1 aggregate demand and supply key concepts key concepts summary ©2005 south-western college...
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3 What is the aggregate demand curve? The curve shows the level of real GDP purchased by households, businesses, government, and foreigners at different price levels during a time period, ceteris paribusTRANSCRIPT
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AggregateDemand and Supply
• Key Concepts• Summary
©2005 South-Western College Publishing
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What is the purpose of this chapter?
In this chapter, you will use aggregate demand and supply analysis to study the business cycle and will be provided the basic tools with which to organize your thinking about the macro economy.
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What is the aggregate demand curve?
The curve shows the level of real GDP purchased by households, businesses, government, and foreigners at different price levels during a time period, ceteris paribus
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What does the horizontal axis
measure? The value of final goods and services included in real GDP measured in base year dollars
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What does the vertical axis measure?
It is an index of the overall price level, such as the GDP deflator or the CPI
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Why does the aggregate demand
curve slope downward to the right?
• Real balance wealth effect• Interest rate effect• Net exports effect
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What is thereal balance effect?
Consumers spend more on goods and services because lower prices make their dollars more valuable
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What is theinterest rate effect?Assuming fixed credit, an increase in the price level translates through higher interest rates into a lower real GDP
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What is thenet exports effect?
A higher domestic price level makes U.S. goods more expensive compared to foreign goods, exports decrease, imports increase, decreasing real GDP
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$200
$150
$100
$50
2 4 6 8
B
A
1210
AD
Pric
e Le
vel
Real GDP
The Aggregate Demand Curve
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What can cause a shift in the aggregate
demand curve?Consumption, investments, government spending and net exports can change
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200
150
100
50
2 4 6 8
BA
Real GDP1210
AD2AD1
Pric
e Le
vel (
CPI
)
A Shift in the Aggregate Demand Curve
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What is theaggregate supply
curve?The curve that shows the level of real GDP produced at different price levels during a time period, ceteris paribus
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Why did Keynes assume fixed product
prices and wages?During a deep recession or depression, there are many idle resources in the economy
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Why do idle resources mean fixed prices?
Producers are willing to sell additional output at current prices because there is plenty of resources to go around for everyone who wants them
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Why do idle resources mean fixed wages?
The supply of unemployed workers willing to work for the prevailing wage rate diminishes the power of workers to increase their wages
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What kind of supply curve would explain
fixed prices and wages?
A horizontal supply curve
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200
150
100
50
2 4 6 8
E2E1
Real GDP
Pric
e Le
vel (
CPI
)
1210
ASAD2
AD1
The Keynesian Horizontal Aggregate Supply Curve
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Government spending (G)
increases
Aggregate demand increases and the economy moves
from E1 to E2
Price level remains constant, while real
GDP and employment rise
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According to Keynes, what will a shift in
aggregate demand do?It will restore a
depressed economy to full employment
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200
150
100
50
2 4 6 8
E2E1
Real GDP
Pric
e Le
vel (
CPI
)
1210
ASAD2
AD1
The Keynesian Horizontal Aggregate Supply Curve
full employment
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What is the Classical view of the aggregate
supply curve?It is a vertical line at the full employment output
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According to the Classical economists,
where does the economy normally
operate? The economy normally operates at its full employment level
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How do the Classical
economists view prices and costs?
The price level of products and production costs change by the same percentage in order to maintain full employment
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200
150
100
50
2 4 6 8AD2
E2
E1
AD1
10 12 14 16Real GDP
Full employment
The Classical Aggregate Supply CurveAS
Pric
e Le
vel (
CPI
)
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Surplus
E
26YK
Real GDP
Keynesian Range
Three Ranges of the Aggregate Supply CurveAS
Pric
e Le
vel
Intermediate Range
Classical Range
YF
Full Employment
272 4 6 8 10 12
AS
0
50
100
150
200
Full Employment
Pric
e Le
vel
AD1
AD2AD3
AD4
AD6AD5
Real GDP
Increasing Demand
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What factors can cause a shift in the
aggregate supply curve?
A change in• resource prices• technology• taxes• subsidies• regulations
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150
100
50
2 4 6 8 10 12 14 16
full employment
A Rightward Shift in the Aggregate Supply Curve
AS1Pr
ice
Leve
l
17
AD
E1
E2
AS2
Real GDP
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Change in one or more nonprice-level determinants: resource prices, technological change,
taxes, subsidies, and regulations
Increase in the aggregate supply curve
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What are the two types of inflation?
