Aggregate Demand and Aggregate SupplyMeaning » Aggregate demand is the total demand for final goods and services at a given time and price level. It gives the amounts of goods and services that will be demanded at all possible price levels. In other words This is the demand for the gross domestic product of a country. YE» The aggregate demand curve (AD) describes the total volume of aggregate expenditures in the economy at different price levels. » Aggregate demand consists of the amount households plan to spend on goods (C), plus planned spending on capital investment, (I) + government spending, (G) + exports (X) minus imports (M) from abroad. The standard equation is: AD=C+1+G+(X-M) YEAggregate Demand (AD) Curve » The aggregate demand curve is plotted with real output on the horizontal axis and the price level on the vertical axis. » the aggregate demand curve, AD, like the demand curves for individual goods, is downward sloping, implying that there is an inverse relationship between the price level and the quantity demanded of real GDP. aNumerical Example of aggregate demand PRICELEVEL | C | 1 | G | XM m | 300 [| 0] 0 Ta of 30 | oo | ts |S @ | 40 | 70 00 i0 m in wm 380 i0 30325 a0 a 300 60 75AD Curve Price tevel AD Real GDP eSWhy the Aggregate-Demand Curve Is Downward Sloping » The Price Level and Consumption: The Wealth Effect » The Price Level and Investment: The Interest Rate Effect » The Price Level and Net Exports: The Net- export Effect YEThe Wealth Effect » The aggregate demand curve is drawn under the assumption that the government holds the supply of money constant. One can think of the supply of money as representing the economy's wealth at any moment in time. As the price level rises, the wealth of the economy, as measured by the supply of money, declines in value because the purchasing power of money falls. As buyers become poorer, they reduce their purchases of all goods and services. On the other hand, as the price level fa//s, the purchasing power of money rises. Buyers become wealthier and are able to purchase more goods and services than before. The wealth effect, therefore, provides one reason for the inverse relationship between the price level and real GDP that is reflected in the downward-sloping demand curve. ——The Wealth Effect ° A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more. This increase in consumer spending means larger quantities of goods and services demanded. Wealth Effect CELT ET CRU) Change ETC in ee TES a lals in ie TCE W Ac} OCT Re a ti ETT CdContinue » The wealth effect occurs because certain financial assets have returns stated in nominal dollars. If the price level rises unexpectedly, the real return on these assets falls. LLFor example » suppose that a person purchases a $100 bond that will pay a 10 percent return, so the bondholder will receive $110 in one year. The bondholder forecasts no inflation over the year, but the inflation rate turns out to be 5 percent. When the bondholder receives the $110 payment, the real return is less than the bondholder expected because the purchasing power of the $110 is less than it was a year ago. In effect, the rising price level reduces the bondholder's wealth. If the value of a person's financial assets declines, she will reduce consumption, and Aggregate Demand will decline. _The Interest Rate Effect » As the price level rises, households and firms require more money to handle their transactions. However, the supply of money is fixed. The increased demand for a fixed supply of money causes the price of money, the interest rate, to rise. As the interest rate rises, spending that is sensitive to rate of interest will decline. Hence, the interest rate effect provides another reason for the inverse relationship between the price level and the demand for real GDP. a° A lower price level reduces the interest rate, which encourages greater spending on investment goods. ° This increase in investment spending means a larger quantity of goods and services demanded. SSThe net exports effect » As the domestic price level rises, foreign-made goods become relatively cheaper so that the demand for imports increases. However, the rise in the domestic price level also means that domestic-made goods are relatively more expensive to foreign buyers so that the demand for exports decreases. When exports decrease and imports increase, net exports (exports — imports) decrease. Because net exports are a component of real GDP, the demand for real GDP declines as net exports decline. YEMovements Along vs. Shifts in the Aggregate Demand Curve » A change in the level of Aggregate Demand that is caused by a change in the price level is referred to as a movement along the Aggregate Demand curve. » The figure titled "Movement Along AD Curve" illustrates a movement from point A to point B. >» As the price level rises, consumption and net exports decline because of the wealth and international trade effects, respectively. The economy moves along the Aggregate Demand