Download Price Level

10
Aggregate Demand
and Aggregate Supply
10-1
Copyright 2008 The McGraw-Hill Companies
Learning objectives
In this chapter students will learn:
1. About aggregate demand (AD) and the factors that cause
it to change.
2. About aggregate supply (AS) and the factors that cause it
to change.
3. How AD and AS determine an economy’s equilibrium
price level and level of real GDP.
4. How the AD-AS model explains periods of demand-pull
inflation, cost-push inflation, and recession.
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Aggregate demand
• Aggregate demand is a schedule or curve that shows the
various amounts of real domestic output that domestic and
foreign buyers will desire to purchase at each possible price
level.
• The aggregate demand curve is shown in Figure 10.1.
1. It shows an inverse relationship between price level and real
domestic output.
2. The explanation of the inverse relationship is not the same as
for demand for a single product, which centered on
substitution and income effects.
a. Substitution effect doesn’t apply within the scope of domestically
produced goods, since there is no substitute for “everything.”
b. Income effect also doesn’t apply in the aggregate case, since income
now varies with aggregate output.
3. What is the explanation of the inverse relationship between
price level and real output in aggregate demand?
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AD – AS Model
Price Level
Aggregate Demand Curve
Aggregate
Demand
AD
Real Domestic Output, GDP
Click to Link to Appendix 10: Relationship of AD to the AE Model
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• Real balances effect: When price level falls, the
purchasing power of existing financial balances rises,
which can increase spending and vice versa.
• Interest-rate effect: A decline in price level means
lower interest rates that can increase levels of certain
types of spending and vice versa.
• Foreign purchases effect: When price level falls,
other things being equal, domestic prices will fall
relative to foreign prices, which will tend to increase
spending on exports and also decrease import
spending in favor of home products that compete
with imports and vice versa. (Similar to the
substitution effect)
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Determinants of aggregate demand
Change in price level will change AD from one point
to another on the AD curve. AD will not Shift.
•
Determinants of AD are the “other things” that can
cause a shift or change in demand (AD shifters).
1. Changes in consumer spending:
If consumers decide to buy more, AD will shift to the
right and vice versa. Factors affecting consumer
spending are:
a) Consumer wealth (financial and real): An increase in the
real value of wealth prompts people to save less and buy
more; AD shifts to RHS, and vice versa.
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a) Consumer expectations: When consumers expect their
real incomes to increase, they spend more of their
income. When they expect surging inflation in the
near future, they will spend more before prices
escalate, AD will shift to RHS, and vice versa.
b) Household indebtedness: If households’ indebtedness
rises beyond normal levels, consumers may be forced
to consume less in order to pay interest and principle
on their debt, and vice versa.
c) Taxes: A tax rise reduces disposable income of the
public and forces the public to buy less, AD shifts to
LHS, and vice versa
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2. Changes in investment spending
An increase in investment spending shifts AD to the
RHS, and vice versa. Changes in investment can be
caused by changes in several factors.
a) Real interest rates: An increase in interest rates will
lower investment spending, AD shifts to the LHS.
Remember, we are not referring here to the interest
rate effect resulting from a change in price level, but
due to changes in money supply.
b) Expected returns: higher expected returns will increase
investment and AD shifts to the RHS, and vice versa.
Expected returns are affected by:
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-
Expectations about future business conditions.
Technology
Degree of excess capacity
Business taxes
3. Changes in government spending: An increase in G
will shift AD to the RHS, and vice versa.
4. Changes in net export spending (unrelated to price
level): A rise in net exports, will shift AD to the
RHS and vice versa. Remember that these changes
are not prompted by changes in price level. These
are due to changes in other factors such as:
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– National income abroad: Rising national incomes abroad
encourages foreigners to buy more of our products, Xn
rises and AD shifts to the RHS.
– Exchange rates: Depreciation of the KD. encourages
Kuwait’s exports since Kuwait’s products become less
expensive when foreign buyers can obtain more KDs for
their currency. Conversely, dollar depreciation
discourages import buying in Kuwait because our KD
can’t be exchanged for as much foreign currency.
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Copyright 2008 The McGraw-Hill Companies
Changes in Aggregate Demand
Changes in Aggregate Demand Curve
Price Level
Increase in
Aggregate
Demand
Decrease in
Aggregate
Demand
AD2
AD1
AD3
Real Domestic Output, GDP
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Aggregate supply
•
Aggregate supply is a schedule or curve showing the level of
real domestic output available at each possible price level.
