UNIT 3- Aggregate Demand and Supply

Aggregate Demand (AD)

Aggregate Demand

• Aggregate demand = the relationship between the quantity of goods and services demanded and the price level

Aggregate Demand Curve

• Differs from the curve of an individual product because there’s no substitution effect

  

• Downward sloping curve

  • real balance effect → as the price level falls, cash balances (money people hold) will purchase more

    • at a low price level, the money you have will buy more

  • interest rate effect → lower price levels will lower interest rate, which changes investment

    • Keynes Effect → price level changes interest rate, which changes investment

  • foreign purchases effect → lower prices make domestic goods more attractive than foreign goods

    • lower prices increases net exports

Determinants of Aggregate Demand (AD Shifters)

1. Changes in consumption

   • consumer confidence → if consumers are confident about the economy, there will be an increase in aggregate demand

   • tax policy → a decrease in income taxes will increase consumption; an increase in tax will decrease consumption

   • transfer payments → an increase in transfer payments will increase consumption; a decrease in transfer payments will decrease consumption

   • inflationary expectations → if consumers expect higher prices in the future, there will be an increase in consumption; if consumers expect lower prices in the future, there will be a decrease in consumption

2. Changes in investment

   • expectation of the business firm → if business firms are confident in the economy, there will be an increase in investment; if they’re pessimistic, they’ll decrease investment

   • changes in interest rate → if interest rates decrease, investment will increase; if interest rates increase, investment will decrease

     • government policies effect interest rates

3. Changes in government purchases

   • an increase in government spending increases aggregate demand

   • a decrease in government spending decreases aggregate demand

4. Changes in net exports

   • an increase in net exports will increase aggregate demand

   • a decrease in net exports will decrease aggregate demand

Aggregate Supply (AS)

Aggregate Supply

• Aggregate supply = the relationship between the output produced and the price level

Aggregate Supply Curve (Short Run)

• In the short run, prices and wages are not flexible downward

  • they’re “sticky”

• In the short run, there can be periods of unemployment

  

1. Horizontal/Keynesian Range → low levels of output; unemployment; recession; you can increase output, price levels don’t change

2. Intermediate Range → economy is nearing full employment; price levels start to go up

3. Vertical/Classical Range → full employment in the short run; you can’t generate anymore output

Determinants of Aggregate Supply (AS Shifters)

1. Prices of inputs

   • resources, wages, energy costs

   • price of inputs increases, aggregate supply decreases

   • price of inputs decreases, aggregate supply increases

2. Productivity and technology

   • if workers become more productive/develop better technology, aggregate supply will increase

3. Available supplies of labor and capital

   • if labor force grows or improves in quality, aggregate supply will increase

   • if capital stock increases, aggregate supply increases

   • if supply of natural resources increases, aggregate supply increases

4. Government regulations

   • if the government regulates industry more strictly, aggregate supply will decrease

   • if the government eases regulations, aggregate supply increases

   • government regulation is a cost of production

5. Business taxes

   • cost of production

   • business taxes increase, aggregate supply decreases

   • business taxes decrease, aggregate supply increases

6. Government subsidies

   • if the government cuts subsidies to businesses, aggregate supply decreases

   • if the government raises subsidies to businesses, aggregate supply increases

   • subsidies = funding; giving money to

7. Reduce taxes on savings

   • capital gains = profit after the selling of an asset

     • capital gains get taxed

   • dividends = amount that companies give back to shareholders

     • dividends get taxed

   • interest → earning interest on money that gets taxed

Equilibrium of Aggregate Demand and Supply

Increase in Aggregate Demand

• Price level increases

• Output increases

• Employment increases

• Output and employment are tied

  • output goes up, employment goes up

  • output goes down, unemployment goes up

Decrease in Aggregate Demand

• Price level decreases

• Output decreases

• Employment decreases

Increase in Aggregate Supply

• Price level decreases

• Output increases

• Employment increases

Decrease in Aggregate Supply

• Price level increases

• Output decreases

• Employment decreases

Short Run vs. Long Run Aggregate Supply

Short Run

• Not a definitive time range

• When prices and wages are sticky (inflexible)

• Full employment at high level of output

• You can produce more in the short run because you use your resources more intensively in the short run

  • you can require people to work A LOT of hours, but you can’t sustain that in the long run

• Output level will fall unless long run aggregate supply is increased

Long Run

• Wages and prices are flexible, can adjust

• We’ll always have full employment in the long run

• Fixed technology, efficient use of resources

• Long run aggregate supply curve will shift if we develop more or better resources or have improvements in technology

