Unit 3 - National Income and Price Determination

Aggregate Demand

The amount of real GDP that the private, public, and foreign sector COLLECTIVELY desire to purchase at each given price level.

In aggrgate demand the relationship between the price level and level of real GDP is…

inverse

Why is the aggregate demand line downsloping

• Real-Balances effect

• Interest-Rate effect

• Foreign Purchases effect

Real-Balances effect

At a high price level businesses/households cannot afford to purchase more output. At lower price level they can.

Interest-Rate effect

As price level increases, so does the interest rate which discourages investment. As price level declines, interest rate declines and investment rises.

Foreign purchases effect

A high price level in the US raises demand in US and abroad for foreign, cheaper goods (imports). A lower price level in US increases demand for US exports.

Why does the aggregate demand line shift (to the left or right)?

• Changes in C, Ig, Xn, and G (the determinants of demand)

• A multiplier effect that produces a greater change than the original change in the 4 components above

An increase in AD is signaled by…

a shift RIGHT in AD line

A decrease in AD is signaled by…

a shift LEFT in AD line

Consumption in relation to AD shifts includes…

• Consumer wealth

• Consumer expectations

• Household Indebtedness

• Taxes

Ig (gross private investments) in relation to AD shifts includes…

• Expected return on investment

• Real interest rate

Government spending in relation to AD shifts includes…

• More spending = AD shifts right

• Less spending = AD shifts left

Net Exports in relation to AD shifts includes…

• Exchange Rates

• Relative Income

Aggregate Supply

The level of real GDP that firms will produce at each price level

Long-run aggregate supply

a period of time where INPUT PRICES are completely FLEXIBLE and adjust to changes in price level - level of real GDP supplied is independent of the price level

Short-run aggregate supply

a period of time where INPUT PRICES are STICKY and DO NOT adjust to changes in price level - level of real GDP supplied is directly related to the price level

Input prices means…

land, labor, capital, wagers, entreprenurial ability

What does the short-run aggregate supply line reflect?

As price level increases, profits increase, which provides the incentive for firms to produce more output (Opposite happens with decrease in PL)

In short-run aggregate supply the relationship between the price level and level of real GDP is…

direct/positive

What causes SRAS line shifts?

Changes in per unit cost of production

per unit cost of production (PUPC) formula

total input cost/total output

An increase in SRAS is signaled by…

SRAS line shifting right

An decrease in SRAS is signaled by…

SRAS line shifting left

As the costs of per unit production increase…

SRAS decreases (left shift)

As the costs of per unit production decrease…

SRAS increases (right shift)

Deteriminants of SRAS

• Input prices

• Productivity

• Legal-institutional Environment

Input Prices in relation to SRAS shifts includes…

• Domestic resource prices

• Foreign resource prices

• Market power

Productivity in relation to SRAS shifts includes…

• more productivty = SRAS shifts right (lower PUPC)

• less productivity = SRAS shift left (higher PUPC)

Legal-insititutional environment in relation to SRAS shifts includes…

• Taxes and Subsidies

• Government Regulation

The long-run aggregate supply curve is _______ at the full-employment output level

Vertical

Why is LRAS vertical?

Because economy will produce full-employment output INDEPENDENT of the price level

Explain cycle of LRAS always at full-employment

Rise in labor demand to produce past Qf → Rise in input prices as workers demand more pay → Lower profits → less incentive for firms to produce more output → LRAS returns to Qf

Where does equilibrium occur in the AD/AS model

At the price level that equalizes the amounts of real output supplied and demanded

(establishes equilibrium price level and equilibrium real output)

When aggregate demand curve shifts to right in AD/AS model what is occuring?

Demand-pull inflation (as the increase in AD drives up the price level)

When aggregate demand curve shifts to left in AD/AS model what is occuring? (w/ fixed price level)

Deflation or a recession (including cyclical unemployment - less workers are needed to produce the lesser amount of output)

When (short-run) aggregate supply curve shifts to left in AD/AS model what is occuring?

Cost-push inflation (higer resource prices cause a higher price level)

When (short-run) aggregate supply curve shifts to right in AD/AS model (along with growing aggregate demand) what is occuring?

Full employment, high economic growth, and price stability