1. Long run: resource prices match changes in the price level
2. Short run: resource prices do not respond to price level
changes
• Aggregate supply in the long run
1. In the long run the aggregate supply curve is vertical at the economy’s
full-employment output.
2. The curve is vertical because in the long run resources prices adjust to
changes in the price level, therefore do not change real profit, leaving
no incentive for firms to change their output. Aggregate supply does
not respond to changes the price level.
•
•
Aggregate supply in the short run
Resource prices doe not immediately adjust to changes in the
price level, as the price level increases, real profit rises with
higher this causes the economy to produce more and vice
versa.
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Aggregate Supply
Aggregate Supply in the Long Run
Price Level
ASLR
Long Run
Aggregate
Supply
Real Domestic Output, GDP
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1. The short run aggregate supply curve is upward
sloping.
2. The lag between product prices and resource
prices makes it profitable for firms to increase
output when the price level rises.
3. To the left of full-employment output, the curve is
relatively flat. The relative abundance of idle
inputs means that firms can increase output
without substantial increases in production costs
and thus product prices.
4. To the right of full-employment output the curve
is relatively steep. Shortages of inputs and
production bottlenecks will require substantially
higher prices to induce firms to produce.
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Aggregate Supply
Aggregate Supply in the Short Run
Per-Unit
Production Cost
Total Input Cost
=
Units of Output
W 10.1
Price Level
Aggregate Supply
(Short Run)
0
Qf
Real Domestic Output, GDP
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Copyright 2008 The McGraw-Hill Companies
Determinants of aggregate supply
•
As price level changes, AS moves from one point to
another along the AS curve.
•
Determinants are the “other things” (other than
the price level) that cause changes or shifts in
aggregate supply (AS shifters). At each price level,
these shift AS either to RHS or LHS.
1. Input prices:
Higher input prices increase per-unit cost and
reduces AS, and vice versa. Resources can either be
domestic or imported.
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a.
Domestic resource prices: Increases in supply of resources
reduce per-unit cost and shifts AS to RHS, and vice versa.
–
Capital. Additions to the stock of capital. A fall in Price of
machinery and equipments decreases per-unit production
costs and AS shifts to the RHS and vice versa.
–
Labor. Wages and salaries make up about 75% of all business
costs. Immigration, influx of women to the labor market put
downward pressures on wages and AS shifts to RHS. Labor
supply increases because immigration reduce per-unit
production costs. AS shifts to the RHS. Rapid early
retirements increase wages and shift AS to the LHS.
–
Land. Discoveries of mineral deposits, irrigation, technical
innovations. These lowers rents and shift AS to the RHS.
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b.
Prices of imported resources: For example oil, tin…etc.
when increase will shift AS to LHS, and vice versa.
Exchange rate fluctuations are one factor that affects
imported factor prices.
c.
Market power in certain industries: Ability to set market
prices, e.g., OPEC can push oil price up and thus AS to LHS
in oil importing countries.
2. Changes in productivity:
3.
(productivity = real output / input) can cause changes in perunit production cost (production cost per unit = total input
cost / units of output). Productivity improvement is very
important in business efforts to reduce costs.
•
•
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If productivity rises, unit production costs will fall. This can shift
aggregate supply to the right and lower prices.
If productivity falls, unit production costs will rise. This can shift
aggregate supply.
Copyright 2008 The McGraw-Hill Companies
3. legal-institutional environment:
• Change in legal-institutional environment in which
businesses operate. Examples of these can changes
are:
- business taxes and subsidies
- government regulation. More regulation tends to push perunit costs and shifts AS to LHS.
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Changes in Aggregate Supply
Changes in Aggregate Demand Curve
Price Level
AS3
AS1
Decrease in
Aggregate
Supply
AS2
Increase in
Aggregate
Supply
Real Domestic Output, GDP
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Copyright 2008 The McGraw-Hill Companies
Equilibrium: Real Output and the Price Level
Equilibrium price and quantity are found where the aggregate
demand and supply curves intersect.
Real Output
Demanded
(Billions)
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 Price Level
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Equilibrium and Changes in
Equilibrium
Price Level
AS
Equilibrium
100
a
92
b
AD
502
510 514
Real Domestic Output, GDP
(Billions of Dollars)
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INCREASES IN AGGREGATE DEMAND
•
Increases in aggregate demand cause demand-pull
inflation (Figure 10.7).
