Chapter 15 Aggregate Demand and Aggregate Supply The Aggregate Demand Curve Summarizes how the price level influences real GDP The Price Level and the Money Market When we hold money we give up the interest we could have earned if we were holding other assets The money demand curve tells us how much of their wealth people want to hold as money at each interest rate An increase in the price level with no change in the money supply shifts the money demand curve rightward and raises the equilibrium interest rate Understanding the Assumptions Assume a constant money supply o So we have a benchmark against which we can later compare different possible Fed responses o Helps us understand the economy s self correcting mechanism o Viewing the money supply as determined by forces outside of our model Helps us understand how the economy can over time correct itself even without a central bank or a Fed to give it a nudge Nominal and real interest rates are the same because assuming no ongoing inflation Only a single interest rate o As people try to acquire more money by selling other assets the prices of these other assets fall and their interest rates rise causing the average interest rate to rise as well Deriving the Aggregate Demand Curve Rise in price level initial impact in the money market o Money demand curve will shift right and interest rate will rise Higher interest rate decreases interest sensitive spending business investment new housing and consumer durables AE line shifts downward and equilibrium real GDP decreases New equilibrium caused by a rise in the price level o The money demand curve has shifted rightward o The interest rate is higher o The AE line has shifted downward o Equilibrium GDP is lower A rise in the price level with a constant money supply causes a decrease in equilibrium GDP The Aggregate Demand curve tells us the equilibrium real GDP at any price level with a constant money supply Understanding the AD Curve NOT a demand curve Each point on the curve represents a short run equilibrium in the economy Equilibrium output at each price level curve Movements along the AD curve Whenever the price level changes move along the AD curve Rise in price level increases the demand for money raises interest rate decreases autonomous consumption and investment spending works through the multiplier decrease equilibrium GDP Decrease in price level decrease in money demand decrease in interest rate increases autonomous consumption and investment spending increases equilibrium GDP Shifts of the AD curve When a change in the price level causes equilibrium GDP to change we move along the AD curve Whenever anything other than the price level causes equilibrium GDP to change the AD curve itself shifts Equilibrium GDP will change when there is a change in o Government purchases o Taxes o Autonomous consumption spending o Investment spending o Net exports o Money supply An Increase in Government Purchases The AD curve shifts rightward when govt purchases investment spending autonomous consumption spending or net exports increase or when net taxes decrease Changes in the Money Supply An increase in the money supply shifts the AD curve rightward o Cause the interest rate to decrease increasing investment spending and autonomous consumption spending The Aggregate Supply Curve Costs and Prices individual business firms Changes in price level affect output changes in output affect price level The price level in the economy results from the pricing behavior of millions of Assumption Firm sets the prices of their products as a markup over their cost per unit Concerned with average percentage markup in the economy o The average percentage markup in the economy is determined by competitive conditions in the economy The competitive structure of the economy changes very slowly so the average percentage markup should be somewhat stable from year to year In the short run the price level rises when there is an economy wide increase in unit costs and the price level falls when there is an economy wide decrease in unit costs How GDP Affects Unit Costs As total output increases Greater amounts of inputs may be needed to produce a unit of output As output increases firms hire new untrained workers who may be less productive than existing workers Firms begin using capital and land that are less well suited to their industry o Greater amounts of labor capital land and raw materials are needed to produce each unit of output The prices of nonlabor inputs rise In addition to needing greater quantities of inputs firms will have to pay a higher price for them An increase in the output of final goods raises the demand for these inputs causing their prices to rise The nominal wage rate rises As firms compete to hire increasingly scarce workers they must offer higher nominal wage rates to attract them Higher nominal wages increase unit costs and therefore result in a higher price level Short Run versus Long Run rather quickly When total output increases new less productive workers will be hired The prices of certain key inputs may rise While wages in some lines of work might respond very rapidly we can expect wages in many industries to change very little or not at all for a year or more after a change in output Wage stickiness For a year or so after a change in output nominal wages are sticky and are less important than other forces in changing unit costs Why Are Nominal Wages Sticky Economists are interested in understanding why wages are sticky bc they can prolong deviations from full employment output Some explanations for sticky wages o Many firms have union contracts that specify wages for up to 3 years o Wages in many large corporations are set by slow moving bureaucracies o Wage changes in either direction can be costly to firms o Firms may benefit from developing reputations for paying stable wages Sticky Wages and the Short Run Assume the nominal wage rate is fixed in the short run o We assume that changes in output have no effect on the nominal wage rate in the sort run A rise in real GDP raises firms unit costs because o Input requirements per unit of output rise and o The prices of nonlabor inputs rise A drop in real GDP lowers unit costs because o Input requirements per unit of output fall and o The prices of nonlabor inputs fall Deriving the Aggregate Supply Curve A rise in real GDP increases unit costs which given a stable average markup in the economy causes the price level to rise A decrease
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