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Aggregate Demand • Aggregate demand is the total demand in an economy for all the goods and services produced. • The aggregate demand schedule is a schedule relating the total demand for all the goods and services produced in an economy to the price level. • The aggregate demand curve slopes down. Aggregate Demand P Note that at P2, the higher price level, aggregate demand equals Y1, but at P1, the lower price level, aggregate demand equals Y2. P2 P1 AD 0 Y1 Y2 Y Aggregate Demand • Aggregate demand slopes down because: – As the price level increases, the purchasing power of real wealth decreases, resulting in less spending and lower Y. – As the price level increases, the real money supply decreases, pushing up interest rates. – As the domestic price level increases, foreigners buy less of our goods and services. Aggregate Demand AS AE AE2(P1) B We begin at point A where income is Y1 and the price level is P2. AE1(P2) Y1 and P2 comprise one point on the aggregate demand curve, AD. A 0 P Y1 P2 A P1 Y2 Y At P1, equilibrium income is Y2. B AD Y 0 Y1 Y2 We let the price level fall to P1. At the lower price level, purchasing power increases, causing aggregate expenditures to shift up from AE1 to AE2. Y2 and P1 comprise another point on aggregate demand curve, AD. Changes in Aggregate Demand • Aggregate demand increases when people want to buy more goods and services and decreases when people want to buy less. • There are two types of aggregate demand change that can occur – A change in aggregate demand caused by a change in the price level. – A changes in aggregate demand caused by events not related to a change in the price level. Moving along the AD Curve • Changes in aggregate demand caused by a change in the price level are shown by a movement along the aggregate demand schedule. – Increases in the price level decrease aggregate demand – Decreases in the price level increase aggregate demand. Moving along the AD Curve P P2 Note that at P2, the higher price level, aggregate demand equals Y1, but as the price level falls to P1, the lower price level, aggregate demand rises to Y2. P1 AD 0 Y1 Y2 Y Shifting the AD Curve • A change in any of the variables in the AE/AS model except the price level shifts AD. • Examples: – – – – – An increase or decrease in investment An increase or decrease in consumption An increase or decrease in taxes An increase or decrease in government spending. An increase or decrease in the money supply Shifting the AD Curve P Increases in AD are shown by shifting the AD curve from AD1 to AD2. Note that at the price level P1, aggregate demand on AD2 is greater than on AD1. P1 Decreases in AD are shown by shifting the AD curve from AD2 to AD1. Note AD2 that at the price level P , aggregate 1 AD1 demand on AD1 is less than on AD2. 0 Y1 Y2 Y Shifting Aggregate Demand AS AE AE2(P1) B AE1(P1) A 0 P P1 Y1 A Y2 Y AD1 Y1 Increases in spending shift aggregate expenditures from AE1 to AE2. Increases in spending shift aggregate demand from AD1 to AD2. B 0 Y2 Y An increase in spending that is NOT caused by a change in the price level causes the aggregate demand curve to shift. AD2 Decreases in spending shift aggregate expenditures from AE2 to AE1. Decreases in spending shift aggregate demand from AD2 to AD1. Aggregate Demand and the Multiplier AS AE AE2(P1) B AE1(P1) A change in spending that is not caused by a change in the price level shifts the aggregate demand curve. A 0 P P1 Y1 Y2 When aggregate expenditures rise, income increases by more than the increase in expenditures. Y Note that the price level is P1 at both Y1 and Y2. C The distance Y1Y2 = CD reflects the impact of the multiplier effect in the D AD1 0 Y1 Y2 Y AD2 aggregate demand model. Practice • How does a lower price level change aggregate demand? Is this a shift in AD or a movement along the AD schedule? • What will cause the AD schedule to shift up? List three real world examples of such an AD shift. • What will cause the AD schedule to shift down? List three real world examples of such an AD shift. Aggregate Supply • Aggregate supply is the total quantity of goods and services produced in an economy. • The aggregate supply schedule is a schedule relating the total supply of all the goods and services produced in an economy to the price level. Short-Run Aggregate Supply Curve • The short run aggregate supply curve shows how aggregate supply increases as the price level rises but factor costs do not change. – The short run is defined as that period of time over which nominal factor costs do not change. • Nominal factor costs include wages, interest paid on loans, and the cost of plant and equipment. • The short run aggregate supply curve may be flat or upward sloping. Short Run Aggregate Supply Curve P AS Aggregate supply is drawn as a horizontal line over the range of output that is far below the economy’s full capacity. Over this range, 0Y1, there is no shortage of inputs and the economy can expand without a price level increase. As the economy approaches full capacity, Yfe, employers have difficulty finding skilled workers and must hire less productive employees. The price level rises due to diminishing returns. This is reflected in an upward sloping AS curve. 