ECN 212 Chapter 25, Spring 2007

Aggregate Demand, Aggregate Supply, and Inflation 1 CHAPTER 25 Aggregate Demand Aggregate Demand  Aggregate demand schedule: the quantity of real GDP demanded at each price level  Aggregate demand curve: a graph of the aggregate demand schedule  AD = C + I + G + X - IM 2 Price Level Real GDP 120 100 80 $4.5 $5.0 $5.5 AD 3 Why does AD slope downward?  AD IS THE HORIZONTAL SUM OF MICROECONOMIC DEMANDS  THE MICROECONOMIC DEMAND CURVE SLOPES DOWNWARD  THEREFORE THE HORIZONTAL SUM OF DOWNWARD SLOPING CURVES IS SUPPOSED TO SLOPE DOWNWARD AS WELL 4  ALTHOUGH THE MACROECONOMIC AD CURVE IS NEGATIVELY SLOPED BECAUSE IT IS THE SUM OF NEGATIVELY SLOPED MICROECONOMIC DEMAND CURVES  YET THE REASONINGS BEHIND THE NEGATIVE SLOPE OF MACRO-AD ARE NOT THE SAME AS THAT OF MICRO- DEMANDS 5 REASONINGS_BEHIND_THE MICROECONOMIC_DEMAND  THE INCOME EFFECT  THE SUBSTITUTION EFFECT 6 THE_INCOME_EFFECT  AS PRICE RISES,  INCOMES_HELD_CONSTANT,  THE PURCHASING POWER OF THE FIXED INCOMES FALLS,  PEOPLE DEMAND TO BUY LESS OF ANY COMMODITY,  SO QUANTITY DEMANDED FALLS 7 SUBSTITUTION_EFFECT  AS THE PRICE OF A COMMODITY “A” RISES,  PRICES_OF_OTHER_GOODS_HELD_CONSTANT,  “A” SEEMS TO BE MORE EXPENSIVE THAN OTHER GOODS,  SOME OF THE CUSTOMERS OF “A” SUBSTITUTE OTHER GOODS FOR “A”,  BY BUYING LESS OF “A” AND MORE OF OTHER GOODS,  AS A RESULT, QUANTITY DEMANDED OF “A” FALLS 8 THE_INCOME_EFFECT_CAN_NOT_BE_A_REASONING _BEHIND_THE_NEGATIVE_SLOPE_OF_”AD” (9) TO PROVE THE NEGATIVE SLOPE OF “AD”, WE NEED TO CHECK THAT AS “PL” CHANGES, HOW DOES “Y” CHANGE. A CHANGE IN “Y” MEANS A CHANGE IN INCOME. HOW COME WE CAN PROVE THAT INCOME SHALL CHANGE, WHEN IN THE INCOME EFFECT, WE ASSUME INCOMES TO BE HELD CONSTANT? THE_SUBSTITUTION_EFFECT_CAN_NOT_BE_A REASONING_BEHIND_THE_NEGATIVE SLOPE_OF_”AD”  TO PROVE THE NEGATIVE SLOPE OF “AD”, WE NEED TO CHECK THAT AS “PL” CHANGES, HOW DOES “Y” CHANGE.  HOW COME WE CAN START WITH A CHANGE IN “PL”, WHEN IN THE SUBSTITUTION EFFECT, WE ASSUME PRICES OF MOST GOODS TO BE HELD CONSTANT? (10) THE_RATIONALE_OF DOWNSLOPING_”AD”  THE REASONINGS BEHIND THE NEGATIVE SLOPE OF “AD” ARE  THE INTEREST RATE EFFECT  THE REAL BALANCES EFFECT  THE FOREIGN PURCHASES EFFECT (11) THE INTEREST RATE EFFECT MONEY MARKET i $ SM DM i1 0 12 ASSUME A FIXED SUPPLY OF MONEY. IF PRICE LEVEL  CONSUMERS’ NEED FOR MONEY  PRODUCERS’ NEED FOR MONEY   DM   i  13 MONEY MARKET i $ SM DM i1 0 14 DM’ i1’ AS i  PRODUCERS WOULD WISH TO PRODUCE LESS, SINCE THEIR COST AS INTEREST NOW IS > RATE OF RETURN. CONSUMERS WILL PREFER TO DEPOSIT THEIR MONEY AND EARN HIGH INTERESTS, RATHER THAN BUYING.  REAL NATIONAL OUTPUT  15 REAL BALANCES EFFECT AS “PL”    THE REAL VALUE OF ONE’S WEALTH ( MONEY AT BANK AND BONDS )   SPENDING 16 FOREIGN PURCHASES EFFECT AS “PL”   FOREIGN PRICE LEVELS CONSTANT  CHEAPER PRICES OUTSIDE  IMPORTS  AND EXPORTS   REAL NATIONAL OUTPUT  17 Which of the following is not a macro-economic reasoning? a. As prices fall, people substitute a commodity by another. b. As prices rise, people substitute foreign goods for locally produced goods. c. As prices fall the demand for money falls. d. All of the above. e. None of the above. The correct answer is “a” The aggregate demand curve a. Shows the