UNIT 3: AGGREGATE DEMAND

 

aggregate demand: shows amount of real GDP that the private, public, and foreign sector collectively desire to purchase at each possible level.

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

reasons why AD is downward sloping:

1. real balance effect: when price levels is high, households and businesses cannot afford to purchase as much output. vice versa.
2.  interest rate effect: higher price level increases interest rate which tends to discourage investment. vice versa.
3. foreign purchase effect: higher price level increases demand for relatively cheaper imports. lower price level increases the foreign demand for relatively cheaper U.S. exports.

 shifts in aggregate demand:

• changes in C, Ig, G, and Xn
• multiplier effect that produces a greater change than the original change in the 4 components. 

increase in AD = AD right
decrease in AD = AD left


consumption:
household spending is affected by

• consumer wealth: more wealth - more spending (AD right) ; less wealth = less spending (AD left)
• consumer expectation: positive expectations = more spending (AD right) ; negative expectation = less spending (AD left)
• household indebtness: less debt = spend more (AD right) ; more debt = less spending (AD left)
• taxes: less tax = more spending (AD right) ; more taxes = less spending (AD left)

gross private investment:
investment spending is sensitive to:
real interest rate:

• lower real interest rate = more investment (AD right)
• higher real interest rate = less investment (AD left)

expected returns:

• higher expected returns = more investment (AD right)
• lower expected returns = less investment (AD left)

expected returns are influenced by:

• expectations of future profitability
• technology
• degree of excess capacity (existing stock of capital)
• business taxes

government spending:

• more gov. spending (AD right)
• less gov. spending (AD left)

net exports:
net exports are sensitive to:
exchange rate (international value of $)

• strong $ = more imports and fewer exports (AD left)
• weak $ = fewer imports and more exports (AD right)

relative income:

• stronger foreign econ. = more exports (AD right)
• weaker foreign econ. = less exports (AD left)

aggregate supply: level of real GDP (GDPr) that firms will produce at price level (PL) ; what is happening in short-run.

long run:

• period of time where input prices are completely flexible and adjust to change in price level. 
• long-run, level of real GDP supplied is independent of price level. 

short run:

• period of time where input prices are sticky and do not adjust to change in price level.
• level of real GDP supplied is directly related to the price level. 

long-run aggregate supply (LRAS)

• long run aggregate supply or LRAS makes the level of full employment in the econ. (analogous to PPC)
• because input prices are completely flexible in long term changes in price level do not change firms' real profits and therefore do no change firms' level of output. this means that LRAS is vertical at econ's level of full employment. 

short-run AS (SRAS):
because input prices are sticky in short run, SRAS is upward sloping.



change in SRAS:
increase SRAS ; shift right
decrease SRAS ; shift left

key to understand shifts in SRAS is per unit cost of production.
formula:   per unit cost = total input cost
                                      total output cost

determinants of SRAS:

• input prices
• productivity
• legal-institutional enviroment

input prices:
domestic resource prices:

• wages (75% of business cost)
• capital cost
• raw material (commodity cost)

foreign resource prices:

• strong $ = lower foreign resource prices
• weak $ = higher foreign resource prices

market power:
monopolies and cartels that control resources control the price of those resources.

increase in resource prices = SRAS left
decrease in resource prices = SRAS right

productivity:
formula:       productivity = total output
                                           total input
more productivity = lower unit production cost (SRAS right)
less productivity = higher unit production cost (SRAS left)

legal-institutional environment:
taxes and subsides:

• taxes ($ to gov) on business increase per unit of production cost = SRAS left
• subsides ($ from gov) to business reduce per unit production cost = SRAS right

gov. regulations:

• gov regulations creates a cost of compliance (SRAS left)
• deregulation reduces compliance cost (SRAS right)

per unit cost of productions:
formula:          per unit cost
                   productivity level