Unit 3 - Aggregate Demand (AD) & Aggregate Supply (AS)

Aggregate Demand Curve

AD = C + I + G + Xn

Shows the demand by consumers, businesses, government, and foreign countries.

Changes in the price level cause a move along the curve.

Why is the AD downward sloping?

1. Real-Balance Effect
• Higher price levels reduce the purchasing power of money.
• This decreases the quantity of expenditures.
• Lower price levels increase purchasing power and expenditures.
2. Interest-Rate Effect
• When the price level increases, lenders need to charge higher interest rates to get a REAL return on their loans.
• Higher interest rates discourage consumer spending and business investment.
3. Foreign Trade Effect
• When U.S. price level rises, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods.
• Exports fall and imports rise causing real GDP demanded to fall (Xn decreases).

Shifters of Aggregate Demand

• GDP = C + Ig + G + Xn
• Two parts to a shift in AD:
• A change in C, Ig, G, and/or Xn.
• A multiplier effect that produces a greater change than the original change in the 4 components.
• Increase in AD = AD > 
• Decrease in AD = AD < 
• Consumption
• 
• Household spending is affected by:
• Consumer wealth ( ^ wealth, ^ spending)
• Consumer expectations ( ^ expectations, ^ spending)
• Household indebtedness ( if debt decreases, spending ^) 
• Taxes (if taxes decrease, spending ^)

• Gross Private Investment
• Investment spending is sensitive to:
• Real Interest Rate (if interest rate decreases, investment ^)\
• Expected returns ( ^ expected returns = ^ Investment)
• Influenced by: 
• Expectations of future profitability
• Technology
• Degree of excess capacity
• Business taxes
• Government Spending
• ^ government spending = AD > 
• Decrease in government spending = AD < 
• Net Exports
• Sensitive to:
• Exchange rates (International value of $)
• Strong $ = more imports/fewer exports (AD < )
• Weak $ = fewer imports/more exports (AD > )
• Relative Income
• Strong foreign economy = ^ exports (AD >)
• Weak foreign economy = less exports ( AD < )

Aggregate Supply

• Long Run
• Input prices are completely flexible and adjust to changes in the price-level.
• Real GDP is independent of price-level.
• Short Run
• Input prices are sticky and don't adjust to a change in price-level.
• Level of Real GDP is directly related to price level.
• Long Run Aggregate Supply (LRAS)
• Marks the level of full employment in the economy.
• Because input prices are completely flexible in the long-run, changes in price-level do not change firms' real profits.
• LRAS = Vertical
• Changes in SRAS
• Increase in SRAS = >
• Decrease in SRAS = < 
• Per-Unit cost of production =  total input cost / total output

Determinants of SRAS

• Input prices, productivity, and legal institutional environment affect unit cost per production.
• Input prices
• Domestic Resource prices
• Wages (75% of all business costs)
• Cost of capital
• Raw Materials (Commodity prices)
• Foreign Resource prices
• Market power
• Increase in Resource prices = SRAS < 
• Decrease in Resource prices = SRAS >
• Productivity = Total output / total input
• More productivity = lower unit of production = SRAS >
• Less productivity = higher unit of prodution = SRAS <
• Legal Institutional Environment
• Taxes and subsidies
• Government regulation
• Cost of compliance = SRAS <
• Re-regulation = SRAS > 

Full Employment

• FE Equilibrium exists where AD intersects SRAS and LRAS at the same time.
• Recessionary Gap: When equilibrium point occurs below full employment output.
• Inflationary Gap: When equilibrium point occurs beyond full employment output.
• 
• Classical(Vertical) Range: Inflationary 
• Keynesian(Horizontal) Range: Recession