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Aggregate Demand and Aggregate Supply Shows the amount of Real GDP that the private, public and foreign sector collectively desire to purchase at each possible price level The relationship between the price level and the level of Real GDP is inverse See graph PL Aggregate Demand Curve AD GDPR Real-Balances Effect Interest-Rate Effect When the price-level is high households and businesses cannot afford to purchase as much output. When the price-level is low households and businesses can afford to purchase more output. A higher price-level increases the interest rate which tends to discourage investment A lower price-level decreases the interest rate which tends to encourage investment Foreign Purchases Effect A higher price-level increases the demand for relatively cheaper imports A lower price-level increases the foreign demand for relatively cheaper U.S. exports There are two parts to a shift in AD: A change in C, IG, G and/or XN A multiplier effect that produces a greater change than the original change in the 4 components Increases in AD = AD Decreases in AD = AD Increase in Aggregate Demand PL AD AD1 GDPR Decrease in Aggregate Demand PL AD1 AD GDPR Consumption (C) Gross Private Investment (IG) Government Spending (G) Net Exports (XN) = Exports - Imports (X – M) Household spending is affected by: Consumer wealth More wealth = more spending (AD shifts ) Less wealth = less spending (AD shifts ) Consumer expectations Positive expectations = more spending (AD shifts ) Negative expectations = less spending (AD shifts ) Household indebtedness Less debt = more spending (AD shifts ) More debt = less spending (AD shifts ) Taxes Less taxes = more spending (AD shifts ) More taxes = less spending (AD shifts ) Investment Spending is sensitive to: The Real Interest Rate Lower Real Interest Rate = More Investment (AD) Higher Real Interest Rate = Less Investment (AD) Expected Returns Higher Expected Returns = More Investment (AD) Lower Expected Returns = Less Investment (AD) Expected Returns are influenced by Expectations of future profitability Technology Degree of Excess Capacity (Existing Stock of Capital) Business Taxes Hyperlink to InvestmentDemand.pps More Government Spending (AD) Less Government Spending (AD) Net Exports are sensitive to: Exchange Rates (International value of $) Strong $ = More Imports and Fewer Exports = (AD ) Weak $ = Fewer Imports and More Exports = (AD ) Relative Income Strong Foreign Economies = More Exports = (AD ) Weak Foreign Economies = Less Exports = (AD ) AD reflects an inverse relationship between PL and GDPR Δ in PL creates real-balance, interest-rate, and foreign purchase effects that explain AD’s downward slope Δ in C, IG, G, and/or XN cause Δ in GDPR because they Δ AD. Increase in AD = AD Decrease in AD = AD The level of Real GDP (GDPR) that firms will produce at each Price Level (PL) Long-Run Period of time where input prices are completely flexible and adjust to changes in the price-level In the long-run, the level of Real GDP supplied is independent of the pricelevel Short-Run Period of time where input prices are sticky and do not adjust to changes in the price-level In the short-run, the level of Real GDP supplied is directly related to the price level The Long-Run Aggregate Supply or LRAS marks the level of full employment in the economy (analogous to PPC) Because input prices are completely flexible in the long-run, changes in price-level do not change firms’ real profits and therefore do not change firms’ level