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Unit 3: Aggregate Demand and Supply and Fiscal Policy 1 Shifters of Aggregate Demand AD = C + I + G + X Change in Consumer Spending Change in Government Spending Change in Investment Spending Net EXport Spending Shifters of Aggregate Supply AS = I + R + A + P Change in Change in Change in Change in Inflationary Expectations Resource Prices Actions of the Government Productivity (Investment) 2 Practice 3 Answer and identify shifter: C.I.G.X or I.R.A.P B A D A D B A A C A A major increase in productivity. 4 Putting AD and AS together to get Equilibrium Price Level and Output 5 Inflationary and Recessionary Gaps 6 Example: Assume the government increases spending. What happens to PL and Output? Price Level LRAS AS PL and Q will Increase PL1 PLe AD QY Q1 AD1 GDPR 7 Inflationary Gap Output is high and unemployment is less than NRU LRAS Price Level AS Actual GDP above potential GDP PL1 AD1 QY Q1 GDPR 8 Example: Assume the price of oil increases drastically. What happens to PL and Output? Price Level LRAS AS1 AS PL1 Stagflation PLe Stagnate Economy + Inflation AD Q1 QY GDPR 9 Recessionary Gap Output low and unemployment is more than NRU LRAS AS1 Price Level Actual GDP below potential GDP PL1 AD Q1 QY GDPR 10 AD and AS Practice Worksheet 11 How does this cartoon relate to Aggregate Demand? 12 Draw AD and AS at full employment Price Level LRAS AS P2 P1 AD2 AD=C+I+G+X Qf Q2 (Y*or FE) Output Increases GDPR PL Increases 13 Short Run and Long Run 14 Shifts in AD or AS change the price level and output in the short run Price Level LRAS AS PLe AD QY GDPR 15 Example: Assume consumers increase spending. What happens to PL and Output? Price Level LRAS AS PL1 PLe AD QY Q1 AD1 GDPR 16 Now, what will happen in the LONG RUN? Inflation means workers seek higher wages and production costs increase LRAS AS1 Price Level AS PL2 Back to full employment with higher price level PL1 PLe AD QY Q1 AD1 GDPR 17 Example: Consumer expectations fall and consumer spending plummets. What happens to PL and Output in the Short Run and Long Run? Price Level LRAS AS AS1 AS increases as workers accept lower wages and production costs fall PLe PL1 PL2 AD1 Q1 QY AD GDPR 18 The Ratchet Effect A ratchet (socket wrench) permits one to crank a tool forward but not backward. 19 Does deflation (falling prices) often occur? Not as often as inflation. Why? • If prices were to fall, the cost of resources must fall or firms would go out of business. • The cost of resources (especially labor) rarely fall because: • Labor Contracts (Unions) • Wage decrease results in poor worker morale. • Firms must pay to change prices (ex: repricing items in inventory, advertising new prices to consumers, etc.) Like a ratchet, prices can easily move up but not down! 20