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					Chapter 29 - Aggregate Demand and Aggregate Supply



                                    CHAPTER TWENTY-NINE
                  AGGREGATE DEMAND AND AGGREGATE SUPPLY

CHAPTER OVERVIEW
The aggregate expenditures model developed in Chapter 28 is a fixed-price-level model. Its focus is on
changes in real GDP, not on changes in the price level. This chapter introduces a variable-price model
in which it is possible to simultaneously analyze changes in real GDP and the price level. This
distinction should be made explicit for those students who have covered Chapter 28. What students learn
in this chapter will help organize their thoughts about equilibrium GDP, the price level, and government
macroeconomic policies. The tools learned will be applied in later chapters.
The present chapter introduces the concepts of aggregate demand and aggregate supply, explaining the
shapes of the aggregate demand and aggregate supply curves and the forces causing them to shift. The
equilibrium levels of prices and real GDP are considered. Finally, the chapter analyzes the effects of
shifts in the aggregate demand and/or aggregate supply curves on the price level and size of real GDP.
This was Chapter 10 in the 17th edition.

INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:

  1. Define aggregate demand and aggregate supply.
  2. Give three reasons why the aggregate demand curve slopes downward.
  3. State the determinants of the aggregate demand curve‘s location, and explain how the curve will
     shift when one of these determinants changes.
  4. Distinguish between an initial shift in aggregate demand and the full shift after multiplier effects
     have been incorporated.
  5. Explain the shape of the long-run aggregate supply curve.
  6.   Explain the shape of the short-run aggregate supply curve.
  7. Indicate the determinants of the aggregate supply curve‘s location, and explain how the curve will
     shift when one of those determinants changes.
  8. Find an economy‘s equilibrium price level and real domestic output using AD-AS.
  9. Explain how the multiplier effect is weakened when there is demand-pull inflation.
10. Demonstrate and explain how a decrease in aggregate demand can cause a recession without a
    drop in the price level.
11. Demonstrate and explain the effects of shifts in aggregates supply on the equilibrium price level
    and real domestic output of an economy.
12. Explain how an economy can maintain full employment and stable prices under conditions of
    rising aggregate demand.
13. Explain how the impact of oil price fluctuations has changed for the U.S. economy over the past
    couple decades.
14. Define and identify terms and concepts at the end of the chapter and in the appendix.



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Chapter 29 - Aggregate Demand and Aggregate Supply



LECTURE NOTES
I.      Introduction to AD-AS Model
        A. Learning objectives – In this chapter students will learn:
            1. About aggregate demand (AD) and the factors that cause it to change.
            2. About aggregate supply (AS) and the factors that cause it to change.
            3. How AD and AS determine an economy‘s equilibrium price level and level of real GDP.
            4. How the AD-AS model explains periods of demand-pull inflation, cost-push inflation,
               and recession.
        B. AD-AS model is a variable price model. The aggregate expenditures model in Chapter 28
           assumed constant price.
        C. AD-AS model provides insights on inflation, unemployment and economic growth.
II.     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.
        A. The aggregate demand curve is shown in Figure 29.1.
            1. It shows an inverse relationship between price level and real domestic output.
            2. The explanation of the inverse relationship is not the same as for demand for a single
               product, which centered on substitution and income effects.
                a. Substitution effect doesn‘t apply within the scope of domestically produced goods,
                   since there is no substitute for ―everything.‖
                b. Income effect also doesn‘t apply in the aggregate case, since income now varies with
                   aggregate output.
            3. What is the explanation of the inverse relationship between price level and real output in
               aggregate demand?
                a. Real balances effect: When price level falls, the purchasing power of existing
                   financial balances rises, which can increase spending.
                b. Interest-rate effect: A decline in price level means lower interest rates that can
                   increase levels of certain types of spending.
                c. Foreign purchases effect: When price level falls, other things being equal, U.S.
                   prices will fall relative to foreign prices, which will tend to increase spending on
                   U.S. exports and also decrease import spending in favor of U.S. products that
                   compete with imports. (Similar to the substitution effect.)