curve. aMovement Along AD Curve Price Level,Shift of the Aggregate Demand curve » A change in any factor other than a change in the price level that changes the level of Aggregate Demand results in a shift of the Aggregate Demand curve » The figure titled "Shift of Aggregate Demand Curve" illustrates a rightward shift. » Factors that Shift the Aggregate Demand curve include changes in autonomous consumption, investment, government expenditures and net exports. >Shift of Aggregate Demand Curve Price LevelDETERMINANTS OF AGGREGATE DEMAND » An increase in autonomous consumption : the portion of consumption that is independent of disposable income shifts the Aggregate Demand curve to the right because for a given price level, the level of Aggregate Demand is higher than before. LLFor example » An increase in consumer confidence shifts the Aggregate Demand curve to the right. An increase in expected future income also shifts the Aggregate Demand curve rightward because consumers believe that their incomes will increase over time. A decrease in taxes shifts the Aggregate Demand curve to the right because for each price level, disposable income and, hence, consumption are higher than before. Le» Achange in investment expenditures It is another factor that shifts the Aggregate Demand curve. An increase in plant and equipment expenditures, for example, shifts the Aggregate Demand curve to the right because the level of Aggregate Demand is higher at each price level. Investment could also increase due to an increase in business confidence or a fall in interest rates. As we will explore in a later chapter, the BNR Reserve may lower interest rates to stimulate investment. LS» A change in government expenditures It is a third factor that shifts the Aggregate Demand curve. A decrease in government spending to cut back on defense spending at the end of the Cold War, for example, shifted the Aggregate Demand curve to the left. LeAggregate Supply » Meaning: Aggregate supply (AS) is defined as the total amount of goods and services produced and supplied by an economy's firms over a period of time. The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy.» A significant difference exists between the short-run Aggregate Supply curve and the long-run Aggregate Supply curve. In the short run the Aggregate Supply curve is upward sloping. In the long run the Aggregate Supply curve is vertical. SSThe Aggregate Supply curve in the short run » The Aggregate Supply curve in the short run is a time period in which the costs of production wages, raw materials, energy, and so on are held constant; only output prices vary. When prices rise, the level of Aggregate Supply also rises because firms seek to take advantage of the profit opportunities. A firm's profit is the difference between its revenues and costs over a given time period, say one year. SSFor Example » Suppose that a firm produces picture frames and it uses only one input, labor. Each picture frame requires one labor hour to produce, and wages are $8 per hour. The firm sells each picture frame for $10 so the profit her picture frame is $2 ($10 - $8). If the firm sells 2,000 picture frames in the first year, its total profit is $4,000 (2,000 x $2). In the second year, the firm increases the price per picture frame to $11. By assumption, wages are unchanged at $8 per hour. The firm's profit per frame produced is $3. The chance for the firm to increase its profits provides an incentive for the firm to increase production. a» By producing and selling 2,500 picture frames in the second year, the firm's profits rise to $7,500 (2,500 x $3). An increase in the price level, therefore, leads to a short run increase in Aggregate Supply. The Figure labeled "Short Run Aggregate Supply Curve" is upward sloping, which illustrates the positive relationship between the price level and Aggregate Supply. PSShort run AS Short Run Aggregate Supply CurveThe long run Aggregate Supply Curve » the long run as a time period in which all prices and costs are variable. An increase in the price level will have no impact on Aggregate Supply in the long run because all firms' costs (e.g. wages and resource costs) will rise proportionally with the price level. LeFor example » the picture frame company increased profits by increasing the price of picture frames from $10 to $11. Over time, workers adjust their wage demands upward because goods and services are more expensive and because good workers are harder to find as employment rises with the level of production. Suppose that workers increase their wage demands to $9 per hour. Now the firm earns the same $2 profit per frame as it did before the price level increase and the level of output returns to 2,000, the same level of production as in the first year. a» In the long run, the Aggregate Supply curve is vertical as illustrated in the Figure labeled "Long Run Aggregate Supply Curve." When resources such as labor and capital are fully employed, the economy's production is at the