Cost pushDemand pull
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What iscost push inflation?A rise in the general price level resulting from an increase in the cost of production
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What is stagflation?The condition that occurs when an economy experiences the twin maladies of high unemployment and rapid inflation simultaneously
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200
150
100
50
2 4 6 8 10 12 14 16
full employment
Cost Push Inflation
Pric
e Le
vel
17
ADE1
E2
AS1
Real GDP
AS2
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What isdemand pull inflation?A rise in the general price level resulting from an excess of total spending
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200
150
100
50
2 4 6 8 10 12 14 16
full employment
Demand Pull Inflation
Pric
e Le
vel
17
AD1
E1
E2
AS
Real GDP
AD2
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What determines the business cycle?
Shifts in the aggregate demand and aggregate supply curves
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What happens when both curves increase?
That depends on how much each increases
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200
150
100
50
2 4 6 8 10 12 14 16
Pric
e Le
vel
17
AD1
AS1
Real GDP
AD2
AS2
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Key Concepts
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• What is the aggregate demand curve?• Why does the aggregate demand curve slope
downward to the right?• What can cause a shift in the aggregate dem
and curve?• What is the aggregate supply curve?• Why did Keynes assume fixed product prices
and wages?• What kind of supply curve would explain fixed
prices and wages?
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• According to Keynes, what will a shift in aggregate demand do?
• What is the Classical view of the aggregate supply curve?
• According to the Classical economists, where does the economy normally operate?
• What factors can cause a shift in the aggregate supply curve?
• What are the two types of inflation?
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Summary
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The aggregate demand curve shows the level of real GDP purchased in the economy at different price levels during a period of time.
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Reasons why the aggregate demand curve is downward-sloping include the following three effects:
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(1) The real balances or wealth effect is the impact on real GDP caused by the inverse relationship between the purchasing power of fixed value financial assets and inflation, which causes a shift in the consumption schedule.
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(2) The interest-rate effect assumes a fixed money supply, and, therefore, inflation increases the demand for money. As the demand for money increases, the interest rate rises, causing consumption and investment spending to fall.
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(3) The net exports effect is the impact on real GDP caused by the inverse relationship between net exports and inflation. An increase in the U.S. price level tends to reduce U.S. exports and increase imports, and vice versa.
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200
150
100
50
2 4 6 8
BA
Real GDP1210
AD2AD1
Pric
e Le
vel (
CPI
)
A Shift in the Aggregate Demand Curve
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The aggregate supply curve shows the level of real GDP that the economy will produce at different possible price levels.
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The shape of the aggregate supply curve depends on the flexibility of prices and wages as real GDP expands and contracts. The aggregate supply curve has three ranges:
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(1) The Keynesian range of the curve is horizontal because neither the price level nor production costs will increase when there is substantial unemployment in the economy.
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(2) In the intermediate range, both prices and costs rise as real GDP rises toward full employment. Prices and production costs rise because of bottlenecks, the stronger bargaining power of labor, and the utilization of less productive workers and capital
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(3) The classical range is the vertical segment of the aggregate supply curve. It coincides with the full-employment output. Because output is at its maximum, increases in aggregate demand will only cause a rise in the price level.
55YK
Real GDP
Keynesian Range
Three Ranges of the Aggregate Supply CurveAS
Pric
e Le
vel
Intermediate Range
Classical Range
YF
Full Employment
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Aggregate demand and aggregate supply analysis determines the equilibrium price level and the equilibrium real GDP by the intersection of the aggregate demand and the aggregate supply curves.
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Stagflation exists when an economy experiences inflation and unemployment simultaneously. Holding aggregate demand constant, a decrease in aggregate supply results in the unhealthy condition of a rise in the price level and a fall in real GDP and employment.
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Cost-push inflation is inflation that results from a decrease in the aggregate supply curve while the aggregate demand curve remains fixed.
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Cost-push inflation is undesirable because it is accompanied by declines in both real GDP and employment.
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200
150
100
50
2 4 6 8 10 12 14 16
Cost Push Inflation
Pric
e Le
vel
17
AD
E2
AS1
Real GDP
full employment
E1
AS2
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Demand-pull inflation is inflation that results from an increase in the aggregate demand curve in both the classical and the intermediate ranges of the aggregate supply curve while the aggregate supply curve is fixed.
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200
150
100
50
2 4 6 8 10 12 14 16
Demand Pull Inflation
Pric
e Le
vel
17
AD1
E1
E2
AS
Real GDP
AD2
full employment
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