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Chapter 20 Aggregate

Demand and Supply• Key Concepts• Summary• Practice Quiz• Internet Exercises

©2002 South-Western College Publishing

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What is the aggregate demand curve?

The curve shows the level of real GDP purchased by households, businesses, government, and foreigners at different price levels during a time period, ceteris paribus

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What does the horizontal axis

measure? The value of final goods and services included in real GDP measured in base year dollars

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What does the vertical axis measure?

It is an index of the overall price level, such as the GDP deflator or the CPI

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Why does the aggregate demand

curve slope downward to the right?

• Real balance wealth effect• Interest rate effect• Net exports effect

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What is thereal balance effect?

Consumers spend more on goods and services because lower prices make their dollars more valuable

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What is theinterest rate effect?Assuming fixed credit, an increase in the price level translates through higher interest rates into a lower real GDP

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What is thenet exports effect?

A higher domestic price level makes U.S. goods more expensive compared to foreign goods, exports decrease, imports increase, decreasing real GDP

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$200

$150

$100

$50

2 4 6 8

B

A

1210

AD

Pri

ce L

evel

Real GDP

The Aggregate Demand Curve

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What can cause a shift in the aggregate

demand curve?Consumption, investments, government spending and net exports can change

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200

150

100

50

2 4 6 8

BA

Real GDP

1210

AD2AD1

Pri

ce L

evel

(C

PI)

A Shift in the Aggregate Demand Curve

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What is theaggregate supply

curve?The curve that shows the level of real GDP produced at different price levels during a time period, ceteris paribus

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Why did Keynes assume fixed product

prices and wages?During a deep recession or depression, there are many idle resources in the economy

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Why do idle resources mean fixed prices?

Producers are willing to sell additional output at current prices because there is plenty of resources to go around for everyone who wants them

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Why do idle resources mean fixed wages?

The supply of unemployed workers willing to work for the prevailing wage rate diminishes the power of workers to increase their wages

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What kind of supply curve would explain

fixed prices and wages?

A horizontal supply curve

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200

150

100

50

2 4 6 8

E2E1

Real GDP

Pri

ce L

evel

(C

PI)

1210

ASAD2

AD1

The Keynesian Horizontal Aggregate Supply Curve

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Government spending (G)

increases

Aggregate demand increases and the economy moves

from E1 to E2

Price level remains constant, while real

GDP and employment rise

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According to Keynes, what will a shift in

aggregate demand do?It will restore a

depressed economy to full employment

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200

150

100

50

2 4 6 8

E2E1

Real GDP

Pri

ce L

evel

(C

PI)

1210

AS

AD2AD1

The Keynesian Horizontal Aggregate Supply Curve

full employment

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What is the Classical view of the aggregate

supply curve?It is a vertical line at the full employment output

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According to the Classical economists,

where does the economy normally

operate? The economy normally operates at its full employment level

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How do the Classical

economists view prices and costs?

The price level of products and production costs change by the same percentage in order to maintain full employment

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200

150

100

50

2 4 6 8AD2

E2

E1

AD1

10 12 14 16Real GDP

Full employment

The Classical Aggregate Supply Curve

ASP

rice

Lev

el (

CP

I)

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Surplus

E

25YK

Real GDP

Keynesian Range

Three Ranges of the Aggregate Supply CurveAS

Pri

ce L

evel

Intermediate Range

Classical Range

YF

Full Employment

262 4 6 8 10 12

AS

0

50

100

150

200

Full Employment

Pri

ce L

evel

AD1

AD2AD3

AD4

AD6

AD5

Real GDP

Increasing Demand

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What factors can cause a shift in the

aggregate supply curve?

A change in• resource prices• technology• taxes• subsidies• regulations

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200

150

100

50

2 4 6 8 10 12 14 16

full employment

A Rightward Shift in the Aggregate Supply Curve

AS1P

rice

Lev

el

17

AD

E1

E2

AS2

Real GDP

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Change in one or more nonprice-level determinants: resource prices, technological change,

taxes, subsidies, and regulations

Increase in the aggregate supply curve

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What are the two types of inflation?

