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The Product Demand curve is determined by:

The Law of Demand The substitution effect The income effect

The Aggregate Demand curve is the relationship between all spending on domestic output and the average price level of that output
It is NOT the summation of all of the individual demand curves for the products produced in an economy Instead, it shows how domestic spending changes when the overall level of prices changes

AD measures the sum of

Consumption spending by households (C) Investment spending by business firms (I) Government purchases of goods and services (G) Net exports purchased by foreign consumers (X M)

The Substitution Effect and the shape of the product demand curve
When the price of coffee increases, consumers substitute consumption of tea, Red Bull, Jolt, etc. for their consumption of coffee. This causes the product demand curve to slope downward

If the price level is increasing, the price of coffee, tea, Red Bull, Jolt, etc. may all be rising. Why would the AD curve also have a downward slope?

There are three general groups of substitutes for national output that would cause the AD curve to slope downward
Foreign Sector Substitution effect
x When the average price of US output rises, US consumers look for similar items produced elsewhere x The increase in imports causes net exports to fall and GDP to fall x US items sold in foreign markets likewise become less attractive, causing exports to fall. x This decrease in exports lowers net exports further, also causing GDP to fall

The Interest Rate effect

x If the average price level rises, consumers are more likely to need to borrow to purchase large ticket items such as automobiles or college educations x When the number of households who need to borrow increases, interest rates rise. x Firms postpone investment in plants (factories) and equipment and households postpone their purchases of more expensive items x This reduces the Investment and Consumption components of GDP

The Wealth effect

x Wealth is the value of accumulated assets such as stocks, bonds, savings and, especially, cash on hand x As the average price level increases, the purchasing power of wealth begins to fall x This causes the quantity of domestic output purchased (C) to fall.
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Thus, a downward sloping aggregate demand curve is a consequence of the following substitution effects
Foreign sector Interest rate Wealth

Price Level

As the price level rises, consumption of domestic output (real GDP) falls. This is seen as a movement from point A to point B.

AD

Real GDP

Price Level

Decreased AD

Increased AD

AD1

AD2

AD3

Real GDP

In order to stimulate AD, we need to increase

Consumer Spending (C). This is accomplished by x Increasing disposable income and greater consumer optimism Investment (I). This is accomplished by x An increase in return on investment x Lower borrowing costs x Greater business optimism Government Spending (G). This is accomplished by x Increased government purchases of goods and services x Lower taxes x Increasing transfer payments Net Exports (X M). This is accomplished by x Increasing foreign incomes (foreign GDPs) which increase exports x Increasing foreign consumer preferences for US goods x A weak (cheap) dollar makes US goods more attractive in foreign markets

Aggregate Supply is the relationship between the average level of domestic prices and the level of domestic output produced The model of AS and the resulting AS curve depends upon whether the economy has adjusted to market forces and price changes This gives rise to two supply curves:
The Short Run Aggregate Supply curve
x Input prices have not adjusted to product market changes

The Long Run Aggregate Supply curve

x Input prices have fully adjusted to market forces

The shape of the Short-Run Aggregate Supply curve (SRAS) in determined by the lag between the increase in output prices and the increase in input prices. This creates an SRAS that can be described in three stages:
Stage 1:
x The economy is in recession with low levels of GDP, GDP(u), and many unemployed resources. x Increasing output puts little pressure on input costs and minimal increase on the overall price level.