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Chapter 29 - Aggregate Demand and Aggregate Supply



        B. Determinants of aggregate demand: Determinants are the ―other things‖ (besides price level)
           that can cause a shift or change in demand (see Figure 29.2 in text). Effects of the following
           determinants are discussed in more detail in the text.
            1. Changes in consumer spending, which can be caused by changes in several factors.
                a. Consumer wealth,
                b. Consumer expectations,
                c. Household debt, and
                d. Taxes.
            2. Changes in investment spending, which can be caused by changes in several factors.
                a. Interest rates, and
                b. Expected returns, which are a function of
                               Expected future business conditions
                               Technology
                               Degree of excess capacity
                               Business taxes
            3. Changes in government spending.
            4. Changes in net export spending unrelated to price level, which may be caused by changes
               in other factors such as:
                a. National income abroad, and
                b. Exchange rates: Depreciation of the dollar encourages U.S. exports since U.S.
                   products become less expensive when foreign buyers can obtain more dollars for
                   their currency. Conversely, dollar depreciation discourages import buying in the
                   U.S. because our dollars can‘t be exchanged for as much foreign currency.
III.    Aggregate supply is a schedule or curve showing the level of real domestic output available
        at each possible price level.
        A. Aggregate supply in the long run (Figure 29.5)
            1. In the long run the aggregate supply curve is vertical at the economy‘s full-employment
               output.
            2. The curve is vertical because in the long run resources prices adjust to changes in the
               price level, leaving no incentive for firms to change their output.
        B. Aggregate supply in the short run (Figure 29.4)
            1. The short run aggregate supply curve is upward sloping.
            2. The lag between product prices and resource prices makes it profitable for firms to
               increase output when the price level rises.
            3. To the left of full-employment output, the curve is relatively flat. The relative
               abundance of idle inputs means that firms can increase output without substantial
               increases in production costs.




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Chapter 29 - Aggregate Demand and Aggregate Supply


            4. To the right of full-employment output the curve is relatively steep. Shortages of inputs
               and production bottlenecks will require substantially higher prices to induce firms to
               produce.
            5. References to ―aggregate supply‖ in the remainder of the chapter apply to the short run
               curve unless otherwise noted.
        C. Aggregate supply in the immediate short-run (Figure 29.3)
            1. The aggregate supply curve is horizontal at a given price level due to the rigidity of prices
        D. Determinants of aggregate supply: Determinants are the ―other things‖ besides price level
           that cause changes or shifts in aggregate supply (see Figure 29.6 in text). The following
           determinants are discussed in more detail in the text.
            1. A change in input prices, which can be caused by changes in several factors.
                a. Domestic resource prices
                b. Prices of imported resources, and
                c. Market power in certain industries.
            2. Changes in productivity (productivity = real output / input) can cause changes in per-unit
               production cost (production cost per unit = total input cost / units of output). If
               productivity rises, unit production costs will fall. This can shift aggregate supply to the
               right and lower prices. The reverse is true when productivity falls. Productivity
               improvement is very important in business efforts to reduce costs.
            3. Change in legal-institutional environment, which can be caused by changes in other
               factors.
                a. Business taxes and/or subsidies, and
                b. Government regulation.
IV.     Equilibrium: Real Output and the Price Level
        A. Equilibrium price and quantity are found where the aggregate demand and supply curves
           intersect. (See Key Graph 29.7 for illustration of why quantity will seek equilibrium where
           curves intersect.) (Key Questions 4 and 7)
        B. Try Quick Quiz 29.7.
        C. Increases in aggregate demand cause demand-pull inflation (Figure 29.8).
            1. Increases in aggregate demand increase real output and create upward pressure on prices,
               especially when the economy operates at or above its full employment level of output.
            2. The multiplier effect weakens the further right 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.
        D. Decreases in AD: If AD decreases, recession and cyclical unemployment may result. See
           Figure 29.9. Prices don‘t fall easily.
            1. Fear of price wars keeps prices from being reduced.
            2. Menu costs discourage repeated price changes.
            3. Wage contracts are not flexible so businesses can‘t afford to reduce prices.




