CHAPTER 12 (Part I): CHAPTER 12 (Part I): AGGREGATE DEMAND-SUPPLY AGGREGATE DEMAND-SUPPLY

MODELMODEL

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12.1 Aggregate Demand Curve12.1 Aggregate Demand Curve

12.2 Aggregate Supply Curve12.2 Aggregate Supply Curve

CHAPTER OUTLINE

12.1 AGGREGATE DEMAND 12.1 AGGREGATE DEMAND CURVECURVE Aggregate Demand (AD):

Definition: The total demand for all goods &

services in the economy. AD curve plots aggregate demand

against price level (P).

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But aggregate demand is not only influence by price level but other factors as follow: Consumption Investment Federal Budget (Fiscal policy)

i) Government spendingii) Taxes

Net Exports Money supply (Monetary policy)

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Shift in AD curve

12.1 AGGREGATE DEMAND 12.1 AGGREGATE DEMAND CURVECURVE Aggregate Demand Curve:

Definition: A curve that shows the negative relationship (downward slopping) between aggregate output (income) and the price level. Each point on the AD curve is a point at which both the goods market and the money market are in equilibrium.

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How to derive it?

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0 Real GDP (trillions of RM)

0

140

Ag

gre

gat

e e

xpen

dit

ure

(t

rill

ion

s o

f d

oll

ars)

e

AE (P = 130)

e

130

12.0

12.0 Real GDP (trillions of RM)

45°

(a) Income-expenditure model

(b) Aggregate demand curve

In panel (a), the AE function intersects the 45 degree line at point e to yield RM12 trillion in real GDP demandedPanel b shows that when the price level is 130, real GDP demanded is RM12 trillion and we have one point on the aggregate demand curve, e P

rice

le

vel

Deriving AD Curve

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0 Real GDP (trillions of RM)A

gg

reg

ate

ex

pe

nd

itu

re

(tri

llio

ns

of

do

lla

rs)

AE' (P = 140)

e'

11.5

AE (P = 130)

e

12.0

AE" (P = 120)e"

12.5

45°

If the price level increases to 140, the increase in the price level reduces consumption, planned investment, and net exports as shown by the downward shift of the aggregate expenditure line from AE to AE' and real GDP demanded declines from RM12 trillion to RM11.5 trillionIf the price level falls, the opposite occurs: consumption, investment, and net exports increase at each real GDPThe AE function shifts to AE': real GDP increases to RM12.5 trillionConnecting these three equilibrium points yields the AD curve

(a) Income-expenditure model

0

140

AD

e'

11.5

e130

12.0 Real GDP (trillions of RM)

120e"

12.5

Pri

ce

le

ve

l

(b) Aggregate demand curve

12.1 AGGREGATE DEMAND 12.1 AGGREGATE DEMAND CURVECURVE Why the AD is downward sloping?

Real balance effect The Price Level and Consumption

Interest rate effect The Price Level and Investment

International trade effect The Price Level and Net exports

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Definition: The inverse relationship between the price

level and the quantity demanded of Real GDP is established through changes in the value of monetary wealth or money holdings based on the purchasing power of the person.

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Summary: A fall in the price level causes

purchasing power to rise, which increases a person’s monetary wealth. As people become wealthier, the quantity demanded of Real GDP rises.

A rise in the price level causes purchasing power to fall, which decreases a person’s monetary wealth. As people become less wealthy, the quantity demanded of Real GDP falls.

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Definition: The inverse relationship between the price

level and quantity demanded of Real GDP is established through changes in household and business spending that is sensitive to changes in interest rate.

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Summary: Price level falls

As the interest rate drops, households and business borrow more, so they end up buying more goods. Thus, the quantity demanded of Real GDP rises.

Price level rises As the interest rate rises, households

borrow less to finance. Thus, the quantity demanded of Real GDP falls.

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Definition: The inverse relationship between the price

level and the quantity demanded of Real GDP is established through foreign sector spending, which includes local spending on foreign goods (import) and foreign spending on domestic goods (export).

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Summary Price level falls.

When the price level for domestic goods falls, the domestic goods become relatively cheaper than foreign goods. As a result, the foreigners will buy more domestic goods. Thus, the demanded quantity of (local) Real GDP rises.

Price level rises. When the price level for domestic goods

rises, the domestic goods become relatively more expensive than foreign goods. As a result, the foreigners will buy fewer domestic goods. Thus, the demanded quantity of (local) Real GDP falls. 14

Change in the quantity demanded of Real GDP: Movement along the AD curve from one

point to another point. Result of a change in the price level.

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Aggregate Output

PriceLevel

0

Aggregatedemand

P

Y Y2

P2

1. A decreasein the pricelevel . . .

2. . . . increases the quantity ofgoods and services demanded.

Definition: Represented as a shift in the aggregate

demand curve.

