Economics: Unit 3-Chapter 11 & 16: Aggregate Demand and Aggregate Supply and Determinants & LRAS vs. SRAS

Aggregate Demand: Shows the amount of real GDP that the private, public, and foreign sector collectively desire to purchase at each possible price level.

• The relationship between the price level and the level of Real GDP is inverse. 

Aggregate Demand Curve

3 Reasons AD is downward sloping

1. Real-Balances Effect

• When the price level is high, households and businesses cannot afford to purchase as much output.
• When the price level is low, households and businesses can afford to purchase more output.

2. Interest-Rate Effect

• A higher price level increases the interest rate which tends to discourage investment.
• A lower price level decreases the interest rate which tends to encourage investment

3. Foreign-Purchase Effect

• A higher price level increases the demand for relatively cheaper imports
• A lower price level decreases the foreign demand for relatively cheaper exports

Shifts in Aggregate Demand (AD)

There are 2 parts to a shift in AD:

1. A change in C (Personal Consumption), Ig (Gross Private Investment), G (Government Spending), and/or Xn (Net Exports)
2. A multiplier effect that produces a greater change than the original change in the 4 components

An INCREASE in AD = AD shift to the RIGHT
A DECREASE in AD = AD shift to the LEFT

Consumption

• Household spending is affected by: 
• Consumer wealth
• More Wealth = More Spending (AD shift to the right)
• Less Wealth = Less Spending (AD shift to the left)
• Consumer Expectations
• Positive Expectations = More Spending (AD shift to the right)
• Negative Expectations = Less Spending (AD shift to the left)
• Household Indebtedness
• Less Debt = More Sending (AD shift to the right)
• More Debt = Less Spending (AD shift to the left)
• Taxes
• Less Taxes = More Spending (AD shift to the right)
• More Taxes = Less Spending (AD shift to the left)

Gross Private Investment

Investment Spending is sensitive to:

• The Real Interest Rate
• Lower Real Interest Rate = More investment (AD shift to the right)
• Higher Real Interest Rate = Less investment (AD shift to the left)
• Expected Returns
• Higher expected returns = More investment (AD shift to the right)
• Lower expected returns = Less Investment (AD shift to the left)
• Expected returns are influenced by:
• Expectations of future profitability
• Technology
• Degree of Excess Capacity (Existing Stock Capital)
• Business Taxes

Government Spending

• More government spending (AD shift to the right)
• Less government spending (AD shift to the left)

Net Exports

Net Exports are sensitive to:

• Exchange Rates (international value of the dollar)
• Strong Dollar = More imports and fewer exports (AD shift to the left)
• Weak Dollar = Fewer imports and more exports (AD shift to the right)
• Relative Income
• Strong Foreign Economics = More exports (AD shift to the right)
• Weak Foreign Economics = Less exports (AD shift to the left)

Aggregate Supply

Aggregate Supply: The level of Real GDP (Real GDP) that firms will purchase at each price level (PL)

Long-Run vs. Short-Run

Long-Run

• Period of time where input prices are completely flexible and adjust to changes in the price level
• In the long-run, the level of Real GDP supplies is independent of the price-level.

Short-Run

• Period of time where input prices are sticky and do not adjust to change in the price-level.
• In the short-run, the level of Real GDP supplied is directly related to the price level.

Short-Run Graph

Long-Run Graph

Short-Run and Long-Run Integrated Together

Long-Run Aggregate Supply (LRAS)

• The long-run aggregate supply or LRAS marks the level of full employment in the economy (analogous to PPC) changes in SRAS
• An INCREASE in SRAS is seen as a shift to the RIGHT
• A DECREASE in SRAS is seen as a shift to the LEFT
• The key to understanding shifts in SRAS is per unit cost of production
• Per Unit Cost of Production = Total Inputs/Total Outputs

Determinants of SRAS (all of the following affect unit production cost)

• Input Prices
• Domestic Resources Prices
• Wages (75% of all business costs)
• Cost of Capital
• Raw Material (commodity prices)
• Foreign Resource Prices
• Strong Dollar = Lower Foreign Resources Prices
• Weak Dollar = Higher Foreign resources Prices
• Market Power
• Monopolies and cartels that control the use of those resources 

INCREASE in Resource Price = SR shift to the RIGHT

DECREASE in Resource Price = SR shift to the LEFT

Productivity = Total Inputs / Total Outputs

• More productivity = Lower unit-production cost (SRAS shift to the right)
• Less Productivity = Higher unit-production cost (SRAS shift to the left)

Legal-Institutional Environment

• Taxes and Subsidies
• Taxes (money to government) on business increase per unit production cost (SRAS shift to the left)
• Subsidies (money from the government)  to businesses reduce per unit production cost (SRAS shift to the right)
• Government Regulation
• Government regulation creates a cost of compliance (SRAS shift to the left)
• Deregulation reduces compliance cost (SRAS shift to the right)

The AS/AD Model

The AS/AD Model: The equilibrium of AS and AD determine current output (Real GDP) and the price level

Full employment equilibrium: Exists where AD intersects SRAS and LRAS at the same point

Recessionary GDP: Exists when the equilibrium occurs below the full employment output

Inflationary GAP: Exists when equilibrium occurs beyond full employment output

Changes in AD

• Consumption
• An increase in Consumption results in:
• An AD shift to the right
• An increase in Real GDP and Price Level
• A drop in the unemployment rate
• A rise in the inflation rate
• A decrease in Consumption results in:
• An AD shift to the left
• An decrease in Real GDP and Price Level
• A decrease in the unemployment rate
• A fall in the inflation rate
• Gross Domestic Investment
• An increase in Gross Domestic Investment results in:
• An AD shift to the right
• An increase in Real GDP and Price Level
• A drop in the unemployment rate
• A rise in the inflation rate
• A decreases in Gross Domestic Investment results in:
• An AD shift to the left
• A decrease in Real GDP and Price Level
• A rise in the unemployment rate
• A fall in the inflation rate
• Government Spending
• An increase in Government Spending results in:
• An AD shift to the right
• An increase in Real GDP and Price Level
• A drop in the unemployment rate
• A rise in the inflation rate
• A decreases in Government Spending results in:
• An AD shift to the left
• A decrease in Real GDP and Price Level
• A rise in the unemployment rate
• A fall in the inflation rate
• Net Exports
• An increase in Net Exports results in:
• An AD shift to the right
• An increase in Real GDP and Price Level
• A drop in the unemployment rate
• A rise in the inflation rate
• A decreases in Net Exports results in:
• An AD shift to the left
• A decrease in Real GDP and Price Level
• A rise in the unemployment rate
• A fall in the inflation rate

3 Ranges of the Aggregate Supply Curve

1. Horizontal/Keynesian: Includes only levels of Real output that are less than the full employment output.
• Implies that the economy is in a recession, therefore you have a decrease in real output
2. Vertical/Classical Range: The economy reaches its full capacity real output
3. Intermediate Range: There is an expansion of real output price level