amount of spending required to entice producers to produce various output levels. b. Is upward-sloping, showing that prices must rise to cover higher costs of production. c. Is downward-sloping, showing that prices will decrease because costs of production decline as more is produced. d. Shows the amount of output that will be purchased at different price levels. e. Shows none of the above. The correct answer is “d” 19 The negative slope of AD a. Is due to changes in purchasing power b. Is not due to changes in purchasing power c. Is due to substitution d. Has the same reasoning of the negative slope of micro-economic demand e. None of the above The correct answer is “b” What shifts the AD curve?  Recall : AD = C + I + G + X - IM  AD shifts rightward when:  C, I, G, or X increases  IM decreases 21 Price Level Real GDP 100 $4.5 $5.0 $5.5 AD 120 80 AD’ 22 Leftward Shifts in AD  AD shifts leftward when:  C, I, G, or X decreases  IM increases 23 Price Level Real GDP 100 $4.5 $5.0 $5.5 AD 120 80 Price Level Real GDP 100 $4.5 $5.0 $5.5 AD 120 80 AD’ 25 Aggregate Demand, Aggregate Supply, and Inflation Aggregate Supply 25 Aggregate Supply  Aggregate supply (AS): the amount of goods firms are willing to produce at a particular price level 24 AGGREGATE SUPPLY KEYNESIAN CLASSICAL INTERMEDIATE AS PL Y 0 25 x YFE Y2’ Y1 Y2 PL1 c a b • AN UNEMPLOYED, WHEN EMPLOYED, DOESN’T ASK FOR A RAISE. • WHEN WE DISCHARGE SOME WORKERS, WE DO NOT REDUCE THE PAY OF THE REMAINING. 29 CLASSICAL RANGE AT FULL EMPLOYMENT, FIRMS WILL EXPAND OUTPUT BY BIDDING RESOURCES AWAY FROM OTHER FIRMS. REAL NATIONAL OUTPUT IS THE OUTPUT OF ALL FIRMS FIRM “A” WILL EXPAND ITS OUTPUT, AT THE EXPENSE OF A REDUCED OUTPUT BY FIRM “B”  NATIONAL OUTPUT SHALL NOT CHANGE, BUT RESOURCE PRICES SHALL RISE  PRICE LEVEL  30 INTERMEDIATE RANGE  NOT ALL INDUSTRIES REACH FULL EMPLOYMENT AT THE SAME TIME  THE INFLATION THAT REACHES IN THE INTERMEDIATE RANGE IS KNOWN AS PREMATURE INFLATION 31 AS PL Y 0 AD A Assume the economy is in equilibrium at point A. An increase in personal income taxes would a. Increase the slope of the aggregate demand curve. b. Decrease the slope of the aggregate demand curve. c. Shift the aggregate supply curve outward. d. Shift the aggregate demand curve to the right. e. Shift the aggregate demand curve to the left. The correct answer is “e” T F On the aggregate supply curve, the vertical range is the Keynesian range. 33 FALSE If the general price level is above equilibrium, then a. The planned spending level is greater than the planned production level and prices will rise. b. The planned spending level is greater than the planned production level and prices will fall c. The planned production level is greater than the planned spending level and prices will fall d. The planned production level is greater than the planned spending level and prices will rise e. None of the above The correct answer is “c” 34 The aggregate demand curve a. Is upward sloping, showing the relationship between the general price level and the total spending level. b. Is downward sloping, showing the relationship between the general price level and the total spending level. c. Is upward sloping, showing the relationship between the general