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Macroeconomic

Aggregate Demand and


Aggregate Supply
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In this chapter,
look for the answers to these questions:

What are economic fluctuations? What are


their characteristics?
How does the model of aggregate demand
and aggregate supply explain economic
fluctuations?
Why does the Aggregate-Demand curve
slope downward? What shifts the AD curve?
What is the slope of the Aggregate-Supply
curve in the short run? In the long run?
What shifts the AS curve(s)?

Short-Run Economic
Fluctuations
Economic activity fluctuates from year to year.
In most years production of goods and services rises.
On average over the past 50 years, production in the
U.S. economy has grown by about 3 percent per year.
In some years normal growth does not occur, causing a
recession.

A recession is a period of declining real incomes,


and rising unemployment. Since 1965, the U.S.
economy has suffered six recessions.
A depression is a severe recession. The Great
Depression occurred in 1929-1941 when output
fell by about 30 percent and unemployment rose
to 25 percent.

THREE KEY FACTS ABOUT ECONOMIC


FLUCTUATIONS
Economic
fluctuations
irregular and unpredictable.

are

Fluctuations in the economy are often


called the business cycle.

Most macroeconomic variables


fluctuate together.
As output falls, unemployment
rises.

Three Facts About Economic Fluctuations


FACT 1: Economic fluctuations

are irregular and


unpredictable.
U.S. real GDP,
billions of 2005
dollars

The
shaded
bars are
recessions

Three Facts About Economic Fluctuations


FACT 2: Most macroeconomic

quantities fluctuate
together.
Investment
spending,
billions of 2005
dollars

Three Facts About Economic Fluctuations


FACT 3: As output falls,

unemployment rises.
Unemployment
rate,
percent of labor
force

Aggregate Demand and Aggregate Supply

Explaining these fluctuations is


difficult, and the theory of economic
fluctuations is controversial.
Most economists use the model of
aggregate
demand
and
aggregate
supply
to study fluctuations.

The Model of Aggregate Demand and Aggregate Supply


P

The price
level

The model
determines
the eqm
price level
and eqm
output
(real GDP).

SRAS
P1
Aggregate
Demand
Y1

Short-Run
Aggregate
Supply
AD
Y

Real GDP, the


quantity of output

Aggregate Demand
Aggregate demand is the total demand
for goods and services in the economy.
It is the sum of all expenditure in the
economy over a period of time.
Formula:
AD = C+I+G+(X-M)

C= Consumption Spending
I = Investment Spending
G = Government Spending
(X-M) = difference between spending on imports
and receipts from exports (Balance of Payments)

Consumption Expenditure
Exogenous factors affecting consumption:
Tax rates
Incomes short term and expected income over
lifetime
Wage increases
Credit
Interest rates
Wealth
Property
Shares
Savings
Bonds

Investment Expenditure
Spending on:

Machinery
Equipment
Buildings
Infrastructure

Influenced by:

Expected rates of return


Interest rates
Expectations of future sales
Expectations of future inflation rates

Government Spending

Defence
Health
Social Welfare
Education
Foreign Aid
Regions
Industry
Law and Order

Import Spending (negative)


Goods and services bought from abroad
represents an outflow of funds from the UK
(reduces AD)

Export Earnings (Positive)


Goods and services sold abroad represents a
flow of funds into the UK (raises AD)

The Aggregate-Demand (AD) Curve


P
The AD curve
shows the
quantity of
all G&S
demanded
in the economy
at any given
price level.

P2

P1
AD
Y2

Y1

Why the AD Curve Slopes


Downward
P

Y=C+I+G+
NX
Assume G fixed
by govt policy.
To understand
the slope of AD,
must determine
how a change in
P affects C, I, and
NX.

P2

P1
AD
Y2

Y1

The Wealth Effect (P and C )


Suppose P rises.
The dollars people hold buy fewer
g&s, so real wealth is lower.
People feel poorer.
Result: C falls.

The Interest-Rate Effect (P and I )


Suppose P rises.
Buying g&s requires more dollars.
To get these dollars, people sell bonds
or other assets.
This drives up interest rates.
Result: I falls.
(Recall, I depends negatively on
interest rates.)

The Exchange-Rate Effect (P and


NX )
Suppose P rises.
U.S. interest rates rise (the interest-rate
effect).
Foreign investors desire more U.S. bonds.
Higher demand for $ in foreign exchange
market.
U.S. exchange rate appreciates.
U.S. exports more expensive to people abroad,
imports cheaper to U.S. residents.
Result: NX falls.

Changes in Aggregate Demand

Price level

Increase in AD

AD2
Decrease in AD
AD3

Real gross domestic output


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McGraw-Hill Australia Pty

8-21

AD1

Why the AD Curve Might Shift


Any
event
that
changes C, I, G, or NX
except
a change in Pwill
shift the AD curve.
Example:
A stock market boom
makes households feel
wealthier, C rises,
the AD curve shifts
right.

P1

AD1
Y1

Y2

AD2
Y

Why the AD Curve Might Shift


Changes in C
Stock market boom/crash
Preferences re: consumption/saving tradeoff
Tax hikes/cuts

Changes in I
Firms buy new computers, equipment,
factories
Interest rates, monetary policy
Investment Tax Credit or other tax incentives

Why the AD Curve Might Shift


Changes in G
Federal spending, e.g., defense
State & local spending, e.g., roads, schools

Changes in NX
Booms/recessions in countries that buy
our exports
Appreciation/depreciation resulting from
international
speculation
in
foreign
exchange market

Aggregate Supply (AS)


Indicates the level of real GDP that will
be produced at each possible price
level

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McGraw-Hill Australia Pty

8-25

Short-Run Aggregate
Supply Curve
Upward sloping and is constructed on
the basis of two assumptions:
a given price level
nominal wages have been established
on the expectations that the given price
level will persist

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McGraw-Hill Australia Pty

8-26

Short-Run AS
AS1

A2

Price level

P2
A1

P1
P3

Copyright 2004
McGraw-Hill Australia Pty

A3

Q3
QP
Q2
Real gross domestic output
8-27

Aggregate Supply
Inflation

LRAS

Yf

This is because they


Classical
believe that in the
economists
long run, there will be
no
unemployment
of
assume
the long
resources because
run aggregate
markets will clear,
supply
curve
thus whatever
the
rate of inflation,
firms
(LRAS)
is vertical
will
supply the
(perfectly
maximum capacity of
inelastic).
the economy.

Real National Income

Non-Price Determinants of AS
Changes in input prices
Changes in productivity
Changes in the legal and institutional
environment

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McGraw-Hill Australia Pty

8-29

Changes in Short-Run AS
AS2

Price level

Decrease in
Short-run AS

0
Real gross domestic output
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McGraw-Hill Australia Pty

8-30

AS1

Changes in Short-Run AS
AS1

Price level

AS3

Increase in
Short-run AS

0
Real gross domestic output
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McGraw-Hill Australia Pty

8-31

Price level

The AS curve

P2

Classical range;
No multiplier
effect
price response
only
Intermediate range;
Multiplier reduces as
economy approaches full
employment

P1

Keynesian range;
full multiplier effect
Real domestic product
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Copyright 2004
6-32University of Canberra, Australia
Slides prepared by Muni Perumal,
McGraw-Hill Australia Pty

8-32

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