Chapter 22 Notes

Aggregate Demand (AD)

- Sum of the demand for all goods and services in the economy.
- Can be seen as the quantity of real Gross Domestic Product (GDP) deman
ded at different price levels.
(AD) = C + I + G + (X - M)
C
I
G
(X

- Consumption
- Investment
- Government Purchases
- M) - Net Exports
Exports - Imports

Aggregate Demand Curve

- Reflects total amount of real goods and services that all groups toget
her want
to purchase in a given time period.
- Slopes downward
An inverse/opposite relationship exists between price level and
real gross domestic
product (RGDP) demanded.
- Increase in price level causes RGDP demanded to fall.
- Decrease in price level, quantity of RGDP demanded rise.
Why Negative Slope?
- Wealth Effect
Consumer spending (C) falls, when price level increase.
Consumer spending rises, when price level decrease.
- Interest Rate Effect
Higher price level raises the interest rate and discourages inve
stment spending
and decreases the quantity of RGDP demnded.
Lower price level reduces the interest rate and encourages inves
tment spending
causing RGDP demanded to rise.
- Open Economy Effect
Many goods and servces are bought and sold in global markets.
Price level in United States rises relative to those in gobal ma
rkets, United States
exports will become relatively less expensive.
If foreign consumers will stop buying United States good, United
States exports
will fall, imports will rise.
Net exports will fall, reducing the amount of RGDP purch
ases in U.S.
Lower price level makes U.S. exports less expensive, foreign imp

orts more expensive.

Increased net exports, increased amount of RGDP purchase
d.
Shift of the Aggregrate Demand
- Increase in C, I, G, (X - M) will cause AD to shift right.
- Decrease in C, I, G, (X - M) will cause AD to shift left.
- Changing Consumption (C)
Shift Right
Increase in consumer confidence.
Increase in wealth.
A tax cut.
Increase in population.
Shift Left
Consumers expect a recession.
Tax increase.
- Changing Investment (I)
Shift Right
Business investment will increase if business confidence
increases,
or real interest rates fall.
Business taxes fall.
Shift Left
Interest rates increase.
Business taxes rise.
- Changing Government Purchase (G)
Shift Right
Increase government purchases, other things held constan
t.
Shift Left
Decrease government purchases, other things held constan
t.
- Changing Net Exports
Shift Right
Economic boom in economies of major trading partners may
lead
to an increase in U.S. exports to them, causing net expo
rts to rise.
Shift Left
Major trading partners are experiencing economic slowdow
ns,
demand fewer U.S. imports.
Aggreate Supply (AS) Curve

- Relationship between total quantity of final goods and services suppli

ers are willing and able
to produce and the overall price level.
- Represents how mcuh RGDP suppliers will be wiilling to produce at diff
erent price levels.
Shifts
Any change in the quantity of any factor of production a
vailable (capital, land,
labor, or technology) can cause
a shift in both the long-run and short-run
aggregate supply curves.
Capital Affects (Shift Right)
Changes in stock of capital will alter the amount of goo
ds and services the
ecnomy can produce.
Investing in capital improves the quantity and quality o
f capital stock,
lowering the cost of production in the short run.
Shift SRAS curve rightward, allows output to be
permanently greater
than before, shifting the LRAS curve rightward,
ceteris paribus.
Human Capital (Shift Right)
Educational or vocational programs, on-thejob training
Causes productivity to rise.
Shift SRAS curve right, more skiller workforce l
owers cost of
production. LRAS curve shifts right, because gre
ater output
is achievable on a permanent or sustainable basi
s, ceteris paribus.
Technology and Entrepreneurship (Shift Right)
Lowers costs, increase productivity.
SRAS and LRAS shifts right by lowering costs and
expanding real
output possibilities.
Land - Natural Resources (Shift Right/Left)
Right - Increase in natural resources - Oil exploratio
n would lower costs of
production and expand economy's sustainable rate of outp
ut,
shifting SRAS and LRAS to the right.
Left - Decrease in available natural resources would sh
ift SRAS and LRAS
left.
Labor Force (Shift Right)
Addition of workers to labor force, ceteris paribus, can
increase aggregate

