1. Aggregate Demand, Aggregate
Supply, and Equilibrium
Academic Decathlon
Lesson 12
Berryhill

2. Aggregate Demand
• Aggregate demand is a schedule or
curve that shows the amounts of real
output that buyers collectively desire to
purchase at each possible price level
• The relationship between the price level
and the amount of real GDP demanded
is inverse or negative

3. Aggregate Demand Curve
• Why downward sloping?
• Real-balances effect--A higher price level reduces
the real value or purchasing power of the public,
because of this, the public is poorer and will
reduce its spending
• Interest-rate effect--As the price level rises, there
is an increase in money demand and the price
paid for its use (interest rate); higher interest
rates curtail investment spending and the amount
of real output demanded

4. Aggregate Demand Curve
• Why downward sloping?
• Foreign purchases effect--when the U.S.
price level rises relative to foreign price
levels, foreigners buy fewer U.S. goods and
Americans buy more foreign goods thereby
reducing the quantity of U.S. goods
demanded as net exports

5. Determinants of Aggregate
Demand
• Change in consumer spending
• Consumer wealth
• Consumer expectations
• Household indebtedness
• Taxes

6. Determinants of Aggregate
Demand
• Change in investment spending
• Interest rates
• Expected returns
• Expected future business conditions
• Technology
• Degree of excess supply
• Business taxes

7. Determinants of Aggregate
Demand
• Change in government spending
• Change in net export spending
• National income abroad
• Exchange rates

8. Aggregate Supply
• Aggregate supply is a schedule or curve
showing the level of real domestic
output that firms will produce at each
price level
• This is a direct or positive relationship
between the price level and the amount
of real output that firms offer for sale

9. Aggregate Supply Curve
• Three distinct ranges
• The horizontal or Keynesian range
• The intermediate (upsloping) range
• The vertical or Classical range

10. Horizontal/Keynesian Range
• Includes only levels of real output that
are substantially less than the full-
employment output
• Firms can put idle workers/machinery
on hold and rehire without upward
pressure on price level
• Because input costs remain the same
here (no increase in wages--sticky
wages), there is no reason to raise
prices

11. Intermediate (Upsloping)
Range
• Expansion of real output is
accompanied by a rising of price level
• As we reach full employment, input
costs increase and firms will raise the
price level to compensate

12. Vertical or Classical Range
• Economy is overstressed
• Economy is already operating at full
capacity (full employment)
• Companies may try to out bid other
companies for employees, the gain of
output for the firm will be offset by the
loss of another
• Bidding raises input costs and that will
increase price level

13. Determinants of Aggregate
Supply
• Change in input prices
• Domestic resource availability
• Land
• Labor
• Capital
• Entrepreneurial ability

14. Determinants of Aggregate
Supply
• Changes in input prices
• Prices of imported resources
• Market Power

15. Determinants of Aggregate
Supply
• Change in productivity
• Change in legal-institutional
environment
• Business taxes and subsidies
• Government regulations

16. Equilibrium
• Equilibrium occurs where the AD curve
crosses the AS curve on the graph
• This point determines the economy’s
equilibrium price level and equilibrium
real output

17. Changes in Equilibrium:
Changes in AD
• Increases in AD: Demand-Pull Inflation
• Say households and businesses decide to increase
their consumption and investment spending and
the AD curve shifts to the right (ceteris paribus)
• The inflationary effects of this shift depend on the
stage we are in
• Horizontal range-- in AD leads to an in output
with no inflationary effects
• Intermediate range-- in AD leads to an in both
real output and price level
• Vertical range-- in AD leads to an in price level
only because output can’t increase

18. Changes in AD
• Demand-pull inflation
• Rising price levels in the intermediate and
vertical ranges of the AS curve constitute
demand-pull inflation, which results
because shifts in AD pull up the price level

19. Decreases in AD
• Most economists believe that decreases
in AD occur mostly in the horizontal
range of AS
• A decrease in AD at this range will have
no effect on price level but will
decrease real output
• Real output would take the brunt of the
decline due to “sticky” prices or wages

20. “Sticky” Prices and Wages
• Numerous reasons for the downward
inflexibility of prices and wages
• Wage contracts
• Morale, effort and productivity
• Minimum wage
• Menu costs
• Fear of price wars

21. Decreases in AS
• If there is a decrease in AS (ceteris
paribus), real output declines and price
level rises
• This is called cost-push inflation--a
disruption in production forces costs of
production up and this will push up
prices

22. Increases in AS
• Alone increases in AS would decreases
prices (deflation--very bad) and
increase real output
• Usually (in the U.S.) we see an increase
in AS only after there is an increase in
AD, which keeps price levels low but
increases output

