Chapter 13 Textbook_

Chapter 13: What Is the Aggregate Demand-Aggregate Supply Model?

Macroeconomic Study Paths

• Long-run Growth and Development: Focuses on GDP growth, employment, and factors influencing economic progress over decades.

• Short-run Fluctuations (Business Cycles): Examines real GDP changes and unemployment over shorter periods (typically five years or less).

The Business Cycle

• Basic Business Cycle: Real GDP increases during the expansion phase and decreases during contraction (recession).

• Recession Indicators: Slowing GDP growth and rising unemployment rates.

• Data Overview:

  • Figure 13.1(a): Real GDP growth in the U.S. (1990-2021) shows periods of recession.

  • Figure 13.1(b): Unemployment rates spike during recessions, with a peak at 14.7% in April 2020 during COVID-19.

Aggregate Demand - Aggregate Supply Model

• Model Focus: Examines the economy through aggregate demand (AD) and aggregate supply (AS).

• Definitions:

  • Aggregate Demand (AD): Total demand for final goods and services in an economy.

  • Aggregate Supply (AS): Total supply of final goods and services.

• Next Sections: Focus on defining AD and AS separately before integrating them.

What Is Aggregate Demand?

• Aggregate demand represents the spending side of the economy. An increase in spending positively affects the economy.

Determining Aggregate Demand

• Components of AD: Total spending comprises four sources:

  • Consumption (C): Spending by private domestic consumers.

  • Investment (I): Spending by businesses on capital goods.

  • Government Spending (G): Purchases made by the government for services.

  • Net Exports (NX): Exports minus imports.

• Equation: AD = C + I + G + NX (Equation 13.1)

Aggregate Demand Curve

• Graphical Representation: AD curve plots quantities of final goods (GDP) vs. overall price level.

• Price Level (P): General price index, as measured by the GDP deflator, which is set at 100 in a specific period.

• Curve Characteristics: Negative slope means that higher price levels lead to lower quantity demanded.

Slope of the Aggregate Demand Curve

• Negative Relationship: Increases in price level decrease quantity of aggregate demand.

• Reasons for the Negative Slope:

  1. Wealth Effect: Higher prices reduce real wealth leading to less consumption.

  2. Interest Rate Effect: Rising prices lead to decreased savings and investments due to higher interest rates.

  3. International Trade Effect: Higher U.S. prices make exports less competitive, decreasing net exports.

Wealth Effect Explained

• Higher general price levels decrease real wealth, resulting in reduced consumption of goods and services.

  • Example: If pizza prices double, purchasing power diminishes, leading to decreased demand.

Interest Rate Effect Explained

• Increasing prices curtail savings; less savings mean decreased investment, which is part of aggregate demand.

  • Example: Higher interest rates reduce firms' willingness to invest.

International Trade Effect Explained

• Rising domestic prices decrease the attractiveness of U.S. goods, leading to lower net exports.

Shifts in Aggregate Demand Curve

• Causes of Shifts: A variety of factors affect aggregate demand beyond price level changes:

  • Changes in Consumption: Influenced by wealth, future income expectations, and taxes.

  • Changes in Investment: Governed by business confidence, interest rates, and money supply.

  • Changes in Government Spending: Directly impacted by fiscal policy decisions.

  • Changes in Net Exports: Affected by international income changes and exchange rates.

Important Factors Shifting Aggregate Demand

• Increases in AD: Occur due to increased wealth, consumer confidence, government spending, and foreign income.

• Decreases in AD: Happen with reduced wealth, higher taxes, and increased interest rates.

What Is Aggregate Supply?

• Aggregate supply shows the capacity and willingness of producers to supply goods at various price levels.

Firm Functionality

• Inputs and Outputs: Firms use resources (labor, capital) to produce goods/services, where costs (input prices) and revenues (output prices) affect decisions.

Long-Run vs. Short-Run Aggregate Supply

• Long-Run Aggregate Supply (LRAS): Depicts the output when prices are fully adjusted (vertical line).

• Short-Run Aggregate Supply (SRAS): Shows a direct relationship between price level and output due to sticky input prices.

• Factors Affecting LRAS: Changes in resources, technology, and institutional factors.

Short-Run Aggregate Supply Characteristics

• Positive slope driven by sticky input prices, menu costs, and money illusion, which leads firms to produce more when prices rise.

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Shifts in Aggregate Supply

• Causes for SRAS Shifts: Changes in production costs can arise from wage changes, resource prices, and supply shocks.

• Supply Shock Examples: COVID-19 pandemic caused sudden shifts in costs, affecting production capacity.

Equilibrium in Aggregate Demand-Aggregate Supply Model

• Market Equilibrium: Seen where AD equals AS at a particular price level, leading to adjustments in prices over time.

• Equilibrium Process: Involves movement towards point where aggregate demand equals aggregate supply, illustrating main economists' theories on price and output levels.

Summary of Economic Effects

• Understanding shifts in AD/AS helps predict changes in GDP, price levels, and employment, showcasing how macroeconomic events influence the economy over different time frames.