Chapter 22: Aggregate Demand/Supply & Equilibrium
Aggregate Demand/Supply, Curve Shifts, Spending, Factors of Production, Employment
What is a Recession?
A period of significant decline in GDP growth rates & employment lasts more than a few months. Normally, during recessions, production falls, employment falls, and unemployment rises. Historically, inflation tended to rise before recessions and then fall during and after recessions.
What is Aggregate Demand & Supply?
- Aggregate Demand: Total amount of products that consumers (foreign & domestic), businesses (foreign & domestic), and governments are willing/able to buy at each overall level of prices.
- Aggregate Supply: Total amount of production (aggregate quantity supplied) of products that businesses & governments are willing/able to produce at each overall level of prices, given the size & quality of the labor force, the stock of productive capital, and technology.
The quantities & prices used in the aggregate models are quite different from the quantities & prices in the individual market model.
The quantities are all products. We will use real GDP as a measure of those quantities.
The appropriate measure for price is the average price level of all products, which is measured by the GDP price index (also known as the GDP deflator).
Movements Along the Aggregate Quantity Demanded Curve
Now that the model includes all products, it’s difficult to understand how consumers switch from all products to other products. Thus, it’s different than an individual market model.
If overall price level change, there are 3 possible effects on spending: a change in net exports, consumption spending & investment. These changes lead to a change in total spending. All of these are movements along the AD curve.
As our prices increase (assuming all else equal), our exports fall & imports rise. To keep things simple, we assume for now that exchange rates remain unchanged.
Factors that influence consumption spending, include individuals’ incomes, taxes, wealth, desires for saving, expectations & interest rates. The primary way changes in prices affect consumption spending is through the effects on wealth, which affects consumption.
Currency & bank deposits make up a portion of most people’s wealth. If the real value of wealth falls, consumption should fall.
As prices rise, the demand for money rises. The rationale is that as the dollar volume of sales increases, households & businesses need more money to facilitate a higher volume of transactions. The increase in the demand for money causes an increase in interest rates. As interest rates rise, investment spending falls; & one part of total spending decreases. Therefore, higher prices have caused total spending to fall by way of a fall in investment spending.
If prices change consumption, investment, or net exports will change & there will be a movement along the aggregate demand curve.
Shifts in Aggregate Demand
An increase in incomes abroad causes an increase in the quantity demanded at every price level, causing the curve to shift right.
Aggregate demand shifts left when businesses & consumers reduce spending at any given price level. Some businesses will reduce their investment spending, and some individuals will reduce their consumption spending. As these two parts of total spending fall, aggregate demand will decrease.
If consumption, investment, government, or net export spending change for reasons other than changes in prices, the entire aggregate demand curve shifts.
Factors Influencing Aggregate Demand
A Multiplied Effect on Total Spending
What is the Spending Multiplier?
Total spending will change by a multiple of the change in consumption, investment, government, or net export spending. That multiple is the spending multiplier.
The Shape of the Aggregate Supply Curve
Supply for the entire economy is quite like supply in an individual market. Aggregate supply, represents production of all products (real GDP) that will occur at each price.
Supply for the entire economy depends upon prices of all inputs, technology, & availability/quality of all labour/capital.
We assume that labour, capital, technology & prices of inputs are fixed. We then get the aggregate quantity supplied, the relationship between level of output (real GDP) & price level.
The slope of the AS curve depends on the level of real GDP. At low levels, businesses will increase production without price increases because of excess capacity. As spending increases, diminishing marginal product kicks in & it becomes costlier to produce additional units so prices rise. Eventually, economy reaches full capacity & increases in spending only result in price increases with no additional output.
Movement Along the Aggregate Quantity Supplied Curve
An AS curve assumes that the labor force & amount of capital are fixed. A movement along the aggregate supply curve means that businesses are using more or less of the available labour & capital.
Shifts in Aggregate Supply
When the labour force or the skills of the existing labour increases, or the amount of capital increases, aggregate supply will increase (shift to the right).
Improvements in technology cause increases in aggregate supply & a shift to the right.
An increase in input prices will reduce the aggregate supply & shift it to the left.
Equilibrium is when aggregate quantity supplied is equal to aggregate quantity demanded. The economy will always move where spending equals output.
Investment’s Unique Effect on Aggregate Demand/Supply
Effect on Aggregate Demand
The aggregate demand curve shifts right (increases) as investment spending increases.
Effect on Aggregate Supply
Investment increases the amount of capital available to produce products. Aggregate supply depends upon the amounts of labor/capital, and the level of technology. Thus, AS will increase.