• Cost push• Demand pull

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What iscost push inflation?A rise in the general price level resulting from an increase in the cost of production

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200

150

100

50

2 4 6 8 10 12 14 16

full employment

Cost Push Inflation

Pri

ce L

evel

17

ADE1

E2

AS1

Real GDP

AS2

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What isdemand pull inflation?A rise in the general price level resulting from an excess of total spending

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200

150

100

50

2 4 6 8 10 12 14 16

full employment

Demand Pull Inflation

Pri

ce L

evel

17

AD1

E1

E2

AS

Real GDP

AD2

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What determines the business cycle?

Shifts in the aggregate demand and aggregate supply curves

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Key Concepts

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Key Concepts• What is the aggregate demand curve?• Why does the aggregate demand curve slope

downward to the right?• What can cause a shift in the aggregate dem

and curve?• What is the aggregate supply curve?• Why did Keynes assume fixed product prices

and wages?• What kind of supply curve would explain fixed

prices and wages?

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Key Concepts cont.• According to Keynes, what will a shift in aggreg

ate demand do?• What is the Classical view of the aggregate sup

ply curve?• According to the Classical economists, where d

oes the economy normally operate?• What factors can cause a shift in the

aggregate supply curve?• What are the two types of inflation?

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Summary

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The aggregate demand curve shows the level of real GDP purchased in the economy at different price levels during a period of time.

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Reasons why the aggregate demand curve is downward-sloping include the following three effects:

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(1) The real balances or wealth effect is the impact on real GDP caused by the inverse relationship between the purchasing power of fixed value financial assets and inflation, which causes a shift in the consumption schedule.

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(2) The interest-rate effect assumes a fixed money supply, and, therefore, inflation increases the demand for money. As the demand for money increases, the interest rate rises, causing consumption and investment spending to fall.

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(3) The net exports effect is the impact on real GDP caused by the inverse relationship between net exports and inflation. An increase in the U.S. price level tends to reduce U.S. exports and increase imports, and vice versa.

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200

150

100

50

2 4 6 8

BA

Real GDP

1210

AD2AD1

Pri

ce L

evel

(C

PI)

A Shift in the Aggregate Demand Curve

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The aggregate supply curve shows the level of real GDP that the economy will produce at different possible price levels.

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The shape of the aggregate supply curve depends on the flexibility of prices and wages as real GDP expands and contracts. The aggregate supply curve has three ranges:

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(1) The Keynesian range of the curve is horizontal because neither the price level nor production costs will increase when there is substantial unemployment in the economy.

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(2) In the intermediate range, both prices and costs rise as real GDP rises toward full employment. Prices and production costs rise because of bottlenecks, the stronger bargaining power of labor, and the utilization of less productive workers and capital

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(3) The classical range is the vertical segment of the aggregate supply curve. It coincides with the full-employment output. Because output is at its maximum, increases in aggregate demand will only cause a rise in the price level.

51YK

Real GDP

Keynesian Range

Three Ranges of the Aggregate Supply CurveAS

Pri

ce L

evel

Intermediate Range

Classical Range

YF

Full Employment

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Aggregate demand and aggregate supply analysis determines the equilibrium price level and the equilibrium real GDP by the intersection of the aggregate demand and the aggregate supply curves.

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Stagflation exists when an economy experiences inflation and unemployment simultaneously. Holding aggregate demand constant, a decrease in aggregate supply results in the unhealthy condition of a rise in the price level and a fall in real GDP and employment.

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Cost-push inflation is inflation that results from a decrease in the aggregate supply curve while the aggregate demand curve remains fixed.

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Cost-push inflation is undesirable because it is accompanied by declines in both real GDP and employment.

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200

150

100

50

2 4 6 8 10 12 14 16

Cost Push Inflation

Pri

ce L

evel

17

AD

E2

AS1

Real GDP

full employment

E1

AS2

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Demand-pull inflation is inflation that results from an increase in the aggregate demand curve in both the classical and the intermediate ranges of the aggregate supply curve while the aggregate supply curve is fixed.

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200

150

100

50

2 4 6 8 10 12 14 16

Demand Pull Inflation

Pri

ce L

evel

17

AD1

E1

E2

AS

Real GDP

AD2

full employment

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END