Aggregate Demand and Aggregate Supply

Aggregate Demand

• Real GDP desired at each price level.
• Inverse relationship.

Changes in Aggregate Demand

• Determinants:
  • Change in consumer spending.
  • Change in investment spending.
  • Change in government spending.
  • Change in export spending.
• Increase in aggregate demand: shifts the AD curve to the right.
• Decrease in aggregate demand: shifts the AD curve to the left.

Consumer Spending

• Influenced by:
  • Consumer wealth.
  • Household borrowing.
  • Consumer expectations.
  • Personal taxes.

Investment Spending

• Influenced by:
  • Real interest rates.
  • Expected returns, which are affected by:
    • Expectations about future business conditions.
    • Technology.
    • Degree of excess capacity.
    • Business taxes.

Government Spending

• Increases:
  • Aggregate demand increases (assuming constant interest and tax rates).
  • Examples: More transportation projects.
• Decreases:
  • Aggregate demand decreases.
  • Examples: Less military spending.

Net Export Spending

• Influenced by:
  • National income abroad.
  • Exchange rates:
    • Dollar depreciation: increases net exports.
    • Dollar appreciation: decreases net exports.
• Net Exports of Goods and Services, Selected Nations, 2019
  • Germany: 210 billion
  • China: 170 billion
  • Italy: 60 billion
  • Japan: 10 billion
  • France: −25 billion
  • Canada: −26 billion
  • United Kingdom: −28 billion
  • United States: −550 billion

Aggregate Supply

• Total real output produced at each price level.
• Relationship depends on the time horizon:
  • Immediate short run.
  • Short run.
  • Long run.

AS: Immediate Short Run

• Horizontal aggregate supply curve.

Aggregate Supply: Short Run

• Upward-sloping aggregate supply curve.

Aggregate Supply: Long Run

• Vertical aggregate supply curve at the potential output level.

Changes in Aggregate Supply

• Determinants:
  • Change in input prices.
  • Change in productivity.
  • Change in legal-institutional environment.
• Changes raise or lower per-unit production costs.
• Increase in aggregate supply: shifts the AS curve to the right.
• Decrease in aggregate supply: shifts the AS curve to the left.

Input Prices

• Domestic resource prices:
  • Labor.
  • Capital.
  • Land.
• Prices of imported resources:
  • Imported oil.
  • Exchange rates.

Productivity

• Real output per unit of input.
• Increases in productivity reduce costs.
• Decreases in productivity increase costs.

Legal-Institutional Environment

• Legal changes alter per-unit costs of output.
• Examples:
  • Taxes and subsidies.
  • Extent of government regulation.

Equilibrium

• Equilibrium occurs where aggregate demand equals aggregate supply.
• Example:
  • Real Output Demanded (billions) = 506, 508, 510, 512, 514
  • Price Level (index number) = 108, 104, 100, 96, 92
  • Real Output Supplied (billions) = 513, 512, 510, 507, 502

AD Increases: Demand-Pull Inflation

• Increase in aggregate demand leads to an increase in both the price level and real output.

Decreases in AS: Cost-Push Inflation

• Decrease in aggregate supply leads to an increase in the price level and a decrease in real output.

Downward Price-Level Inflexibility

• Prices are downwardly inflexible due to:
  • Fear of price wars.
  • Menu costs.
  • Wage contracts.
  • Morale, effort, and productivity considerations.
  • Minimum wage law.

Decreases in AD: Recession

• Decrease in aggregate demand leads to a decrease in real output, with the price level potentially remaining unchanged due to downward price inflexibility.

GDP Gaps

• Size of GDP Gaps, Selected Countries, 2017 (as a percentage of potential GDP):
  • Iceland: 2.5
  • Czech Republic: 3
  • Germany: 2
  • Sweden: 1
  • Japan: 0.2
  • Mexico: −0.2
  • Canada: −0.3
  • United States: −0.4
  • Spain: −3
  • Chile: −4
  • Greece: −12

The Multiplier Effect

• Shifts in aggregate demand embody an “initial change” in spending.
• Price levels and average wage levels are becoming more flexible downward.