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PriceLevel

0

Aggregatedemand, D1

P1

Y1

D2

Y2 Aggregate Output

Shifts might arise from changes in: Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX) Money supply (Ms)

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An events that makes consumers spend more at a given price level shifts the aggregate demand curve to the right.

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↑C

An event that makes firms invest more at a given price level shifts the aggregate demand curve to the right.

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↑I

An increase in government purchases (G) or a decrease in net taxes shifts the aggregate demand curve to the right.

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An event that raises spending on net exports at a given price level shifts the aggregate demand curve to the right.

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↑NX

An increase/ decrease in the quantity of money supplied (MS) at a given price level shifts the aggregate demand curve to the right/ left.

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Factors That Shift the Aggregate Demand Curve (Government Policy)

Expansionary monetary policy

Ms AD curve shifts to the right

Contractionary monetary policy

Ms AD curve shifts to the left

Expansionary fiscal policy

G AD curve shifts to the right

Contractionary fiscal policy

G AD curve shifts to the left

T AD curve shifts to the right T AD curve shifts to the left

Any changes in autonomous component of AE

12.2 AGGREGATE SUPPLY 12.2 AGGREGATE SUPPLY CURVECURVE

Aggregate Supply (AS): Definition:

The total supply for all goods & services in the economy.

The relationship between the economy’s price level and the amount of outputs firms are willing and able to supply, with other things constant.

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12.2 AGGREGATE SUPPLY CURVE12.2 AGGREGATE SUPPLY CURVE

Aggregate Supply Curve: Definition:

The relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level.

In the short-run, the aggregate supply curve has a positive slope.

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12.2 AGGREGATE SUPPLY CURVE12.2 AGGREGATE SUPPLY CURVE

Why short-run AS curve upward sloping? The Sticky-Wage Theory The Sticky-Price Theory The Misperceptions Theory

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Nominal wages are slow to adjust to changing economic conditions, or are “sticky” in the short run

Nominal wages do not adjust immediately to a fall in the price level. A lower price level makes employment and production less profitable.

This induces firms to reduce the quantity of goods and services supplied.

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Prices of some goods and services adjust sluggishly in response to changing economic conditions.

An unexpected fall in the price level leaves some firms with higher-than-desired prices. For a variety of reasons, they may not want to or be able to change prices immediately.

This depresses sales, which induces firms to reduce the quantity of goods and services they produce.

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Changes in the overall price level temporarily mislead suppliers about what is happening in the markets in which they sell their output.

A lower price level causes misperceptions about relative prices.

These misperceptions induce suppliers to decrease the quantity of goods and services supplied.

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Aggregate Output

PriceLevel

0

Short-runaggregate

supply

1. A decreasein the pricelevel . . .

2. . . . reduces the quantityof goods and servicessupplied in the short run.

Y

P

Y2

P2

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Output level & price/ output response When the economy is operating at low

levels of output, an increase in aggregate demand is likely to result in an increase in output with little or no increase in the overall price level (e.g. from A to B).

At low levels of aggregate output, the AS curve is fairly flat.

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Capacity constraints Even if firms are not holding excess labor

and capital, the economy may be operating below its capacity if there is cyclical unemployment.

As the economy approaches maximum capacity, firms respond to further increases in demand only by raising prices (e.g. from C to D).

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Response of inputs prices and changes in the overall price level If input prices changed at exactly the

same rate as output prices, the AS curve would be vertical.

Wage rates may increase at exactly the same rate as the overall price level if the price level increase is fully anticipated.

Input prices—particularly wage rates—tend to lag behind increases in output prices for a variety of reasons. 36

Shifts might arise from changes in: Cost shock/ supply shock Economic growth Stagnation and lack of investment Public policy Weather, wars and natural disaster

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Price of other inputs The aggregate supply curve is shifted

to the left by an increase in the price of any inputs to the production process, and it is shifted to the right by any decrease.

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Available supplies of labor and capital As the labor force grows or improves in

quantity, and as investment increase the capital stock, the AS curve shifts to the right, meaning that more output can be produced at any given price level.

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Technology and productivity Improvements in technology may

enable more to be produced at each price and shift the AS curve outward.

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Lack of investment If an economy fails to invest in both

public capital and private capital at a sufficient rate, the stock of capital will decline. Then, the AS curve will shift to the left.

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Government regulation More regulation therefore tends to

increase per-unit production cost and shift the AS curve to the left.

Deregulation will reduce the per-unit cost and shift the AS to the right.

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Change in weather can shift the AS curve.

If an economy is damaged by war or natural disaster, the AS curve will shift to the left.

Whenever part of the resource base of an economy is reduced or destroyed, AS curve shift to the left.

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Aggregate Output

PriceLevel

0

Aggregate demand

3. . . . and the price level to rise.

2. . . . causes output to fall . . .

1. An adverse shift in the short-run aggregate-supply curve . . .

Short-runaggregate

supply, AS

Y

AP

AS2

B

Y2

P2

Continue …

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