potential level of output, Y,. » When the economy is on the Long Run Aggregate Supply curve, GDP is equal to potential output. SeLong run AS Long Run Aggregate Supply Curve PriceMovements Along vs. Shifts of the Short-Run Aggregate Supply curve » Movements Along AS Curve: Short-run Aggregate Supply is influenced bya number of factors. One factor that we have discussed is a change in the price level. When the price level changes but resource costs are held constant, there is a movement along the Aggregate Supply curve. The figure titled "Movement Along AS Curve" graphs this scenario. As the price level rises from PL, to PLg, Aggregate Supply rises from AS, to AS». aMovements Along AS Curve Movement Along AS CurveShifts of the Short-Run Aggregate Supply curve » A change in any factor other than a change in the price level that changes the level of Aggregate Supply shifts the Aggregate Supply curve. Three nonprice factors that shift the Aggregate Supply curve are changes in resource costs, technology and inflation expectations. » An increase in the cost of a resource will shift the Aggregate Supply curve to the left. Resource costs include wages, capital, energy, and so on PeFor example >» the picture frame firm increased production when it had a chance to earn higher profits and reduced production when wages increased, reducing profits. If resource costs increase a firm's incentive to produce decreases as its profits decline. When oil costs increase, for example, profits decrease because energy costs increase as utility bills and fuel expenses rise. For a given price level, firms respond to rising resource costs by decreasing Aggregate Supply. aChange in technology » Asecond factor that shifts the Aggregate Supply curve isa change in techmalogy. As the Figure titled "Shift of Aggregate Supply Curve" illustrates, an increase in technology shifts the Aggregate Supply curve to the right. Technological progress influences the economy in a variety of ways. One channel is the introduction of entirely new goods and services. Just a few years ago an on-line textbook was not possible. Advances in the Internet, however, have enabled information to be delivered in a new way. Another way that technology influences the economy is through quality enhancements of products» . In contrast to automobiles produced in the 1970s, today's cars are more dependable thanks to fuel injection systems and other automated components. » Newer automobiles are also more fuel- efficient, and they have air bags and other safety features that older cars lack. a» A third way that technology is integrated into the economy is through cost-reducing innovations. The same product can be produced at a lower cost. First-generation computers used to take up areas the size of football fields. Today some hand-held calculators are just as powerful as those computer but the cost of producing a calculator is far less than the cost of producing an old-generation computer. Given the price level, cost-reducing technological advancements allow firms to increase production and boost profits. >Changes in inflation expectations » Changes in inflation expectations also shift the Aggregate Supply curve. If workers believe that inflation will increase in the future, they will bid up wages to compensate for the coming inflation. For a given price level, the increase in wages shifts the Aggregate Supply curve to the left. aEquilibrium and Disequilibrium in the Aggregate Demand/Aggregate Supply Model » Equilibrium in the macroeconomic sense occurs when the demand for final goods and services equals the supply of final goods and services. A short-run equilibrium, however, differs from a long-run equilibrium because in the long run the economy must be producing at the potential level of output so that all factors of production are fully employed. >Short-Run Equilibrium » The short-run equilibrium occurs where the Aggregate Demand curve crosses the short- run Aggregate Supply curve. The intersection of Aggregate Demand and Aggregate Supply in the figure labeled "Short Run Equilibrium" determines both the price level and the equilibrium level of GDP in the economy. The level of output can be above or below potential output. aFor example >» suppose that the economy produces $9 trillion of goods and services in the year 2005 and potential output is $8.5 trillion. As long as the demand for final goods and services is also $9 trillion, the economy is at a short-run equilibrium. Because supply and demand are equal, firms do not overproduce, which would lead to an unintended accumulation of inventories. Nor do firms underproduce, which would lead to an unintended depletion of inventories. PeShort run Equilibrium Short Run EquilibriumLong-Run Equilibrium » The long-run equilibrium can only occur where the Aggregate Demand curve crosses the vertical Long Run Aggregate Supply curve because in the long run, equilibrium output must equal potential output where all resources are fully employed. This condition