Chapter 8

Part I.
I. AGGREGATE DEMAND
- Aggregate demand is the quantity demanded of these U.S. goods and services, or the
quantity demanded of U.S. Real GDP, at various price levels, ceteris paribus.
Why does the Aggregate Demand Curve slope downward?
- The aggregate demand curve is downward sloping, meaning it has an inverse relationship
between the price level and the quantity demanded of Real GDP.
- The inverse relationship and the resulting downward slope of the AD curve are explained
by: The Real Balance Effect, The Interest Rate Effect, and The International Trade Effect.
1. Real Balance Effect
- The inverse relationship between the price level and the quantity demanded of Real GDP
is established through changes in the value of monetary wealth, or the value of a
person’s monetary assets.
2. Interest Rate Effect
- The inverse relationship between the price level and the quantity demanded of Real GDP
is established through changes in the part of household and business spending that is
sensitive to changes in interest rates.
3. International Trade Effect
- The change in foreign sector spending (spending on imports and exports) as the price
level changes.
- If the price level in the US falls, US goods become cheaper than foreign goods thus
increasing the quantity demanded of US Real GDP
- If the price level in the US rises, US goods become more expensive than foreign goods,
so both Americans and foreigners buy fewer US goods. The quantity demanded of US Real
GDP falls.
A. A Change in the Quantity Demanded of Real GDP Versus a Change in Aggregate
Demand
(a) A change in the quantity demanded of Real GDP is graphically represented as a
movement from Point A to Point B on the same line. A change in the quantity
demanded of Real GDP is the result of a change in the price level.
(b) A change in aggregate demand is graphically represented as a shift in the aggregate
demand curve to the left or to the right
B. Changes in Aggregate Demand: Shifts in the AD Curve
- The simple answer is that aggregate demand changes when spending on U.S. goods
and services changes. If spending increases at a given price level, aggregate demand
rises; if spending decreases at a given price level, aggregate demand falls.
C. How Spending Components Affect Aggregate Demand
- A rise in consumption, investment, government purchases, or net exports will raise
spending on U.S. goods and services:
o Consumption, investment, government purchases, or net exports rise, aggregate
demand will rise and the AD curve will shift to the right.
o Consumption, investment, government purchases, or net exports fall, aggregate
demand will fall and the AD curve will shift to the left.
D. Factors that can change C, I, G, and NX and therefore can change AD (Shift the AD
Curve)
1. Consumption
4 Factors can affect consumption
a. Wealth
- The value of all assets owned, both monetary and nonmonetary.
- ↑ Wealth = ↑ Consumption = ↑ AD = AD curve shifts to the right
- ↓ Wealth = ↓ Consumption = ↓ AD = AD curve shifts to the left
 b. Expectations about Future Prices and Income
Future Prices:
- Expect higher future prices = ↑ Consumption = ↑ AD
- Expect lower future prices = ↓ Consumption = ↓ AD
Future Income:
- Expect higher future income= ↑ Consumption = ↑ AD
- Expect lower future income = ↓ Consumption = ↓ AD
c. Interest Rate
- ↑ Interest Rate = ↓ Consumption = ↓ AD
- ↓ Interest Rate = ↑ Consumption = ↑ AD
d. Income Taxes
- higher taxes means lower take-home pay, thus lessens consumption
- ↑ Income Taxes = ↓ Consumption = ↓ AD
- ↓ Income Taxes = ↑ Consumption = ↑ AD
2. Investment
3 Factors change investment
a. Interest Rate
- Changes in interest rates affect business decisions
- ↑ Interest Rate = ↑ Cost of investment project = ↓ Investment = ↓ AD
- ↓ Interest Rate = ↓ Cost of investment project = ↑ Investment = ↑ AD
b. Expectations About Future Sales
- Businesses invest because they expect to sell the goods they produce.
- Business is optimistic about future sales = ↑ Investment = ↑ AD
- Business is pessimistic about future sales = ↓ Investment = ↓ AD
c. Business Taxes
- Businesses naturally consider expected after-tax profits when they make their
investment decisions
- ↑ Business Taxes = ↓ Expected Profitability = ↓ Investment = ↓ AD
- ↓ Business Taxes = ↑ Expected Profitability = ↑ Investment = ↑ AD
3. Net Exports
2 Factors change Net Exports
a. Foreign Real National Income (FRNI)
- Adjusted earnings of people from other countries for price changes
- ↑ FRNI = Foreigners buy more US goods/service = ↑ Exports = ↑ Net Ex. = ↑ AD
- ↓ FRNI = Foreigners buy more US goods/service = ↓ Exports = ↓ Net Ex. = ↓ AD
b. Exchange Rate
- The price of one currency in terms of another currency
- Appreciated: An increase in the value of one currency relative to other currencies.
- Depreciated: A decrease in the value of one currency relative to other currencies.
For ex. $1.25 = €1 to $1.50 = €1
More dollars are needed to buy €1, hence the Euro has appreciated
More dollars are needed to buy €1, hence the Dollar has depreciated
- Depreciation makes foreign goods more expensive
- Appreciation makes foreign goods cheaper
- $ Depreciates = Foreign goods more expensive = ↓ Imports and ↑ Exports = ↑ AD
- $ Appreciates = Foreign goods more expensive = ↑ Imports and ↓ Exports = ↓ AD