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Chapter 29 - Aggregate Demand and Aggregate Supply


            4. Employers are reluctant to cut wages because of impact on employee effort, etc.
               Employers seek to pay efficiency wages – wages that maximize work effort and
               productivity, minimizing cost.
            5. Minimum wage laws keep wages above that level.
            6. CONSIDER THIS … Ratchet Effect
        E. Shifting aggregate supply occurs when a supply determinant changes. (See Key Questions 5,
           6, 7):
            1. Leftward shift in curve illustrates cost-push inflation (see Figure 29.10).
            2. Rightward shift in curve will cause a decline in price level (see Figure 29.11). See text
               for discussion of this desirable outcome.
            3. In the late 1990s, despite strong increases in aggregate demand, prices remained
               relatively stable (low inflation) as aggregate supply shifted right (productivity gains).
V.      LAST WORD: Has the Impact of Oil Prices Diminished?
            A. In the mid- and late 1970s, oil price shocks caused cost-push inflation, rising
               unemployment, and a negative GDP gap (stagflation).
            B. In the late 1980s and through most of the 1990s, oil prices fell, prompting OPEC (along
               with Mexico, Norway, and Russia) to restrict output and raise prices (up to $34 per
               barrel in March 2000). This price shock did not cause the cost-push inflation and
               recessionary conditions as with previous shocks.
            C. In 2005, conflict in the Middle East, combined with rapidly rising demand for oil in India
               and China, pushed oil prices above $60 per barrel (and over $70 per barrel in July 2006).
               U.S. inflation rose in 2005, but not core inflation (inflation rate minus price changes in
               food and energy).
            D. A number of reasons explain why oil price shocks have had less of an impact:
                1. Lower production costs from productivity increases have offset inflationary
                   pressures from oil price increases.
                2. The amount of gas and oil used to produce each dollar of output has declined by
                   about 50 percent since 1970. (from 14,000 BTUs to 7,000 BTUs per dollar of GDP).
                3. Federal reserve monetary policy helped keep oil price increases from becoming
                   generalized.


ANSWERS TO END-OF-CHAPTER QUESTIONS
29-1    Why is the aggregate demand curve downsloping? Specify how your explanation differs from
        the explanation for the downsloping demand curve for a single product. What role does the
        multiplier play in shifts of the aggregate demand curve?
        The aggregate demand (AD) curve shows that as the price level drops, purchases of real domestic
        output increase. The AD curve slopes downward for three reasons. The first is the interest-rate
        effect. We assume the supply of money to be fixed. When the price level increases, more money
        is needed to make purchases and pay for inputs. With the money supply fixed, the increased
        demand for it will drive up its price, the rate of interest. These higher rates will decrease the
        buying of goods with borrowed money, thus decreasing the amount of real output demanded.




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Chapter 29 - Aggregate Demand and Aggregate Supply


        The second reason is the real balances effect. As the price level rises, the real value—the
        purchasing power—of money and other accumulated financial assets (bonds, for instance) will
        decrease. People will therefore become poorer in real terms and decrease the quantity demanded
        of real output.
        The third reason is the foreign purchases effect. As the United States‘ price level rises relative to
        other countries, Americans will buy more abroad in preference to their own output. At the same
        time foreigners, finding American goods and services relatively more expensive, will decrease
        their buying of American exports. Thus, with increased imports and decreased exports,
        American net exports decrease and so, therefore, does the quantity demanded of American real
        output.
        These reasons for the downsloping AD curve have nothing to do with the reasons for the
        downsloping single-product demand curve. In the case of the dropping price of a single product,
        the consumer with a constant money income substitutes more of the now relatively cheaper
        product for those whose prices have not changed. Also, the consumer has become richer in real
        terms, because of the lower price of the one product, and can buy more of it and all other
        products. But with the AD curve, moving down the curve means all prices are dropping—the
        price level is dropping. Therefore, the single-product substitution effect does not apply. Also,
        whereas when dealing with the demand for a single product the consumer‘s income is assumed to
        be fixed, the AD curve specifically excludes this assumption. Movement down the AD curve
        indicates lower prices but, with regard to the circular flow of economic activity, it also indicates
        lower incomes. If prices are dropping, so must the receipts or revenues or incomes of the sellers.
        Thus, a decline in the price level does not necessarily imply an increase in the nominal income of
        the economy as a whole.


