McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 08Aggregate

Demand and Aggregate

Supply

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Chapter Outline• Aggregate Demand• Aggregate Supply• Shifts in Aggregate Demand

and Aggregate Supply• Causes of Inflation• Supply-Side Economics• How the Government Can

Influence (but probably not control) the Economy

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Aggregate Demand

• Aggregate Demand: the amounts of real domestic output which domestic consumers, businesses, governments, and foreign buyers collectively will desire to purchase at each possible price level

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Figure 1 Aggregate Demand

RGDP

PI

AD

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Why Aggregate Demand is Downward Sloping

• Real Balances Effect• Because higher prices reduce real spending

power, prices and output are negatively related.

• Foreign Purchases Effect• When domestic prices are high, we will export

less to foreign buyers and we will import more from foreign producers. Therefore higher prices leads to less domestic output.

• Interest Rate Effect• higher prices lead to inflation which leads to

less borrowing and a lowering of RGDP

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Aggregate Supply

• Aggregate Supply: the level of real domestic output available at each possible price level

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Figure 2 The Aggregate Supply Curve

RGDP

PI

Keynesian Range

Classical Range

Intermediate Range

AS

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The Ranges of AS• Keynesian Range• Large amounts of unemployment make it so

that increases in aggregate demand have no affect on wages or prices.

• Classical Range• Full employment makes it so that increases in

aggregate demand only increase wages or prices.

• Intermediate Range• Some sectors of the economy reach full

employment more quickly than others.

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Variables that Shift Aggregate Demand

• Taxes• Interest Rates• Confidence• Strength of the Dollar• Government Spending

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Determinants of ADVariable GDP

Component C,I,G,X

Effect of an increase on AD

Effect of a decrease on AD

Taxes C,I Decrease soAD <=

Increase soAD =>

Interest Rates

C,I Decrease soAD <=

Increase soAD =>

Confidence C,I Increase soAD =>

Decrease soAD <=

Strength of the Dollar

X (exports-imports)

Decrease soAD <=

Increase soAD =>

Government Spending

G Increase soAD =>

Decrease soAD <=

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Figure 3 AD Increases

AD’

AS

AD

RGDP

PI

PI*

RGDP*

PI’

RGDP’

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Figure 4 AD Decreases

AD’

AS

AD

RGDP

PI

PI*

RGDP*

PI’

RGDP’

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Variables that Shift AS

• Input Prices• Productivity• Government Regulation

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Determinants of AS

Variable Effect of an Increase on AS

Effect of an Decrease on AS

Input Prices Decrease soAS

Increase so AS

Productivity

Increase so AS

Decrease soAS

Government Regulation

Decrease soAS

Increase so AS

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Figure 5 Increase in AS

AS

AD

RGDP

PI

PI*

RGDP*

AS’

PI’

RGDP’

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Figure 6 Decrease in AS

RGDP

AS

AD

PI

PI*

RGDP*

AS’

PI’

RGDP’

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Causes of Inflation

• Demand Pull Inflation: inflation caused by an increase in aggregate demand

• Cost Push Inflation: inflation caused by a decrease in aggregate supply

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Government Influence: Aggregate Demand

• Government can influence economic activity with aggregate demand side policies affecting:• Taxes• Government Spending• Interest Rates

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Government Influence: Aggregate Supply

• Government can influence economic activity with aggregate supply side policies affecting• input costs (labor and wage)• reducing regulation• Increase incentives to • Work• Take Risks

• The actions are call Supply Side Economics