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Chapter 14: Aggregate Demand and Aggregate Supply McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved Aggregate Demand – Aggregate Supply Model The AD-AS model enables us to analyze changes in real GDP and price level simultaneously. The AD-AS model provides keen insights on inflation, recession, unemployment, and economic growth. Aggregate Demand – Aggregate Supply (AD-AS) model is the macroeconomic model that uses aggregate demand and aggregate supply to determine and explain the price level and level of real domestic output. LO: 14-1 14-2 Aggregate demand curve is a schedule that shows the total quantity of goods and services demanded at difference price levels. There is an inverse relationship between the price level (as measured by the GDP price index) and real output demanded (real GDP). Price Level Aggregate Demand and Aggregate Demand Curve Aggregate Demand AD Real Domestic Output, GDP LO: 14-1 14-3 Changes in Aggregate Demand Determinant: Factor(s) of Determinant: AD shifts: Consumer Spending Consumer wealth increases Consumers’ real incomes rise Household indebtedness rises Tax increases Investment Spending Increases in real interest rate Higher expected returns LEFT RIGHT Government Spending Increase in government spending RIGHT Net export Spending Rising national income abroad Depreciation of the dollar RIGHT RIGHT LEFT LO: 14-1 14-4 Shifts in Aggregate Demand Curve Price Level Increase in Aggregate Demand Decrease in Aggregate Demand AD2 AD1 AD3 LO: 14-1 Real Domestic Output, GDP 14-5 Aggregate Supply Aggregate supply curve is a schedule that shows the total quantity of goods and services supplied at difference price levels. The aggregate supply curve in the short run and in the long run vary by degrees of wage adjustment In the immediate short run, output and input prices are fixed, and the AS curve is horizontal In the short run, output prices are flexible while input prices are sticky, thus the AS curve is positively sloped In the long run, all prices are flexible, economy is at the full employment (output is equal to potential), the AS curve is vertical LO: 14-2 14-6 Price Level Immediate Short Run Aggregate Supply ASISR Immediate Short Run Aggregate Supply LO: 14-2 Real Domestic Output, GDP 14-7 Short Run Aggregate Supply Price Level Aggregate Supply (Short Run) 0 Qf Real Domestic Output, GDP LO: 14-2 14-8 Long Run Aggregate Supply Price Level ASLR Long Run Aggregate Supply LO: 14-2 Real Domestic Output, GDP 14-9 Changes in Aggregate Supply Determinant: Input Prices Factor(s) of Determinant: Domestic resource prices rise Prices of imported resources rise AS shifts: LEFT Increased market power Productivity Increases in productivity LegalInstitutional Environment Higher business taxes More government regulation RIGHT LEFT LO: 14-2 14-10 Shifts in Aggregate Supply Curve AS3 AS1 Decrease in Aggregate Supply Price Level AS2 Increase in Aggregate Supply LO: 14-2 Real Domestic Output, GDP 14-11 Equilibrium Price Level and Real GDP Equilibrium occurs at the price level that equalizes the amount of real output demanded and supplied. Equilibrium point is the intersection of the aggregate demand curve and aggregate supply curve. This intersection determines the equilibrium price level and equilibrium real output. LO: 14-3 14-12 Equilibrium Real Output Demanded (Billions) LO: 14-3 Price Level (Index Number) Real Output Supplied (Billions) $506 108 $513 508 104 512 510 100 510 512 96 507 514 92 502 Equilibrium Price Level and Equilibrium Real GDP 14-13 Equilibrium Price Level AS Equilibrium 100 AD LO: 14-3 510 Real Domestic Output, GDP (Billions of Dollars) 14-14 Using AD-AS Model to Explain Inflation and Recession When aggregate supply and aggregate demand change, inflation and recession can occur in the short run. Demand-pull inflation occurs when aggregate demand increases (AD curve shifts to the right). Cost-push inflation occurs when costs of production rise (AS curve shifts to the left). Recession occurs when aggregate demand falls (AD curve shifts to the left) and prices are sticky downwards. LO: 14-4 14-15 Demand-Pull Inflation Increase in Aggregate Demand Price Level AS Demand-Pull Inflation P2 P1 AD1 AD LO: 14-4 Qf Q1 Real Domestic Output, GDP 14-16 Cost-Push Inflation Decrease in Aggregate Supply Price Level AS1 Cost-Push Inflation P2 P1 AS b a AD LO: 14-4 Q1 Qf Real Domestic Output, GDP 14-17 Recession Decrease in Aggregate Demand Price Level AS b P1 a Creates a Recession AD1 AD2 LO: 14-4 Q2 Qf Real Domestic Output, GDP 14-18