Chapter 8 Parks Econ 104

Aggregate Demand and Aggregate Supply

The Circular Flow Diagram

The circular flow diagram shows the flows of production and aggregate demand in the economy.

Aggregate Demand

• Aggregate Demand (AD) is composed of the sum of Consumption (C), Investment (I), Government Expenditures (G) and net exports (NX).

AD = C + I + G + NX

Investment vs. Saving

• • The terms “saving” and “investment” are often used interchangeably in common usage, but they have very different meanings in economics.

Saving

(S) is disposable income not consumed. It is not a component of Aggregate Demand. In contrast,

Investment

(I) expands the productive capacity of the economy.

• • Note that

saving

is a flow – one year – while WEALTH is the sum of the flows.

Investment

is a flow while CAPITAL is the sum of the flows of Investment minus depreciation. We talk about GROSS investment and NET investment. Net Domestic Product (NDP) is the amount produced minus depreciation.

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The Aggregate Demand Curve and its Slope

• The AD curve is downward sloping because of the wealth effect and the international trade effect.

The Wealth Effect

• The wealth effect is a situation in which a price level increase reduces the purchasing power of financial assets, which leads to a reduction in a person’s wealth and, hence, consumption.

The International Trade Effect

• The international trade effect occurs when, for a fixed nominal exchange rate, an increase in the domestic price level leads to an appreciation of the domestic currency, which reduces net exports.

Movements Along the Aggregate Demand Curve

• Any factor that changes the price level leads to a movement along the AD curve.

Shift of the Aggregate Demand Curve

• A change in any factor other than a change in the price level that changes the level of Aggregate Demand results in a shift of the Aggregate Demand curve.

Factors that Shift the AD Curve

• Factors that shift the AD curve include: – A change in consumption (perhaps due to a change in income taxes) – A change in investment – A change in government expenditures – A change in net exports (perhaps induced by a change in exchange rates or foreign incomes) – Because AD = C + I + G + (X-M) AD(Price)=C(Price)+I+G+(X(Price)-M(Price))

Aggregate Supply

The

Aggregate Supply curve

graphs the total amount of output (Y) produced at various price levels. The curve slopes upward in the

short run

because some input costs are assumed fixed.

Long-run Aggregate Supply

The long run is a period of time in which all prices and costs are variable. An increase in the price level will have no impact on long-run Aggregate Supply because all firms' costs will rise proportionately with the price level.

Movements Along the Short-Run Aggregate Supply curve

• When the price level changes but resource costs are held constant, there is a

movement along

the Aggregate Supply curve

Shifts of the Short-Run Aggregate Supply curve

• A change in any factor other than a change in the price level that changes the level of Aggregate Supply shifts the Aggregate Supply curve.

Factors that shift the AS Curve

• Three nonprice factors that shift the Aggregate Supply curve are – changes in resource costs: an increase (decrease) in resource costs shifts the AS curve to the left (right).

– An advance in technology shifts the AS curve to the right.

– An increase (decrease) in inflation expectations shifts the AS curve to the left (right).

Short-Run Equilibrium

• A short-run equilibrium occurs where the AD and AS curves intersect at point E.

Long-Run Equilibrium

The long-run equilibrium can only occur where the Aggregate Demand curve crosses the vertical Long Run Aggregate Supply curve because in the long run, equilibrium output must equal potential output.

Disequilibrium: AD exceeds AS

• If AD > AS, firms’ inventories unexpectedly deplete, leading firms to ramp up prices and production, helping to restore equilibrium.

Disequilibrium: AS exceeds AD

• If AS > AD, firms’ inventories unexpectedly accumulate, leading firms to reduce prices and production, helping to restore equilibrium.

Aggregate Demand, Aggregate Supply, and the Business Cycle

• “Typical" business cycles are generated by fluctuations in Aggregate Demand.

Aggregate Demand, Aggregate Supply, and the Business Cycle

• However, business cycles can also result from fluctuations in Aggregate Supply (e.g. oil shocks), which may lead to stagflation.

Paradox of Thrift

• The

Paradox of Thrift

states that an increase in the desire of the economy as a whole to save more

may

lead to a decrease in output and employment, thus thwarting the attempt to save more.

• Is it good for the economy to save income or to consume?

• The U.S. in the post-war era had much higher consumption rates (and lower saving rates) than in Japan, yet Japan’s economy grew more slowly. Why?

Paradox of Thrift

AD=C+I+G+(X-M) If C decreases, AD must decrease unless I or G or X increases or M decreases. As C declined due to increased saving, and saving does not affect G or I or X-M, AD must decrease.

Paradox of Thrift

The paradox of thrift

assumes

that investment

is constant

with the increased saving, so AD shifts to the left and Y decreases.

• The Paradox of Thrift is not really a paradox but possibly a too simple model . The simplest model has

Investment

fixed and unchanging with any other variables.

• The slightly more complicated model will have

Investment depend on interest rates

.

• No model we consider links saving and investment as a (market) behavior. S=I is an equilibrium condition (in the simple model) but not a behavioral equation.

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