Download Theories and AD-AS

Aggregate Demand
Aggregate Demand is:
A schedule, graphically represented as a
curve, which shows the various amounts
of goods and services--the amounts of
real domestic output--which domestic
consumers, businesses, governments,
and foreign buyers collectively will desire
to purchase at each possible price level
**Assumes a constant Money Supply**
Price Level
AD
Real Domestic Output (Real GDP)
Less Domestic output will be produced and purchased at
higher price levels and visa-versa
Determinants of A.D.
• Wealth Effect--different price levels either
increase or decrease the purchasing
power of accumulated assets
• Interest Rate Effect--different interest rates
(due to different price levels) will either
increase or decrease consumption of
domestic output
• Foreign Purchases Effect--different price
levels will either increase or decrease
foreign purchases of domestic output (net
exports)
Factors that Shift
Aggregate Demand
• Changes in Consumer Spending
-- Consumer Wealth
-- Consumer Expectations
-- Consumer Indebtedness
-- Taxes (Changes in...)
Factors that Shift
Aggregate Demand
• Changes in Investment Spending
(Business)
– Interest Rates
– Profit expectations on investment
projects
– Business Taxes
– Technology
– Degree of Excess Capacity
Factors that Shift
Aggregate Demand
• Change in Government Spending
-- New national spending priorities
-- Budgetary cutbacks
• Change in Net Export Spending
-- National income abroad
-- Exchange Rates
Price Level
AD+
AD
ADReal Domestic Output (Real GDP)
Examples:
• Higher consumer indebtedness from
past spending will curtail current
spending causing AD to shift left.
• Increases in Business taxes will curtail
current investment spending causing
AD to shift left (inward).
• Depreciation of the $dollar will cause
foreign currencies to be more valuable,
increasing exports, decreasing imports.
AD will shift right (outward)
Examples (Cont’d):
• Decreases in interest rates, caused by
changes in the money supply, will
increase consumer spending and
investment shifting the AD curve to the
right.
• Government cutbacks in purchases
(e.g. military budget) will result in lower
government spending, shifting AD curve
to the left
• New technology stimulates investment
spending, shifting AD to the right.,
Aggregate Supply
Aggregate Supply
A schedule, graphically
represented by a curve,
showing the level of real
domestic output (GDP)
available at each possible
price level
Price Levels
Classical Range
AS
Intermediate Range
Keynesian Range
Real Domestic Output (GDP)
Aggregate Supply:
Keynesian Range
• GDP levels in this range indicate unused
or idle resources
• GDP levels in this range implies economic
contraction with accompanying
unemployment
• GDP output can be increased due to idle
resources without an increase in price
levels, resulting in horizontal AS.
Aggregate Supply:
Intermediate Range
• Increases in Real GDP are
accompanied by increases in price
levels
• Uneven expansion in different product
and factor markets results in increases
in price levels in some market segments
but not others
• “Bottlenecks” in labor and capital use
result in uneven price level increases in
different market segments.
Aggregate Supply:
Classical Range
• At some specific level of GDP output,
productive capacity is fully utilized.
• Because economy is at a level of full
employment and productive capacity,
higher price levels will not result in greater
production.
Factors that Shift
Aggregate Supply
• Change in Input Prices
– Resource availability and prices
– Market Power of resource providers
• Labor Unions
• Monopoly resource owners
• Changes in Productivity
• Changes in Legal-Institutional
Environment
– Business Taxes and Subsidies
– Government regulation
Price Levels
AS-
Decreased AS
Increased AS
Real Domestic Output (GDP)
AS AS+
Classical Theory
• Jean-Baptiste Say (1767-1832)
• Assumes highly competitive
marketplace with little or no
government interaction
• Assumes natural state of equilibrium at full
employment
• Say’s Law: Supply creates its own
Demand
• Predominant economic theory until 1930’s
Keynesian Theory
• John Maynard Keynes: The General Theory
of Prices and Equilibrium
• There is no “natural” balance in the economy
• Aggregate Demand is the primary influence on
employment and price levels.
• Advocated use of “Fiscal Policy” by government
to adjust equilibrium toward full employment
Fiscal Policy is the use of government taxing
and spending authorities to achieve economic
goals.
Monetary Theory
(Monetarism)
• Milton Friedman (Nobel Prize)
• The supply of money in the economy
will affect interest rates therefore
investment, and consumption.
• Too much $$ results in inflation; too
little in unemployment.
• Advocated a balance between $$ supply and
economic productivity and less gov’t
involvement
http://pw1.netcom.com/~garretc/politics/friedman.html
Interest Rate
Monetarist Model
S
money
S’
D
Q1 Q2
Quantity of Money
Neo-Classical
(Supply-Side)
• Gained prominence during 1970’s
“Stagflation”.
a.k.a. “Voodoo Economics”(G.Bush)
• Re-focus on Aggregate Supply
• Advocated:
– Lower Taxes on business and investors
– Increased privatization of gov’t programs
– Decreased regulation of business
Stagflation = high inflation with high unemployment
Supply-Side Model
AS1
AS2
Price Level
FE
AD
GDP
FE= Full Employment