Unit 3 Macroeconomics

Chapter 28Aggregate Demand and Aggregate

Supply

I. Aggregate Demand

a) All the goods and services (real GDP) that buyers are willing and able to purchase at different price levels.

1. Inverse relationship2. If the price level:

i. Increases, then real GDP demanded fallsii. Decreases, then real GDP demanded increases

II. Aggregate Demand Curve

III. Why AD is downward sloping

a) Wealth effect of a change in aggregate price level.

1. Higher price level reduces purchasing power and reduces spending

b) Interest rate effect of a change in aggregate price level

1. Higher price level reduces purchasing power of money holdings leading to a rise in interest rates and a fall in spending.

IV. Shifters of Aggregate Demand

IV. Shifters of Aggregate Demand

1. Change in Consumer Spending– Consumer wealth, Taxes, Expectations

2. Change in Investment Spending– Interest Rates, Productivity, Taxes, Expectations

3. Change in Government Spending– War, National Health Care, Infrastructure

4. Change in Net Exports1. Exchange Rates, National Income abroad

V. Aggregate Supply

a) The amount of goods and services (real GDP) that firms will produce in an economy at different price levels.

b) Short-run Aggregate Supply1. Wages and resource prices will not increase as

price levels increase.

c) Long-run Aggregate Supply1. Wages and resource prices will increase as price

levels increase.

VI. Short-Run Aggregate Supply

a) Wages and resource prices will NOT increase as price levels increase.

Example: 1. A firm currently makes 100 units that are sold for $1 each.

The only cost is $80 of labor.2. How much profit? $203. What happens in the SHORT-RUN if price level doubles?4. 100 units sell for $2, how much is profit?5. $1206. With higher profits, the firm has the incentive to increase

production.

VII. Long-Run Aggregate Supply

a) Wages and resources prices WILL increase as price levels increase.

1. The firm has TR of $100 and uses $80 on labor.2. Profit=$203. What happens in the LONG-RUN if price level doubles?4. Now TR = $2005. Workers now demand higher wages to match prices. So

labor costs double to $1606. Profit = $40, but REAL profit is unchanged.7. If REAL profit doesn’t change the firm has no incentive to

increase output.

VIII. Shifters of Aggregate Supply

a) Change in Inflationary Expectations1. If people expect higher prices…..

b) Change in Resource Prices1. Supply Shocks

c) Change in Actions of Government (NOT government spending)

1. Taxes on producer, subsidies, government regs.

d) Change in Productivity1. Technology (teleportation machine)

IX. Short Run Equilibrium

a) Aggregate quantity supplied is equal to aggregate quantity demanded.

X. Long-Run Equilibrium

a) Point of short-run equilibrium is on the long-run aggregate supply curve.

FRQ 2006 AP Test

1. Assume the United States economy is currently operating at an equilibrium below full employment.

a) Draw a correctly labeled graph of aggregate demand and aggregate supply, and show each of the following.

i. Long-run aggregate supplyii. Current equilibrium

b) Now assume a significant increase in the world price of oil, a major production input for the United States. Show on your graph in part (a) how the increase in the oil price affects each of the following in the short run.

i. Short-run aggregate supplyii. Real output and price level

c) Given your answer in part (b), explain what will happen to unemployment in the United States in the short run.