        The multiplier acts on an ―initial change in spending‖ to generate an even greater shift in the
        aggregate demand curve. (Figure 29.2)
29-2    Distinguish between ―real-balances effect‖ and ―wealth effect,‖ as the terms are used in this
        chapter. How does each relate to the aggregate demand curve?
         The ―real balances effect‖ refers to the impact of price level on the purchasing power of asset
        balances. If prices decline, the purchasing power of assets will rise, so spending at each income
        level should rise because people‘s assets are more valuable. The reverse outcome would occur at
        higher price levels. The ―real balances effect‖ is one explanation of the inverse relationship
        between price level and quantity of expenditures.
        The ―wealth effect‖ assumes the price level is constant, but a change in consumer wealth causes
        a shift in consumer spending; the aggregate expenditures curve will shift right. For example, the
        value of stock market shares may rise and cause people to feel wealthier and spend more. A
        stock decline can cause a decline in consumer spending.
29-3    What assumptions cause the immediate short-run aggregate supple curve to be horizontal? Why
        is the long-run aggregate supply curve vertical? Explain the shape of the short-run aggregate
        supply curve. Why is the short-run curve relatively flat to the left of the full employment output
        and relatively steep to the right?
        The immediate short-run supply curve is horizontal because of contractual agreements. These
        ‗contracts‘ for both input and output prices imply that prices do not change along the immediate
        short-run aggregate supply curve.




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Chapter 29 - Aggregate Demand and Aggregate Supply


        The long-run aggregate supply curve is vertical (at the full-employment or potential output)
        because the economy‘s potential output is determined by the availability and productivity of real
        resources, not by the price level. The availability and productivity of real resources is reflected
        in the prices of inputs, and in the long run these input prices (including wages) adjust to match
        changes in the price level. Firms have no incentive to increase production to take advantage of
        higher prices if they simultaneously face equally higher resource prices.
        The shape of the short-run supply curve is upsloping. Wages and other input prices adjust more
        slowly than the price level, leaving room for firms to take advantage of these higher prices
        (temporarily) by increasing output. Firms face increasing per unit production costs as they
        increase output, making higher prices necessary to induce them to produce more.
        To the left of full-employment output the curve is relatively flat because of the large amounts of
        unused capacity and idle human resources. Under such conditions, per-unit production costs rise
        slowly because of the relative abundance of available inputs. Additional resources are easily
        brought into production, as the suppliers of these resources (especially labor) are anxious to
        employ them and are happy to accept current prices.
        To the right of full-employment output the curve is relatively steep because most resources are
        already employed. Those resources that are not yet in production require higher prices to induce
        them, or generate higher per-unit production costs because they are less productive than currently
        employed inputs. Firms trying to increase production bid up input prices as they attempt to
        attract resources away from other firms. Even if the firm succeeds in pulling resources from
        another firm, the aggregate increase in output is minimal at best, as resources are merely shifted
        from one productive process to another.


29-4    (Key Question) Suppose that aggregate demand and supply for a hypothetical economy are as
        shown:


                 Amount of                                                 Amount of
                real domestic                                             real domestic
              output demanded,                 Price level               output supplied,
                   billions                   (price index)                  billions

                     $100                            300                       $450
                      200                            250                        400
                      300                            200                        300
                      400                            150                        200
                      500                            100                        100


        a. Use these sets of data to graph the aggregate demand and aggregate supply curves. What is
           the equilibrium price level and the equilibrium level of real output in this hypothetical
           economy? Is the equilibrium real output also necessarily the full-capacity real output?
           Explain.
        b. Why will a price level of 150 not be an equilibrium price level in this economy? Why not
           250?




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Chapter 29 - Aggregate Demand and Aggregate Supply


        c. Suppose that buyers desire to purchase $200 billion of extra real domestic output at each
           price level. Sketch in the new aggregate demand curve as AD1. What factors might cause
           this change in aggregate demand? What is the new equilibrium price level and level of real
           output?
        (a) See the graph. Equilibrium price level = 200. Equilibrium real output = $300 billion. No,
            the full-capacity level of GDP is more likely at $400 billion, where the AS curve starts to
            become steeper.
        (b) At a price level of 150, real GDP supplied is a maximum of $200 billion, less than the real
            GDP demanded of $400 billion. The shortage of real output will drive the price level up. At
            a price level of 250, real GDP supplied is $400 billion, which is more than the real GDP
            demanded of $200 billion. The surplus of real output will drive down the price level.
            Equilibrium occurs at the price level at which AS and AD intersect.
        (c) See the graph. Increases in consumer, investment, government, or net export spending might
            shift the AD curve rightward. New equilibrium price level = 250. New equilibrium GDP =
            $400 billion.




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