Chapter 32 _ Aggregate Demand and Aggregate Supply _ ECON 2020.pdf - \u201cAggregate demand and aggregate supply are the featured elements of the aggregate

Chapter 32 _ Aggregate Demand and Aggregate Supply _ ECON 2020.pdf

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“Aggregate demand and aggregate supply are the featured elements of the aggregate demand–aggregate supply model (AD-AS model), the focus of this chapter. The aggregate expenditures model of the previous chapter is an immediate-short-run model, in which prices are assumed to be fixed. In contrast, the AD-AS model in this chapter is a “variable price–variable output” model that allows both the price level and level of real GDP to change. It can also show longer time horizons, distinguishing between the immediate short run, the short run, and the long run. Further, in subsequent chapters, we will see that the AD-AS model easily depicts fiscal and monetary policies such as those used in 2008 and 2009 to try to halt the downward slide of the economy and promote its recovery.” 32.1 [Aggregate Demand]: Define aggregate demand (AD) and explain how its downward slope is the result of the real-balances effect, the interest-rate effect, and the foreign purchases effect. Aggregate demand is a schedule or curve that shows the amount of a nation’s output (real GDP) that buyers collectively desire to purchase at each possible price level. These buyers include the nation’s households, businesses, and government along with consumers located abroad (households, businesses, and governments in other nations). The relationship between the price level (as measured by the GDP price index) and the amount of real GDP demanded is inverse or negative: When the price level rises, the quantity of real GDP demanded decreases; when the price level falls, the quantity of real GDP demanded increases. Aggregate Demand Curve The downsloping aggregate demand curve AD indicates an inverse (or negative) relationship between the price level and the amount of real output purchased. Why the downward slope? The explanation is not the same as that for why the demand for a single product slopes downward. That explanation centered on the income effect and the substitution effect. When the price of an individual product falls, the consumer’s (constant) nominal income allows a larger purchase of the product (the income effect). And, as price falls, the consumer wants to buy more of the product because it becomes relatively less expensive than other goods (the substitution effect). But these explanations do not work for aggregates. A decline in the price level does not necessarily mean an increase in the nominal income of the economy as a whole. Thus, a decline in the price level need not produce an income effect, where more output is purchased because lower nominal prices leave buyers with greater real income. Basically, declining price levels doesn’t mean that more people will buy things because lower prices means lower amounts of GDP to distribute for wages, rents, etc. Similarly, in Figure 32.1, prices in general are falling as we move down the aggregate demand curve, so the rationale for the substitution effect (where more of a specific product is purchased because it becomes cheaper relative to all other products) is not applicable. There is no overall substitution effect among domestically produced goods when the price level falls.
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