23. Aggregate Supply
• Aggregate supply is a schedule or curve
showing the level of real domestic
output that firms will produce at each
price level
• This is a direct or positive relationship
between the price level and the amount
of real output that firms offer for sale

24. Aggregate Supply Curve
• Three distinct ranges
• The horizontal or Keynesian range
• The intermediate (upsloping) range
• The vertical or Classical range

25. Horizontal/Keynesian Range
• Includes only levels of real output that
are substantially less than the full-
employment output
• Firms can put idle workers/machinery
on hold and rehire without upward
pressure on price level
• Because input costs remain the same
here (no increase in wages--sticky
wages), there is no reason to raise
prices

26. Intermediate (Upsloping)
Range
• Expansion of real output is
accompanied by a rising of price level
• As we reach full employment, input
costs increase and firms will raise the
price level to compensate

27. Vertical or Classical Range
• Economy is overstressed
• Economy is already operating at full
capacity (full employment)
• Companies may try to out bid other
companies for employees, the gain of
output for the firm will be offset by the
loss of another
• Bidding raises input costs and that will
increase price level

28. Determinants of Aggregate
Supply
• Change in input prices
• Domestic resource availability
• Land
• Labor
• Capital
• Entrepreneurial ability

29. Determinants of Aggregate
Supply
• Changes in input prices
• Prices of imported resources
• Market Power

30. Determinants of Aggregate
Supply
• Change in productivity
• Change in legal-institutional
environment
• Business taxes and subsidies
• Government regulations

31. Fiscal Policy
• Fiscal Policy—deliberate changed in
government spending and tax
collections to achieve full employment,
control inflation, and encourage
economic growth

32. Historical Fiscal Policy
• Early 1960s—cut taxes to increase sluggish
economic growth
• 1970—it placed a 10% surcharge (a tax on
top of existing taxes) on both corporate and
personal income taxes to reduce aggregate
demand and curb inflation
• Early 1980s—cut personal income taxes by
25% over 3 years to increase work incentives
and encourage economic growth

33. Historical Fiscal Policy
• Early 1990s—it increased taxes to
reduce large Federal budget deficits,
which were thought to be causing high
interest rates, low levels of investment,
and slow economic growth
• Each of these had varying degrees of
success

34. Other Countries Historical Fiscal
Policy
• In recent years Japan launched a series
of government spending programs
designed to increase aggregate demand
and extract its economy from a major
recession

35. Legislative Mandates
• In the US, the idea of fiscal policy to
stabilize the economy emerged during
the Depression (1930s) with the
ascension of Keynesian economics
• Since then, Keynesian economics has
played a major role in the design of
fiscal policy
• We have also learned of its limitations

36. Employment Act of 1946
• Commits the Federal government to use
all practical means, consistent with a
market system, “to create economic
conditions under which there will
be…employment opportunities,
including self-employment, for those
able, willing, and seeking work, and to
promote maximum employment,
production, and purchasing power.”

37. Employment Act of 1946
• Commits the Federal government to
take action through monetary and fiscal
policy in order to maintain economic
stability

38. CEA and JEC
• Executive branch is responsible for
fulfilling the purposes of the act
• The act also established the Council of
Economic Advisors (CEA) to assist and
advise the president on economic
matters
• Also established the Joint Economics
Committee (JEC) of Congress to
investigate a wide range of economic
problems of national interest

39. Fiscal Policy and the AD-AS
model
• The fiscal policy we have described is
discretionary (or “active”)
• The changes in government spending
and taxes are at the option of the
Federal government
• They do not occur automatically

40. Fiscal Policy and the AD-AS
Model
• Some fiscal policy is nondiscretionary
(or “passive” or “automatic”)
• We’ll look at those later

41. Fiscal Policy and the AD-AS
• When a recession occurs, an
Model
expansionary fiscal policy may be in
order
• Say there is a sharp decline in Ig
spending and the AD curve has shifted
left
• As a result GDP declines and there is an
increase in unemployment
• The economy is experiencing both
recession and cyclical unemployment

42. Fiscal Policy and the AD-AS
Price LRAS SRAS
Model
Level
AD’ AD
FE GDPr

43. Expansionary Fiscal Policy
• What fiscal policy should the Federal
government adopt in order to
stimulate the economy?
1. Increase government spending
2. Reduce taxes
3. Use a combination of the two

44. Expansionary Fiscal Policy
• Expansionary fiscal policy is government
action to increase GDP and decrease
unemployment by shifting the AD curve
to the right to correct a recession

45. Expansionary Fiscal Policy
• If the Federal budget is balanced at the
outset, expansionary fiscal policy will
create a government budget deficit—
government spending in excess of tax
revenues