Stage 2:
x GDP approaches full employment, GDP(f), and available resources become more difficult to find x If the price level rises faster than input costs, producers have an incentive to increase output x Most of the time the economy operates within this range

Stage 3:
x As the economy approaches the nations productive capacity, GDP (c), firms cannot find unemployed resources x Input costs and the price level rise sharply and the SRAS becomes almost vertical

Price Level

Short-Run AS

Stage 1

Stage 2

Stage 3 Real GDP

In the period of time referred to as the macroeconomic long-run, input prices have fully adjusted to market forces
All product and input markets are in equilibrium The economy is at full employment

In this long-run equilibrium, the LRAS curve is vertical at full employment, GDP(f) According to the Classical School of economics, the economy always gravitates to this point

Price Level

Long-Run AS

Short-Run AS

Real GDP GDP(u) GDP(f) GDP(c)

The most common factor that shifts the Short-Run AS curve is an economy-wide change in input prices
Input prices:
x If input prices fall, SRAS increases without changing the fullemployment level of GDP

Tax policy
x If taxes aimed at producers, supply side taxes, are lowered, SRAS increases

Deregulation
x The regulation of industries can restrict their ability to produce. If regulations are relaxed, SRAS can increase

Political or Environmental phenomena

x In an economy as large as the US, wars (ex, Iraq, Afghanistan), and natural disasters (ex, Hurricane Katrina), can decrease the SRAS without affecting the permanent level of full employment

These factors affect both the LRAS and the SRAS and fundamentally affect the level of full employment in a nations economy
Availability of resources
x A larger labor force x More widely available natural resources x Larger stock of capital goods

Technology and Productivity

x Better technology raises the productivity of both labor and capital x Better training and education increases labor productivity

Policy Incentives
x Unemployment insurance provides an incentive for more people to join the labor force x Tax incentives to invest in technology or capital goods cause GDP(f) to rise

Price Level

1990 Long-Run AS

2000 Long-Run AS

1990 Short-Run AS

2000 Short-Run AS

Real GDP 1990 GDP(f) 2000 GDP(f)

When the quantity of real output demanded is equal to the quantity of real output supplied, the macro economy is said to be in equilibrium Gaps
When the economy is in equilibrium, but not at the level of GDP that corresponds to full employment (GDP(f)), the economy is experiencing either a recessionary or inflationary gap.

LRAS SRAS Price Level AD

Recessionary Gap Real GDP GDP(r) GDP(f)

A recessionary gap exists when the economy is operating below the full employment level of GDP
The risk to the economy is too low a level of unemployment

The amount of the recessionary gap is the difference between current GDP and full employment GDP
Please note: A recessionary gap is measured in terms of GDP differences. It is expressed in dollar amounts It represents the amount that GDP must rise to achieve full employment

LRAS Price Level

SRAS

Inflationary Gap

AD

Real GDP GDP(f) GDP(i)

An inflationary gap exists when the economy is operating above the full employment level of GDP
The risk to the economy is too high an increase in the price level

The amount of the inflationary gap is the difference between current GDP and full employment GDP
Please note: An inflationary gap is also measured in terms of GDP differences. It is expressed in dollar amounts It represents the dollar amount real GDP must fall to avoid too high a level of price inflation

If the economy is in equilibrium at a low level of GDP, increases in AD will reduce unemployment but not raise prices If AD moves beyond the full employment level of GDP, the price level begins to rise as consumption increases throughout the economy.
This is referred to as demand-pull inflation

If AD continues to increase major increases in the price level accompany decreasing increases in real GDP

AD(3) Price Level AD(2) AD(1)

LRAS SRAS

PL(3)

PL(2) PL(1)

Real GDP GDP(r) GDP(f) GDP(i)

The full multiplier effect is only observed if the economy is operating on the horizontal (Stage 1 or Keynesian) segment of the SRAS curve. In other words, the multiplier effect is smaller if there is an increase in the price level.