  • economic growth

Keynesian vs. Classical Theory

Keynesian Theory

• Output and employment are determined by the level of Aggregate Demand/Expenditures

  • demand side theory

• Savers and investors are two different people, therefore; interest rates don’t automatically adjust to the level of savings; savings doesn’t always equal investment

• Wages and prices are “sticky” (unions and monopoly power of business)

• Unemployment is a reality

• Economy CANNOT automatically adjust

  • government needs to take an active role in order for economy to achieve full employment

• Aggregate supply curve is horizontal

  • only vertical at full employment (when government takes an active role)

Classical Theory

• Say’s Law: supply creates its own demand

• Interest rates automatically adjust to the level of savings; investment will offset the loss in savings

• Wages and prices are flexible downward; full employment is always achieved

• Economy can correct itself to full employment with little or no government intervention necessary (Laissez-faire)

• Aggregate supply curve is vertical

Keynesian- Income Expenditure Model (AE Model)

• Assumes a fixed price level

• Strength: you can see the effects of changes in consumption, investment, and government spending on the equilibrium level

• 1) Consumption and savings

  

  • Two types of consumption:

    1. Induced consumption

       • an increase or decrease in consumption caused by an increase or decrease in consumer incomes

    2. Autonomous consumption

       • an increase or decrease in consumption at all levels of income (a shift)

         • increase shifts up, decrease shifts down

       • changes in real wealth → real wealth increases, consumption increases; real wealth decreases, consumption decreases

       • price level → price level decreases, consumption increases; price level increases, consumption decreases

       • consumer debt → consumer debt decreases, consumption increases; consumer debt increases, consumption decreases

       • consumer confidence → consumer confidence increases, consumption increases; consumer confidence decreases, consumption decreases

       • inflationary expectations → consumers expect higher prices in the future, consumption increases; consumers expect lower prices in the future, consumption decreases

       • tax policy → income taxes decrease, consumption increases; income taxes increase, consumption decreases

  • Marginal Propensity to Consume (MPC)

    • percentage of disposable income consumers spend on goods and services

    • (change in consumption / change in disposable income)

  • Marginal Propensity to Save (MPS)

    • percentage of disposable income consumers save

    • (change in savings / change in disposable income)

    • MPS + MPC = 100%

• 2) Investment

  

  • Determinants:

    • expected rate of profit → expected rate of profit is high, increase in investment; expected rate of profit is low, decrease in investment

    • real interest rates → real interest rates are low, investments will increase; real interest rates are high, investments will decrease

• 3) Spending Multiplier

  • the amount by which equilibrium GDP changes with a change in expenditures

  • (change in equilibrium / change in Aggregate Expenditure)

  • (1 / (1-MPC)) or (1 / MPS)

  • higher MPC, higher multiplier

• 4) Total Change in Real GDP (Income)

  • (initial change in spending x multiplier)

• 5) Tax Multiplier

  • (-MPC / MPS)

  • will always be negative

• 6) Recessionary Gap

  • occurs when equilibrium GDP falls short of full employment in a recession

    

• 7) Inflationary Gap

  • occurs when equilibrium GDP exceeds full employment

    

Fiscal Policy

Fiscal Policy

• Changes in Federal income taxes and government spending to affect the level of Aggregate Demand (AD)

• Implemented by the President and Congress

  • people who make decisions on fiscal policy are elected

    • fiscal policy is heavily influenced by politics

• Use of spending multiplier is helpful

  • tax multiplier is also helpful

Expansionary Fiscal Policy

• The goal is to increase aggregate demand and is used during a recession

• Decrease income taxes and/or increase government spending

• Balanced budget = spending is equal to taxes

  • budget isn’t balanced during expansionary fiscal policy

    • spending more than you collect in taxes

    • deficit spending

Contractionary Fiscal Policy

• The goal is to decrease aggregate demand and is used to fight inflation

• Increase in income taxes and/or decrease in government spending

• Government collects more and spends less

  • contributes towards a budget surplus

Discretionary Stabilizers

• The government must pass a law or take some specific action to change tax or spending policies

• Deliberate action by government

Automatic Stabilizers

• A policy change that happens due to a change in the economy

• Recession → government spending goes up because more people are collecting unemployment; government receiving less tax revenue

  • deficit spending

• Expansion → government spending decreases because less people are collecting unemployment; government receving more tax revenue

  • surplus spending