Unit 3 Key Ideas

Unit 3: Aggregate Demand and Aggregate Supply: Fluctuations in Outputs and Prices

Aggregate demand (AD) and aggregate supply (AS) curves look and operate much like the supply and demand curves used in microeconomics. However, these macroeconomic AD and AS curves depict different things, and they change for different reasons than microeconomic demand and supply curves. AD and AS curves can be used to illustrate changes in real output and the price level of an economy.

The downward sloping aggregate demand curve is explained by the wealth effect, the income effect, and the foreign purchases effect.

The aggregate supply curve is divided into three ranges: the horizontal or Keynesian range, the upward sloping or intermediate range, and the vertical or classical range.

Changes in the price level and output are illustrated by shifts and movements along the aggregate demand and supply curves.

Shifts in the aggregate demand can change the level of output and the price level or both. The determinants of AD include changes in consumer spending, investment spending, government spending, and net export spending.

Shifts in aggregate supply can also change the level of output and the price level. Determinants of AS include changes in input prices, productivity, the legal institutional environment, and the quantity of available resources.

Changes in outputs can also be illustrated by the Keynesian expenditure-output mode. This model differs from the AD/AS model because in the Keynesian model the price level is assumed to be constant. The Keynesian model has fixed prices.

The AD/AS model can be reconciled with the Keynesian expenditure-output model. In the Keynesian (horizontal) range of the AS curve, both models are identical. The models differ in the intermediate and vertical range of the AS curve.

Autonomous spending is the part of AD that is independent of the current rate of economic activity.

Induced spending is that part of AD that depends upon the current rate of economic activity.

The multiplier is a number that influences the relationship of changes in autonomous spending to changes in real GDP.

The formula for calculating the multiplier is: M=1/MPS or M=1/1-MPC

The multiplier results from subsequent rounds of induced spending that occur when autonomous spending changes.

Keynesian economists believe the equilibrium levels of GDP can occur at less than or more than the full-employment level of GDP. Classical economists believe that long-run equilibrium can occur only at full employment.

Fiscal policy consists of government actions that may increase or decrease aggregate demand. These actions involve changes in government spending and taxing.

The government uses an expansionary fiscal policy to try to increase or decrease aggregate demand. These actions involve changes in government spending and taxing.

The government uses a contractionary fiscal policy to try to decrease aggregate demand during a period of inflation. The government may increase taxes, decrease spending, or do a combination of the two.

Discretionary fiscal policy means the federal government must take deliberate action or pass a new law changing taxes or spending. The automatic or built-in stabilizers change government spending or taxes without new laws being passed or deliberate action being taken.

The balanced budget multiplier indicates that equal increases or decreases in taxes and government spending increase or decrease equilibrium GDP by an amount equal to that increase or decrease.

Stagflation can be explained by a decrease in aggregate supply.