Aggregate Demand and Aggregate Supply
Lesson 19

Aggregate Demand

1. Aggregate Demand - a schedule that shows how much goods and services people want to buy and the price level

• Focus on the consumers' side
  • Total goods and services is GDP
  • Price level - index of all prices for final goods and services
• AD Function has a negative slope
  • Not a demand function!
  • Why the negative slope?
    1. Real balance effect - the value of people's money, savings and investment after adjusting for inflation
       • A high price level results from inflation
         • Inflation - price level is increasing
       • Inflation reduces the value of money, savings, and investments like stocks and bonds
         • Reduces GDP
         • People feel poor
       • Wealth Effect - At a lower price level, people have a higher real balance effect and spend more on goods and services
    2. Interest rate effect - more complicated
       • Money in economy is fixed until central bank increases it
       • At higher price levels, people reduce their savings in financial institutions
         • Interest rates must be high to attract funds
         • i.e. Fisher Equation
       • At higher interest rates, businesses and people invest less in structures, machines, and equipment
         • Lower GDP
         • Note - Inflation causes greater interest rates
    3. Foreign purchases effect - how one country's price level compares to another country
       • The U.S. price level increases relative to another country
       • Exchange rates do not change, so the price level impacts exports and imports directly
       • Americans increase imports, because they are cheaper
       • Foreigners decrease exports, because they are more expensive
• Aggregate Demand is shown below

2. Shifts in Aggregate Demand

• Remember AE = C + G + Ig + X - M
• Consumers
  1. Consumer spending - consumers decide to save less income and consume more, thus increasing the aggregate demand function, shifting it rightward
  2. Real Wealth - if consumers wealth increases, consumers spend more and aggregate demand shifts right
     • Stock prices dropped significantly during 2008
     • People lost wealth because pension plans and investments have lost value
     • Aggregate demand shifts left
  3. Consumer expectations
     • If consumers are optimistic about the future, they spend more now, boosting aggregate demand
     • If consumers are pessimistic about the future, they reduce their spending
       • If a worker expects layoffs, a tough job market, he or she likely reduces spending and increase savings
  4. Household debt -
     • If households have low debt, they can increase their spending by borrowing more, shifting aggregate demand rightward
     • If households have high debt, they reduce their spending in order to pay it back, decreasing aggregate demand
  5. Taxes
     • Government increase taxes which reduces disposable income, so households consume and save less, and AD shifts leftward
     • Government decreases taxes, disposable income increase, so households can consume and save more, thus, AD shifts right
• Investment
  1. Real interest rates
     • Households - invest in more new houses, new cars, and appliances, when real interest rates are low
       • Not caused by a change in price level, otherwise we have a movement along an AD curve
     • Businesses - invest in more structures, machines, and equipment
       • AD increases and shifts right
  2. Expected Returns or Profits - businesses invests more if they expect future profits
     1. Businesses are optimistic about the future business climate
        • Economy is growing along with consumers' demands
     2. Businesses adopt new technologies
        • Technology lowers production costs, increases workers' productivity, or increases quality
     3. Businesses are using their capital at full capacity
        • Businesses invest in capital to boost the capacity level
     4. Taxes - if government decreases taxes, then businesses may invest more
• Government - government is a large sector of economy
  • If government increases spending, then AD increases and shifts right
  • If government decreases spending, then AD decreases and shifts left
• International sector
  • Not caused by a change of the price level
  • If net exports increase
    • Either exports increase and/or imports decrease
    • More products and services are produced here and exported, shifting the AD rightward
  • Foreign income - if a foreign country becomes richer, they import more
    • Our exports increase, shifting AD rightward
  • Exchange rates
    • If U.S. dollar appreciates or becomes stronger, then
      • Exports decrease
      • Imports increase
      • AD shifts left

Aggregate Supply

1. Aggregate Supply - a schedule that shows the amount of goods and services producers manufacture at each price level

• Focus on the production side
• Short run - prices for some resources do not change immediately to changes in the price level
• Long run - prices for all resources change immediately to price level changes
• Short-run aggregate supply has positive slope
  • If the price level increases but wages do not change, companies can expand production
  • Firms receive greater revenue as inflation makes prices for goods and services greater
    • Firms pay lower costs if real wages fall, or real wages = nominal wages / price level
    • The total value of goods and services are higher, because the price level is higher
    • Sticky wages - wages are stuck at the same level, so firms earn profits when expanding output
    • Companies enter into contracts with workers
    • Companies rarely lower wages
• Another explanation for positive slope - firm can fool its workers
  • Workers do not know inflation has lowered their real wages as employers work them more
  • Instructor - employers may exploit workers because many jobs, employees cannot demand greater wages
• Short-run aggregate supply is shown below

