Unit 3 - National Income and Price Determination

Aggregate Demand and Supply

Aggregate Demand

• Definition: A schedule or curve illustrating the total quantity of real output that buyers collectively desire to purchase at each possible price level.

• Relationship: An inverse relationship exists between the price level (PL) and the amount of real GDP (rGDP) demanded.

Shape of the Aggregate Demand Curve

• Wealth Effect:

  • A higher price level reduces the real value of the public's accumulated savings, and vice versa.

  • As the public experiences a decrease in wealth in terms of real dollars, it curtails spending.

• Interest-Rate Effect:

  • When the price level rises, individuals need more money, leading to an increased demand for borrowed funds, which, in turn, elevates interest rates.

  • Higher interest rates discourage spending.

• Foreign Purchases Effect:

  • An increase in the U.S. price level leads to a decrease in foreign purchases of American goods, while Americans increase their purchases of foreign goods.

  • This results in increased imports and decreased exports, causing a decrease in net exports (X_n).

• Basis: All effects are based on changes in the price level (PL).

Determinants of Aggregate Demand

• Relationship to GDP: Aggregate Demand is the total amount of GDP demanded.

  • Equation: GDP = C + Ig + G + Xn

• Changes in Components: A change in any of these components will shift the AD curve.

  • An increase in any component increases AD.

  • A decrease in any component decreases AD.

Consumer Spending

• Consumer Wealth

• Consumer Expectations

• Household Indebtedness

• Taxes

Government Spending

• Increases or Decreases in government spending directly affect aggregate demand.

Net Export Spending

• Increase in X_n (Net Exports): Causes an increase in AD.

  • U.S. exports increase, U.S. imports decrease, or both.

• Decrease in X_n (Net Exports): Causes a decrease in AD.

  • U.S. exports decrease, U.S. imports increase, or both.

• National Income Abroad

• Exchange Rates

  • Depreciation of USD leads to increased net exports.

  • Appreciation of USD leads to decreased net exports.

Investment Spending

• An increase in investment causes an increase in AD.

• A decrease in investment causes a decrease in AD.

• Volatility: Investment is the most volatile component of GDP.

Investment Demand

• Real Interest Rates (rIr): As real interest rates increase, the quantity of investment demand decreases.

• Expected Rate of Return

  • Expected Profit = Expected Revenue - Expected Cost

  • Expected Profit/Cost = Expected Rate of Return

  • If the expected rate of return exceeds the real interest rate, a business should invest, even if the firm doesn't borrow money to invest.

Investment Demand Shifters

• Cost of Capital Goods: If costs increase, investment demand (ID) will decrease.

• Business Taxes: If taxes increase, ID will decrease.

• Technology: If technology improves, ID will increase.

• Expectations of Future Sales, Costs, and Profits: If firms expect these to increase, they will invest more at every given price; ID will increase.

• Excess Capacity: If firms have a lot of excess capacity, they will be less likely to purchase new capital; ID will decrease.

Aggregate Supply

• Definition: A schedule or curve showing the level of real domestic output that firms will produce at each price level.

• Relationship: A direct relationship exists between the price level (PL) and output.

Shape of the Aggregate Supply Curve

Horizontal Range

• Levels of output that are below Full Employment (Y_f).

• Per-unit production cost does not increase when output increases.

• Characterized by sticky prices.

• Corresponds to a recessionary period.

Intermediate Range

• Levels of output between Yu and Yc.

• Per-unit production costs increase as output increases.

• Factors causing increased costs:

  • Increases in labor costs.

  • Shortage of skilled workers or raw materials in some industries.

  • Use of older and less-efficient machinery.

  • Hiring of less capable workers.

  • Decrease in labor productivity.

• Output can increase past full employment to capacity (Y_c) in the short run.

Vertical Range

• Increases in price level will produce no additional output.

• The economy is already operating at its full capacity.

• Bidding wars increase prices due to competition for scarce resources, leading to increased costs.

Aggregate Supply Shifters

• Input Prices

  • Higher input prices increase per-unit production costs and decrease AS, and vice versa.

  • Changes in resource availability of land, labor, capital, and entrepreneurial ability.

  • Changing prices of imported resources.

• Exchange rates, tariffs

• Changes in Market Power: Ability to set above-competitive prices of resource providers (e.g., OPEC).

• Productivity

  • Productivity = (total outputs/total inputs)

• Legal-Institutional Environment

  • Business Taxes

  • Government Regulation