Download Chapter 8

Chapter 8
Aggregate Demand
and Aggregate Supply
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-1
Learning Objectives
• Introduce the concepts of aggregate
demand and aggregate supply.
• Distinguish between short-run and long-
run aggregate supply.
• Discuss the relationship that exists
between the aggregate expenditures
model and the aggregate demand curve.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-2
Learning Objectives (cont.)
• Combine the aggregate demand and
aggregate supply curves to provide a
model of macroeconomic equilibrium.
• Discuss how the aggregate demand–
aggregate supply model may be used to
analyse the circumstances outlined in
Chapter 5.
• Contrast demand-pull and cost-push
inflation.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-3
Learning Objectives (cont.)
• Discuss the reasons why the general
level of prices is downwards ‘sticky’—
the ratchet effect.
• Explain the impact of price-level
changes on the size of the multiplier.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-4
Aggregate Demand (AD)
• Represents the amount of goods and
services that consumers, businesses,
government and foreign buyers are
willing and able to buy at various price
levels
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-5
AD Curve
The AD curve is downsloping due to:
• Interest-rate effect
• Real-balances effect (wealth effect)
• Foreign-purchases effect
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-6
Price level
Aggregate Demand Curve
AD
0
Real gross domestic output
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-7
Interest-Rate Effect
• Rising price level causes higher
nominal interest rates, which causes
reduction in certain kinds of
consumption and investment
spending—most importantly,
investment spending
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-8
Real-Balances Effect
• Also known as ‘wealth effect’
• At a higher price level, the real value
or purchasing power of the
accumulated financial assets held by
the public falls (real wealth falls),
leading to a fall in consumption
spending
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-9
Foreign-Purchases Effect
• Higher domestic prices cause the
relative price of foreign goods (local
goods) to decrease (increase)
• This causes increased imports and
decreased exports, resulting in a fall
in net exports
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-10
Deriving the AD Curve
• Aggregate expenditure model
–
drawn at a constant price level
• Aggregate demand model
–
real GDP at various price levels
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-11
Deriving the AD Curve
(cont.)
(C + I + G + NX) at P
Spending
(billions of dollars)
1
(C + I + G + NX)2 at P 2
1
(C + I + G + NX)2 at P3
2
3
Real GDP
0
Price level
1
P3
P2
3′
The Aggregate Demand
can be Constructed
2′
1′
P1
0
Real GDP
GDP3 GDP2 GDP1
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-12
Non-Price Determinants
of Aggregate Demand
• Results in shift in the AD curve
• Changes in consumer spending
–
Consumer wealth
–
Consumer expectations
–
Consumer indebtedness
–
Taxes
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-13
Non-Price Determinants
of Aggregate Demand (cont.)
• Changes in investment spending
–
Interest rates
–
Profit expectation on investment projects
–
Business taxes
–
Technology
–
Degree of excess capacity
• Changes in Government spending
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-14
Non-Price Determinants of
Aggregate Demand (cont.)
Changes in net export spending:
• Growth in foreign GDP
• The level of the exchange rates
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-15
Changes in Aggregate Demand
Price level
Increase in AD
AD2
Decrease in AD
0
AD3
AD1
Real gross domestic output
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-16
Shifts of AD
• Caused by changes of non-price
determinants
• Movements left or right
• Degree of shift affected by the
multiplier
• Shift in AD = change in spending
times the multiplier
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-17
Shifts in AD and AE
Spending (billions
of dollars)
(C + I + X + G)2 at P1
(C + I + G + NX)1 at P1
Real GDP
Price level
0
GDP1 GDP2
AS
P1
AD2
AD1
0
Real GDP
GDP1 GDP2
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-18
Aggregate Supply (AS)
• Indicates the level of real GDP that
will be produced at each possible
price level
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-19
Short-Run Period
• Short run is a period in which input
prices, particularly nominal wages
remain fixed while other prices
change
• Input prices are fixed due to:
–
–
workers not being aware of higher or lower
prices
existence of fixed wage contracts
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-20
Long-Run Period
• This is a period in which input prices—
wages etc., are fully responsive to
changes in the price level
• Workers are freed from existing wage
contracts and can negotiate new
nominal wages and salaries
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-21
Short-Run Aggregate
Supply Curve
• Upward sloping and is constructed on
the basis of two assumptions:
–
a given price level
–
nominal wages have been established on
the expectations that the given price
level will persist
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-22
Short-Run AS
Price level
AS1
A2
P2
A1
P1
P3
0
A3
Q3
QP
Q2
Real gross domestic output
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-23
Long-Run AS
AS2 AS1 AS3
Price level
ASLS
P2
P1
P3
0
A2
B1
A1
A3
C1
QP
Real gross domestic output, GDP
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-24
Non-Price Determinants of
AS
• Shift the AS curve
• Changes in input prices
–
Domestic resource availability




–
–
land
labour
capital
entrepreneurial ability
Imported resource prices
Market power
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-25
Non-Price Determinants of
AS (cont.)
