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Chapter 22 Notes

Aggregate Demand (AD)
- Sum of the demand for all goods and services in the economy.
- Can be seen as the quantity of real Gross Domestic Product (GDP) deman
ded at different price levels.
(AD) = C + I + G + (X - M)
C
I
G
(X

- Consumption
- Investment
- Government Purchases
- M) - Net Exports
Exports - Imports

Aggregate Demand Curve
- Reflects total amount of real goods and services that all groups toget
her want
to purchase in a given time period.
- Slopes downward
An inverse/opposite relationship exists between price level and
real gross domestic
product (RGDP) demanded.
- Increase in price level causes RGDP demanded to fall.
- Decrease in price level, quantity of RGDP demanded rise.
Why Negative Slope?
- Wealth Effect
Consumer spending (C) falls, when price level increase.
Consumer spending rises, when price level decrease.
- Interest Rate Effect
Higher price level raises the interest rate and discourages inve
stment spending
and decreases the quantity of RGDP demnded.
Lower price level reduces the interest rate and encourages inves
tment spending
causing RGDP demanded to rise.
- Open Economy Effect
Many goods and servces are bought and sold in global markets.
Price level in United States rises relative to those in gobal ma
rkets, United States
exports will become relatively less expensive.
If foreign consumers will stop buying United States good, United
States exports
will fall, imports will rise.
Net exports will fall, reducing the amount of RGDP purch
ases in U.S.
Lower price level makes U.S. exports less expensive, foreign imp

Changing Government Purchase (G) Shift Right Increase government purchases. Increased net exports. A tax cut.Decrease in C. Business taxes rise. .orts more expensive.Changing Consumption (C) Shift Right Increase in consumer confidence. Shift Left Consumers expect a recession. Increase in population. . demand fewer U. exports to them. I.S.Changing Net Exports Shift Right Economic boom in economies of major trading partners may lead to an increase in U.Changing Investment (I) Shift Right Business investment will increase if business confidence increases. increased amount of RGDP purchase d. . (X . imports. G. Shift Left Interest rates increase. other things held constan t. Shift Left Major trading partners are experiencing economic slowdow ns.Increase in C.M) will cause AD to shift right. Tax increase. (X . G. other things held constan t. causing net expo rts to rise. Shift of the Aggregrate Demand . Shift Left Decrease government purchases. I. . Aggreate Supply (AS) Curve . Increase in wealth.M) will cause AD to shift left. Business taxes fall. or real interest rates fall.S. .

lowering the cost of production in the short run. Left . Labor Force (Shift Right) Addition of workers to labor force. allows output to be permanently greater than before. SRAS and LRAS shifts right by lowering costs and expanding real output possibilities. because gre ater output is achievable on a permanent or sustainable basi s. Shift SRAS curve right.Relationship between total quantity of final goods and services suppli ers are willing and able to produce and the overall price level. Capital Affects (Shift Right) Changes in stock of capital will alter the amount of goo ds and services the ecnomy can produce. Shifts Any change in the quantity of any factor of production a vailable (capital. or technology) can cause a shift in both the long-run and short-run aggregate supply curves.Represents how mcuh RGDP suppliers will be wiilling to produce at diff erent price levels.Natural Resources (Shift Right/Left) Right . Investing in capital improves the quantity and quality o f capital stock. Human Capital (Shift Right) Educational or vocational programs. increase productivity.Oil exploratio n would lower costs of production and expand economy's sustainable rate of outp ut.. . more skiller workforce l owers cost of production. Shift SRAS curve rightward.Decrease in available natural resources would sh ift SRAS and LRAS left. LRAS curve shifts right. Land . labor. ceteris paribus. ceteris paribus. land. can increase aggregate . ceteris paribus.Increase in natural resources . shifting SRAS and LRAS to the right. Technology and Entrepreneurship (Shift Right) Lowers costs. shifting the LRAS curve rightward. on-thejob training Causes productivity to rise.

