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.