Aggregate Demand & Aggregate Supply, Exercises of Macroeconomics

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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