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Aggregate Demand & Aggregate Supply, Exercises of Macroeconomics

The AD curve is DIFFERENT! ▫Aggregate Demand is a macroeconomic concept. Elements of Macroeconomics ▫ Johns Hopkins University ...

Typology: Exercises

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Aggregate Demand & Aggregate Supply
Adding Swings in the Overall Price Level to the Model
Elements of Macroeconomics ▪ Johns Hopkins University
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Aggregate Demand & Aggregate Supply

Adding Swings in the Overall Price Level to the Model

Outline

  1. Aggregate Demand
  2. Aggregate Supply
  3. Macroeconomic Equilibrium
  • Textbook Readings: Ch. 13

The Aggregate Demand Curve

  • A downward sloping AD curve § As the overall price level falls, the level of output rises

Why the AD Curve is Downward Sloping?

  • Microeconomic theory: § Law of demand: When the price of an individual good falls, demand rises § Assuming all other prices are stable! § Why demand curves slope downward? v Substitution effect – Good is cheaper relative to other goods v Income effect – Increase in purchasing power
  • The AD curve is DIFFERENT! § Aggregate Demand is a macroeconomic concept

Why Fall In Price Level Associated With Higher Output?

  • Wealth Effect : § Some HH wealth is held in nominal assets § As price level rises, real value of HH wealth declines ➞ Less consumption
  • Interest Rate Effect : § When prices rise, HH and firms need more money to finance buying and selling (increase in demand for money) § “Price” of holding money (interest rate) rises, discouraging investments
  • International Trade Effect : § As price level rises, domestic goods become relatively expensive, NX fall

The Wealth Effect Explained

  • Ernie has $20,000 in the bank § Prices: Moped = $8,900 ; TV = $9,200 ; Vacation = $9,
  • He plans to buy two of these three items, after graduation
  • By then, prices leap: Inflation is 20% § New prices: Moped = $10,680 ; TV = $11,040 ; Vacation = $11,
  • Ernie now buys only one of the items

The Interest Rate Effect: Example

  • Bert, Ernie, Big Bird, Miss Piggy and the Count all keep, on average, $5,000 in their checking account to pay bills
  • Prices fall : Inflation is - 1%
  • Now they only need $3,000 in their accounts to pay bills
  • They all buy bonds ➞ Supply of funds rise ➞ Interest rates fall
  • Lower real rates boost investment spending (e.g. home building)

The International Trade Effect Explained

  • As domestic prices go up , foreigners can afford less domestic goods § Exports go down
  • Likewise, foreign goods are relatively cheaper § Imports go up
  • Net exports go down unambiguously

From AE Model to AD-AS Model: A Simple Derivation

  • AE model assumes that the overall price level is fixed § Reflects assumption that there is enough capacity to increase output
  • Here we relax that assumption
  • Prices jump from period 1 to period 2, what happens to AE? § AE line falls at any level of output § Equilibrium is now lower
  • Thus, we can ‘derive’ the AD line by manipulating our AE model

AE Model: ‘Embedded’ in the AD-AS Model

AE Y 𝐴𝐸# Y = AE Y 2 𝐴𝐸$ Y 1 P ↑

Shifts in the AD Curve

  • Demand shock : Unexpected event that causes AD curve to shift
  • AD shifts when: § Government policies change § Expectations of HH and firms about the future change § Foreign variables change

AD Shifts: Changes in Government Policy

  • Changes in government policies could shift aggregate demand
  • Two categories of government policies: 1. Monetary policy : Central bank manages the money supply and interest rates § Example: If it causes interest rates to rise, investment spending will fall 2. Fiscal policy : Government collects taxes (T) and spends (G) on goods and services § Decisions about T and G shift AD curve

AD Shifts: Changes in Expectations

Variables That Shift the Aggregate Demand Curve

AD Shifts: Changes Relative to Foreign Variables

  • In 2015, many emerging economies fell into recessions § Their incomes and spending shrunk § Their imports of U.S. goods fell