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22
c h a p t e r
t w e n t y – t w o
Aggregate Demand and
Aggregate Supply
22.1
The Determinants of Aggregate Demand
22.2
The Aggregate Demand Curve
22.3
Shifts in the Aggregate Demand Curve
22.4
The
Aggregate Supply Curve
22.5
Shifts in the Aggregate Supply Curve
22.6
Macroeconomic Equilibrium:
The Short Run and the Long Run
22.7
The Classical and the Keynesian
Macroeconomic Model
Chris Hondros/Getty Images
In this chapter, we develop the aggregate demand and
aggregate supply model. The AD/AS model is a variable
price model; that is, it allows us to see changes in the price
level and changes in real GDP simultaneously. We explain
changes in the price level and real GDP in both the short run and long run.
This model will help us understand such key macroeconomic variables as
inflation, unemployment, and economic growth. In the following chapters,
we will also use this model to help us understand how stabilization policies
Wproblems that result from recession and inflationary expansion.
can help with
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Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
633
chapter 22 Aggregate Demand and Aggregate Supply
The Determinants of Aggregate Demand
What is aggregate demand?
What are government purchases?
What is consumption?
What are net exports?
22.1
What is investment?
What Is Aggregate Demand?
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Consumption (C)
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Consumption is by far the largest component L
in aggregate demand. Expenditures for consumer goods and services typically absorb almost
I 70 percent of total economic activity, as
measured by GDP. Understanding the determinants of consumption, then, is critical to an
understanding of the forces leading to changes S
in aggregate demand, which, in turn, changes
total output and income.
,
aggregate demand (AD)
the total demand for all the
final goods and services in
the economy
© Flying Colours
Ltd/Jupiterimages
Aggregate demand (AD) is the sum of the demand for all final goods and services in the
economy. It can also be seen as the quantity of real gross domestic product demanded at
different price levels. The four major components of aggregate demand are consumption (C),
investment (I), government purchases (G), and net exports (X – M). Aggregate demand, then,
is equal to C + I + G + (X – M).
What are four major components of aggregate demand?
Investment (I)
K
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Because investment spending (purchases of investment
goods) is an important component of
aggregate demand, which in turn is a determinant
S of the level of GDP, changes in investment
spending are often responsible for changes in the level of economic activity. If consumption
S
is determined largely by the level of disposable income, what determines the level of investA expenditure is the most unstable category
ment expenditure? As you may recall, investment
of GDP; it is sensitive to changes in economic,N
social, and political variables.
Many factors are important in determining the level of investment. Good business conditions “induce” firms to invest because a healthyD
growth in demand for products in the future
seems likely, based on current experience. We R
will consider the key variables that influence
investment spending in the next section.
A
What is the most unstable
component of GDP?
Government Purchases (G)2
Government purchases, another component 1
of aggregate demand, include spending by
federal, state, and local governments for the purchase
of new goods and services produced.
6
For example, an increase in highway or other transportation projects will increase aggregate
1 and taxes constant.
demand, holding other factors like interest rates
Net Exports (X – M)
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The interaction of the U.S. economy with the rest of the world is becoming increasingly
important. Up to this point, for simplicity, we have not included the foreign sector. However,
international trade must be incorporated into the framework. Models that include the effects
of international trade are called open economy models.
open economy
a type of model that
includes international trade
effects
Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
634
PART 7 The Macroeconomic Models
net exports
the difference between the
value of exports and the
value of imports
Remember, exports are goods and services that we sell to foreign customers, such as
movies, wheat, and Ford Mustangs; imports are goods and services that we buy from foreign companies, such as BMWs, French wine, and Sony TVs. Exports and imports can alter
aggregate demand. Exports minus imports is what we call net exports. If exports are greater
than imports (X > M), we have positive net exports. If imports are greater than exports
(X < M), net exports are negative.
The impact of net exports (X – M) on aggregate demand is similar to the impact of
government purchases on aggregate demand. Suppose that the United States has no trade
surplus and no trade deficit—zero net exports. What would happen if foreign consumers
started buying more U.S. goods and services, while U.S. consumers continued to buy imports
at roughly the same rate? The result would be positive net exports (X > M) and greater
demand for U.S. goods and services—a higher level of aggregate demand. What if a country
has a trade deficit? Assuming, again, that the economy initially has zero net exports, a trade
deficit, or negative net exports (X < M), would lower U.S. aggregate demand, ceteris paribus.
SECTION QUIZ
1. The largest component of aggregate demand is
a. government purchases.
b. net exports.
c. consumption.
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d. investment.
2. A reduction in personal income taxes, other things being equal, will
a. leave consumers with less disposable income.
b. decrease aggregate demand.
c. leave consumers with more disposable income.
d. increase aggregate demand.
e. do both (c) and (d).
