Chapter 9 - Aggregate Demand and Aggregate Supply

Aggregate demand (AD)

The inverse relationship between all spending on domestic output and the aggregate price level of that output

From how many sources does demand in macroeconomy comes from

Four general sources used to calculate real GDP

what does AD measures

AD measures the sum of consumption spending by households, investment spending by firms, government purchases of goods and services, and net exports (exports minus imports).

Foreign sector substitution effect

Goods and services produced in other nations

Interest rate effect

Goods and services in the future

Wealth effect

Money and financial assets

what does the combination of the foreign sector substitution, interest rate, and wealth effects predict

a downward-sloping AD curve

AD is the sum of the four components of domestic spending \[C, I, G, (X-M)\], if any of these components increases

AD increases increasing real GDP

If the AD components decrease

AD decreases decreasing real GDP

Components of AD

• Consumer Spending (C)

• Investment Spending (I)

• Government Spending (G)

• Net Exports (X-M)

  • Foreign incomes

  • Consumer tastes

  • Exchange rates

Aggregate supply (AS)

The relationship between the aggregated price level of all domestic output and the level of domestic output produced

Short-run aggregate supply (SRAS)

The positive relationship between the level of domestic output produced and the aggregate price level of that output

What happens in the macroeconomic short run period of time

The prices of goods and services are changing in their respective markets, but input prices have not been adjusted to those product market changes.

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The curve is drawn as upward sloping.

GDPu

Low production

GDPf

Full employment

GDPc

Nation’s productive capacity

What happens in the macroeconomic long run

The input prices have enough time to fully adjust to market forces. Here all product and input markets are balanced, and economy is at full employment (GDPf)

Classical school of economics

Asserts that the economy always gravitates toward full employment.

what is the cornerstone of classical macroeconomics

A vertical AS curve.

Terms on vertical axis

Aggregate price level or PL

Terms on horizontal axis

Real output or real GDP

Most common factor that affects short-run AS

An economy-wide change in input (or factor) prices.

Short-Run Shifts

• Input prices

• Tax policy

• Deregulation

• Political or environmental phenomena

Input prices

If input prices fall economy-wide, the short-run AS curve increases without changing the level of full employment

Tax policy

If these “supply-side taxes” are lowered, short-run AS shifts to the right.

Deregulation

When the regulation of industries restrict their ability to produce, the short-run AS likely increases

Political or environmental phenomena

For larger nations, wars and natural disasters can decrease the short-run AS without permanently decreasing the level of full employment. For smaller ones, it could be a permanent decrease in the ability to produce.

Long-Run Shifts

• Availabity of resources

• Technology and productivity

• Policy incentives

Availability of resources

A larger labor force, larger stock of capital, or more widely available natural resources can increase the level of full employment

Technology and productivity

Better technology raises the productivity of both capital and labor.

Policy incentives

If policy provides large incentives to quickly find a job, full-employment real GDP rises. If government gives tax incentives to invest in capital or technology, GDPf rises.

what indicates a shift to the right of LRAS

economic growth

Determinants of AS

AS is a function of many factors that impact the production capacity of the nation. If these factors make it easier, or less costly, for a nation to produce, AS shifts to the right. If these factors make it more difficult, or more costly, for a nation to produce, AS shifts to the left.

Macroeconomic equilibrium

Occurs when the quantity of real output demanded is equal to the quantity of real output supplied.

Recessionary gap

The amount by which full-employment GDP exceeds equilibrium GDP

Inflationary gap

The amount by which equilibrium GDP exceeds full employment GDP

Demand-pull inflation

This inflation is the result of stronger consumption from all sectors of AD as it continues to increase in the upward-sloping range of SRAS.

what happens when AD increases from 0 to 1

The price level may only slightly increase, while real GDP significantly increases and the unemployment rate falls.

what happens when AD increases from 1 to 2

The price level begins to rise and inflation is felt in the economy.

what happens when AD increases past 3

Inflation is quite significant and real GDP experiences minimal increases.

Recession

In the AD and AS model, a recession is typically described as falling AD with a constant SRAS curve. Real GDP falls far below full employment levels and the unemployment rate rises.

Deflation

A sustained falling price level, usually due to severely weakened aggregate demand and a constant SRAS

Most common cause of recession

Falling AD because it lowers real GDP and increases unemployment rate.

when is the full multiplier effect only observed

when the price level does not increase

when is the full multiplier effect not observed

when there’s no increase in the price level

Supply-side boom

When the SRAS curve shifts outward and the AD curve stays constant, the price level falls, real GDP increases and the unemployment rate falls

Stagflation (Cost-push inflation)

A situation in the macroeconomy when inflation and the unemployment rate are both increasing.

whats the cause of falling SRAS when AD is constant

stagflation

best possible macroeconomic situation

an increase in SRAS

one of the worst possible macroeconomic situation

decrease in SRAS

what does a decrease in SRAS create

Inflation, it lowers real GDP and increases unemployment rate.

Supply shocks

An economy-wide phenomenon that affects the costs of firms and the position of the SRAS curve, either positively or negatively

Positive supply shocks

It’s the result of higher productivity or lower energy prices

Negative supply shocks

Usually occur when economy-wide input prices suddenly increase.

One of the hallmarks of a recession

a decreased demand for many factors of production

what happens if AD rises

price level and real GDP rises

Phillips curve

A graphical device that shows the relationship between inflation and the unemployment rate. It shows the inverse relationship between inflation and unemployment rate.

effect of supply shocks on the phillips curve

Supply shocks shift the Phillips curve inward when SRAS shifts to the right and outward when SRAS shifts to the left.

whats the phillips curve like at the natural rate of employment

vertical

Natural rate of employment

The unemployment rate where cyclical unemployment is zero