chapter 8--aggregate demand and aggregate supply · aggregate demand and aggregate supply ......

©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8 1

SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE

Aggregate Demand and Aggregate

Supply

©2005 McGraw-Hill Ryerson Ltd. 2Macroeconomics, Chapter 8

In this chapter you will learn

8.1 What determines the shape of the aggregate demand curve and what factors shift the entire curve

8.2 What determines the shape of the aggregate supply curve, and what factors shift the entire curve

8.3 How the equilibrium price level and real GDP are determined

8.4 How the economy arrives at its long run equilibrium

8.5 Equilibrium vs. full-employment GDP


Chapter 8 Topics

8.1 Aggregate Demand

8.2 Aggregate Supply

8.3 Equilibrium GDP & Changes in

Equilibrium

8.4 From the Short Run to the Long Run

8.5 Equilibrium Versus Full-Employment

GDP


Aggregate Demand (AD)

• The amounts of real output that buyers

collectively desire to purchase at each

possible price level



• Aggregate Quantity Demanded (Real GDP) and

the Price Level are inversely related as follows:P

rice L

eve

l

Real GDP

AD

Figure 8 - 1



• slopes downward because of the

following effects of a change in price

level:

1. Real-balances Effect

2. Interest-rate Effect

3. Foreign Trade EffectRemember: these effects are caused

by price level changes


Pri

ce

le

ve

l

Real domestic output, GDP

AD1

AD Can Increase

Changes in Aggregate DemandFigure 8 - 2


AD Can Increase

shift RIGHT

AD2

Pri

ce

le

ve

l


AD1



Pri

ce

le

ve

l


AD1

AD Can Decrease



Pri

ce

le

ve

l


AD1

AD Can Decrease

shift LEFT


AD3


Determinants of Aggregate Demand

• Consumer Spending

– Consumer wealth

– Consumer expectations

– Taxes

– Household indebtedness



• Investment Spending

– Real Interest Rates

– Expected Returns

• Expectations about future business conditions

• Technology

• Degree of excess capacity

• Business taxes



• Government Spending

• Net Export Spending

– National Income Abroad

– Exchange Rates


Chapter 8 Topics




Equilibrium



GDP


Aggregate Supply

• The level of real domestic output that will

be produced at each price level

• Production responses to price level

changes differ in the long run & the short

run


Aggregate Supply in the Long Run

• in the long run, the aggregate supply curve

is vertical at the economy’s full-

employment output (potential GDP)

ASLR

GDPf

Real domestic

output, GDP

Price

le

ve

l


Aggregate Supply in the Long Run

• in the long run, wages & other input prices

rise or fall to match changes in the price

level

• changes in the price level do not change

real profit & there is no change in real

output


Aggregate Supply in the Short Run

• in reality, nominal wages adjust only slowly to

changes in the price level

• short-run aggregate supply curve is upward-

sloping

GDPf

Real domestic

output, GDP

Price level

AS


Aggregate Supply in the Short Run

• as the economy expands in the short run, per-unit production costs generally rise

• the extent of the rise depends on where the economy is operating, relative to its capacity– an economy operating below its full-employment

output has idle capital & labourlittle upward pressure on production costs

– when the economy is operating beyond its full-employment output, most available resources are already employedper-unit production costs increase as economy expands

unless stated otherwise,

“aggregate supply”

