Aggregate Demand and Aggregate Supply

 Read this introduction to Assignment 12. Then, read Chapter 12, “Aggregate Demand and Aggregate Supply,” on pages 230–248 and 251–253 in your textbook Macroeconomics.

The aggregate expenditures model of the economy that you learned about in Chapter 11 is a fixed-price model that focuses on changes in real GDP, not on changes in the price level. In contrast, this chapter introduces a macro model of the economy that’s based on aggregate demand and aggregate supply. This is a variable-price model in which it’s possible to simultaneously analyze changes in real GDP and the price level. This model can be used to explain real domestic output and the level of prices at any point in time. It can also be used to understand what causes output and the price level to change.

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Aggregate Demand Aggregate demand is a schedule or curve that shows the various amounts of real domestic output that domestic and foreign buyers will desire to purchase at each possible price level. The aggregate demand curve shows an inverse relationship between price level and real domestic output. The explanation of the inverse relationship isn’t the same as for demand for a single product, which centered on substitution and income effects.

The substitution effect doesn’t apply within the scope of domestically produced goods, since there’s no substitute for everything. The income effect also doesn’t apply in the aggregate case, since income now varies with aggregate output. The explanation of the inverse relationship between the price level and the real output in aggregate demand includes real balances effects, interest-rate effects, and foreign purchases effects.



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Changes in Aggregate Demand The aggregate demand curve can increase or decrease due to a change in one of the determinants of aggregate demand, which are the other things (besides price level) that can cause a shift or change in demand. Effects of the following determi- nants are discussed in more detail in the textbook:

n Changes in consumer spending, which can be caused by changes in consumer wealth, consumer expectations, household debt, and taxes

n Changes in investment spending, which can be caused by changes in interest rates and expected returns

n Changes in government spending

n Changes in net export spending unrelated to price level

You’ll learn that there are factors that can cause each determinant to change. The size of the change involves two components. For example, if one of these spending determi- nants increases, then aggregate demand will increase. The change in aggregate demand involves an increase in initial spending plus a multiplier effect that results in a greater change in aggregate demand than the initial change.

Aggregate Supply Aggregate supply is a schedule or curve that shows the level of real domestic output available at each possible price level. In the long run, the aggregate supply curve is vertical at the economy’s full-employment output. The curve is vertical, because in the long run, resources prices adjust to changes in the price level. This leaves no incentive for firms to change their output.

The short-run aggregate supply curve is upward-sloping. The lag between product prices and resource prices makes it profitable for firms to increase output when the price level rises. To the left of full-employment output, the curve is rela- tively flat. The relative abundance of idle inputs means that firms can increase output without substantial increases in production costs. To the right of full-employment output, the



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curve is relatively steep. Shortages of inputs and production bottlenecks will require substantially higher prices to induce firms to produce.

The aggregate supply curve is horizontal at a given price level due to the rigidity of prices. The determinants of aggregate supply are the things besides price level that cause changes or shifts in aggregate supply. The following determinants of aggregate supply are discussed in more detail in the textbook:

n Changes in input prices, which can be caused by changes in domestic resource prices, prices of imported resources, and market power in certain industries

n Changes in productivity, which can cause changes in per-unit production cost

n Changes in the legal or institutional environment, which can be caused by changes in business taxes, subsidies, and government regulation

Changes in Equilibrium Equilibrium real output and the equilibrium price level are found where the aggregate demand and aggregate supply curves intersect. If we assume that the determinants of aggregate supply and aggregate demand don’t change, then there are pressures that will tend to keep the economy at equilibrium. If a determinant changes, then aggregate supply, aggregate demand, or both, may shift.

Increases in aggregate demand will lead to changes in equilibrium real output and the price level. If the economy is operating at or above full employment, the increase in aggregate demand will cause demand-pull inflation. The multiplier effect weakens the farther to the right that the aggregate demand curve moves along the aggregate supply curve. More of the increase in spending is absorbed into price increases instead of generating greater real output. In contrast, if aggregate demand decreases, recession and cyclical unemployment may result.



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Aggregate supply may also increase or decrease. An increase in aggregate supply causes prices to fall, and output and employment increase. In contrast, a decrease in aggregate supply causes the price level to increase, and output and employment fall. This is referred to as cost-push inflation.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 12, as well as the chapter’s online quiz at Compare your answers for the self-check with those at the end of this study guide.

Self-Check 12 Indicate whether each of the following statements is True or False.

______ 1. An increase in imports (independent of a change in the U.S. price level) will increase

both U.S. aggregate supply and U.S. aggregate demand.

______ 2. An increase in business excise taxes will shift the aggregate supply curve to the left.

______ 3. The price level in the United States is more flexible upward than downward.

______ 4. In the immediate short run, both input and output prices are fixed.

______ 5. The equilibrium price level and equilibrium level of real GDP occur at the intersection

of the aggregate demand curve and the aggregate supply curve.

______ 6. The real-balances effect indicates that inflation makes people feel wealthier, and

therefore they spend more out of their current incomes.

______ 7. Other things equal, an increase in productivity will shift the short-run aggregate

supply curve to the right.



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