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Aggregate Demand and Aggregate Supply

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❶The Interest Rate Effect The interest rate effect explains impact that the price level has on interest rates, and thus on certain components of AD.

BREAKING DOWN 'Aggregate Supply'

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Aggregate Supply
What is 'Aggregate Supply'?

There are several factors unrelated to changes in the price level that could increase or decrease Investment and thereby shift the AD curve. For instance, any change in the interest rate not brought about by a change in the price level would change the level of investment in the economy, and shift the AD curve.

Increases in the interest rate will reduce investment demand; decreases in the interest rate will increase investment demand.

Business taxes can be structured to either encourage investment shifting the AD to the right or discourage investment shifting AD to the left. Technological improvements in an industry might make old equipment obsolete and stimulate investment, shifting AD to the right. Finally, like the impact of expectations on consumers, optimism or pessimism on the part of business owners can lead to increases or decreases in investment activity and shift the AD curve to the right or left.

The political process will sometimes lead to increases or decreases in the level of government spending. Increases in government spending will shift the AD curve to the right; decreases in government spending will shift the AD curve to the left. There are two important factors unrelated to the price level that could increase or decrease the level of Net Exports and thereby shift the AD Curve. The first has to do with changes in national income abroad. As income abroad grows relative to income in the United States, foreigners are able to buy US products more easily and Americans can afford fewer foreign goods.

Net exports will go up, shifting the AD curve to the right. If incomes abroad fall relative to income in the US, the AD curve will shift left due to a decrease in net exports. The second factor has to do with exchange rates, or the relative value of our currency to the currency of a trading partner. If the value of the yen relative to the dollar changes so that it takes Yen to buy one US dollar, this will decrease the amount that Japanese citizens will buy in the US, and increase the amount that US citizens can buy in Japan.

This change in the exchange rate will cause net exports to fall and the AD curve to shift to the left. If the Japanese Yen were to appreciate relative to the dollar, net exports would rise and the AD curve would shift to the right.

Return to the course in I-Learn and complete the activity that corresponds with this material. Aggregate Supply AS is a curve showing the level of real domestic output available at each possible price level. Typically AS is depicted with an unusual looking graph like the one shown below.

There is a specific reason for why the AS has this peculiar shape. The various ranges depict three different states in which the economy may find itself. The three states of the economy can all be thought of in relation to what is called the full-employment level of output, labeled Qf in the graph below. We will now discuss each of the three ranges of the AS.

In the Keynesian range of AS, we are at outputs which are substantially below Qf. This horizontal range implies an economy in severe recession or depression. Remember that Keynes wrote his General Theory during the heights of the Great Depression, so the range of AS that is associated with his name corresponds to such an economy.

Assume that you were running a factory during a severe recession with high unemployment, and you decided that you would like to increase output. You realize that, to increase output, you are going to have to employ more inputs, primarily more labor—however, a similar argument could be made about high unemployment of any of the other factors of production. You go to the factory door, open it, and find thousands of unemployed workers standing in line, wanting to work at your factory.

How much would you have to pay them to get them to go to work for you? Certainly, you would not have to pay them more than the going wage rate in the market, right? Essentially, you could hire as many unemployed resources as you would like without bidding up wages and prices, because of the substantial unemployment. The horizontal or Keynesian AS illustrates the idea of the economy being able to increase real output with no increase in the price level during periods of high unemployment.

In the Classical Range of AS, we are at or very near the full-employment level of output. This range is named after the Classical Economists who assumed that the economy, in the long run, would always achieve full employment. Assume again that you are running a factory, only this time, the economy is at full-employment. You go to the factory door and open it to find nobody waiting in line.

There does not appear to be anyone looking for a job because everyone already has one! How much are you going to have to pay these workers to get them to do that? Most likely you will have to pay them more than they are currently making. As you bid up wages in the labor market to attract additional workers, prices in the economy will also rise, because now it costs more to produce your product. That additional cost is passed to the consumer in the form of higher prices, to the extent possible.

Attempts to increase output in the Classical Range leads to higher price levels in the economy but what about real GDP? Does it actually increase? Well, your output may go up, but the output of the factory where your new workers used to work will go down, so the overall output in the economy stays the same at Qf.

In the Intermediate Range, we are at output levels that are below full employment, but not so far below as to constitute a deep recession or depression.

In this range, increasing output is possible, but only at the expense of rising prices. While that Keynesian Range is a rare short-run occurrence, and the Classical Range is the long-run steady state of the economy, the Intermediate Range is probably where we find ourselves most often in the economy. Depending on the state of the economy, any attempt to change the output of the economy will move us along a given AS curve.

