AP Macroeconomics Unit III Notes Part B

Aggregate Demand and Aggregate Supply

Earlier we learned about supply and demand curves. We learned how these relate to individual products.

Yet the single product supply and demand model does not explain
1) why prices rise or fall in general
2) What determines aggregate (combined) output
3) What determines changes in level of aggregate output.

In order to look at it from a macro level we must combine the prices of all goods. And the equilibrium quantities. This is the aggregate (combined)

Aggregate Demand: is a schedule .... which shows the various amounts of goods and services (Real Domestic Output, Real GDP) which consumers, businesses, governments and foreign buyers collectively will desire to purchase at each price level (CPI, PPI…).

This is the same thing as saying the amount of GDP that all buyers in an economy will buy at all possible levels of prices.

Price levels are measured as price indexes.

However, the inverse relationship does not apply in the same manner as the single demand curve. In the single product demand curve it had an inverse relationship because of the substitution effect (as the price of an item increases the more of a substitute they will purchase and therefore the less of this product they will want, and income effect (the more income one has the more of a product they will demand.)

In the Aggregate model we can not substitute for everything. (things do not become cheaper relative to other products.)
And all income varies with aggregate output. (Because of the circular flow model if the price is higher wages will be higher.)

What then is the explanation for the inverse relationship of the AD curve. (Why is it downward sloping?

1) Wealth, or real balances effect: When prices fall the money that people have will be worth more. (The real value will be worth more.) And vice versa
Ex: If my salary gives me 8,000 dollars in purchasing power I might buy a new car. However, if inflation goes way up and may salary only gives me 4,000 dollars in purchasing power I may not be able to afford the car.

2) Interest Rate Effect: As the price level rises so will the interest rate. This will reduce consumption. (This is because the higher prices means consumers (business, individuals...) will need more money. They will seek to borrow it and this will drive up interest rates. (We will learn about this in detail next unit) Eventually what will happen is that consumers will decide not to make purchases because interest rates are too high.

3) Foreign Purchases (NX) Effect: When price levels in the United States increase this means U.S. prices are higher than foreign prices. Purchase of exports will decrease causing amount of Goods and Services demanded to decrease.

A model should predict 1) Why prices are stable in some periods but surge in others. AD when combined with AS should predict this.

What causes AD curve to shift? (change in AD v. change in quantity of real output demanded)
Known as Determinants of Aggregate Demand because they determine the location of the demand curve.

1) Change in consumer spending caused by changes in

a) consumer wealth: When people have less money to save. This causes the curve to shift to the left. (decrease in AD) This has nothing to do with price. This is a change in real income due to non-market factors. (Decrease in stock prices will lead to less wealth.)

b) consumer expectations: If people think that their future income will decrease or that inflation will decrease (it will be cheaper to buy later) they will spend less now. This will cause the AD curve to shift left. This is why they poll people about consumer confidence.

c) Consumer indebtedness: If people have spent a lot in the past and are in debt they are going to spend less now. This will shift the curve to the left.

d) Taxes (Fiscal Policy): If taxes increase the people have less money and will then spend less. AD shifts to the left

e) interest rates (monetary policy): When interest rates increase AD decreases

C, D and E (above) all affect disposable income

2) Change in investment spending: people (businesses) changing spending on capital goods will affect AD curve.

a) Interest Rates: Increase in interest rates will decrease AD (Business will buy less capital goods). This in not the interest rate effect. It has nothing to do with the price. Rather it has to do with changes in interest rates through something like a change in the money supply (which we will learn later).

b) profit expectations on Investment projects: If the business foresee profits for investment they will increase demand for consumer goods. This will shift the AD curve.

If we are in a huge depression and i is = 0, business will still not increase I unless they have expectations for a good return on investment.

c) Business Taxes: Increase business taxes will lead to a decrease in investment spending and the AD curve will shift to left.

d) technology: new technology increases investment spending.

e) Amount of excess capacity: If they are not using the capital they have they will not purchase new capital. This will cause a decrease in AD. If they are at full capacity then they will increase I.

3) Change in government spending: Increased government spending (without change in taxes or interest rates) will increase AD. This could be a planned Fiscal policy move or they may just want to increase G. (give more money to education....)