• Long-Run Aggregate Supply - all resource prices increase with the price level
  • Workers wages rise with the cost of inflation
  • Long-run aggregate supply is a vertical line
  • Country produces at that level of GDP regardless of the price level
    • Is this correct? Remember hyperinflation?
    • Hyperinflation can destroy an economy
  • Long-run aggregate supply is shown below

2. Shifts in Aggregate Supply

• Input Prices
  1. Labor - largest expense for businesses
     • Immigration - if many new workers enter the market, wages tend to fall
       • Labor costs are cheaper and AS shifts right
     • Some workers retires, supply of workers decreases and wages may increase
       • Labor becomes more expensive and AS shifts left
  2. Capital like machines, equipment, and structures
     • Price of capital decreases, businesses invest more, causing AS to increase
     • If capital from foreign countries becomes cheaper, businesses import and invest more
  3. Materials
     • If resources used for inputs become cheaper, then firms expand production, causing AS to increase
     • More petroleum or mineral deposits are discovered, then prices for these products tend to fall
     • If resources from foreign countries becomes cheaper, firms use more and import more
  4. Market Power - an industry with market power can impact whole economy
     • OPEC sets production quotas on petroleum, boosting petroleum price
     • Petroleum is used in many products and transportation, raising prices for everything in the economy
       • AS decreases and shifts and left
• Productivity - firms produce a level of output given that it uses labor to make the output
  • Increases in productivity is firms produce more output given the same level of labor
    • Adopt new technology
    • Workers become more productive over time
      • Productivity increases approximately 2% per year in U.S.
      • AS increases and shifts right
• Legal environment - government impacts businesses greatly
  • If government changes legal structure that lowers businesses' production costs
    • Government lowers business taxes
    • Improved property rights
    • Government reduces regulations and bureaucratic red tape
    • Government increases subsidies
      • AS increases and shift right

Changes in Equilibrium

1. Equilibrium - state of rest; nothing changes

• Price level and level of GDP do not change
• At P', businesses and producers produce at Q ₁ while consumers want to buy Q ₂
  • Consumers bid up prices until the price level is at P*
  • Business inventories are falling
  • Businesses boost production to accumulate inventories

• At P" businesses and producers produce at Q ₂ but consumers want to buy Q ₁
  • Inventories are increasing
  • Businesses reduce prices to sell inventories and cut back on production
    • Price level falls until it equals P*

2. AD increases and shifts right

• Businesses increase investment
• Government increases spending or lowers income taxes
• If the economy was at full employment (FE) and AD increases
  • GDP increases
  • Price level increases
• Creates Demand Pull Inflation

3. AD decreases and shifts left

• Business investment decreases
• Government decreases spending (not typical)
• Government increases taxes on incomes
• Note - prices in an economy tend not to decrease
  • If prices could fall (deflation), then economy is in a recession at Q ₁
  • If prices do not fall, then economy is in a recession at Q ₂
    • The recession is worse

• Why prices do not fall?
  • Companies do not want to start a price war
    • Price wars destroy profits, as companies keep trying to under cut each other
  • Menu costs - changing prices imposes additional costs on companies
    • If firms believe recession will be short live, they may not lower their prices
    • Menu costs
      • Cost of printing new catalogs, menus, etc.
      • Cost to re-price merchandise that is in inventory
      • Cost to communicate prices to consumers
        • Consumers get angry if prices change suddenly or unexpectedly
  • Labor is a major cost and firms may not be able to lower workers' wages
    • Wage contracts - companies and workers agreed to wages specified in a contract
    • Efficiency wages - some employers may pay greater wages than the market
      • Attracts the best workers
      • Workers boost their productivity
      • Wages reflect productivity
    • Reducing wages may decrease workers' morale and work habits
      • Workers reduce their productivity
      • Workers could steal from employer
      • Workers can sell trade secrets, software, etc.
      • Best workers flee and work for rival firms
    • Minimum wage laws - firms cannot lower wages below the minimum wage

4. AS decreases and shifts left

• War
• Natural disaster
• Energy price shock
  • Example is OPEC
• Leads to lower output and a higher price level
  • Cost Push inflation
  • Stagflation

5. AS increases and shifts right

• Producers adopt new technology
• Increased immigration, which lowers wages
• Output increases
  • If prices could fall, then economy grows to Q ₁
  • If prices are rigid, then economy grows larger to Q ₂
    • Prices may not fall because prices and wages are sticky

If an economy has rigid prices, where prices cannot fall, then changes can have a much larger impact on the economy.

Terminology