Aggregate Demand and Aggregate Supply

Aggregate Demand

We want to develop a model of the economy that will let us address issues such as what causes a recession and what are sources of inflation. The model will look at demand and supply for the economy as a whole.

Aggregate demand is the total amount of spending at each possible price level. Aggregate demand is equal to consumption spending + investment spending + government spending on goods and services + exports - imports.

The aggregate demand curve is downward sloping:

1. real balances effect - a fall in the price level increase the purchasing power of consumers' wealth so consumption spending rises
2. foreign purchases effect - a fall in the price level makes domestic goods relatively cheaper compared to foreign goods so imports fall and exports rise
3. interest rate effect - a fall in the price level reduces the inflation rate so interest rates fall, meaning that any spending that is interest rate sensitive such as consumption and investment spending rises

Aggregate Supply

Aggregate supply is the level of GDP available at each possible price level.

The aggregate supply curve is upward sloping over much of its relevant range.

Macroeconomic Equilibrium

Equilibrium occurs at the intersection of the aggregate demand and aggregate supply curves. Equilibrium need not be at the full employment level of GDP

Shifts of the AD Curve

Aggregate demand (AD) is the total amount of spending at each possible price level.

AD = C + I + G + EX - IM

• taxes
  • a reduction in taxes leaves households with more disposable income so consumption spending rises  AD increases and the AD curve shifts up to the right
  • a tax increase leaves households with less disposable income to spend  AD decreases and the AD curve shifts down to the left
• interest rates
  • lower interest rates decrease the cost of borrowing money so households and business borrow more to spend and invest in new capital  AD curve shifts up to the right
  • higher interest rates make money more costly for households and businesses to borrow so consumption and investment spending fall  AD curve shifts down to the left
• consumer and business confidence
  • more optimistic  AD curve shifts up to the right
  • more pessimistic  AD curve shifts down to the left
• government spending
  • government spending is one of the components of aggregate demand so an increase in government spending causes AD to increase  AD curve shifts up to the right
  • decrease in government spending  AD curve shifts down to the left
• strength of the dollar
  

  The U.S. economy is linked to the rest of the world through exchange rates. An exchange rate is the price of one national currency in terms of another.

  Suppose an American tourist in Mexico buys a bottle of Kahlua for 85 pesos and that the exchange rate is $1 = 7.9060 pesos. Then, that bottle of Kahlua costs $10.75 in terms of US dollars.

  • If the exchange rate goes to $1 = 8.0230 pesos, the dollar appreciates and a bottle of Kahlua now costs $10.59. Therefore, when the dollar appreciates, foreign goods become less expensive to American buyers and imports rise.
  • If the exchange rate went instead to $1 = 7.5015 pesos, the dollar depreciates and a bottle of Kahlua now costs $11.33. So, when the dollar depreciates, foreign goods become more expensive to American buyers and imports fall.

  Suppose A Mexican tourist in York buys a 6-pack if Yuengling Black and Tan for $5.75. At $1 = 7.9060 pesos, the beer costs 45.46 pesos.

  • When the dollar appreciates to 8.0230 pesos, the beer costs 46.13 pesos. Therefore, when the dollar appreciates, American goods become more expensive to foreign buyers and exports fall.
  • If the dollar depreciates to 7.5015 pesos, the beer costs 43.13 pesos. So, when the dollar depreciates, American goods become less expensive to foreign buyers and exports rise.
    
    So,
  • a rise in the value of the dollar increases imports and reduces exports  AD curve shifts down to the left
  • a fall in the value of the dollar lowers imports and increases exports  AD curve shifts up to the left

Shifts of the AS Curve

• input prices
  • higher input prices AS curve shifts up to the left
  • lower input prices AS curve shifts down to the right
• productivity
  • higher productivity AS curve shifts down to the right
  • lower productivity AS curve shifts up to the left
• government regulation
  • more regulation AS curve shifts up to the left
  • less regulation AS curve shifts down to the right

Causes of Inflation

1. demand-pull inflation - increase in aggregate demand
2. cost-push inflation - decrease in aggregate supply

Causes of a Recession

1. a fall in aggregate demand

   A fall in aggregate demand shifts the AD curve to the left: total spending in the economy decreases at every price level. In response to the fall in demand, some firms lower prices but others reduce output and employment. Real GDP falls below the full employment level.
   

2. decrease in aggregate supply (supply shock)

   A supply shock such as a rise in oil prices causes the AS curve to shift up to the left: the economy's total output falls
   

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