Aggregate Demand and Aggregate Supply
Lecture 12

Aggregate Demand

Aggregate Demand – schedule that shows how much goods and services people want to buy for a price level

1. Price level – price index for all goods and services

2. GDP – total value of all goods and services produced in an economy in one year

   1. Not a market demand function!

3. Negative Slope

   1. Real Balance Effect

      1. An increasing price level is inflation

      2. A decreasing price level is deflation

      3. As the price level increases, inflation reduces the value of money, saving, and investments

         1. People buy less goods and services

         2. Lower wealth

   2. Interest Rate Effect – ignore

   3. Foreign Purchase Effect – how one country’s price level compares to another

      1. If the U.S. price level is higher to another country

         1. U.S. imports more

         2. U.S. exports less

         3. Exchange rate did not change

4. AD Shifts

   1. Economy has four sectors that buy goods and services

      1. GDP = C + I + G +NX

      2. C is consumers

      3. I is business investment

      4. G is government spending

      5. NX is net exports

      6. Trick – does it increase spending or decrease spending?

   2. Consumers

      1. Consumer spending

      2. Real wealth

      3. Household debt

      4. Consumer expectations

      5. Taxes

   3. Business investment

      1. Interest rates

      2. Expected profits

      3. Technology

      4. Taxes

      5. Production capacity

   4. Gov. spending

   5. International sector

      1. Net exports

      2. Exchange rates

      3. Foreign income

Aggregate Supply

Aggregate Supply – schedule that shows amount of goods and services producers will supply

1. Short run – some resource prices do not change immediately to changes in price level

Resource prices : Manufacturing : Product prices

• Usually workers’ wages lag behind the price level

1. Long run – all resource prices change immediately to changes in the resource price

2. Short-run aggregate supply

1. 1. Has positive slope

   2. Why?

      1. If price level increases, then producers produce more, thus GDP increases

      2. Workers real wages decrease, so workers are “fooled” into producing more for a lower real wage

      3. Change “fooled” into “exploited”

         • W / P

2. Long-run Aggregate Supply

1. 1. All resource prices increase with the price level

   2. Keynes – “In the long run, we are all dead!”

   3. Thus, nominal prices are irrelevant for the long run

   4. Note – hyperinflation causes society to breakdown, thus GDP decreases; problems with the AD-AS graph

3. Shifting the AS curve

   1. Trick – does it increase or decrease business cost or resource prices?

   2. Labor – immigration; causes wages to decrease

   3. Capital – buildings, machines, and equipment

   4. Materials

   5. Productivity – workers produce more given the same output

   6. Market power

      1. OPEC – higher energy prices cause AS to shift left

   7. Legal Structure

Equilibrium

1. A price shock causes the price level to increase to P”

   1. Price level is too high

   2. Producers produce too much and consumers buy too little

   3. Business inventories increase

   4. Producers reduce production until economy is at GDP_FE again

2. A price shock causes the price level to decrease to P’

   1. Price level is too low; consumers want to buy more than what is available

   2. Business inventories are falling

   3. Producers increase production

Examples

1. Government allows immigrants into the country

   1. Wages fall; thus decreasing business costs

1. 1. GDP may increase to Q₁ or Q₂, depending on the price level

   2. Price level is ambiguous

      1. If prices are flexible, then the price level falls and output increases to Q₁

      2. If prices are “sticky” downward, then price level does not decrease and GDP increases to Q₂

   3. Sticky prices may causes GDP to swing more than if prices were flexible

2. Why prices do not decrease?

   1. Companies do not want to start a price war

   2. Menu costs – company has to change prices in inventories, catalogues, etc.

   3. Wage contracts – workers are “locked” into wage contracts

      1. Unions

      2. Minimum wage laws reflect a workers’ level of productivity

         1. If a business lowered wages, then workers’ morale and work habits decrease

         2. Workers lower production

         3. Lower wages creates bitter feelings

            1. Employees may steal more

            2. Sabotage – plant a virus into a computer system

            3. Espionage – post trade secrets on the internet or send it to competitors

3. OPEC causes a price shock by increasing the price of oil

1. 1. Petroleum is used in many manufacturing products, fertilizers, plastics, and transportation fuels

   2. Thus, business costs increase, causing the AS curve to shift leftward

   3. The GDP falls, causing a recession

   4. The price level increases, creating inflation

   5. Cost push inflation – the worst kind; the economy has inflation and a recession (i.e. higher unemployment).