There are factors that influence aggregate supply, illustratable by shifting the AS curve—these factors are referred to as determinants of AS. When these other factors change, they cause a shift in the entire AS curve and are sometimes called aggregate supply shifters.

The graph below illustrates what a change in a determinant of aggregate supply will do to the position of the aggregate supply curve. As we consider each of the determinants remember that those factors that cause an increase in AS will shift the curve outward and to the right and those factors that cause a decrease in AS will shift the curve upward and to the left.

Anything that causes input prices to rise will decrease AS and shift the AS curve to the left. Anything that causes input prices to fall will increase AS and shift the AS curve to the right. For instance, if a particular input into the production process is readily available from domestic suppliers, it will generally be cheaper, holding all else constant cet.

If for no other reason, transportation costs of delivering a domestic resource to a domestic producer will be less than delivering the identical resource from a foreign supplier.

That does not even take into account the problems of getting a foreign resource such as duties and tariffs, political or social instability abroad, or other international disruptions. Another factor that can influence input prices would be the market power of the suppliers of the resource. The more competition in the supply of a resource, the cheaper that resource will be, cet. If the resource is supplied by a monopolist or a cartel think OPEC oil , the price of that resource will be higher than if the resource is supplied by a more competitive industry think corn-produced ethanol.

Independent of its price, anything that makes resources more productive will increase AS and shift the AS curve to the right; anything that makes resources less productive will decrease AS and shift the AS curve to the left.

If workers become more productive because of investments in physical or human capital, the economy will be able to produce more and the AS curve will shift to the right. If workers become less productive because of outmoded equipment, insufficient training, or excessive union interference in their workplace, the economy will be less productive, and the AS curve will shift to the left.

In brief, business taxes increase the cost of production and shift the AS curve to the left; subsidies decrease the cost of production and shift the AS curve to the right. Government regulations also influence the costs of production. What does the equilibrium between AD and AS determine? Equilibrium is illustrated below as the intersection between AD and AS. Notice that in the intermediate range, there is a tradeoff between two of the key economic variables that concern US citizens: Typically, we would like both inflation and unemployment to be low.

In the intermediate range, however, if we increase AD, inflation will go up as unemployment falls notice that if real GDP is going up, unemployment is going down: On the other hand, if we decrease AD, inflation will fall but unemployment will rise. There is no way to simultaneously decrease inflation and decrease unemployment using demand side shifts. Do you think that decreases in AD have exactly the opposite effects as the increases? Why do you think that prices would go up very easily but fall only slowly?

Part of the answer has to do with the fact that it actually costs businesses money to change their prices think of printing new catalogs, printing new menus, recoding prices in a computer and on scanners, or sending a worker out to change the prices on a marquee. It is worth it to the business to incur this expense when the price is going up, but when the price is going down they are hesitant to take on the expense of changing prices!

During the s, a variety of factors shifted the AS curve to the left. The high inflation that was combined with a stagnant economy low levels of output and high unemployment gave rise to the term Stagflation. When Ronald Reagan was elected President in , the inflation rate was Reagan employed supply side policies that were designed to shift the AS curve to the right and reduce both inflation and unemployment simultaneously.

When the demand for a product is high and its supply is low, this usually causes the price of that commodity to increase Similarly when supply for a product is high and the demand for that product is low, it causes the price of that product to decrease. Hence the supply is inversely related to the price of any product Provided the Demand is in accordance to the two points mentioned above.

What are the components of Aggregate Supply? How is GDP related to aggregate supply and aggregate demand? What are some determinants of individual supply? The price of the product, the price of input goods that are used to make it, the state of the industry's technology, government taxes and subsidies and expectations about the future market price of the good.

What are the determinant of supply? The determinant of supply can be listed as follows: What will happen if Aggregate demand increases and aggregate supply decreases?

An increase in aggregate demand and a decrease in aggregate supply will result in a shortage: What is the aggregate supply curve?

A graphical relationship of the total amount of final goods and services that suppliers are willing and able to produce at a given price level.

Aggregate demand and Aggregate supply curve? The aggregate demand curve show what consumers are willing to buy at a given price level, whereas the aggregate supply curve shows what producers are willing to produce at a given price level. What are the determinants of aggregate demand?

A higher price level reduces the purchasing power of financial wealth. Assets such as stocks, bonds, cash, and checking account balances are worth less, which shrinks the amounts you can buy. Thus, higher average prices reduce the amount of domestic production sold along an Aggregate Demand curve. Higher prices cause domestic consumers to buy more imports and fewer domestic goods.

Foreign buyers respond similarly, shrinking our exports. Investment is affected in a similar fashion. Hikes in the price level drive up domestic production costs.

