciates in foreign exchange markets, foreign currency gets stronger, and so it appears that U.S. products are cheaper. In this case, demand for U.S. exports increases. At the same time, because the U.S. dollar is weaker, imports look more expensive, and so imports decrease. Because exports increase while imports decrease, net exports increase, increasing Chapter 29: Aggregate Demand and Aggregate Supply 20t . th U S dollar appreciates in currency markets ' aggregate demand. If foreign incomes declIne or e . ' U.S. aggregate demand falls. Taking the EEK! Out of Economics . . Causes of the downward slope of aggregate demand may seem ~ery Similar to the causes of shifts ect in the aggregate demand curve. The real balances effect looks hke the wealth et:r , and the interest rate and foreign purchases effects look very similar to causes of change m aggregate the three factors demand. A way to keep them straight is to look at the cause of each effect. in that explain the downward slope, a higher price level is the root cause of each effe~t. The price level causes a decline in the value of wealth, a higher interest rate for borrowmg, and a shift toward buying relatively lower-priced imports. At higher prices, people buy fewer products. But for the causes of change in aggregate demand, shifts in the curve result from causes other than a change in the prices of products in the economy. Changes in expectations for economic performance, tax rates, incomes, and currency values are among the reasons the entire curve . would shift. Aggregate Supply Aggregate supply is the quantity of goods produced in an economy at all price levels. The shape of the aggregate s~pply curve varies depending on the time period discussed. The costs of inputs sticky or unchangeable in the short run (resources) and pnces of outputs to consumers tend to but more flexible in the long run. In the immediate short run (or immediate period), both costs resources and the prices ~harge~ to cus~omers are fixed. As a result, the aggregate supply curve is horizontal in the Immediate penod. If aggregate demand increases in this time period, output increases but the pnce level does not change. ' AS o~--------------------~ Qr Real domestic output. GOP The aggregate supply curve (short run) In the short run, output prices are flexible but res stickiness is primarily due to wages beca~se source costs are either fixed or very sticky The .' 0 many workers ar 'd' . e pal Via a contract whose terms carmot be changed qUickly. As a result th h P d ' ' e sort-run aggr t . sIopmg. ro ucers proVide more products as the . I . ega e supply curve is upwardlevel falls. When current output is significantly I pnce evel nses and fewer products as the price . . . OWer than the firm' s capaCity, . firms can increase in productIOn cost. B t . ou t put WI·th l'IttIe mcrease u as ProduCtlOn ap proac hes or even passes full- 202 Chapter 29' A . ggregate Demand and Aggregate Supply employment output, the per-unit cost of production short-run aggregate supply curve slopes upward, becoming much more quickly. As a result, as output increases. ASLR / Lon,.run ag,regate supply o Qr Real domestic output, GDP Aggregate supply in the long run Bear in Mind The aggregate supply curve can also be presented as representing Keynesian, intermediate, and classical ranges. Aggregate Supply AS P Classical Range r i c e L e v e Intermediate Range I RealGDP Remember, classical economists were convinced that the economy naturally produced at fullemployment output. While prices and wages were flexible, output was not. This theory is represented in the vertical range of the aggregate supply curve. Keynesian theory held the opposite assumptions, with flexible output and employment but fixed and wages. These assumptions are found in the horizontal section of the aggregate supply curve. The intermediate supply curve range of the aggregate supply curve corresponds with the short-run discussed in the text. AP macroeconomics exam questions about short-run aggregate supply generally to this upward-sloping aggregate supply curve unless they specifically note are a vertical or horizontal aggregate supply curve. lfyou see a question referring to the intermediate range of the aggregate supply curv~,itis_referring to tl1~llP\lVard-sloping section. "'U<1plJer 29: Aggregate Demand and Aggregate Supply 203 In the long run, the costs of inputs, including labor, as weU as the prices charged to customers, are flexible. Long-run aggregate supply is a vertical curve, located at full-employment output Although increases in aggregate demand may cause short-run increases in production beyond fun-employment GDP, the additional costs of paying workers overtime and paying a premium for resources will cause finns to reduce production back to full-employment GDP in the long run. Changes in Aggregate SuppJy Changes in aggregate supply are directly connected to changes in the per-unit costs of production faced by firms. If costs of production fall, aggregate supply increases, shifting the curve to the right so that more output is produced at every price leveL Increases in the cost of production reduce aggregate supply, shifting the curve leftward. Changes in the costs of land, labor, and capital resources are a major determinant of changes in aggregate supply. As costs increase, firms reduce supply, lowering output and employment and raising prices. Productivity is another important determinant of aggregate supply. If productivity increases as a result of better worker education or technology, aggregate supply increases, so firms increase output and employment while lowering prices. Changes in government policy can also affect aggregate supply. Ifbusiness taxes are increased or the government institutes