supply.
Depress wages and increase SRAS, ceteris paribus
.
Increase economy's potential output, increasing
LRAS.
Government Regulations (Shift Right/Left)
Redution in government regulations on businesses would l
ower the costs
of production and expand potential real output.
SRAS and LRAS shift right.
Increases can make it more costly for producers.
Increase in production costs results in left shi
ft of SRAS, and a
reduction in society's potential output shifts L
RAS left.
Short-run Aggregate Supply (SRAS)
Period when output can change in response to supply and demand,
but input prices have not yet been able to adjust
ex: nominal wages are assumers to adjust slowly in the short run
Why Positively Sloped?
- Higher price levels, producers are willing to supply more real
output.
Reasons
Profit Effect
Ouput prices rise relative to input pric
es (cost),
raising producer's short-run profit marg
ins.
Misperception Effect
If producers see the prise of his output
rising and think
the relative price of his output is risi
ng (i.e. his product
becoming more valuable in real terms), h
e will supply more.
- Lower price levels, producers are willing to supply less real
output.
Shifts
Wages, other input prices, non-labor input prices, changes in ex
pected future price level,
and unexpected supply shocks.
Input Prices (Shift Left) - Bad
Increase in input prices.
Higher price levels.
Price level rise, real output falls below potent
ial output.

Higher prices, lower real output, more unemploym

ent, recessionary
gap.
Lower outputs.
Higher rates of unemployment.
Money or Nominal Wages (Shift Left)
Increase without a corresponding increase in labor productivity,
it becomes costlier
for suppliers to produce goods and services at every price level
, causing SRAS to shift left.
Non-labor Input Prices (Shift Right/Left)
Right - Decrease in price of non-labor input (like oil) will lo
wer production costs
(making firms more profitable), and producers will be more willi
ng to
increase supply, shifting SRAS right.
Left - If price steel or oil rises, automobile producers will f
ind it more expensive to do
business because their production costs will rise resulting in a
leftward shift in the
short-run aggregate supply curve.
LRAS will not shift, as long as capacity to make steel h
as not been reduced.
Expected Future Price Level (Shift Right/Left)
If workers and fims believe that the price level is going to inc
rease in near future, they
will adjust their wages and other input prices to compensate for
the price level
increase.
Right - Adjusting to the price level being lower than e
xpected, SRAS will shift
right.
Left - Successful in getting wage increase of labor uni
on members, cause
SRAS to shift left.
Supply Shocks / Unexpected Temporary Events (Shift Right/Left)
Positive supply shocks (favorable weather conditions/temporary p
rice reductions of
imported resources like oil).
Shifts SRAS right.
Negative supply shocks (natural disasters/disruptions in trade d
ue to war/labor strike)
can increase the costs of production.
SRAS shift left, ceteris paribus
Once temporary effects have been felt, no apprec

iable change in
the economy's productive capacity has occurred,
so LRAS does
not shift.
Short-run Equillibrium Level
- Real output and price level are determined by intersection of AD curv
e and SRAS curve.
- When equillibrium occurs at the potential output level, on the long-r
un aggregate supply curve, the
economy is operating at full employment.
- Only at potential output can short-run equillibrium also be a long-ru
n equillibium.
Change
AD curve shifts or SRAS curve shifts right/left.
Long-run equillibrium level of RGDP only changes when LRAS curve
shifts.
Shocks
Unexpected shifts to supply/demand.
Long-run Aggregate Supply (LRAS)
Period long enough for the prices of outputs and all inputs to
fully adjust to changes in the economy.
- Always positioned at natural rate of output, where all resources are f
ully employed (RGDP nr)
- Firms will always produce at maximum sustainable level allowed by thei
r capital, labor, and
technological inputs, regardless of price levels.
Why Vertical?
Two sets of prices are changing: price of outputs and price of i
nputs.
ex: a 10% increase in the price of goods and services i
s matched by a
10% increase in the price of inputs.
Insensitive to price level, relacting the fact that the level of
RGDP producers are
willing to suppy is not affected by changed in price level.
Long-run Equillibrium Level
- Where the economy will settle when undisturbed, and all resources are
fully employed.
- Economy will always be at the intersection of AS and AD but that will
not always be at the natural
rate of output RGDP nr.
- Will only occur were AS and AD interesct along the long-run aggregate
supply curve at the natural,
or potential, rate of output.
Recessionary Gap