A higher price level shrinks investment both foreign and domestic, firms would find it relatively more profitable to invest abroad. In sum, trends toward imports and foreign investments reinforce the wealth effect in making Aggregate Demand curves negatively sloped. The amount of borrowing required to finance a major purchase rises if the price level rises.

A higher price level increases the demand for loanable funds and, consequently, increases the interest rate, which is the cost of credit. This increase in interest rates reduces investment and such consumer purchases as new homes, cars, or appliances.

The figure below summarizes how these effects cause movements along Aggregate Demand curves as the price level changes. Why is the long run aggregate supply model curve vertical? It is the ideal aggregate supply, where all the resources and labor are being used fully. Because of this, the supply can't have a horizontal aspect, because it would mean a possibility for an increase in GDP, which can't be sustained unless the whole equilibrium moves to adjust to a change in long-run AS.

Production cannot increase, so only price can change, which is on the vertical axis, making the line vertical. What is the Aggregate supply curve and its axis? The aggregate supply curve show the relationship between price level and the quantity of goods and services that producers are willing to produce when their goods are at a certain price.

On the x-axis is RGDP representing quantity of goods that suppliers are willing to produce in terms of the value of the products adjusted for inflation. On the Y-axis is price level. Why does the short run aggregate supply curve slope upward? Why aggregate supply curve is vertical? Aggregate supply curve in the long run is vertical. This is because in the long run, wages and other input prices rise and fall to coordinate with the price level.

Therefore, price level will not affect how much is supplied. What is the long run aggregate supply curve? The graphical relationship between RGDP and price level after input prices have been allowed to adjust in response to changes in output prices.

Why does the aggregate supply curve have a positive slope? Because as the price goes up, producers find that production of the good in relation to other goods is more profitable There is a mathematical proof out there but it escapes me right now. Non-price determinants of supply? This depends on the model and supply function used.

Generally, the variability in supply will depend on at least a few others factors: What is the difference between aggregate supply in the short and long run? In the long run ceteris paribus , aggregate supply is perfectly inelastic, represented by a vertical line. No matter the inflation or deflation, there will be constant real product. However, in the short run, aggregate supply is much more elastic and, according to Keynes, can become perfectly elastic horizontal if the economy gets into a rut.

The real GDP will change because of the price level. But by definition, in the long run real variables are resistant to nominal changes, so real GDP will not be influenced by price level while in the short run it is not constant. What factors determine money supply?

When does inflation occur in a dynamic aggregate demand and supply model? Inflation raises the prices of the goods, so the real wages fall ceteris paribus. So we are moving on the demand curve up and left. The companies can afford to produce more for that height of the prices, so the gap appears. What is the Importance of aggregate supply curve? What is meant by aggregate demand and aggregate supply?

Aggregate simply means a collection of things. So aggregate demand is the total quantity of an economy's final good and services demanded at different price levels. Aggregate supply is the total quantity of final goods and services that firms in the economy want to sell at different price levels.

These are used primarily in Macroeconomics to calculate how the economy is doing as a whole. Why unemployment can be caused by a decrease of aggregate demand and supply?

Let's take a simpler approach here. Consider an economy with just one good in production: THe economy only produces cars and only employs people to produce cars. The demand for the car in that economy is And in order to produce Now, to produce cars, the economy only needs people. Therefore, those people are fired, creating unemployment. Aggregate demand works the same with the only different that it's the total demand of every single goods in an economy cars,oils,house Supply works in the same way if not simpler.

Back to the car example, if for suddenly a factory blows up and forces the production to go down from Therefore, the economy employs more employees than it needs to produce those cars. Thus, it creates unemployment where those people are fired. In aggregate world, if the total aggregate supply falls, all those people who are on the "excess" level would be fired and become unemployed, thus generating unemployment rate. Why does aggregate demand go up when money supply increases?

Money supply has no effect on aggregate demand. Aggregate demand is only effected by the buying power of money , real interest rate , and the real prices of exports and imports.


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Determinants of Aggregate Supply. Changes in labor force: Anything that causes the amount of workers to increase in an economy will cause aggregate supply to increase or shift to the right. If the labor force decreases, the overall supply of goods and services will decrease also.

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Aggregate supply determinants are held constant when the aggregate supply curves are constructed. A change in any of these determinants causes a shift of either the short-run aggregate supply curve, the long-run aggregate supply curve, or both.

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Learn aggregate supply determinants with free interactive flashcards. Choose from different sets of aggregate supply determinants flashcards on Quizlet. Long Run Aggregate Supply Aggregate Supply represents the ability of an economy to produce goods and services. In the Long Run this ability to produce is based on the level of production technology and the availability of factor inputs. As stated earlier, production refers to the conversion of inputs -- the factors of production into desired output.

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