0 Y1 Yfe Y At Yfe, we have full employment of all resources. Output is fixed. Aggregate Supply and the Price Level P AS A fall in the price level from P2 to P1 causes a decrease in profits, given fixed resource costs. P2 Lower profits are an incentive for lower levels of production and output. P1 A rise in the price level from P1 to P2 results in an increase in profits, given fixed resource costs. Higher profits are an incentive for higher levels of production and output. 0 Y1 Yfe Y Shifting the Aggregate Supply Curve AS1 P AS2 AS3 A shift in the aggregate supply curve represents any change in aggregate supply that is not caused by a change in the price level. Shifts in aggregate supply are caused by events such as a change in the overall level of resource productivity and changes in resource availability. Tax policy also can affect AS. Increases in AS are shown by a shift of the curve to the right. 0 Y Decreases in AS are shown by a shift of the curve to the left. Practice • How does a lower price level change aggregate supply? Is this a shift in AS or a movement along the AS schedule? • What will cause the AS schedule to shift up? List three real world examples of such an AS shift. • What will cause the AS schedule to shift down? List three real world examples of such an AS shift. Equilibrium in the AD/AS Model • Equilibrium in the AD/AS model occurs where aggregate demand just equals aggregate supply. • It is a stable equilibrium. – If AD>AS, the price level rises and Y falls – If AD<AS, the price level falls and Y rises. Equilibrium in the AD/AS Model P AS Equilibrium occurs at the point E where the price level is P1 and output is Y1. At this point, aggregate demand is just equal to aggregate supply. All the goods and services produced are demanded by the members of the economy. P1 E AD 0 Y1 Yfe Y The equilibrium is stable. If the economy is not at equilibrium, there are forces that push AD and AS towards equilibrium. Equilibrium in the AD/AS Model P Equilibrium occurs at point E, where the price level is Pe and output is Ye. AS A Deflationary Gap B At price levels below Pe, AD>AS by the amount CD. Firms will not be able to meet demand with current production levels, resulting in a decline in inventories and a rise AD in both production and the price level. E Pe C 0 At price levels above Pe, AS >AD by the amount AB. Firms will not be able to sell all the goods they produce, resulting in an increase in inventories and a decline in both production and the price level. D Inflationary Gap Ye Y Changes in Aggregate Demand P AS Increases in aggregate demand shift the AD curve to the right. Both income and the price level rise. P2 P1 Decreases in aggregate demand shift the AD curve to the left. Both income and the price level fall. B A AD2 AD1 0 Y1 Y2 Y Changes in Aggregate Supply P AS1 AS2 A P2 Decreases in aggregate supply shift the AS curve to the left. Income falls and the price level rises.. We move from point B to point A. B P1 AD 0 Y1 Y2 Increases in aggregate supply shift the AS curve to the right. Income rises and the price level falls. We move from point A to point B. Y Practice • Assume the economy is at full employment and increase AD. What happens to P and Y? • Now assume the economy is at full employment and increase AS. What happens to P and Y? • If you were in charge of increasing Y while avoiding inflation, which curve would you want to shift? How would you do it? Practice • Explain and show graphically what will happen to P and Y under the following circumstances: (Assume the economy is neither in a recession or at full employment) – – – – – – Taxes on consumers fall Taxes on businesses fall Interest rates rise Business optimism falls Oil prices double People begin to save more at every rate of interest Practice • In the Great Depression, the price level and GDP fell. What shift or combination of shifts in AD and AS would best describe the Great Depression? • Currently, we are in an economic expansion. Is our expansion caused by changes in AD or AS? Explain your answer.