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In-Depth Notes on Aggregate Demand and Supply Concepts

Reasons for Downward Sloping Aggregate Demand

  • Reason #1: Real Balances Effect

    • As price levels fall, the real value of money increases, allowing consumers to feel richer.
    • Result: Increased consumption because people feel they have more purchasing power.

  • Reason #2: Interest Rate Effect

    • Falling price levels lead to lower interest rates.
    • Lower interest rates encourage greater investment as borrowing costs decrease.
    • More investment leads to greater production capacity and subsequently lower price levels.

  • Reason #3: Transfer of Expectations

    • If consumers are optimistic about the future, they tend to spend more.

    • Factors influencing this include government spending on projects and increased exports.

    • Conversely, if consumers feel pessimistic (e.g., stock market downturn), spending decreases.

Spending Multiplier and Economic Gaps

  • Key Formula:

    • Spending Multiplier = \frac{1}{MPS}
    • $MPS$: Marginal Propensity to Save.

  • Practical Example:

    • If there's a $50 billion gap and the multiplier is 5, the government only needs to spend \frac{50,000,000,000}{5} = 10,000,000,000 to close the gap.

  • Tax Multiplier:

    • Always one less than spending multiplier; typically around 4.

Investment Demand and Interest Rates

  • Investment Demand Relationship:
    • Firms are more likely to invest in machinery when interest rates are low.
    • High-interest rates deter investment due to increased borrowing costs.

Aggregate Supply

  • Short-run Aggregate Supply (SRAS):

    • Upward sloping due to sticky prices and wages which adjust slowly.
    • Short-run shifts are affected by cost of production changes (e.g., oil prices).

  • Long-run Aggregate Supply (LRAS):

    • Perfectly vertical as wages and prices adjust fully to reflect the economy’s potential output.
    • Long-run changes caused by increased resources and capital.

Government Intervention and Aggregate Demand

  • Shifting Aggregate Demand:

    • Government actions such as increasing spending or lowering interest rates aim to shift AD curves.
    • If deficit spending occurs, it raises interest rates and can shift the AD curve left, reducing investment.

  • Inflationary and Recessionary Gaps:

    • In inflation, government may raise taxes or cut spending to decrease AD.
    • During recession, stimulus payments can boost consumer demand by providing disposable income.

Problems with Fiscal Policy

  • Lag Time Issues:

    • Recognition Lag: Time taken to identify economic trends (6 months for recession recognition).
    • Administrative Lag: Time taken for proposals to be enacted (bills going through Congress).
    • Operational Lag: Time taken to actually spend approved amounts (e.g., infrastructure projects).

  • Automatic Stabilizers:

    • Systems in place that automatically help stabilize the economy (e.g., unemployment benefits).
    • Allow individuals to spend, preventing a sharp drop in aggregate demand during downturns.

  • Discretionary Stabilizers:

    • Involves active changes in spending or taxes to influence the economy.