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Unit 3:

Aggregate Demand and

Supply and Fiscal Policy

Aggregate Demand

Aggregate Demand Curve Price Level Real domestic output (GDP R )

AD

AD is the demand by consumers, businesses, government, and foreign countries What definitely doesn’t shift the curve? Changes in price level cause a move along the curve = C + I + G + Xn

Why is AD downward sloping?

1. Real-Balance Effect-

• (^) Higher price levels reduce the purchasing

power of money

• (^) This decreases the quantity of expenditures
• (^) Lower price levels increase purchasing power

and increase expenditures

Example:

• (^) If the balance in your bank was $50,000, but inflation erodes your purchasing power, you will likely reduce your spending.
• (^) So…Price Level goes up, GDP demanded goes down.

Why is AD downward sloping?

3. Foreign Trade Effect

• (^) When U.S. price level rises, foreign buyers

purchase fewer U.S. goods and Americans

buy more foreign goods

• (^) Exports fall and imports rise causing real

GDP demanded to fall. (X

N

Decreases)

• (^) Example: If prices triple in the US, Canada will no longer buy US goods causing quantity demanded of US products to fall.
• (^) Again, Price Level goes up, GDP demanded goes down (and Vice Versa). Why is AD downward sloping?

Shifts in Aggregate Demand Price Level Real domestic output (GDP R )

AD

An increase in spending shift AD right, and decrease in spending shifts it left = C + I + G + Xn

AD

1 AD 2

Shifters of Aggregate Demand

1. Change in Consumer Spending Consumer Wealth (Boom in the stock market…) Consumer Expectations (People fear a recession…) Household Indebtedness (More consumer debt…) Taxes (Decrease in income taxes…)
2. Change in Investment Spending Real Interest Rates (Price of borrowing $) (If interest rates increase…) (If interest rates decrease…) Future Business Expectations (High expectations…) Productivity and Technology (New robots…) Business Taxes (Higher corporate taxes means…)

Unit 3:

Aggregate Demand and

Supply and Fiscal Policy

Aggregate SupplyAggregate Supply

Short-Run Aggregate Supply In the Short Run, wages and resource prices will NOT increase as price levels increase. Example:

• (^) If a firm currently makes 100 units that are sold for $1 each. The only cost is $80 of labor. How much is profit?
• (^) Profit = $100 - $80 = $ What happens in the SHORT-RUN if price level doubles?
• (^) Now 100 units sell for $2, TR=$200. How much is profit?
• (^) Profit = $

With higher profits, the firm has the incentive to

increase production. 16

Aggregate Supply Curve Price Level Real domestic output (GDP R )

AS

AS is the production of all the firms in the economy

Long run Aggregate Supply Price level GDP R

In Long Run, price level increases but GDP doesn’t

LRAS

Long-run Aggregate Supply Q Y Full-Employment (Trend Line)

We also assume that in the long run the economy

will be producing at full employment.

19

Shifters Aggregate Supply

I. R. A. P.