Input Prices (Shift Left) .Lower price levels. SRAS and LRAS shift right. Government Regulations (Shift Right/Left) Redution in government regulations on businesses would l ower the costs of production and expand potential real output. non-labor input prices. Misperception Effect If producers see the prise of his output rising and think the relative price of his output is risi ng (i. Depress wages and increase SRAS.e. Shifts Wages. Increase economy's potential output.Higher price levels. Reasons Profit Effect Ouput prices rise relative to input pric es (cost). . Short-run Aggregate Supply (SRAS) Period when output can change in response to supply and demand. Increases can make it more costly for producers. producers are willing to supply more real output. Increase in production costs results in left shi ft of SRAS. and unexpected supply shocks. . increasing LRAS. raising producer's short-run profit marg ins. his product becoming more valuable in real terms). Price level rise.Bad Increase in input prices. real output falls below potent ial output. h e will supply more. other input prices. and a reduction in society's potential output shifts L RAS left. Higher price levels. ceteris paribus .supply. but input prices have not yet been able to adjust ex: nominal wages are assumers to adjust slowly in the short run Why Positively Sloped? . changes in ex pected future price level. producers are willing to supply less real output.

Shifts SRAS right. Left . ceteris paribus Once temporary effects have been felt. no apprec .Adjusting to the price level being lower than e xpected. SRAS shift left. cause SRAS to shift left. Supply Shocks / Unexpected Temporary Events (Shift Right/Left) Positive supply shocks (favorable weather conditions/temporary p rice reductions of imported resources like oil). causing SRAS to shift left.Successful in getting wage increase of labor uni on members. Lower outputs.Higher prices. as long as capacity to make steel h as not been reduced. shifting SRAS right. Expected Future Price Level (Shift Right/Left) If workers and fims believe that the price level is going to inc rease in near future. automobile producers will f ind it more expensive to do business because their production costs will rise resulting in a leftward shift in the short-run aggregate supply curve. and producers will be more willi ng to increase supply. recessionary gap.Decrease in price of non-labor input (like oil) will lo wer production costs (making firms more profitable). it becomes costlier for suppliers to produce goods and services at every price level . they will adjust their wages and other input prices to compensate for the price level increase. Higher rates of unemployment. lower real output. Negative supply shocks (natural disasters/disruptions in trade d ue to war/labor strike) can increase the costs of production. more unemploym ent. Left . Money or Nominal Wages (Shift Left) Increase without a corresponding increase in labor productivity. LRAS will not shift. SRAS will shift right.If price steel or oil rises. Non-labor Input Prices (Shift Right/Left) Right . Right .

iable change in the economy's productive capacity has occurred.Only at potential output can short-run equillibrium also be a long-ru n equillibium. Long-run Aggregate Supply (LRAS) Period long enough for the prices of outputs and all inputs to fully adjust to changes in the economy.Will only occur were AS and AD interesct along the long-run aggregate supply curve at the natural. .Firms will always produce at maximum sustainable level allowed by thei r capital. relacting the fact that the level of RGDP producers are willing to suppy is not affected by changed in price level.When equillibrium occurs at the potential output level. labor.Economy will always be at the intersection of AS and AD but that will not always be at the natural rate of output RGDP nr. .Always positioned at natural rate of output. . regardless of price levels. Why Vertical? Two sets of prices are changing: price of outputs and price of i nputs. Long-run Equillibrium Level . Short-run Equillibrium Level . Insensitive to price level. ex: a 10% increase in the price of goods and services i s matched by a 10% increase in the price of inputs. Recessionary Gap . and all resources are fully employed. .Where the economy will settle when undisturbed. . rate of output. the economy is operating at full employment. and technological inputs. where all resources are f ully employed (RGDP nr) . Shocks Unexpected shifts to supply/demand. Change AD curve shifts or SRAS curve shifts right/left. or potential. so LRAS does not shift. Long-run equillibrium level of RGDP only changes when LRAS curve shifts.Real output and price level are determined by intersection of AD curv e and SRAS curve. on the long-r un aggregate supply curve.

