Aggregate Demand and Aggregate Supply

Aggregate Demand

• Shows various levels of output (real GDP) that consumers desire to buy at each price level
• Inverse relationship due to substitution and income effects
  • Real balances effect: Price level falls, purchasing power of existing financial balances rises.
  • Interest rate effect: Decline in price level means lower interest rates, increasing certain types of spending.
  • Foreign purchases effect: Domestic prices down, domestic goods are cheaper compared to foreign goods.
• $Aggregate Demand = C + I + G + NX$ or $Aggregate Demand = Real GDP$
  • C = Consumer Spending
  • I = Investment Spending
  • G = Government Spending
  • NX = Net Export Spending

Changes in Aggregate Demand

• Determinants of aggregate demand: factors affecting C, I, G, Xn.
  • C: Change in consumer spending
    • Consumer wealth: difference between household assets (homes and stocks and bonds) and liabilities (loans and credit cards).
    • Household borrowing: borrow money now, spend now
    • Consumer expectations: Of future income changes or price level changes
    • Personal taxes: Changes disposable income which could raise/lower GDP
  • I: Change in real interest rates or expected returns
    • Real interest rates changes, the cost of borrowing changes
    • Expectations about future business conditions
    • Technology
    • Changes in excess capacity
    • Business taxes
  • G: Change in government spending
    • Government spending increases: Aggregate demand increases (as long as interest rates and tax rates do not change), more transportation projects
    • Government spending decreases: Aggregate demand decreases, less military spending
  • Xn: Changes in factors such as national incomes abroad and exchange rates
    • National income abroad
    • Exchange rates:
      • Dollar depreciation
      • Dollar appreciation

Aggregate Supply

• Shows the total real output produced at each price level.
• Depends on if input prices are fixed or flexible
• Relationship depends on time horizon:
  • Immediate short run: both input prices and output are fixed
  • Short run: Input prices are fixed, output flexible
  • Long run: both are flexible and can vary

Changes in Aggregate Supply

• Determinants of aggregate supply:
  • Shift factors
  • Changes raise or lower per-unit production costs
    • Input prices, Population, Technology, Government Laws, Natural disasters
  • Input Prices
    • Domestic resource prices:
      • Labor- increase or decrease in labor force
      • Capital-
      • Land-
    • Prices of imported resources:
      • Imported oil- needed for almost all firms
      • Exchange rates- Input parts from overseas
• Productivity
  • Real output per unit of input
  • Increases in productivity reduce costs
  • Decreases in productivity increase costs
  • $Per-unit production cost = \frac{total \ input \ cost}{total \ output}$
  • $Productivity = \frac{total \ output}{total \ inputs}$
• Legal-Institutional Environment
  • Legal changes alter per-unit costs of output:
    • Business taxes and subsidies
    • Government regulation

The Equilibrium Price Level and Equilibrium Real GDP

• Equilibrium achieved where aggregate demand and aggregate supply intersect.
• An Increase in Aggregate Demand That Causes Demand-Pull Inflation
• A Recession Resulting from a Leftward Shift of Aggregate Demand When the Price Level Is Downwardly Inflexible
• Decreases in AD: Recession and Cyclical Unemployment
• Prices are downwardly inflexible:
  • Fear of price wars
  • Menu costs
  • Wage contracts
  • Efficiency wages
  • Minimum wage law
• A Decrease in Aggregate Supply That Causes Cost-Push Inflation
• Growth, Full-Employment, and Relative Price Stability

Last Word: Stimulus and the Great Recession

• Housing collapse triggers bank failures which leads to recession.
• Federal Reserve intervenes:
  • Lowers short-term interest rates.
• Federal government begins largest peacetime program of spending.
• GDP growth has been disappointing.
• High debt load due to low interest rates.
• High rate of savings.
• Unequal impact.
• Price increases rather than output gains.