refers to AS in the short

run


Determinants of Aggregate Supply

1. Change in input prices

a. Domestic resource price

b. Price of imported resources

c. Market power

2. Change in productivity

3. Change in legal-institutional environment

a. Business taxes & subsidies

b. Government regulation


Chapter 8 Topics




Equilibrium



GDP


Equilibrium GDP

• Equilibrium occurs at the price level that

equalizes the amount of real output

demanded & supplied

• A price level too low would mean AD>AS,

putting upward pressure on prices across

the economy


Price Level Too Low

AD

ASPrice

Level

Real

GDP

PL1

AS1 AD1

Figure 8-6

upward

pressure


Equilibrium GDP

• similarly, a price level too high would

mean AD<AS, putting downward pressure

on prices across the economy


AD

ASPrice

Level

Real

GDP

PL2

AS2

Price Level Too High

AD2

Figure 8-6

downwar

d

pressure


Changes in Equilibrium

• Are caused by changes (shifts) in AD

and/or AS


Increases in AD

• for any initial increase in aggregate

demand, the resulting increase in real

output will be smaller the greater is the

increase in the price level

• demand-pull inflation…


Increases in AD

AS

AD1

Real GDP

Pri

ce le

vel

AD2

GDPf

P1

GDP2

P2

GDP1

Figure 8-7

output does not

increase all the way

to GDP1 because of

inflation


Decreases in AD

• Deflation is a rarity in the Canadian economy

• Real output takes the full brunt of the decline in

AD because product prices are “sticky” in the

short run

– wage contracts

– morale, effort, & productivity

– minimum wage

– menu costs

– fear of price wars


Decreases in AD

AS

AD1

Real GDP

Pri

ce le

vel

AD2

GDPf

P1

GDP1

Figure 8-8prices are sticky

downwards


Decreases in AS: Cost-Push Inflation

• effects of a leftward shift in AS are doubly

bad

– output decreases

– price level increases


Decreases in AS

AS1

AD1

Real GDP

Pri

ce le

vel

GDPf

P1

GDP2

P2

Figure 8-9

AS2


Increases in AS

• increases in AD should normally lead to

inflation

• recently, productivity growth has shifted

the long-run AS curve to the right


Increases in AS

AS1

AD1

Real GDP

Pri

ce le

vel

GDP1

P1

Figure 8-10

AD2

AS2

P2

GDP3

P3

GDP2


Chapter 8 Topics




Equilibrium



GDP


From the Short Run to the Long Run

• nominal wages & other input prices may

remain constant in the short run, even

though the price level has changed

• once contracts have expired & nominal

wage adjustments have been made, the

economy enters the long run


Short-Run Aggregate Supply

AS1

P1

GDPf Real domestic output

Pri

ce

le

ve

l

a2

a1

Figure 8-11

P2

GDP2

an increase in

price level

increases

profits &

output,

moving the

economy from

a1 to a2


Short-Run Aggregate Supply

AS1

P1

P3

GDP3 GDPf Real domestic output

Pri

ce

le

ve

l

a1

a3

Figure 8-11

a decrease in

price level

decreases

profits &

output,

moving the

economy from

a1 to a3


Long-Run Aggregate Supply

AS1

AS2

P1

P2

GDPf GDP2 Real domestic output

Pri

ce

le

ve

l

ASLR

Figure 8-11

a2

a1

b1

an increase in

price level

leads to

increases in

nominal

wages,

shifting short-

run AS

leftward

new

equilibrium at

b1


Long-Run Aggregate Supply

AS1

P1

P3

AS3

GDP3 GDPf GDP2 Real domestic output

Pri

ce

le

ve

l

ASLR

Figure 8-11a decrease in

price level

leads to

decreases in

nominal

wages,

shifting short-

run AS

rightward

new

equilibrium at

c1

a1

a3

c1


Equilibrium in the Long-Run AD-AS

Model

AS1

P1

GDPf

Pri

ce

le

ve

l

ASLR

a

AD1

Figure 8-12


Chapter 8 Topics




Equilibrium



GDP


Equilibrium Versus Full-Employment

GDP

• There is no guarantee, in the short run,

that equilibrium GDP will be full-

employment GDP


Recessionary Gap

• A recessionary gap occurs when AD is too

low, and equilibrium GDP is below

potential GDP


Pri

ce le

vel

Real GDP

AS

AD1

490

AD0

510

Recessionary

Gap = 20

ASLR

Potential GDP

P0

P1

Recessionary GapFigure 8-13


Inflationary Gap

• An inflationary gap occurs when AD is too

high, and equilibrium GDP is above

potential GDP


Pri

ce le

vel

AS

AD2

530

AD0

510

Inflationary

Gap = 20

P0

P1

Real GDP

ASLR

Potential GDP

Inflationary GapFigure 8-13


Chapter 8 Topics




Equilibrium



GDP

©2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 8 49

Chapter 8 Appendix

The Relationship of the Aggregate

Expenditures Model to the AD-AS

Model


Derivation of AD Curve

• AD can be derived from the Aggregate

Expenditures Model

illustrated…

Ag

gre

gate

ex

pen

dit

ure

s

(bil

lio

ns

of

do

lla

rs)

0

0

Pri

ce level

P1

1

AE 1 at P 1

1'

GDP1

GDP1

Real GDP at

price level 1

Figure A8 - 1

Real GDP

Real GDP

What if

prices go

up?

Real GDP

Real GDP

0

0

GDP1

GDP1

P1

AE1 at P 1

1

1'

P2

GDP2

GDP2

AE2 at P 2

2

2'

A Lower Real

GDP at price

level 2

Ag

gre

gate

ex

pen

dit

ure

s

(bil

lio

ns

of

do

lla

rs)

Pri

ce level

What if

prices go up

again?

Figure A8 - 1

0

0

GDP1

GDP1

P1

AE1 at P 1

1

1'

P2

GDP2

GDP2

AE2 at P 2

2

2'

AE3 at P 3

3

P33'

A Still Lower

Real GDP Level

at price

level 3

Ag

gre

gate

ex

pen

dit

ure

s

(bil

lio

ns

of

do

lla

rs)

Pri

ce level

GDP3

GDP3

Real GDP

Real GDP

Figure A8 - 1

0

0

GDP1

GDP1

P1

1

1'

P2

2

2'

3

P33'

Aggregate Demand

can be derived from AE

Ag

gre

gate

ex

pen

dit

ure

s

(bil

lio

ns

of

do

lla

rs)

Pri

ce level

GDP2

GDP2GDP3

GDP3

Real GDP

Real GDP

AE1 at P 1

AE2 at P 2

AE3 at P 3

Figure A8 - 1


Shifts in AD

• and shifts in Aggregate Expenditure

illustrated…

0

0

GDP1

GDP1

P1

GDP2

GDP2

AE1 at P 1

AE2 at P 1

An Increase

in Aggregate

Expenditures

AD1

An Increase in

Aggregate DemandAD2

Ag

gre

gate

ex

pen

dit

ure

s

(bil

lio

ns

of

do

lla

rs)

Pri

ce level

Real GDP

Real GDP

Figure A8 - 2

chapter 8--aggregate demand and aggregate supply · aggregate demand and aggregate supply ......

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