regulations, the increased costs of production reduce aggregate supply. If business taxes are reduced, the government grants firms a subsidy, or if regulation is reduced, the lower per-unit costs of production lead firms to increase production, and aggregate supply increases. Equilibrium GDP AS AD i ~ o ! , ..,....",.",- 502 510 514 Real domestic output. GOP (billion. of doll .... ) Equilibrium price level and equilibrium real GDP Equilibrium GDP occurs at the point where aggregate demand equals aggregate supply. This equilibrium establishes price level and real GOP for the economy. In this figure, equilibrium occurs at a real GOP of $5 10 billion in output and a price level of 100. At price level 92, firms would only produce $502 billion of output while aggregate demand at that price level is $514 billion in output. Given the shortage of goods at that price, consumers would bid up the price. The higher price leads firms to increase production and consumers to reduce quantity demanded until equilibrium is again reached. 204 Chapter 29: Aggregate Demand and Aggregate Supply AS o Qr QI Qz Re.1 domestic output, GDP An increase in aggregate demand that causes demand-pull inflation lfthe economy is in equilibrium at full-employment output, an increase in demand causes demand-pull inflation-an inflationary gap. Prices increase as well as real GDP. It is important to note that because the price increased, the full multiplier did not occur. The full multiplier requires a horizontal aggregate supply curve so that the full multiplier effect goes to output, rather than being partially absorbed by a AS o QI Ql Qf Real domestic output. GDP A decrease in aggregate demalld that causes a recessioll A decrease in aggregate demand causes a decrease in production-a recessionary Employment falls and cyclical unemployment rises as a result, because firms do not as many With the workers to produce fewer products. The effect on prices can be harder to lower demand, disinflation (a reduction in the rate of inflation) tends to occur. But do prices actually Wages and prices are sticky downward, so in many recessions, lHJOr~'al'l'lp demand fully impacts output but does not cause a change in price level. As illustrated of the multiplier occurs in the in this when the price does not change, the full changing real GDP. If prices do actually fall, part of the multiplier effect is absorbed by the and teal GDP does not fall by full amount of the change in aggregate demand. Chapter 29: AP'I>TNyMf' n~.~~.",1 and Aggregate Supply 205 AD o Q, Qr Ft.al domestic output. GDP A decrease in aggregate supply that causes cost-push inflation A reduction in aggregate supply causes cost-push inflation. As the cost of production increases, firms reduce output and raise prices. A sustained decrease in aggregate supply is known as stagflation-a stagnant economy, high inflation (thus the name stagflation), and high unemployment all at the same time. High oil prices in the 1970s sent the U.S. economy into its most significant period of stagflation in history. An increase in aggregate supply resulting from increased productivity and technology shifts the aggregate supply curve to the right. Real GDP and employment increase and prices can fall as a result of the lower per-unit costs of production. o Q, Ql QJ Real domestic output. GDP Growth,full employment, and relative price stability It is possible for both aggregate demand and aggregate supply to shift at the same time, as multiple factors affect the economy. In the late 1990s, full employment, higher incomes, and high consumer confidence led to higher aggregate demand. At the same time, increases in technology and productivity via computers increased aggregate supply. Increases in both curves significantly increased real GDP, while the price level only moderately increased because the curve shifts had contradictory effects on prices. Changes in aggregate supply and aggregate demand cause recessionary and inflationary gaps and affect real GDP, employment, and prices. In subsequent chapters, we will examine the tools policymakers have available to mitigate-and potentially reverse-the effects of such curve shifts. 206 Chapter 29: Aggregate Demand and Aggregate Supply Multiple-Choice QUestions l. The ::10'("""'7" demand curve slopes downward because as the price level rises, (A) the real value of consumers' wealth increases (B) (C) (D) (E) interest rates "'-'_1"<'''". consumers mOre imports. the unemployment rate decreases. real output increases. 2. Consumer spending as a component of demand increases when 1. consumer wealth increases. consumer borrowing decreases. consumer expectations about the economy are optimistic. IV. personal taxes increase. (A) I only II and IV only (B) (C) I and III only II, III, and IV only I, II, III, and IV 3. of the following would result in an increase in an increase in (A) interest rates. (B) exports. (C) govemment spending. (D) finns' expected return on investment. exports. (E) incomes in countries buying 4. O'O'rpO'''TP demand EXCEPT supply increases as the result of an increase in cost of production. worker productivity. taxes. government regulation of business. the price of oil. =P'O'''lt" (A) (B) (C) (D) (E) 5. Stagflation is caused by (A) an increase in aggregate demand. (B) a decrease in aggregate demand. (C) an increase in aggregate supply. (D) a decrease in aggregate supply. (E) a simultaneous increase in aggregate supply and ""'"""<.1,p demand. 6. The equilibrium point of aggregate supply and aggregate demand detennines (A) wages and spending. (B) saving and investment. (C) taxes and government "1.1,",U\.1I'UF.' (D) profit and saving. (E) real GDP and price level. Cnaptler 29: Aggregate Demand and Aglgre!