AD(3) Price Level AD(0) AD(2) AD(1)

LRAS

SRAS

PL(0 and1) 1 GDP (r1) GDP(r2) 2 GDP(f) 3 GDP(i)

As GDP goes up, higher domestic incomes cause import demand to rise, reducing net exports As incomes rise, progressive taxes increase the tax burden on consumers, reducing the absolute impact of the increase in pre-tax income As a result, estimates of the spending multipliers actual impact range from a high of 2 to a low of .8

If input prices temporarily fall and the AD curve does not shift,
The price level falls, Real GDP increases, and The unemployment level falls

This is a Supply Side Boom: the best of all possible macroeconomic situations. If AS increases because of more permanent factors such as increased productivity or better technology, the LRAS curve and the level of full employment both increase

Price Level

1990 Long-Run AS

2000 Long-Run AS

1990 Short-Run AS

2000 Short-Run AS

Real GDP 1990 GDP(f) 2000 GDP(f)

If a supply-side boom is the best of macroeconomic outcomes, a Cost-Push Inflation or Stagflation is the worst This is caused when input costs increase, shifting the SRAS curve inward
If there is a permanent decline in resource availability or productivity, the LRAS curve also shifts inward

This causes inflation, higher unemployment and lower GDP

Price Level

1980 Long-Run AS

1976 Long-Run AS

1980 Short-Run AS

1976 Short-Run AS

Real GDP 1980 GDP(f) 1976 GDP(f)

These shifts in AS are called Supply Shocks

Higher productivity or lower energy prices would be positive shocks OPEC oil embargoes or the 1990-91 Gulf War were negative shocks

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If AD goes up, real GDP goes up, unemployment goes down, and the price level goes up If AD goes down, real GDP goes down, unemployment goes up, and the price level goes down If AS goes up, real GDP goes up, unemployment goes down and the price level goes down If AS goes down, real GDP goes down, unemployment goes up and the price level goes up

In the upward sloping section of the AS curve, there is a positive relationship between the price level and output.
If AD is rising, the price level and GDP are both rising. When GDP rises, the unemployment rate declines Thus, there is an inverse relationship between the inflation rate and the unemployment rate

Price Level

Inflation Rate

SRAS C AD2

The Phillips Curve

AD1 AD0 Real GDP

Unemployment Rate

When AS shifts to the right (increases), the price level and unemployment rate both decline. When AS shifts to the left (decreases), the price level and unemployment levels both increase These supply curve shifts cause the Phillips Curve to shift to the right when AS decreases and shift to the left when AS is increasing

Price Level

SRAS

Inflation Rate

. . . . . .
C B C B A AD0

SRAS C AD2

The Phillips Curve C

.
A

AD1

PC Real GDP

PC

Unemployment Rate

Inflation Rate AS is increasing AS is decreasing

PC2 PC0 PC1 Unemployment Rate

The AS/AD model assumes LRAS is vertical at the level of GDP that corresponds to the level of full employment As a result, the long-run Phillips Curve is also vertical at the level of full unemployment This is the level of unemployment where there is no cyclical unemployment in the economy
There is still structural, seasonal and frictional unemployment, however

Inflation Rate

Long-Run Phillips Curve

Short-Run Phillips Curve 5% Unemployment Rate

An inverse relationship between inflation and unemployment in the short run and an unemployment rate at the natural rate of full employment can be confusing The reason for this is there can be a gap between the actual rate of unemployment and the expected rate of unemployment

Assume the current rate of unemployment is at the full employment level (e.g., 5%) and the anticipated inflation rate is at 2% Assume AD unexpectedly rises
This drives the inflation rate up (e.g., 4%) and firms earn higher profits Firms respond by hiring more workers, driving the unemployment rate lower (e.g., 3%)

Inflation Rate

Long-Run Phillips Curve

4%

2%

.
3% 5%

Short-Run Phillips Curve Unemployment Rate

The point at a 4% inflation rate and a 3% unemployment rate will not last (Point B) Workers will realize their real wages are falling and they will demand a raise This will cause higher input prices and it will shift
x x x x the AS curve inward, GDP downward, The Short-Run Phillips Curve outward, and The unemployment upward, back to 5%

Inflation Rate

Long-Run Phillips Curve

4%

2%

. .
5%

Second Short-Run Phillips Curve First Short-Run Phillips Curve

3%

Unemployment Rate