Equillibrium can occur at less than the potential output of the economy.
- When RGDP is less than RGDP nr (full capacity). AD is insufficient t
o fully employ all
of society's resources, so unemployment will be above the normal rate.
Inflationary Gap
Equillibrium can temporarily occur beyond potential output.
- At short-run equillibrium, E sr, at RGDP 3, where AD is so high that
the economy is temporarily
operating beyong full capacaity (RGDP nr).
Inflationary Pressure
Unemployment will be below normal rate.
Equillbrium - Best
Economy is just right where AD 2 and SRAS intersect at RGDP nr - the lon
g-run equillibrium position.
Rare - actual and potential RGDP are equal at RGDP nr or the economy ca
n be at a point where
the potential RGDP and actual RGDP are not equal.
Boom - actual RGDP is greater than potential RGDP.
Recession - actual RGDP is less than potential RGDP.
Economy does not often stray far from potential RGDP.
Recent Exception - financial crisis of 2008.
Demand-Pull Inflation
Price level rises as a result of an increase in AD.
Increase in AD causes increase in the price level and an increas
e in real output.
Causes inflationary gap.
Increase in output occurs as result of increase in price level in the sh
ort-run; firms increase real
output when prices of good they are selling rises faster than costs of i
nputs they use in
production.
Potential output: inflationary gap
Causes (Firms)
Encourage workers to work overtime.
Extend hours of part time workers.
Hire recently retired employees.
Reduce frictional unemployment through more extensive searches f
or employees.
Cost-Push Inflation - Recession
AD did not change significantly but price level did, inflation caused by
supply-side forces, not demand.

Shift left in SRAS: Oil price increase

Stagflation
Lower growth and higher prices occurred together.
Some economists believe that this was caused by a left shift in
AS curve.
Increase in Aggregate Demand
Growing population.
Rising income.
Increases in government spending.
Increases in money supply.
Decrease in Aggregate Demand - Recession
Higher unemployment, reduction in output - a recessionary gap.
2001 Corrective Measures - Shift Right (AD)
Continued lower interest rates by the Federal Reserve, stimulati
ng economy by
encouraging investment, consumption spending.
Tax cut passed by Congress in 2001, and increased government spe
nding to help rebuild
New York City and provide financial assistance to the ailing air
line industry.
Recoveries from Recessionary Gap
Increases in aggregate demand - perhaps consumer and business confidenc
e picks up, government
lower taxes and/or lowers interest rates to stimulate economy.
Eventual right shift to AD curve takes economy back to potential RGDP nr
.
Self-Correct (Keynesian) (Shift Right)
Declining wages and prices.
Firms lay off workers to avoid inventory accumulation.
Firms may cut prices to increase demand for their products.
Unemployed workers and other input suppliers will bid down wages
and prices.
- Eventual return to a long-run equillibrium at potential outpu
t and lower price level.
Slow Adjustments
Slow self-correct = wage and price inflexibility.
Sticky Downwards
Long-term labor contract (union workers)
Legal minimum wage.

Employers paying efficiency wages.

Pay employees more than equillbrium wage as a me
ans to increase
efficiency.
Quantity of labor that would be willingly suppli
ed is greater than
the quantity of labor demanded, resulting in gre
ater unemployment.
AD decreases, firms more reluctant to cut wages,
fearing lower morale,
greater absenteeism, and general productivity lo
sses.
Reluctant to lower wages in recession =
downward wage
inflexibility.
Menu costs.
Adjustment to Inflationary Gap
Price level is higher than workers anticipated, and workers' and input s
uppliers'
purchasing power has fallen as output prices rise.
Real wages fall.
Classical Model
Wages and prices adjust quickly to changes in supply and demand.
Say's Law - Jean Baptiste Say - "supply creates its own demand."
Production of goods and services creates incomes for owners of i
nputs (land, labor, capital,
and entrepreneurship) used in production, which in turn creates
a demand for goods.
Need not worry about output not being utilized; production creat
es income, which creates
demand for goods, which leads to still more production.
Establishes full employment can be maintained because total spen
ding will be great enough
for firms to sell all the output a fully employed economy can pr
oduce.
Keynesian Model
Wages and price are inflexible downwar.
Wage stickiness can arise as result of long-term labor, raw material con
tracts, unions, and minimum
wage laws.
If wages/prices are stickey, and the economy has sufficient exce
ss capacity, SRAS is flat =
full employment of all resources is not reached until RGDP nr.
Unemployment
Full employment does not mean zero unemploment; rather it refers to zero
cyclical unemployment.

Some structural and frictional unemployment occurs naturally in a dynami

s and vibrant economy.
If economy is produing at less than potential output, unemployment is gr
eater than natural rate.
If economy is producing at greate than potential putput, unemployment is
less than natural rate.
Causing inflationary pressures.