E. Can a change in the Money Supply change Aggregate Demand?

- Yes, but it differs on how it changes the aggregate demand. A change in the money
supply affects interest rates (a larger money supply lowers market interest rates, making
it less expensive for consumers to borrow. Conversely, smaller money supplies tend to
raise market interest rates, making it pricier for consumers to take out a loan), a change
 in interest rates changes consumption and investment, and a change in consumption
and investment affects aggregate demand.
- Therefore, a change in the money supply is a catalyst in a process that ends with a
change in aggregate demand
F. If Consumption rises, does some other spending component have to decline?
- If both the money supply and velocity are constant, a rise in one spending component
(such as consumption) necessitates a decline in one or more other spending
components.
- If either the money supply or the velocity rises, one spending component can rise
without requiring any other spending component to decline.

II. SHORT-RUN AGGREGATE SUPPLY

A. Short-Run Aggregate Supply Curve: What it is and Why it is Upward-Sloping
- A Short-Run Aggregate Supply (SRAS) Curve shows the quantity supplied of all goods
and services (Real GDP or output) at different price levels, ceteris paribus.
- As the price level rises, firms increase the quantity supplied of goods and services; as
the price level drops, firms decrease the quantity supplied of goods and services.
- The short-run aggregate supply curve is upward sloping, specifying a direct
relationship between the price level and the quantity supplied of Real GDP.
1. Sticky Wages
- Wages are sticky or inflexible and this may be because wages are locked in for a few
years because of labor contracts that workers and management enter into.
Decline in Price Level and constant nominal wage = ↑ Real Wage = Firms hire fewer
workers = Decline in quantity supplied of Real GDP
2. Worker Misperceptions
- Another explanation for the upward-sloping SRAS curve holds that workers may
misperceive changes in the real wage.
Nominal Wages and Price Level decline by equal % = Real wage remains constant =
But workers mistakenly think Real Wage has fallen = Workers reduce quantity supplied
of labor = Less output is produced
B. What puts the “Short Run” in the SRAS Curve?
- According to most macroeconomists, the SRAS curve slopes upward because of sticky
wages or worker misperceptions. No matter what the explanation, though, things are
likely to change over time. Wages will not be sticky forever (labor contracts will expire),
and workers will figure out that they misperceived changes in the real wage. Only for a
certain period—identified as the short run—are these issues likely to be relevant.
C. Changes in Short-Run Aggregate Supply: Shifts in the SRAS Curve
4 Factors that can shift the SRAS Curve:
1. Wages Rates
- A rise in wage rates shifts the SRAS Curve to the left (This is because profits decrease
and firms reduce production)
- A fall in wage rates shifts the SRAS Curve to the right
2. Prices of Nonlabor Inputs
- An increase in the price of nonlabor input shifts the SRAS Curve to the left
- A decrease in the price of nonlabor input shifts the SRAS Curve to the right
3. Productivity
- The output produced per unit of input employed over some length of time.
- A host of factors lead to increased labor productivity, including a more educated labor
force, a larger stock of capital goods, and technological advancements.
- An increase in labor productivity means that businesses will produce more output with
the same amount of labor, causing the SRAS Curve to shift to the right
 - A decrease in labor productivity means that businesses will produce less output with
the same amount of labor, causing the SRAS Curve to shift to the left
4. Supply Shocks
- Major natural or institutional changes that affect aggregate supply
- Adverse Supply Shocks shift the SRAS curve leftward (Ex. Bad weather destroying
crops, Major cutback in the supply of oil from the Middle East to US)
- Beneficial Supply Shocks shift the SRAS Curve rightward (Ex. Major oil discovery or
good weather leading to increased production of food)

III. PUTTING AD AND SRAS TOGETHER: SHORT-RUN EQUILIBRIUM

A. How Short-Run Equilibrium in the Economy is Achieved
B. Thinking in terms of Short-Run Equilibrium Changes in the Economy
IV. Long-Run Aggregate Supply
A. Going from the Short Run to the Long Run
- The LRAS curve represents the output the economy produces when all economy-wide
adjustments have taken place and workers do not have any relevant misperceptions. It
is a vertical line at the level of Natural Real GDP.
B. Short-Run Equilibrium, Long-Run Equilibrium, and Disequilibrium
- In long-run equilibrium, the economy is producing Natural Real GDP. In short-run
equilibrium, the economy is not producing Natural Real GDP, although the quantity
demanded of Real GDP equals the quantity supplied of Real GDP.
- During the time an economy moves from one equilibrium state to another, it is said to be
in disequilibrium.