of output. This means that the LRAS is vertical at the economy’s level of full employment PL LRAS Yf GDPR Because input prices are sticky in the short-run, the SRAS is upward sloping.This reflects the fact that in the short-run, increases in the price-level increase firm’s profits and create incentives to increase output. As the price-level falls, firm’s profits drop and this creates an incentive to reduce output. PL SRAS GDPR An increase in SRAS is seen as a shift to the right. SRAS A decrease in SRAS is seen as a shift to the left. SRAS The key to understanding shifts in SRAS is per unit cost of production Per-unit production cost = total input cost/total output PL SRAS GDPR SRAS1 PL SRAS1 SRAS GDPR Input Prices Productivity Legal-Institutional Environment Domestic Resource Prices Wages (75% of all business costs) Cost of capital Raw Materials (commodity prices) Foreign Resource Prices Strong $ = lower foreign resource prices Weak $ = higher foreign resource prices Market Power Monopolies and cartels that control resources control the price of those resources Increases in Resource Prices = SRAS Decreases in Resource Prices = SRAS Productivity = total output/total inputs More productivity = lower unit production cost = SRAS Lower productivity = higher unit production cost = SRAS Taxes and Subsidies Taxes ($ to gov’t) on business increase per unit production cost = SRAS Subsidies ($ from gov’t) to business reduce per unit production cost = SRAS Government Regulation Government regulation creates a cost of compliance = SRAS Deregulation reduces compliance costs = SRAS The equilibrium of AS & AD determines current output (GDPR) and the price level (PL) PL LRAS SRAS P AD YF GDPR Full Employment equilibrium exists where AD intersects SRAS & LRAS at the same point. PL LRAS SRAS P AD YF GDPR A recessionary gap exists when equilibrium occurs below full employment output. LRAS PL SRAS P AD Y YF GDPR An inflationary gap exists when equilibrium occurs beyond full employment output. PL LRAS SRAS P AD YF Y GDPR Δ Consumption (C) Δ Gross Private Investment (IG) IG↑ .: AD .: GDPR↑ & PL↑ .: u%↓ & π%↑ IG↓ .: AD .: GDPR↓ & PL↓ .: u%↑ & π%↓ Δ Government Spending (G) C↑ .: AD .: GDPR↑ & PL↑ .: u%↓ & π%↑ C↓ .: AD .: GDPR↓ & PL↓ .: u%↑ & π%↓ G↑ .: AD .: GDPR↑ & PL↑ .: u%↓ & π%↑ G↓ .: AD .: GDPR↓ & PL↓ .: u%↑ & π%↓ Δ Net Exports (XN) XN↑ .: AD .: GDPR↑ & PL↑ .: u%↓ & π%↑ XN↓ .: AD .: GDPR↓ & PL↓ .: u%↑ & π%↓ LRAS PL P1 P SRAS AD1 AD Y YF GDPR C↑, IG↑, G↑ and/or XN↑ .: AD .: GDPR↑ & PL↑ .: u%↓ & π%↑ LRAS SRAS P PL P1 AD YF Y AD1 GDPR C↓, IG↓, G↓ and/or XN↓ .: AD .: GDPR↓ & PL↓ .: u%↑ & π%↓ Δ Input Prices Input Prices↓ .: SRAS .: GDPR↑ & PL↓ .: u%↓ & π%↓ Input Prices↑ .: SRAS .: GDPR↓ & PL ↑ .: u%↑ & π%↑ Δ Productivity Productivity↑ .: SRAS .: GDPR↑ & PL↓ .: u%↓ & π%↓ Productivity↓ .: SRAS .: GDPR↓ & PL ↑ .: u%↑ & π%↑ Δ Legal-Institutional Environment Deregulation .: SRAS .: GDPR↑ & PL↓ .: u%↓ & π%↓ Regulation .: SRAS .: GDPR↓ & PL ↑ .: u%↑ & π%↑ SRAS LRAS PL SRAS1 P P1 AD Y YF GDPR Input Prices↓, Productivity↑, and/or Deregulation .: SRAS .: GDPR↑ & PL↓ .: u%↓ & π%↓ SRAS1 LRAS PL SRAS P1 P Y1 YF AD GDPR Input Prices↑, Productivity↓, and/or Regulation .: SRAS .: GDPR↓ & PL↑ .: u%↑ & π%↑ ΔC, ΔIG, ΔG, and/or ΔXN = Δ AD AD .: GDPR↑ & PL↑ .: u%↓ & π%↑ AD .: GDPR↓ & PL↓ .: u%↑ & π%↓ Δ Input Prices, Δ Productivity, and/or Δ Regulation = Δ SRAS SRAS .: GDPR↑ & PL↓ .: u%↓ & π%↓ SRAS .: GDPR↓ & PL ↑ .: u%↑ & π%↑ The AS/AD Model is the most important graph in AP Macroeconomics. 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