Chapter 9 - Aggregate Demand and Aggregate Supply

• “Too slow” or “too fast” real GDP growth are examples of Economic fluctuations —movements of GDP away from potential output.

9.1 Stick Prices and Their Macroeconomic Consequences

• Normally, the price system efficiently coordinates what goes on in an economy. The price system provides signals to firms as to who buys what, how much to produce, what resources to use, and from whom to buy.
• On a day-to-day basis, the price system works silently in the background, matching the desires of consumers with the output from producers.

Flexible and Sticky Prices

• If prices are slow to adjust, then they do not give the proper signals to producers and consumers quickly enough to bring them together.
• Demands and supplies will not be brought immediately into equilibrium, and coordination can break down.
• Action prices are prices that adjust on a nearly daily basis and custom prices are prices that adjust slowly.
• Economists often refer to slowly adjusting prices as “sticky prices”.
• Sticky wages cause sticky prices and hamper the economy’s ability to bring demand and supply into balance in the short run.

How Demand Determines Output in the Short Run

• Typically, in the short run, firms will meet changes in the demand for their products by adjusting production with only small changes in the prices they charge their customers.
• Short-run in macroeconomics is the period in which prices do not change or do not change very much.
• Both formal and informal contracts between firms mean that changes in demand will be reflected primarily in changes in output, not prices.

9.2 Understanding Aggregate Demand

What Is the Aggregate Demand Curve?

• Aggregate demand is the total demand for goods and services in an entire economy. It refers to the economy as a whole, not to individual goods or markets.
• The aggregate demand curve (AD) shows the relationship between the level of prices and the quantity of real GDP demanded.
• It plots the total demand for GDP as a function of the price level.

The Components of Aggregate Demand

• Components of aggregate demand

  1. Consumption spending (C)
  2. Investment spending (I)
  3. Government purchases (G)
  4. Net exports (NX)

Why the Aggregate Demand Curve Slopes Downward

• As the price level or average level of prices in the economy changes, so does the purchasing power of your money.

• As the purchasing power of money changes, the aggregate demand curve is affected in three different ways:

  1. The wealth effect: the increase in spending that occurs because the real value of money increases when the price level falls.
  2. The interest rate effect: With a given supply of money in the economy, a lower price level will lead to lower interest rates. With lower interest rates, both consumers and firms will find it cheaper to borrow money to make purchases.
  3. The international trade effect: In an open economy, a lower price level will mean that domestic goods become cheaper relative to foreign goods, so the demand for domestic goods will increase.

Shifts in the Aggregate Demand Curve

• An increase in aggregate demand means that total demand for all the goods and services contained in real GDP has increased.

• Factors that decrease aggregate demand shift the curve to the left:

  1. Changes in the supply of money: An increase in supply of money in the economy will increase aggregate demand and shift the aggregate demand curve to the right.
  2. Changes in taxes: A decrease in taxes will increase aggregate demand and shift the aggregate demand curve to the right.
  3. Changes in government spending: At any given price level, an increase in government spending will increase aggregate demand and shift the aggregate demand curve to the right.
  4. All other changes in demand: Any change in demand from households, firms, or the foreign sector will also change aggregate demand.

How the Multiplier Makes the Shift Bigger

• The ratio of the total shift in aggregate demand to the initial shift in aggregate demand is known as the multiplier.

• The relationship between the level of income and consumer spending is known as the consumption function.

  • C = Ca + by, where C is consumption spending.

• Ca is a constant and is independent of income which is called autonomous consumption spending.

• Autonomous spending is spending that does not depend on the level of income.

• The by represents the part of consumption that is dependent on income.

• It is the product of a fraction, b, called the marginal propensity to consume (MPC), and the level of income, or y, in the economy.

• The MPC tells us how consumer spending will increase for every dollar that income increases.

  • MPC = additional consumption/additional income

• The marginal propensity to save (MPS) is defined as the ratio of additional savings to additional income.

• The sum of the MPC and the MPS always equals one.

• Multiplier = 1/(1-MPC)

• The multiplier is important because it means that relatively small changes in spending could lead to relatively large changes in output.

• Knowing the value of the multiplier is important for two reasons:

  1. It tells us how many shocks to aggregate demand are “amplified.”
  2. To design effective economic policies to shift the aggregate demand curve

9.3 Understanding Aggregate Supply

• The aggregate supply curve (AS) shows the relationship between the level of prices and the total quantity of final goods and output that firms are willing and able to supply.
• To determine both the price level and real GDP, we need to combine both aggregate demand and aggregate supply.

The Long-Run Aggregate Supply Curve

• Long-run aggregate supply curve: A vertical aggregate supply curve that reflects the idea that in the long run, the output is determined solely by the factors of production and technology.
• The intersection of an aggregate demand curve and an aggregate supply curve determines the price level and equilibrium level of output.
• In the long run, the output is determined solely by the supply of human and physical capital and the supply of labor, not the price level.

The Short-Run Aggregate Supply Curve

• Short-run aggregate supply curve is a relatively flat aggregate supply curve that represents the idea that prices do not change very much in the short run and that firms adjust production to meet demand.
• It has a relatively flat slope because we assume that in the short run firms supply all the output demanded, with small changes in prices.
• The key factors that determine the costs firms must incur to produce output:
  • Input prices (wages and materials): Increase in input prices will increase firms’ costs
  • The state of technology
  • Taxes, subsidies, or economic regulations
• With sticky prices, changes in demand in the short run will lead to economic fluctuations and over- and underemployment. Only in the long run, when prices fully adjust, will the economy operate at full employment.

Supply Shocks

• Supply shocks are external events that shift the aggregate supply curve.
• To maintain their profit levels, firms raised their product prices.
• Stagflation: A decrease in real output with increasing prices

9.4 From the Short Run to the Long Run

• During a boom, because the economy is producing at a level beyond long-run potential, the level of unemployment will be very low.
• Firms will compete for labor and raw materials, and the tendency will be for both wages and prices to increase over time.
• When the economy is producing below full employment or potential output, the process works in reverse. Unemployment will exceed the natural rate, and there will be excess unemployment.
• Adjustments in wages and prices take the economy from short-run equilibrium to long-run equilibrium.

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