46. Expansionary Fiscal Policy
Price LRAS SRAS
Level
AD’ AD
AD”
FE GDPr

47. Increased Government
Spending
• Other things equal, an increase in
government spending will shift an
economy’s aggregate demand to the
right (AD’ to AD”)
• The initial increase in AD is not the end
of the story
• Through the multiplier effect, the AD
curve will increase more than just the
initial amount

48. Increased Government
Spending
• Say the Government spends $5 billion
to increase AD
• The MPC is .75
• The multiplier is 4 (1/1- .75)
• 4 x $5 billion is $20 billiond

49. Tax reductions
• Say the government reduces taxes to
increase Consumption and raise AD’ to
AD”
• Let’s say government reduces personal
income tax by $6.7 billion
• DI increases by $6.7 billion, but
consumption only increases by $5 billion
($6.7 billion x .75) and savings
increases by $1.67 billion (%6.7 billion
x .25)

50. Tax Reductions
• This is just initial consumption because
again, we have to use the multiplier to
understand the true affect on GDP
• You may notice that a tax cut must be
somewhat larger than the proposed
increase in government spending if it is
to achieve the same amount of increase
on GDP

51. Tax Reductions
• This is because part of a tax cut goes to
saving, rather than consumption

52. Combined Gov’t Spending
Increases and Tax Reductions
• Government sometimes uses a
combination of the two
• In our example, they may increase
spending by $1.25 billion while reducing
taxes by $5 billion to get the same
result

53. Contractionary Fiscal Policy
• When demand-pull inflation occurs, a
restrictive or contractionary fiscal policy
may help control it

54. Contractionary Fiscal Policy
AD’
Price LRAS SRAS
Level
AD
FE GDPr

55. Contractionary Fiscal Policy
• This graph takes advantage of the
vertical area of the SRAS graph to
show the inflationary effects of the
shift in AD
• To correct this inflation the
government could
1. Decrease government spending
2. Raise taxes
3. Use some combination of the two

56. Contractionary Fiscal Policy
• By doing any of these, the government
is creating a budget surplus—tax
revenues in excess of government
speding

57. Decreased Government
Spending
• Reduced government spending shifts
the AD curve leftward to AD’
control
demand-pull inflation LRAS SRAS
Price
Level AD
AD”
FE GDPr

58. Decreased Government
Spending
• Real world prices tend to be inflexible
downward
• Stopping inflation is more of a matter of
halting the rise in price level, not trying
to lower it to some previous level
• Demand-pull inflation usually is
experienced as a continual shifting of
the AD curve to the right

59. Decreased Government
Spending
• Fiscal policy is designed to stop a shift,
not to restore a lower price level
• Nevertheless, the graph displays the
basic principle: Reductions in
government expenditures can halt
demand-pull inflation

60. Increased Taxes
• Just as government can use tax cuts to
increase consumption spending, it can
use tax increases to reduce
consumption spending

61. Combination of the two
• The government can use any
combination of the two to slow down
the economy and halt inflation

62. Financing of Deficits and
Disposing of Surpluses
• The expansionary effect of deficit
spending on the economy depends on
the method used to finance the deficit
• Similarly, the anti-inflationary effect of a
budget surplus depends on what is
done with the surplus

63. Borrowing vs. New Money
• Two ways for the government to
finance a deficit: borrowing from the
public (by selling interest-bearing
bonds) and issuing new money to its
creditors

64. Borrowing from the Public
• This is will cause the government to compete
for funds with private business borrowers
• The added demand for funds might drive up
the interest rate and crowd out some private
investment spending and interest-sensitive
consumer spending
• Any decline in private spending will weaken
the expansionary effect of the deficit
spending

65. Money Creation
• If new money is created, the central
government can avoid the crowding out
of private spending
• Federal spending can increase without
adversely affecting investment or
consumption
• The creation of new money is more
expansionary (but potentially more
inflationary) than borrowing

66. Debt Retirement vs. Idle
Surplus
• Contractionary fiscal spending results in
a budget surplus
• The anti-inflationary effect of the
surplus depends on what the
government does with it

67. Debt reduction
• If the surplus is used to pay off debt,
the anti-inflationary impact of the
surplus could be reduced
• To retire the debt, the government buys
back some of its bonds; thereby
transferring its surplus tax revenues
back into the money market, causing
interest rates to fall and investment to
rise

68. Debt reduction
• An increase in investment or
consumption will offset the
contractionary fiscal policy by increasing
AD

69. Impounding
• The government can realize a greater
anti-inflationary effect from its creation
of a budget surplus by impounding the
surplus funds—by letting them stand
idle
• This causes the government to extract
and withhold purchasing power from
the economy

70. Impounding
• If surplus tax revenues are not put back
into the economy, no portion of that
surplus can be spent
• Consequently, there is no chance that
the surplus funds will create inflationary
pressure to offset the anti-inflationary
impact of the contractionary fiscal policy

