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Demand for Goods and Services in the Economy

The curve indicating the inverse relationship between the price level (index) and the quantity of domestically produced goods and services that buyers are willing and able to purchase from the economy is called Aggregate Demand

Aggregate Demand is a downward sloping curve

It shows the level of real GDP that will be purchased by consumers, government, businesses and people in other countries at various price index levels.

The reasons why it slopes down are not the same as the reasons why there is a downward sloping demand for an individual good. Rather, all the reasons have to do with the effect of inflation on the decisions of buyers.

Why Aggregate Demand Slopes Down

There are three major reasons:

1. The effect of the price level on buyers’ wealth (particularly that of consumers). Inflation reduces the value of any wealth that is kept in the form of cash (or non-interest bearing bank deposits). Since each dollar will buy less, each dollar is worth less, and its owner is made that much less wealthy. This is called the "real balance effect" or the "real wealth effect." This is something like the effect of unanticipated inflation on creditors. However, notice that there is a bit of this effect even if the holder of the dollar is not a net monetary creditor (that is, even if they are not owed more money than they owe to others). Since holders of dollars will become poorer, they will be able and willing to buy fewer goods at a high price index level than they would at a lower price index level.

2. The effect of the price level on the ability to borrow. Inflation raises real interest rates. This is because inflation requires that buyers of goods borrow more money to buy the same things as they might have bought before the inflation (since prices are higher). This increases the demand for loans, which raises the interest rate (in both nominal and real terms). However, at a higher real interest rate, borrowing looks less attractive, and will be more difficult to afford. The result is that buyers will not be able to simply borrow enough to keep up with the higher prices of the things they are buying, and will instead buy fewer things. This is called the "real interest effect."

To see this, look at the loanable funds market (described in Chapter 4), only we are using the real interest rate (r) as the "price."

3. The effect of the price level on international trade. When there is inflation in one country, buyers will substitute goods they can purchase in countries that have not had inflation, since domestically produced goods will look comparatively more expensive. This is called the "international substitution effect."


Supply of Goods and Services in the Economy

The curve indicating the relationship between the price level (index) and the quantity of domestically produced goods and services that producers are willing and able to produce in the economy is called Aggregate Supply.

With aggregate supply, the effects of the price level depend on how much time producers have to make and change decisions. For this reason, we actually have two Aggregate Supply curves!

Aggregate Supply in the Short Run

In the short run, some decisions cannot be altered. For example, commitments to sell resources may be made with contracts (such as labor contracts) which cannot be altered right away. This means that the costs to producers of making their products are not likely to change much in the short run, even if there is a rise in the final prices of goods and services. This means that an increase in the price level will cause product prices to go up, but there is no increase in product costs. Producers will have an incentive to increase production (since their products' prices are rising, but costs are not). This will increase producers' profits, also encouraging production to increase.

Aggregate Supply in the Long Run

Given enough time, all decisions can be altered. This amount of time is called the"long run." In the long run, commitments to supply resources can be renegotiated. If inflation occurs, resource owners (including workers) will ask for more money in payment, since the prices of goods and services are going up. As this occurs, producers will find that any increase in the prices in their goods or services will (eventually) be matched by increases in the costs of making their products. So, the producers will have no incentive in the long run to increase production as the price level rises. The amount of production in the economy will be determined instead by the amount of available resources (given that some resources will be unemployed, due to natural unemployment) and the technologies available to producers. The price level has no effect on production in the long run. The amount of real GDP (or real output) that the economy produces in the long run is called "sustainable real GDP," or "potential real GDP," or (since the economy is at full employment, with only natural unemployment) "full employment real GDP."

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Copyright 2016 by Ray Bromley. For economics information, and other information about Ray Bromley, visit www.raybromley.com. Permission to copy for educational use is granted, provided this notice is retained. All other rights reserved.
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