ppt_ch12

Aggregate Demand and Aggregate Supply

Aggregate Demand

Definition:

The aggregate demand curve illustrates the relationship between the aggregate price level and the total quantity of goods and services demanded in the economy. It is fundamental in understanding economic activity and dynamics.

Components:

• Household Demand: Consumption by consumers contributes significantly to aggregate demand, driven by factors such as disposable income, consumer confidence, and interest rates.

• Business Demand: Investment by businesses in capital goods is influenced by expected returns and economic conditions.

• Government Demand: Government spending on goods and services affects aggregate demand directly through fiscal policies.

• Foreign Buyers: Net exports (exports minus imports) contribute to aggregate demand, affected by exchange rates and global economic conditions.

The Aggregate Demand Curve

• Downward Slope: Reflects that a falling aggregate price level leads to an increased quantity of aggregate output demanded. As prices decrease, consumers are typically more willing to purchase goods and services.

• Graphical Representation: Shows the relationship between aggregate price levels and Real GDP, used to analyze economic shifts.

• Key Point: Movement down along the AD curve indicates increased output demanded, often associated with stimulating economic activity in times of recession.

Reasons for Downward Slope of Aggregate Demand Curve

1. Wealth Effect: As the aggregate price level decreases, the real value of money holdings increases, leading to higher consumption because people feel wealthier.

2. Interest Rate Effect: Lower price levels reduce interest rates, which stimulates investment expenditure by businesses, thereby increasing demand for goods and services.

3. Net Export Effect: A decline in domestic prices can lead to a rise in exports due to improved competitiveness, increasing aggregate demand.

Shifts of the Aggregate Demand Curve

Factors Causing Shifts:

• Changes in expectations of future economic conditions, impacting consumer and business confidence.

• Variations in consumer and firm wealth (e.g., stock market fluctuations, real estate values).

• Adjustments in the stock of physical capital, reflecting technological advancements or capital investments.

• Government fiscal and monetary policies, which can stimulate or restrict economic activity.

Rightward Shift

• Implication: Indicates an increase in aggregate demand, driven by factors such as consumer confidence and government spending increases.

Leftward Shift

• Implication: Indicates a decrease in aggregate demand, potentially arising from economic downturns or reductions in government spending.

Factors That Shift the Aggregate Demand Curve

• Changes in Expectations: Optimism in economic outlook can spur increases in aggregate demand through heightened investment and consumption.

• Changes in Wealth: Increased real asset values (like rising house prices) lead to higher consumer confidence and spending.

• Stock of Physical Capital: A smaller existing capital stock typically raises aggregate demand as firms invest more to replace aging infrastructure.

• Fiscal Policy: Government spending increases or tax cuts can lead to higher aggregate demand by increasing disposable incomes.

• Monetary Policy: Adjustments in the money supply or lowered interest rates stimulate aggregate demand through cheaper borrowing costs.

Aggregate Supply

Definition:

The aggregate supply curve displays the relationship between the aggregate price level and the total amount of goods and services supplied in the economy. It helps in understanding production levels in response to price changes.

Short-Run Aggregate Supply Curve

• Characteristics: Upward sloping due to nominal wages being sticky in the short run, meaning they do not adjust immediately to changes in economic conditions.

• Profit Motivation: A higher aggregate price level generally leads to higher profits, encouraging firms to increase output.

• Sticky Wages: Nominal wages are slow to adjust, influencing supply decisions in the short run; businesses often find it hard to change wages quickly.

Shifts of the Short-Run Aggregate Supply Curve

Key Influences:

• Commodity Prices: Increases in the prices of essential inputs can directly raise production costs, shifting the supply curve leftward.

• Nominal Wages: Fluctuations due to economic conditions or negotiations can shift the supply curve based on wage adjustments.

• Productivity: Enhancements in worker productivity or technology lead to a rightward shift in the curve, as more output can be produced at the same cost.

Shift Examples:

• Leftward Shift: Indicates a decrease in short-run aggregate supply; typically occurs during increased costs of production.

• Rightward Shift: Represents an increase in short-run aggregate supply due to improved productivity or reduced production costs.

Long-Run Aggregate Supply Curve

• Definition: Represents the quantity of output supplied when all prices, including wages, are fully flexible, and the economy is at full employment.

• Graphical Influence: Changes in the aggregate price level do not affect long-run output, as it is determined by factors like technology, labor, and capital availability.

Actual vs. Potential Output

• Output Gap: Indicates when actual output is below or above potential output, signaling recessionary (below) or inflationary (above) gaps, which economists monitor closely.

Economic Growth Effects on LRAS Curve

• Long-Run Growth: Economic growth shifts the long-run aggregate supply curve rightward, indicating an increase in the potential output level and overall economic capacity.

Short-Run vs. Long-Run Dynamics

• The economy can transition from short-run to long-run equilibrium through adjustments in aggregate supply and demand, reflecting broader economic conditions.

AD–AS Model

Usage:

The AD–AS model allows economists to analyze economic fluctuations through interactions between aggregate demand and supply curves, facilitating better understanding of macroeconomic phenomena.

Short-Run Macroeconomic Equilibrium

• Achieved when AD intersects with SRAS at a given price level, determining the short-run output and price level in the economy.

Economic Effects of Shocks

• Demand Shocks: P and Y move in the same direction, often leading to inflation or growth cycles.

• Supply Shocks: P and Y move in opposite directions, affecting both inflation and output levels, which can lead to stagflation.

Policy Responses to Economic Conditions

• Self-Correcting Mechanism: Economies possess the ability to adjust over time to reach potential output without intervention, provided prices and wages are flexible.

• Demand Shock Responses: Policies typically aim for both price stability and maintaining output levels.

• Supply Shock Responses: Policies must balance between maintaining price stability and preventing unemployment, posing challenges for policymakers.

Macroeconomic Policy Challenges:

The interplay between inflation control and unemployment management in response to supply shocks requires careful consideration and strategic policy formulation to ensure economic stability and growth.