holds because in the short run, production input costs are held constant, but in the long run, input costs can vary a» When output is above the potential level of output, there is pressure on wages to increase because workers are relatively scarce and employers bid up wages competing for the workers. As wages are bid up, the short- run Aggregate Supply curve shifts to the left until the equilibrium output is equal to potential output. This scenario is graphed in the figure labeled "Long Run Equilibrium.” a» Conversely, the Aggregate Demand curve could intersect the short-run Aggregate Supply curve at a level of output below potential output. In this scenario, unemployment would be above the natural rate of unemployment and there would be pressure on wages to decline, shifting the Aggregate Supply curve to the right. a» This process would continue until the Aggregate Demand curve intersected Aggregate Supply at the potential level of output. Note that in both short-run and long- run equilibriums, Aggregate Demand and Aggregate Supply are equal. The difference between the two is that the long run equilibrium requires the additional condition that output be at the potential level of output. —Long run Equilibrium Long Run EquilibriumDisequilibrium » Suppose the economy is in disequilibrium. Let us consider first the case in which Aggregate Demand exceeds Aggregate Supply, or AD > AS. Demand for goods and services is greater than the production of goods and services. As demand outpaces supply, firms see inventories declining unexpectedly and they respond by increasing output and prices until equilibrium is reached. >» As the price level rises, aggregate demand declines due to the wealth and international trade effects, and aggregate supply rises due to firms’ potential for larger profits. This scenario is illustrated in the figure titled "Aggregate Demand Exceeds Aggregate Supply." aDisequilibrium Aggregate Demand Exceeds Aggregate Supply» The alternative scenario, illustrated in the figure titled "Aggregate Supply Exceeds Aggregate Demand," occurs when the price level is too high such that Aggregate Demand is less than Aggregate Supply, or AD < AS. Demand for goods and services is less than production of goods and services, and firms see inventories increasing unexpectedly. They respond by decreasing production and prices. As the price level falls, Aggregate Demand increases and Aggregate Supply decreases. Again, the economy tends towards equilibrium. _Aggregate Supply Exceeds Aggregate jemand Gr ee ies AD2 AS? YAS-AD Model » the AS-AD model. The intersection of the short-run aggregate supply curve, the long- run aggregate supply curve, and the aggregate demand curve gives the equilibrium price level and the equilibrium level of output. aPrice level Output or IncomeShifts in Aggregate Demand in the AS- AD Model » The primary cause of shifts in the economy is aggregate demand. Recall that aggregate demand can be affected by consumers both domestic and foreign, the Fed, and the government. » In general, any expansionary policy shifts the aggregate demand curve to the right while any contractionary policy shifts the aggregate demand curve to the left. Pa» In the long run, though, since long-term aggregate supply is fixed by the factors of production, short-term aggregate supply shifts to the left so that the only effect of a change in aggregate demand is a change in the price level. LLFor example >» we begin at point A where short-run aggregate supply curve 1 meets the long-run aggregate supply curve and aggregate demand curve 1. The point where the short- run aggregate supply curve and the aggregate demand curve meet is always the short-run equilibrium. The point where the long-run aggregate supply curve and the aggregate demand curve meet is always the long-run equilibrium. Thus, we are in long- run equilibrium to begin. a» the BNR pursues expansionary monetary policy. In this case, the aggregate demand curve shifts to the right from aggregate demand curve 1 to aggregate demand curve 2. The intersection of short- run aggregate supply curve 1 and aggregate demand curve 2 has now shifted to the upper right from point A to point B. At point B, both output and the price level have increased. This is the new short-run equilibrium. a» But, as we move to the long run, the expected price level comes into line with the actual price level as firms, producers, and workers adjust their expectations. When this occurs, the short-run aggregate supply curve shifts along the aggregate demand curve until the long-run aggregate supply curve, the short- run aggregate supply curve, and the aggregate demand curve all intersect. a» This is represented by point C and is the new equilibrium where short-run aggregate supply curve 2 equals the long-run aggregate supply curve and aggregate demand curve 2. Thus, expansionary policy causes output and the price level to increase in the short run, but only the price level to increase in the long run. aOutput or Income