3. Aggregate demand is the sum of ____________.
a. C + I + G
b. C + I + G + X
c. C + I + G + (X – M)
d. C + I + G + (X + M)
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4. Empirical evidence suggests that consumption ____________ with any ____________.
a. decreases; increase in income
2
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c. increases; decrease in consumer confidence
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d. increases; increase in income
1
e. Both (a) and (b) are true.
5. Investment (I) includes
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a. the amount spent on new factories and machinery.
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b. decreases; tax cut
b. the amount spent on stocks and bonds.
c. the amount spent on consumer goods that last more than one year.
d. the amount spent on purchases of art.
e. all of the above.
(continued)
Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
635
chapter 22 Aggregate Demand and Aggregate Supply
S E C T I O N Q U I Z (Cont.)
6. If our exports of final goods and services increase more than our imports, other things being equal,
aggregate demand will
a. increase.
b. be negative.
c. decrease by the change in net exports.
d. stay the same.
e. do none of the above.
1. What are the major components of aggregate demand?
2. How would an increase in personal taxes or a decrease in transfer payments affect consumption?
3. What would an increase in exports do to aggregate demand, other things being equal? An increase in imports?
An increase in both imports and exports, where the change in exports was greater in magnitude?
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Answers: 1. c
2. e
3. c
4. d
5. a
6. a
The Aggregate
Demand Curve
K
A Why is the aggregate demand curve
S downward sloping?
S
A amount of real goods and services that
The aggregate demand curve reflects the total
all groups together want to purchase in a given
N period. In other words, it indicates the
quantities of real gross domestic product demanded at different price levels. Note that this
D
is different from the demand curve for a particular good presented in Chapter 4, which
looked at the relationship between the relativeR
price of a good and the quantity demanded.
Because we are dealing with the economy asAa whole, we need an explanation for why
22.2
How is the aggregate demand curve
different from the demand curve for a
particular good?
aggregate demand
curve
graph that shows the
inverse relationship between
the price level and RGDP
demanded
the aggregate demand curve is downward sloping and why the short-run aggregate supply
curve is upward sloping.
2
How Is the Quantity of Real1 GDP Demanded
Affected by the Price Level?6
1
The aggregate demand curve slopes downward, which means an inverse (or opposite) relaT
tionship exists between the price level and real gross domestic product (RGDP) demanded.
S quantity of RGDP demanded is measured
Exhibit 1 illustrates this relationship, where the
How is the aggregate
demand curve different than
the demand curve for a particular good?
on the horizontal axis and the overall price level is measured on the vertical axis. As we
move from point A to point B on the aggregate demand curve, we see that an increase in
the price level causes RGDP demanded to fall. Conversely, if a reduction in the price level
occurs—a movement from B to A—RGDP demanded increases. Why do purchasers in the
economy demand less real output when the price level rises and more real output when the
price level falls?
Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
636
PART 7 The Macroeconomic Models
section 22.2
exhibit 1
The Aggregate Demand Curve
Price Level
PL2
PL1
Three complementary explanations exist for the negative
slope of the aggregate demand curve: the wealth effect, the
interest rate effect, and the open economy effect.
B
A
AD
© Cengage Learning 2013
Why Is the Aggregate Demand
Curve Negatively Sloped?
The Wealth Effect: Changes in Consumer
Spending
If you had $1,000 in cash stashed under your bed while
the economy suffered a serious bout of inflation, the
0
purchasing power of your cash would be eroded by the
RGDP2
RGDP1
extent of the inflation. That is, an increase in the price
Real GDP
level reduces the real value of money and makes consumW
The aggregate demand curve slopes downward,
ers poorer, encouraging them to spend less. A decrease in
reflecting an inverse relationship between the
I consumer spending means a decrease in quantity of RGDP
overall price level and the quantity of real GDP
demanded. When the price level increases, the
Ldemanded.
quantity of RGDP demanded decreases; when
the event that the price level falls, the reverse would
LholdIntrue.
the price level decreases, the quantity of RGDP
A falling price level increases the real value of money
demanded increases.
I and makes consumers wealthier, encouraging them to spend
Smore. An increase in consumer spending means an increase
in the quantity of RGDP demanded. This is called the wealth
effect of a change in the price ,level. Because of the wealth effect, consumer spending, C, falls
(rises) when the price level increases (decreases).
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What is the wealth effect of
a price level change?
How does a lower price
level lead to lower interest
rates?
The Interest Rate Effect:
A A Change in Investment
If the price level falls, households and firms will need to hold less money to conduct
S
their day-to-day activities. Firms will need to hold less money for such inputs as wages
S to hold less money for such purchases as food, rent, and
and taxes; households will need
clothing. At a lower price level,
A households and firms will shift their “excess” money into
interest-earning assets such as bonds or savings accounts. This will increase the supply of
N
funds to the loanable funds market,
leading to lower interest rates. As interest rates fall,
households and firms will borrow
D more and buy more goods and services—thus, the quantity of RGDP demanded will increase.