financial crisis of 2008. Inflationary Gap Equillibrium can temporarily occur beyond potential output.Best Economy is just right where AD 2 and SRAS intersect at RGDP nr . .actual RGDP is less than potential RGDP. Rare .actual RGDP is greater than potential RGDP. .actual and potential RGDP are equal at RGDP nr or the economy ca n be at a point where the potential RGDP and actual RGDP are not equal. .At short-run equillibrium. inflation caused by supply-side forces. Demand-Pull Inflation Price level rises as a result of an increase in AD. Causes inflationary gap. Recent Exception . AD is insufficient t o fully employ all of society's resources. Equillbrium . Reduce frictional unemployment through more extensive searches f or employees. Hire recently retired employees.the lon g-run equillibrium position.Equillibrium can occur at less than the potential output of the economy. where AD is so high that the economy is temporarily operating beyong full capacaity (RGDP nr). Inflationary Pressure Unemployment will be below normal rate. Boom . Increase in AD causes increase in the price level and an increas e in real output. so unemployment will be above the normal rate. Economy does not often stray far from potential RGDP. Recession . at RGDP 3. not demand. Increase in output occurs as result of increase in price level in the sh ort-run.Recession AD did not change significantly but price level did. Cost-Push Inflation . firms increase real output when prices of good they are selling rises faster than costs of i nputs they use in production. E sr. Extend hours of part time workers.When RGDP is less than RGDP nr (full capacity). Potential output: inflationary gap Causes (Firms) Encourage workers to work overtime.

perhaps consumer and business confidenc e picks up. Increases in money supply. Firms lay off workers to avoid inventory accumulation. Increase in Aggregate Demand Growing population. . . Rising income.Eventual return to a long-run equillibrium at potential outpu t and lower price level. and increased government spe nding to help rebuild New York City and provide financial assistance to the ailing air line industry. consumption spending. Decrease in Aggregate Demand . Recoveries from Recessionary Gap Increases in aggregate demand . Slow Adjustments Slow self-correct = wage and price inflexibility. Tax cut passed by Congress in 2001.Recession Higher unemployment. reduction in output . Eventual right shift to AD curve takes economy back to potential RGDP nr .a recessionary gap. Firms may cut prices to increase demand for their products.Shift left in SRAS: Oil price increase Stagflation Lower growth and higher prices occurred together. Self-Correct (Keynesian) (Shift Right) Declining wages and prices. stimulati ng economy by encouraging investment. Sticky Downwards Long-term labor contract (union workers) Legal minimum wage. 2001 Corrective Measures . government lower taxes and/or lowers interest rates to stimulate economy.Shift Right (AD) Continued lower interest rates by the Federal Reserve. Unemployed workers and other input suppliers will bid down wages and prices. Increases in government spending. Some economists believe that this was caused by a left shift in AS curve.

Wage stickiness can arise as result of long-term labor. fearing lower morale. Real wages fall. Say's Law . which leads to still more production. AD decreases. rather it refers to zero cyclical unemployment. and general productivity lo sses. which in turn creates a demand for goods. Classical Model Wages and prices adjust quickly to changes in supply and demand. which creates demand for goods. Unemployment Full employment does not mean zero unemploment. raw material con tracts. Menu costs. firms more reluctant to cut wages. capital. and the economy has sufficient exce ss capacity. Quantity of labor that would be willingly suppli ed is greater than the quantity of labor demanded.Jean Baptiste Say . Need not worry about output not being utilized. labor. greater absenteeism. . and minimum wage laws. Establishes full employment can be maintained because total spen ding will be great enough for firms to sell all the output a fully employed economy can pr oduce. Pay employees more than equillbrium wage as a me ans to increase efficiency." Production of goods and services creates incomes for owners of i nputs (land. resulting in gre ater unemployment. SRAS is flat = full employment of all resources is not reached until RGDP nr. Reluctant to lower wages in recession = downward wage inflexibility. Adjustment to Inflationary Gap Price level is higher than workers anticipated. Keynesian Model Wages and price are inflexible downwar.Employers paying efficiency wages. and entrepreneurship) used in production."supply creates its own demand. and workers' and input s uppliers' purchasing power has fallen as output prices rise. production creat es income. If wages/prices are stickey. unions.

If economy is producing at greate than potential putput. . unemployment is gr eater than natural rate. Causing inflationary pressures. unemployment is less than natural rate. If economy is produing at less than potential output.Some structural and frictional unemployment occurs naturally in a dynami s and vibrant economy.