1. Increases in aggregate demand increase real output
and create upward pressure on prices, especially
when the economy operates at or above its full
employment level of output.
2. The multiplier effect weakens the further right the
aggregate demand curve moves along the aggregate
supply curve. More of the increase in spending is
absorbed into price increases instead of generating
greater real output.
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Equilibrium and Changes in
Equilibrium
Increase in Aggregate Demand
Price Level
AS
Demand-Pull
Inflation
P2
P1
AD1
AD
Qf
Q1 Q2
Real Domestic Output, GDP
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Copyright 2008 The McGraw-Hill Companies
•
•
DECREASES IN AGGREGATE DEMAND
If AD decreases, recession and cyclical unemployment may
result. See Figure 10.8. Prices don’t fall easily.
1.
2.
3.
4.
5.
Fear of price wars keeps prices from being reduced.
Menu costs discourage repeated price changes.
Wage contracts are not flexible so businesses can’t afford to reduce
prices.
Employers are reluctant to cut wages because of impact on employee
effort, etc. Employers seek to pay efficiency wages – wages that
maximize work effort and productivity, minimizing cost.
Minimum wage laws keep wages above that level.
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Equilibrium and Changes in
Equilibrium
Decrease in Aggregate Demand
Price Level
AS
b
P1
a
c
P2
Creates a
Recession
AD1
AD2
Q1 Q 2 Qf
Real Domestic Output, GDP
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• SHIFTS IN AGGREGATGE SUPPLY
• Shifting aggregate supply occurs when a supply determinant
changes. (See Key Questions 5, 6, 7):
1. Leftward shift in curve illustrates cost-push inflation (see
Figure 10.9).
2. Rightward shift in curve will cause a decline in price level (see
Figure 10.10). See text for discussion of this desirable
outcome.
3. In the late 1990s, despite strong increases in aggregate
demand, prices remained relatively stable (low inflation) as
aggregate supply shifted right (productivity gains).
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Copyright 2008 The McGraw-Hill Companies
Equilibrium and Changes in
Equilibrium
Decrease in Aggregate Supply
Price Level
AS1
Cost-Push
Inflation
P2
P1
AS
b
a
AD
Q1 Qf
Real Domestic Output, GDP
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Copyright 2008 The McGraw-Hill Companies
Equilibrium and Changes in
Equilibrium
Increases in Aggregate Supply –
Full-Employment With Price-Level Stability
Price Level
AS1
P3
P2
P1
AS2
b
c
a
AD2
AD1
Q1
Q2Q3
Real Domestic Output, GDP
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Copyright 2008 The McGraw-Hill Companies
V. LAST WORD: Has the Impact of Oil Prices Diminished?
• In the mid- and late 1970s, oil price shocks caused cost-push
inflation, rising unemployment, and a negative GDP gap
(stagflation).
• In the late 1980s and through most of the 1990s, oil prices fell,
prompting OPEC (along with Mexico, Norway, and Russia) to
restrict output and raise prices (up to $34 per barrel in March
2000). This price shock did not cause the cost-push inflation
and recessionary conditions as with previous shocks.
• In 2005, conflict in the Middle East, combined with rapidly
rising demand for oil in India and China, pushed oil prices
above $60 per barrel (and over $70 per barrel in July 2006).
U.S. inflation rose in 2005, but not core inflation (inflation
rate minus price changes in food and energy).
• A number of reasons explain why oil price shocks have had
less of an impact:
1. Lower production costs from productivity increases have
offset inflationary pressures from oil price increases.
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2. The amount of gas and oil used to produce each dollar of
output has declined by about 50 percent since 1970. (from
14,000 BTUs to 7,000 BTUs per dollar of GDP).
3. Federal reserve monetary policy helped keep oil price
increases from becoming generalized.
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APPENDIX TO CHAPTER 1
• The Relationship of the Aggregate Demand Curve to the
Aggregate Expenditures Model
• Deriving AD-curve from aggregate expenditures model. (See
Appendix Figure 10.1)
• Both models measure real GDP on horizontal axis.
• Suppose initial price level is P1 and aggregate expenditures
AE1 as shown in Appendix Figure 10.1a. Equilibrium real
domestic output is Q1. There will be a corresponding point
on the aggregate demand curve (Point 1 on Appendix Figure
10.1b).