R
If the price level rises, households and firms will need to hold more money to buy goods
Adaily activities. Households and firms will need to borrow
and services and conduct their
money, and this increased demand for loanable funds will result in higher interest rates. At
higher interest rates, consumers may give up plans to buy new cars or houses, and firms may
delay investments in plant and2equipment.
In sum, a higher price level
1 raises the interest rate and discourages investment spending
and decreases the quantity of RGDP demanded. A lower price level reduces the interest rate
6
and encourages investment spending causing RGDP demanded to rise.
1
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The Open Economy Effect
Many goods and services areSbought and sold in global markets. If the price level in the
United States rises relative to the price level in other countries, U.S. exports will become
relatively more expensive and foreign imports will become relatively less expensive. Some
U.S. consumers will shift from buying domestic goods to buying foreign goods (imports).
Some foreign consumers will stop buying U.S. goods. U.S. exports will fall and U.S. imports
will rise. Thus, net exports will fall, thereby reducing the amount of RGDP purchased in
Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
637
chapter 22 Aggregate Demand and Aggregate Supply
the United States. A lower price level makes U.S. exports less expensive and foreign imports
more expensive. So U.S. consumers will buy more domestic goods, and foreign consumers
will buy more U.S. goods. This will increase net exports, thereby increasing the amount of
RGDP purchased in the United States.
SECTION QUIZ
1. The aggregate demand curve
a. is negatively sloped.
b. demonstrates an inverse relationship between the price level and real gross domestic product demanded.
c. shows how real gross domestic product demanded changes with the changes in the price level.
d. All of the above are correct.
2. As the price level increases, other things being equal,
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c. the quantity of real gross domestic product demanded decreases.
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d. aggregate demand increases.
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e. both (a) and (c) occur.
3. According to the real wealth effect, if you are Iliving in a period of falling price levels on a fixed income (that is,
not indexed), the cost of the goods and services
Syou buy ____________ and your real income ____________.
a. decreases; decreases
,
a. aggregate demand decreases.
b. the quantity of real gross domestic product demanded increases.
b. increases; increases
c. decreases; remains the same
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4. As the price level decreases, real wealth ____________,
purchasing power ____________, and the quantity of RGDP
A
demanded ____________.
S
a. increases; decreases; increases
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b. increases; increases; increases
A
c. decreases; decreases; decreases
d. decreases; decreases; increases
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e. increases; decreases; decreases
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5. As the price level increases, interest rates ____________, investments ____________, and the quantity of RGDP
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demanded ____________.
a. decrease; increase; decreases
A
d. decreases; increases
b. increase; increase; decreases
c. decrease; decrease; increases
2
1
e. increase; decrease; decreases
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What is the open economy effect?
a. If prices of the goods and services in the domestic
market rise relative to those in global markets as a result
1
of a higher domestic price level, consumers and businesses will buy less from foreign producers and more
T
from domestic producers.
S
b. People are allowed to trade with anyone, anywhere,
anytime.
d. decrease; increase; increases
6.
c. It is the ability of firms to enter or leave the marketplace—easy entry and exit with low entry barriers.
d. If prices of the goods and services in the domestic market rise relative to those in global markets as a result
of a higher domestic price level, consumers and businesses will buy more from foreign producers and less
from domestic producers, other things being equal.
(continued)
Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
638
PART 7 The Macroeconomic Models
S E C T I O N Q U I Z (Cont.)
7. Which of the following helps explain the downward slope of the aggregate demand curve?
a. the real wealth effect
b. the interest effect
c. the open economy effect
d. all of the above
e. none of the above
8. Which of the following will result as part of the interest rate effect when the price level rises?
a. Money demand will increase.
b. Interest rates will increase.
c. The dollar amount of investment will decrease.
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1. Why is the aggregate demand curve downward sloping?
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2. How does an increased price level reduce the quantities of investment goods and consumer durables demanded?
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3. What is the wealth effect, and how does it imply a downward-sloping
aggregate demand curve?
4. What is the interest rate effect, and how does it implySa downward-sloping aggregate demand curve?
5. What is the open economy effect, and how does it imply
, a downward-sloping aggregate demand curve?
d. A lower quantity of real GDP will be demanded.
e. All of the above will result.
Answers: 1. d
2. c
3. d
4. b
5. e
6. d
7. d
8. e
22.3
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What is the difference between
D a movement along and a shift in the aggregate
R
demand curve?
A
Shifts in the Aggregate Demand Curve
What variables shift the aggregate demand
curve to the right?
What variables shift the aggregate demand
curve to the left?
Shifts versus Movements
along
2
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the Aggregate Demand
Curve
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Like the supply and demand curves described in Chapter 4, the aggregate demand curve may
1
experience both shifts and movements.
In the previous section, we discussed three factors—
the real wealth effect, the interest
rate
effect, and the open economy effect—that result in
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the downward slope of the aggregate demand curve. Each of these factors, then, generates
S de …
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