price level and the total quantity of goods and services that will be produced. d. Is downward sloping, showing the relationship between the general price level and the total quantity of goods and services that will be produced. e. Can never be shifted either to the right or to the left. 35 An increase in aggregate demand will cause a. A recession b. The general price level to rise c. The general price level to decrease d. The national output level to decrease e. Our nation’s income to decrease The correct answer is “b” 36 The aggregate supply curve shows the relation between: a. Total output and the marginal costs of production b. Total output and the price level c. Productivity and prices d. Inflation and unemployment The correct answer is “b” 37 END OF CHAPTER Role of Input Prices  Input price: wages, rental rates, land-use fees, etc.  Input prices help determine the shape and location of the AS curve.  Input prices behave differently in the long run than in the short run. 29 Role of Production Function  Production function: an expression that determines how much output can be produced given a certain amount of inputs 30 Real GDP Labor Hours 100 hours $1000 Production of Output Real GDP Labor Hours 100 hours $1000 Input prices determine how many hours of labor are used. Input prices determine how many hours of labor are used. The production function determines how much GDP gets produced. The production function determines how much GDP gets produced. 32 Short Run  Short Run: a period of time during which input prices do not change  Increases in the price level lead to increases in the quantity of output supplied. 33 Price Level Real GDP 100 $4.5 $5.0 $5.5 120 80 AS Shifts in AS  Cost shocks  Economic growth  Lack of investment  Public policy  Weather, wars, natural disasters Shifts in AS Higher wage implies less output Higher wage implies less output AS shift leftward AS shift leftward Price Level Real GDP 100 $4.5 $5.0 $5.5 120 80 AS Price Level Real GDP 100 $4.5 $5.0 $5.5 120 80 AS1 AS2 Shifts in AS Lower wage implies more output Lower wage implies more output AS shift rightward AS shift rightward Price Level Real GDP 100 $4.5 $5.0 $5.5 120 80 AS Price Level Real GDP 100 $4.5 $5.0 $5.5 120 80 AS1 AS2 Long Run  Long run: a period of time during which input prices can change  Increases in the price level do not change the quantity of output supplied  In the long run, there is full employment. Long run aggregate supply (LRAS) is vertical Price Level Real GDP 100 $4.5 $5.0 $5.5 120 80 LRAS Price Level Real GDP 100 $4.5 $5.0 $5.5 120 80 LRAS AS Shifts in LRAS  Shifts occur as the capacity of the economy to produce changes.  Example: decrease in the labor force Shifts in LRAS  Shifts occur as the capacity of the economy to produce changes.  Example: decrease in the labor force Fewer workers means less output Fewer workers means less output LRAS and AS shift leftward LRAS and AS shift leftward Price Level Real GDP 100 $4.5 $5.0 $5.5 120 80 LRAS AS Price Level Real GDP 100 $4.5 $5.0 $5.5 120 80 LRAS AS Putting it Together: Equilibrium  Equilibrium occurs when the quantity demanded of GDP equals the quantity supplied of GDP. Price Level Real GDP 100 $4.5 $5.0 $5.5 120 80 AS AD