4) Change in net exports (unrelated to price level)

a) income abroad: Increase in foreign demand will cause an increase in AD for U.S.

STRESS THIS! It will be on A.P. test.

b) Exchange Rates: If the dollar becomes worth less (depreciates) in terms to anther currency. This means they have more real income and our AD will increase.

Higher I means more Xn which makes AD increase.
Aggregate Supply: is a schedule, showing the level of real domestic output available at each possible price level.

There are three parts the AS curve.
1) Keynesian (Horizontal) Range: Here price level remains constant with substantial + output variation. The economy is below full employment and will therefore have excess capacity. This means production can be increased without fear of having costs increase.

2) Classical (Vertical) Range: The economy is at full employment and any attempt to increase production will increase prices. Real domestic output will be constant.
3) Intermediate (Upsloping) Range: Expansion of real output is accompanied by a rising price level.
Determinants of Aggregate Supply:

1) Change in input prices:
a) availability of resources: (land, labor, capital and entrepreneuralship) if these resources are more expensive the production costs increase and AS will decrease (shift left)
b) price of imported resources: If the prices increase the AS curve will decrease

c) Market power: The ability to set a price above the point that would be reached in a competitive environment. (If Oil Cartel increases prices the production costs increase. If unions increase prices the production costs increase.)

2) Changes in productivity: (technology)
Productivity = real output/input If per unit cost decrease the companies become more productive and therefore will be willing to supply more. A shift in AS to the right.

3) Change in legal-institutional environment:
a) Business taxes and subsidies: Higher taxes lead to increase unit costs. This means the AS will decrease (shift left)

b) Government Regulation: Increase government regulations will lead to increased production costs. This will mean a decrease in AS.

Equilibrium price level and Equilibrium real domestic output
The intersection of these two is the equilibrium point.

Equilibrium: situation in which there are no forces that will produce change among the variables considered.
In the Keynesian Range the economy is at less than full employment. This means that an increase in AD will not cause an increase in priced because firms just employ those resources that are remaining idol. (Workers out of work will not expect a wage increase)

In the classical range the economy is fully employed. It is on its production possibility curve. Any increase in AD will cause an increase in price with no increase in output.

In intermediate and classical ranges, demand-pull inflation occurs with the increase in aggregate demand. This means shifts in aggregate demand are pulling up the price level. (The increase in price is caused by the increase in aggregate demand.)
The long run AS curve is a vertical line indicating the amount of goods and services a nation can produce using all of its productive resources as efficiently as possible.

The Long Run AS curve is at full employment.

The LRAS curve also assumes that the nation is using all of the productive technologies available to it. In this manner it is similar to the productive possibilities curve. The LRAS curve moves outward when there is economic growth, but it is still a vertical line.
As Disposable Income increases consumption increases. Does this make sense? Of course.

As we make more and more money we tend to spend more and more.
Consumption (C) + Savings (S) = Disposable Income (DI)

DI - C = Savings.

Average Propensity to Consume = Consumption (C) /Income (Y)
APC= C/Y
This is the fraction of total income that is consumed

Average Propensity to Save = Savings (S)/Income (Y)
APS= S/Y
This is the fraction of total income that is saved.
APC + APS = 1

Once we know the average propensities we must then calculate the marginals. These tell us how much they will consume/save when income changes.

MPC = change in consumption/change in income

MPS = change in savings/change in income.

The MPC is the numerical value of the slope of the C schedule.

MPC + MPS = 1

Conclusions:
1) The sums of income and consumption appear to be approaching specific numbers. (a total will be found)

2) Income increases greater than consumption increases by an amount equal to the new income initially introduced. (When they are added together income will be x greater than consumption. x is the original amount introduced.)

3) Income and consumption both increase by a multiple of the original change in income. (both divisible by same amount: total divided original.)

4) The MPC is important because it determines the size of the multiplier by which income changes.

An algebraic formula has been developed that permits much quicker calculation for the amount by which total income changes when someone injects new spending into the economy. The formula, called the multiplier, is defined as follows:

Multiplier = 1/ (1-MPC)