• If price rises to P2, aggregate expenditures will fall to AE2
because purchasing power of wealth falls, interest rates may
rise, and net exports fall. (See Appendix Figure 10.1a) Then
new equilibrium is at Q2. That generates a point (Point 2) up
and to the left of Point 1 on Appendix Figure 10.1b.
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Copyright 2008 The McGraw-Hill Companies
• If price rises to P3, real asset balance value falls, interest rates
rise again, net exports fall and new equilibrium is at Q3.
Again see Appendix Figures 10.1a and 10.1b.
• Technically, the aggregate demand curve is found by drawing
a line (or curve) through Points 1, 2, and 3 on Appendix
Figure 10.1b.
• Aggregate demand shifts and the aggregate expenditures
model (Appendix Figure 10.2):
1. When there is a change in one of the determinants of
aggregate demand, there will be a change in the aggregate
expenditures as well. Look at Appendix Figure 10.2a.
2. The change in aggregate expenditures is multiplied and
aggregate demand shifts by more than the initial change in
spending (see Appendix Figure 10.2b). The text illustrates the
multiplier effect of a change in investment spending.
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3. Shift of AD curve = initial change in spending x multiplier
4. The effect of the shift on real domestic output and the price level
will depend on the starting point relative to full-employment
output, as well as the relative steepness of the aggregate supply
curve.
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Deriving the AD Curve
Aggregate Expenditures
(billions of dollars)
AE1 (at P1 )
AE2 (at P2 )
AE3 (at P3 )
As Price Levels
Increase…
Price Level
45°
P3
Real GDP
Declines
P2
P1
AD
Q1
Q2
Q3
Real Domestic Product, GDP
10-35
Copyright 2008 The McGraw-Hill Companies
Return to Chapter 10
Deriving the AD Curve
AE2 (at P1 )
Aggregate Expenditures
AE1 (at P1 )
Increase in
Aggregate
Expenditures
Price Level
45°
Increase in
Aggregate
Demand
P1
AD2
AD1
Q1
Q2
Real Domestic Product, GDP
10-36
Copyright 2008 The McGraw-Hill Companies
Return to Chapter 10
Deriving the AD Curve
AE2 (at P1 )
Aggregate Expenditures
AE1 (at P1 )
The Shift in the
Aggregate Demand
Curve is a Multiple
of the initial Change
in Aggregate
Expenditures
Price Level
45°
P1
AD2
AD1
Q1
Q2
Real Domestic Product, GDP
10-37
Copyright 2008 The McGraw-Hill Companies
Return to Chapter 10
Key Terms
• aggregate demandaggregate supply (ADAS) model
• aggregate demand
• real-balances effect
• interest-rate effect
• foreign purchases effect
• determinants of
aggregate demand
• aggregate supply
• long-run aggregate
supply curve
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• short-run aggregate
supply curve
• determinants of
aggregate supply
• productivity
• equilibrium price level
• equilibrium real output
• menu costs
• efficiency wages
Next Chapter Preview…
Fiscal Policy,
Deficits, and Debt
Click to Link to Appendix 10: Relationship of AD to the AE Model
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10
Appendix
The Relationship of the
Aggregate Demand
Curve to the Aggregate
Expenditures Model
Return to Chapter 10
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Deriving the AD Curve
Aggregate Expenditures
(billions of dollars)
AE1 (at P1 )
AE2 (at P2 )
AE3 (at P3 )
As Price Levels
Increase…
Price Level
45°
P3
Real GDP
Declines
P2
P1
AD
Q1
Q2
Q3
Real Domestic Product, GDP
10-41
Copyright 2008 The McGraw-Hill Companies
Return to Chapter 10
Deriving the AD Curve
AE2 (at P1 )
Aggregate Expenditures
AE1 (at P1 )
Increase in
Aggregate
Expenditures
Price Level
45°
Increase in
Aggregate
Demand
P1
AD2
AD1
Q1
Q2
Real Domestic Product, GDP
10-42
Copyright 2008 The McGraw-Hill Companies
Return to Chapter 10
Deriving the AD Curve
AE2 (at P1 )
Aggregate Expenditures
AE1 (at P1 )
The Shift in the
Aggregate Demand
Curve is a Multiple
of the initial Change
in Aggregate
Expenditures
Price Level
45°
P1
AD2
AD1
Q1
Q2
Real Domestic Product, GDP
10-43
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Return to Chapter 10
Next Chapter Preview…
Fiscal Policy,
Deficits, and Debt
Return to Chapter 10
10-44
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10-45
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