• Changes in productivity
• Changes in the legal and institutional
environment
–
Business taxes & subsidies
–
Government regulation
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-26
Changes in Short-Run AS
AS2
AS1
Price level
Decrease in
Short-run AS
0
Real gross domestic output
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-27
Changes in Short-Run AS
AS1
Price level
AS3
Increase in
Short-run AS
0
Real gross domestic output
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-28
Changes in Long-Run AS
Price level
ASLS2
ASLS1
Decrease in
Long-run AS
0
QP
QP
Real gross domestic output
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-29
Changes in Long-Run AS
ASLS3
Price level
ASLS1
Increase in
Long-run AS
0
QP
QP
Real gross domestic output, GDP
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-30
Equilibrium
• Intersection of AS and AD determines
equilibrium real GDP and the price
level
• At all other points there will be
pressure on real GDP and/or prices to
change
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-31
Equilibrium Real GDP and
Equilibrium Price Level
Price level
ASLS
AS
P2
Pe
P3
AD
Q1
Qe Q2
Qp
Real domestic output
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-32
Shift in Aggregate Demand
and the Price Level
• The effects of an increase in
aggregate demand on the price level
depend upon the position of the
short-run aggregate supply in which it
occurs
• Demand-pull inflation is a situation of
rising prices due to shift in AD
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-33
Effects of an Increase in AD
Low Employment and the Price Level
ASLS AS
AD3
Price level
AD1 AD2
P3
P2
P1
Q1
Q2
Q2 Qp
Real gross domestic output
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-34
Effects of an Increase in AD
High Employment and the Price Level
ASLS AS
Price level
AD3
P5
P4
P3
AD3
Q3 Qp Q4
Real gross domestic output
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-35
Ratchet Effect
• The result of the tendency for prices
of both products and resources to be
individually ‘sticky’ or inflexible in a
downward direction, leading to a loss
in downward flexibility of the general
level of prices
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-36
Price Inflexibility
Causes:
• Wage inflexibility
• Employers’ interests
• Monopoly power
• Menu costs
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-37
Shift in Aggregate Supply
and the Price Level
Causes
• Higher production costs shift the AS
leftwards, resulting in higher prices and
lower real GDP
• Leads to cost-push inflation
• Adverse shifts in the aggregate supply
result in stagflation, a situation of higher
prices and higher unemployment
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-38
Effects of a Decrease in AS
Price level
AD
ASLS
AS2
AS1
P2
P1
Q2 Q1
Qp
Real domestic product
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-39
Effects of an Increase in AS
ASLS
Price level
AD
AS1
AS3
P1
P3
QeQ3Qp
Real domestic output, GDP
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-40
Price-Level Changes and
the Multiplier
• Shifts of AD in the
–
Horizontal range = Full multiplier effect
–
Intermediate range = Reduced multiplier effect
–
Vertical = No multiplier effect
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-41
Multiplier and the Price Level
AS
AD2
AD1
P3
}
Price level
Full
Multiplier
P1
AD3
Q1
Q2
Real gross domestic product
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8-42
Multiplier and the Price Level
AS
Price level
AD2
Reduced
Multiplier
P3
}
P1
AD3
Q1
Q2
Q3
Q4
Real domestic output, GDP
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-43
Next Chapter:
Fiscal Policy and the
Public Debt
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
8-44