71. Policy Options: G or T?
• Which is a better method? Government
spending or taxes?
• This depends on an individual’s view as
to whether the government is too large
or too small

72. Government too small
• Government spending goes up during
recession
• Tax increases during inflationary
periods
• Both actions increase or preserve the
size of the government

73. Government too big
• Advocate tax cuts during recessions
• Cuts in government spending during
inflationary periods
• Both actions restrain the growth of or
reduce its size

74. Built-In Stability
• To some degree, government tax
revenues change automatically over the
course of the business cycle to stabilize
the economy
• These are nondiscretionary (or
“passive” or “automatic”) budgetary
policies

75. Built-In Stability
• The actual US tax system is such that
net tax revenues vary directly with GDP
• Personal income taxes have progressive
rates (higher rates for higher incomes)
• As GDP rises and more goods and
services are produced, revenues from
corporate income taxes and excise
taxes also increase

76. Automatic or Built-In
Stabilizers
• Built-in stabilizer is anything that
increases the government’s budget
deficit (or reduces its budget surplus)
during a recession and increases its
budget surplus (or reduces its budget
deficit) during inflation without
requiring explicit action by policymakers

77. G and T relationship
• Congress sets a particular level of
spending, so Government expenditures
(G) is fixed and independent of the
level of GDP
• Congress does not determine the
magnitude of tax revenues (T), instead
it establishes tax rates, and tax
revenues then vary directly with the
level of GDP

78. G and T Relationship
T
Surplus
G
Deficit

79. Problems, Criticisms, and
Complications
• Timing problems
--Recognition lag (time between the
beginning of the recession and the
awareness that it is happening)
--Administrative lag (takes time to
implement fiscal policy)
--Operational lag (takes time for policy’s
affect to be seen in the economy)

80. Problems, Criticisms, and
Complications
• A political business cycle?
--Re-election sometimes sways
politicians’ fiscal policy
--Fiscal policy can be manipulated to
maximize voter support, even though
the policy could destabilize the
economy
--Politicians like to cut taxes and
increase government spending when
elections approach

81. • After elections, continued expansion of
the economy will be reflected in
demand-pull inflation

82. Problems, Criticisms, and
Complications
• Offsetting state and local finance
--state and local fiscal policies are often
pro-cyclical (they worsen a recession or
inflation) because they have balanced-
budget restrictions in their constitutions
--They can offset any federal fiscal
policy (raise taxes after a federal tax
decrease)

83. Problems, Criticisms, and
Complications
• Crowding-Out Effect
--An expansionary fiscal policy (deficit
spending) will increase the interest rate
and reduce private spending, thereby
weakening or canceling the stimulus of the
expansionary policy
--This could make fiscal policy largely or
totally ineffective
--Criticisms of crowding-out: some
economists believe there will be little
crowding out during a severe recession;
policy can counteract crowding out by

84. Problems, Criticisms, and
Complications
• The AS curve can complicate the fiscal
policy actions
--The upward sloping portion of the AS curve
may cause some inflation along with
declines in unemployment and increases in
real GDP

85. Problems, Criticisms, and
Complications
• Other nations and our interaction with
them can affect fiscal policy actions
--As our interest rates increase or
decrease, nations want to invest more
or less in our banks. To invest they
need our currency, this will change the
value of the dollar. As the value of the
$ changes, net exports change because
foreign or domestic goods relative
prices change.

86. Supply-Side Fiscal Policy
• Tax changes may alter AS and affect
the results of a change in fiscal policy
--”Supply-side economists” say tax
reductions shift the AS curve to the
right, negating the inflation and
increasing economic growth that the tax
cuts were passed to achieve.

87. Supply-Side Fiscal Policy
• Supply siders give 3 reasons for this
effect:
1. saving and investment—lower taxes
will increase savings and investment,
thereby increasing the nation’s stock of
capital so our production capacity will
grow (AS increase)

88. Supply Side Fiscal Policy
2. Work incentives—lower income tax
rates increase wages and encourage
more people to work
3. Risk taking—lower tax rates
encourage risk takers so
entrepreneurs and businesses will be
more willing to risk their energies on
new production methods and new
products

89. Supply side AS1
Fiscal Policy
PL AS2
P2
P3
P1
AD2
AD1
Q1 Q2 Q3 GDPr

90. Supply side Fiscal Policy
• Most economists are skeptical of supply side
tax cuts—they believe that the positive
effects are not nearly as strong and that the
rightward shifts of AS are slow and long-term
so the AD impact would be more immediate
and potentially more inflationary
• However, most agree that AS effects of fiscal
policy need to be considered when passing
discretionary fiscal policy