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Aggregate Demand and Aggregate Supply
Read Chapter 7 pages 145-165
I Aggregate Demand
A) Basic definitions
1) Aggregate demand is the relationship
between the total quantity of goods and
services demanded and the price level, all
other determinants of spending
unchanged.
2) The aggregate demand curve is a graphical
representation of aggregate demand.
B) The slope of the aggregate demand curve is
negative. This reflects the following
effects.
1) The wealth effect is the tendency for a
change in the price level to affect real
wealth and thus alter consumption.
2) The interest rate effect is the tendency for a
change in the price level to affect the
interest rate and thus the quantity of
investment demanded.
3) The international trade effect is the tendency
for a change in the price level to affect net
exports.
C) Change in the quantity demanded versus a
change in demand
1) A movement along an aggregate demand
curve is a change in the aggregate quantity
of goods and services demanded.
2) A change in the aggregate quantity of
goods and services demanded at every
price level is a change in aggregate
demand.
D) Factors that can change aggregate demand.
1) Changes due to consumption
a) Consumer confidence.
b) Tax and transfer policy.
2) Changes due to investment
a) Expectations about profits for firms.
b) Changes in interest rates due to things
other than a change in the general price
level. (I.e. not the same as the interest rate
effect.)
3) Changes in government purchases.
4) Changes in exports.
a) Change in a foreign countries income
b) Change in the exchange rate.
A countries exchange rate is the price of
its currency in terms of another currency
or currencies, e.g. yen/$. A rise in the
exchange rate makes U.S. goods more
expensive and fewer are purchased.
E) The multiplier
1) The multiplier is the ratio of the change in
the quantity of real GDP demanded at each
price level to the initial change in one or
more components of aggregate demand that
produce it.
2) Multiplier =
change in real demand / initial change in demand component
3) The multiplier occurs due to a domino effect.
II Aggregate Demand and Aggregate Supply
A) Basics of the long run and the short run.
1) The short run in macroeconomic analysis
is a period in which wages and some other
prices do not respond to changes in
economic conditions.
2) A sticky price is a price that is slow to
adjust to its equilibrium level, creating
sustained periods of shortage or surplus.
3) The long run in macroeconomic analysis is
a period in which wages and prices are
flexible.
B) The long run
1) The long-run aggregate supply (LRAS)
curve relates the level of output produced
by firms to the price level in the long run.
2) This curve is vertical at the economy’s
potential output level.
3) Note, although there is a single real wage
that clears the labor market, the price level
and the nominal wage rate can take a
range of values.
3) The long run equilibrium occurs where the
long run aggregate supply and the aggregate
demand curves intersect.
C) The Short Run
1) The short-run aggregate supply (SRAS)
curve is a graphical representation of the
relationship between production and the
price level in the short run.
2) Factors held constant in the short run:
a) Capital stock.
b) Stock of natural resources.
c) Level of technology.
d) Prices of factors of production.
3) A change in the price level produces a
change in the aggregate quantity of goods
and services supplied and is illustrated by
the movement along the short-run aggregate
supply curve.
4) A change in the quantity of goods and
services supplied at every price level in the
short run is a change in short-run aggregate
supply.
D) Reasons for Wage and Price Stickiness
1) Wage Stickiness due to:
a) labor contracts;
b) minimum wages.
2) Price Stickiness due to:
a) induced from labor stickiness;
b) reluctance by a firm to jeopardize;
customer relations
c) long term contracts.
E) Equilibrium Levels of Price and Output in
the short run.
Two examples:
1) A change in health care costs.
2) A change in government purchases.
III Recessionary and Inflationary Gaps and
the Achievement of Long-Run
Macroeconomic Equilibrium
A) Terminology
1) The gap between the level of real GDP
and potential output, when real GDP is
less than potential, is called a recessionary
gap.
2) The gap between the level of real GDP and
potential output, when real GDP is greater
than potential, is called an inflationary
gap.
B) Restoring Long Run Macroeconomic
Equilibrium
1) An increase in Aggregate Demand.
a) Consider an economy initially at long run
equilibrium given by subscripts of “1”.
b) Next, suppose government spending
increases.
2) A decrease in Aggregate Supply
a) Consider an economy initially at long run
equilibrium given by subscripts of “1”.
b) Next, suppose that health care costs rise.
C) Gaps and Public Policy
1) A nonintervention policy is one in which
there is no policy choice taken to try to close
a recessionary or an inflationary gap.
2) A stabilization policy is one in which a policy
choice is taken in an attempt to move the
economy to its potential output.
3) A stabilization policy designed to increase
real GDP is known as expansionary policy.
4) A stabilization policy designed to reduce real
GDP is a contractionary policy.
5) Fiscal policy is the use of government
purchases, transfer payments and taxes to
influence the level of economic activity.
6) Monetary policy is the use of central bank
policies to influence the level of economic
activity.