Aggregate Supply and Aggregate Demand

Introduction

• Studying aggregate supply and aggregate demand.
• Starting with aggregate demand, then discussing aggregate supply.
• Emphasis on the differences between aggregate demand/supply in macroeconomics vs. traditional demand/supply in microeconomics.

Microeconomic Supply and Demand

• Focus on a specific market (e.g., candy bars).
• Vertical axis: Price per unit.
• Horizontal axis: Quantity bought/sold over time.
• Demand curve: Downward sloping.
  • High price: Low quantity demanded (substitution effect).
  • Low price: High quantity demanded.
• Interpretations:
  • Marginal benefit curve: Higher willingness to pay for initial units; benefit decreases with more units.

Aggregate Demand in Macroeconomics

• Focuses on the economy as a whole, not just one good or service.
• Horizontal axis: Real GDP (production of the economy over time).
• Vertical axis: Price level (general level of prices in the economy).
• Aggregate demand curve: Downward sloping (based on economic theories).
• Impact of price levels:
  • High prices -> GDP contracts.
  • Low prices -> GDP expands.

Theories Explaining Downward Sloping Aggregate Demand

Wealth Effect

• Prices decrease -> Real wealth increases -> Higher demand for goods and services.
• Prices increase -> Real wealth decreases -> Lower demand for goods and services.

Interest Rate Effect

• Prices decrease:
  • People spend less on goods/services, save more.
  • More savings -> Increased supply of money for lending -> Lower interest rates.
  • Lower interest rates -> Cheaper borrowing -> Increased investment -> Expanded GDP.
• Prices increase:
  • People spend more on goods/services, save less.
  • Less savings -> Decreased supply of money for lending -> Higher interest rates.
  • Higher interest rates -> Expensive borrowing -> Decreased investment -> Contracted GDP.

Foreign Exchange Effect

• Prices decrease:
  • Lower interest rates -> Investors convert currency for higher returns elsewhere.
  • Currency weakens -> Cheaper domestic goods/services for foreigners -> Higher exports -> Expanded GDP.
• Prices increase:
  • Higher interest rates -> Increased demand for domestic currency.
  • Currency strengthens -> Expensive domestic goods/services for foreigners -> Lower exports -> Contracted GDP.