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Economics 14

Lecture 14: Aggregate Demand and Aggregate Supply

aggregate demand
aggregate supply
macroeconomic equilibrium
shifts of the AD curve

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Aggregate Demand

We want to develop a model of the economy that will let us address issues such as what causes a recession and what are sources of inflation. The model will look at demand and supply for the economy as a whole.

Aggregate demand is the total amount of spending at each possible price level. Aggregate demand is equal to consumption spending + investment spending + government spending on goods and services + exports - imports.

The aggregate demand curve is downward sloping:

1. real balances effect - a fall in the price level increase the purchasing power of consumers' wealth so consumption spending rises
2. foreign purchases effect - a fall in the price level makes domestic goods relatively cheaper compared to foreign goods so imports fall and exports rise
3. interest rate effect - a fall in the price level reduces the inflation rate so interest rates fall, meaning that any spending that is interest rate sensitive such as consumption and investment spending rises

Aggregate Supply

Aggregate supply is the level of GDP available at each possible price level.

The aggregate supply curve is upward sloping over much of its relevant range.

Macroeconomic Equilibrium

Equilibrium occurs at the intersection of the aggregate demand and aggregate supply curves. Equilbrium need not be at the full employment level of GDP

Shifts of the AD Curve

Aggregate demand (AD) is the total amount of spending at each possible price level.

AD = C + I + G + EX - IM

• taxes
  • a reduction in taxes leaves housholds with more disposable income so consumption spending rises AD increases and the AD curve shifts up to the right
  • a tax increase leaves households with less disposable income to spend AD decreases and the AD curve shifts down to the left
• interest rates
  • lower interest rates decrease the cost of borrowing money so households and business borrow more to spend and invest in new capital AD curve shifts up to the right
  • higher interest rates make money more costly for households and businesses to borrow so consumption and investment spending fall AD curve shifts down to the left
• consumer and business confidence
  • more optimistic AD curve shifts up to the right
  • more pessimistic AD curve shifts down to the left
• government spending
  • government spending is one of the components of aggregate demand so an increase in government spending causes AD to increase AD curve shifts up to the right
  • decrease in government spending AD curve shifts down to the left
• strength of the dollar
  

  The U.S. economy is linked to the rest of the world through exchange rates. An exchange rate is the price of one national currency in terms of another.

  Suppose an American tourist in Mexico buys a bottle of Kahlua for 85 pesos and that the exchange rate is $1 = 7.9060 pesos. Then, that bottle of Kahlua costs $10.75 in terms of US dollars.

  • If the exchange rate goes to $1 = 8.0230 pesos, the dollar appreciates and a bottle of Kahlua now costs $10.59. Therefore, when the dollar appreciates, foreign goods become less expensive to American buyers and imports rise.
  • If the exchange rate went instead to $1 = 7.5015 pesos, the dollar depreciates and a bottle of Kahlua now costs $11.33. So, when the dollar depreciates, foreign goods become more expensive to American buyers and imports fall.

  Suppose A Mexican tourist in York buys a 6-pack if Yuengling Black and Tan for $5.75. At $1 = 7.9060 pesos, the beer costs 45.46 pesos.

  • When the dollar appreciates to 8.0230 pesos, the beer costs 46.13 pesos. Therefore, when the dollar appreciates, American goods become more expensive to foreign buyers and exports fall.
  • If the dollar depreciates to 7.5015 pesos, the beer costs 43.13 pesos. So, when the dollar depreciates, American goods become less expensive to foreign buyers and exports rise.
  
  So,
  • a rise in the value of the dollar increases imports and reduces exports AD curve shifts down to the left
  • a fall in the value of the dollar lowers imports and increases exports AD curve shifts up to the left

David A. Latzko Business and Economics Division Pennsylvania State University, York Campus office: 13 Main Classroom Building phone: (717) 771-4115 fax: (717) 771-4062 e-mail: web: www.yk.psu.edu/~dxl31