~iUo;; Supply 207 7. Which of the following situations would most likely result in a decrease in the price level and a decrease in real GOP? (A) a decrease in consumer confidence (B) an increase in wages (C) a decrease in interest rates (D) an increase in productivity (E) an in exports 8. An increa:;;e in aggregate supply causes which of the following output and price level effects? (A) (B) (C) (D) (E) Output Increase Decrease No Increase Decrease Price Level Increase No Decrease Decrease Increase 9. If the aggregate supply curve is horizontal and government spending increases, how will price level, output, and employment be affected? Price Level Output Employment (A) Increase Increase Increase (B) Decrease Decrease Decrease (C) No change Increase Increase (D) Decrease No change No change (E) Increase Decrease 10. If equilibrium is in the intennediate range of aggregate supply and interest rates how will price output. and unemployment be affected? Level Output Cnemploymen{ (A) Increase Increase Increase (B) Decrease Decrease Decrease (C) Increase Decrease Increase (D) Decrease Decrease (E) Increase Increase Free-Response Questions 1. Assume the United States economy is currently operating at equilibrium. (a) Draw a correctly labeled aggregate supply and demand graph, and show of the following. (i) output (ii) price level (b) Now assume the price of oil, an important resource for U.S. production, increases significantly. Illustrate the effect of the oil price increase on the AD-AS graph. (c) Identify and explain the effect of the increase in oil price on each of the following. (i) real output (ii) price level (iii) employment 208 Chapter 2Q: Aggregate Demand and Aggregate Supply 2. (a) (b) (c) Assume the ~nited economy is currently operating at equilibrium. Now assume mterest rates for investment loans increase. (i) ~se a correctly labeled aggregate supply and aggregate demand graph to Illustrate effect of the rate. (ii) Explain the mechanism that causes this change in the curve. Explain effect of the change in investment spending on each ofthe following. 0) real output Oi) price level (iii) employment Identify one fiscal policy government could implement to reverse the change in investment spending. Multiple-Choice Explanations I. (C) When domestic prices rise, consumers buy relatively lower-priced imports, the value of reducing the quantity demanded of domestic goods. Higher prices wealth and result in higher interest rates, which both reduce quantities demanded. With the lower quantity demanded, real output is lower, leading to reduced employment. 2. (C) Increases in wealth and optimism about economic performance lead consumers their demand for products at all prices. An increase in consumer borrowing a reduction in personal taxes would also leave consumers with more available income to increase aggregate demand. 3. (A) An increase in interest rates makes it more expensive for consumers and firms to borrow, so their demand products would de(:reclse. 4. (B) Increases in productivity lower per-unit costs of production, causing an increase in aggregate supply. The other options increase costs. 5. (D) A decrease in aggregate supply and unemployment at the same time, which is characteristic of stagflation. 6. (E) Real GDP and price level are the axes of the aggregate expenditures model graph, and each is determined by the level of aggregate supply and aggregate demand in the economy. 7. (A) If consumers confidence in future economic performance, they a potential loss of a job. aggregate demand out of concern 8. (D) An increase in aggregate supply shifts the curve to the right. 9. (C) An increase in government spending output, so employment to make those products. Because price is inflexible, it not change. 10. (D) Higher interest rates reduce aggregate demand, so price and output fall. Fewer workers are needed to produce output, so unemployment Free-Response Explanations I. 10 points (3 + 1 + 6) (a) 3 points: .. 1 point is earned for a correctly labeled AD-AS .. 1 point is earned for real output from the equilibrium point. .. I point is earned for identifying price level from the equilibrium point. (b) 1 point: • 1 point is earned for shifting the aggregate supply curve to the left. (c) 6 points: • I point is stating that real output will decrease. • I point is earned for explaining that with a higher cost of production, firms produce Chapter 29: Aggregate Demand and Aggregate Supply 209 • • • • 2. (a) • • • (b) • • • (c) • 210 I point is earned for stating that the price level will increase. 1 point is earned for explaining that with a higher cost of production and lower output, firms increase prices. 1 point is earned for stating that employment will fall. I point is earned for explaining that because firms are producing less, they need fewer workers to create the output. 7 points (3 + 3 + I) 3 points: I point is earned for a correctly labeled AD-AS graph. I point is earned for shifting aggregate demand to the left. I point is earned for explaining that because the higher interest rate increases the cost of investment, firms reduce investment spending. 3 points: I point is earned for explaining that real output decreases because of reduced investment spending. I point is earned for explaining that the price level decreases because of reduced aggregate demand or that prices remain the same if the answer specifically explains that prices and wages are sticky downward. I point is earned for explaining that employment decreases because fewer workers are needed to produce the reduced output. I point: I point is earned for identifying either an increase in government spending or a decrease in taxes as an appropriate fiscal policy to increase aggregate demand. Chapter 29: Aggregate Demand and Aggregate Supply