Why does it make sense for the AD curve to slope downward and to the right? We will suggest three different rationales for the downward sloped curve: We make the assumption that at any given point in time, there is a fixed amount of money in circulation. At higher price levels, the money in circulation can purchase fewer items.
A total of items could be purchased under these conditions. At higher prices, the money in circulation will spread over fewer goods. When prices fall, the purchasing power of the money in circulation goes up, and people can buy more goods and services. This relationship between prices and the amount of goods and services that can be purchased with a given money supply is called the real balances effect. It justifies our depiction of the AD curve as a downward sloping curve.
The interest rate effect explains impact that the price level has on interest rates, and thus on certain components of AD. When the price level goes up, people need more money to transact their daily purchases. Therefore, higher prices lead to an increase in the demand for money. With a fixed amount of money in circulation, increasing the demand for money will cause the interest rate to go up.
Think of how you would behave if you were running a bank and the demand for money increased. You would try to encourage additional people to deposit money into the bank, and at the same time discourage people from coming into the bank to demand money. The way to do both simultaneously would be to increase the interest rate. As interest rates go up, investment demand and certain interest-rate sensitive consumption purchases will fall.
Thus, increases in the price lead to increases the interest rate, which reduces the demand for both Consumption and Investment, and thus real output. The interest rate effect is therefore an additional justification for the downward sloping AD curve. Domestic prices also have an impact on Net Exports NX through what is called the foreign purchases effect. Since NX are part of AD, this contributes to an inverse relationship between the price level and the demand for our real domestic output.
The opposite is also true. The foreign purchases effect contributes to our argument for why the AD is downward sloping. Anything that changes the price level triggers these three effects and is represented by movement along a given AD curve.
There are other factors that influence aggregate demand besides the price level, and these factors are referred to as determinants of AD. When these other factors change, they cause a shift in the entire AD curve and are sometimes called aggregate demand shifters. The graph below illustrates what a change in a determinant of aggregate demand will do to the position of the aggregate demand curve. As we consider each of the determinants remember that those factors that cause an increase in AD will shift the curve outward and to the right and those factors that cause a decrease in AD will shift the curve inward and to the left.
There are several factors that could increase or decrease consumption that are unrelated to changes in the price level. For instance, increases in consumer wealth would increase consumption at each price level and would be illustrated by a rightward shift in AD.
Decreases in consumer wealth would have the opposite effect. Increases in consumer indebtedness would decrease consumption and shift the aggregate demand curve to the left, while decreases in indebtedness would have the opposite effect.
Increases in taxes will decrease consumption and shift the AD curve to the left while decreases in taxes will increase consumption and shift the AD curve to the right. Consumer expectations about the future of the economy can have a strong impact on consumptions. Optimism about the economy will increase consumption and shift the AD curve to the right, while widespread pessimism dampens consumer spending and shifts the AD curve to the left.
You can probably think of other factors that will shift the AD curve because they impact consumption independent of the price level. 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.
The tendency for increases in the price level to lower the real value or purchasing power of financial assets with fixed money value and, as a result, to reduce total spending and real output, and conversely for decreases in the price level.
The tendency for increases in the price level to increase the demand for money, raise interest rates, and, as a result, reduce total spending and real output in the economy and the reverse for price-level decreases. The inverse relationship between the net exports of an economy and its price level relative to foreign price levels.
Factors such as consumption spending, investment, government spending, and net exports that, if they change, shift the aggregate demand curve.
A schedule or curve showing the total quantity of goods and services supplied produced at different price levels. An aggregate supply curve for which real output, but not the price level, changes when the aggregate demand curves shifts; a horizontal aggregate supply curve that implies an inflexible price level.
An aggregate supply curve relevant to a time period in which input prices particularly nominal wages do not change in response to changes in the price level. The aggregate supply curve associated with a time period in which input prices especially nominal wages are fully responsive to changes in the price level.
Factors such as input prices, productivity, and the legal-institutional environment that, if they change, shift the aggregate supply curve. A measure of average output or real output per unit of input. For example, the productivity of labor is determined by dividing real output by hours of work.
The gross domestic product at which the total quantity of final goods and services purchased aggregate expenditures is equal to the total quantity of final goods and services produced the real domestic output ; the real domestic output at which the aggregate demand curve intersects the aggregate supply curve. The reluctance of firms to cut prices during recessions that they think will be short lived because of the costs of altering and communicating their price reductions; named after the cost associated with printing new menus at restaurants.
A wage that minimizes wage costs per unit of output by encouraging greater effort or reducing turnover.
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Factors that cause the short-run aggregate supply curve to shift to the left or the right. Decrease in Short-Run Aggregate Supply Producers reduce the quantity of aggregate output they are willing to supply at any given aggregate price level.
Start studying Aggregate Demand & Aggregate Supply. Learn vocabulary, terms, and more with flashcards, games, and other study tools. A shift to the left means a decrease in aggregate supply, a shift to the right means an increase in aggregate supply What does an increase in aggregate supply mean? An increase indicates that firms are willing to produce and .
The price level at which the aggregate demand curve intersects the aggregate supply curve. Equilibrium Real Output The GDP at which the total quantity of final goods and services purchased is equal to the total quantity of final goods and services produced; the real domestic output at which the aggregate demand curve intersects the aggregate . Start studying Determinants of Aggregate Demand and Supply. Learn vocabulary, terms, and more with flashcards, games, and other study tools.