Understanding Aggregate Demand and Supply

Aggregate Demand

Total demand for all goods in a market.

Downward Sloping Curve

Indicates inverse relationship between price and quantity demanded.

Real Wealth Effect

Higher prices reduce real wealth, decreasing demand.

-lower prices increase real wealth leading to more deman

Interest Rate Effect

Increased prices lead to higher interest rates, reducing spending.

-decreases prices lead to a lower interest rate which increases spending

Exchange Rate Effect

Higher domestic prices decrease exports, increasing imports.

-when prices decrease, exports will increase

Price Level (PL)

Average level of prices in an economy.

CIGIE

Components of aggregate demand: Consumption, Investment, Government, Exports.

-a change in these factors will shift the aggregate demand

Multiplier Effect

Initial spending leads to increased total spending.

Marginal Propensity to Consume (MPC)

Fraction of additional income spent on consumption.

-∆Consumption/∆disposable

Marginal propensity to spend

∆savings/∆disposable

Spending Multiplier

1 / (1 - MPC) or 1 / MPS

-determines total impact of spending.

Transfer Payment Multiplier

Multiplier effect from government transfer payments.

-MPC/(1-MPC) or -MPC/MPS; this is the same as the tax multiplier

Money Multiplier

Ratio of deposits to reserves in banking.

autonomous expenditures

-spending independent of income

-things you ahve to buy

-govt/firms spend w/ intention

-if AS increase by $1 GDP and AD in by > 1

-connection b/2 savings and consumption

Short-Run Aggregate Supply (SRAS)

Supply curve showing production at fixed prices.

Shifters of SRAS

Factors affecting production capacity and costs.

-resources prices: costs more to make

-govt actions: not govt spending

-productivity

Productivity Changes

Improvements in technology increase production efficiency.

Sticky Costs

Costs that do not adjust quickly to price changes. (wages, rent prices)

profit

price level - input costs

-if PL dec then AS dec

-movement along a given SRAS causes a change in the quantity of AD

Supply Shock

Unexpected event affecting supply of goods.

capital shock

amt of factoies and goods in the economy

Long-Run Aggregate Supply (LRAS)

Vertical line indicating full employment output.

How does wealth affect AD?

more wealth allows people to buy more [right]

-less wealth allows people to buy less [ left]

how does income affect AD?

inc income: more g+S ad ince [right]

dec income: less g+s buy less [ left]

how do income taxes affect AD?

IT dec, dispsable income increases, you can buy more shift right

-IT inc, disposable income decrease, you can buy less shift left

Natural Rate of Unemployment (NRU)

Unemployment rate when economy is at full capacity.

how does expectations of economic conditions affect AD?

improved: buy more [right]

decreased: buy less [left]

how to interesr rates affect AD?

dec : g+ s paid w/ borrowed dollars become less expensive and people will buy more

inc: G + S w/ borrowed dollars become more expensive and people will buy less

how do exports effect AD?

- increases imports: AD dec

-decrease imports: AD increase

What are types of private spending?

-residential investment: new homes

, non-residential: firms spending money on cpaital

, business inventory: goods busniesse can sell

Demand-Pull Inflation

Inflation caused by increased demand for goods.

Cost-Push Inflation

Inflation caused by rising production costs.

Recession

Economic decline characterized by falling GDP.

Business Cycle

Fluctuations in economic activity over time.

why is the LRAS vertical?

producers have no insentive to change output b/c input prices change in response to changes in the prices levels b/c the prices are not sticky and can move)

how can the LRAS shift?

-same reason as PPC

-a function of NRU

-∆U does not equal LAS or PPC shifts

LRAS = potential output = NRU

when is there a recession gap?

when Yc < Yf

when is there an inflationary gap?

Yc > Yf

stagnation?

decrease outpu and inc Pl

-this occurs when SRAS dec

Shocks

unexpected change that shifts AD or SRAS

-neg = left shift; out dec and unem inc

-pos = right, out inc, unem dec

can't determine the effect on inflation

LRAS self-adjusting

-when the govt does not take action, the SRAS will shift their price wage excpectations

-essentially the AD will not be shfiting because these are only driven by laborers or employers

-only applies when no govt action is taken

fiscal policy

-either the govt increases spending or changes taxes

how does fiscal policy help the economy?

the spending moves the AD and the tax changes decrease consumer disposable income

-spending is direct and has a greater impact while the taxes are indirect

when does AD shift?

when fiscal policy changes

how do economists know how much to spend/tax?

spending and tax multiplier

what is the shortcut for Tax multiplier?

MPC x spending multiplier

-the tax multiplier is always one less in magnitude than the expenditure multiplier, and it is always a negative number

what is an automatic stabilizer?

policies already in place in an economy due to previously passed legislation

-income taxes, unemployment insurance, temporary assistance, and other transfer payments

-not discretionary; automatic stabilizers kick in automatically and do not need additional deliberation or legislation to start working (they aim to slow a peak/trough)