Figure 331

Aggregate supply

Equilibrium price level

Aggregate demand

Equilibrium Quantity of output Output supply. The horizontal axis shows the quantity of output, and the vertical axis shows the price level.

Page 750 The aggregate-demand curve slopes downward for three reasons. First, when prices fall, the value of dollars in people's wallets and bank accounts rises, so they are wealthier. As a result, they spend more, thereby increasing the quantity of goods and services demanded. Second, when prices fall, people need less money to make their purchases, so they lend more out, which reduces the interest rate. The lower interest rate encourages businesses to invest more, increasing the quantity of goods and services demanded. Third, since lower prices lead to a lower interest rate, some U.S. investors will invest abroad, supplying dollars to the foreign-exchange market, thus causing the dollar to depreciate. The decline in the real exchange rate causes net exports to increase, which increases the quantity of goods and services demanded.

Any event that alters the level of consumption, investment, government purchases, or net exports at a given price level will lead to a shift in aggregate demand. An increase in expenditure will shift the aggregate-demand curve to the right, while a decline in expenditure will shift the aggregate-demand curve to the left.

Page 759 The long-run aggregate-supply curve is vertical because the price level does not affect the long-run determinants of real GDP, which include supplies of labor, capital, natural resources, and the level of available technology. This is just an application of the classical dichotomy and monetary neutrality.

There are three reasons the short-run aggregate-supply curve slopes upward. First, the sticky-wage theory suggests that because nominal wages are slow to adjust, a decline in the price level means real wages are higher, so firms hire fewer workers and produce less, causing the quantity of goods and services supplied to decline. Second, the sticky-price theory suggests that the prices of some goods and services are slow to change. If some economic event causes the overall price level to decline, the relative prices of goods whose prices are sticky will rise and the quantity of those goods sold will decline, leading firms to cut back on production. Thus, a lower price level reduces the quantity of goods and services supplied. Third, the misperceptions theory suggests that changes in the overall price level can temporarily mislead suppliers. When the price level falls below the level that was expected, suppliers think that the relative prices of their products have declined, so they produce less. Thus, a lower price level reduces the quantity of goods and services supplied.

The long-run and short-run aggregate-supply curves will both shift if the supplies of labor, capital, or natural resources change or if technology changes. A change in the expected price level will shift the short-run aggregate-supply curve but will have no effect on the long-run aggregate-supply curve.

Page 771 When a popular presidential candidate is elected, causing people to be more confident about the future, they will spend more, causing the aggregate-demand curve to shift to the right, as shown in Figure 33-2. The economy begins at point A with aggregate-demand curve AD1 and short-run aggregate-supply curve AS1. The equilibrium has price level P1 and output level Y1. Increased confidence about the future causes the aggregate-demand curve to shift to AD2. The economy moves to point B, with price level P2 and output level Y2. Over time, price expectations adjust and the short-run aggregate-supply curve shifts up to AS2 and the economy moves to equilibrium at point C, with price level P3 and output level Y1.

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