Chapter Eight: Module Summary -- Aggregate Demand and Aggregate Supply

• The Circular Flow Diagram is a graphical way to illustrate how the different pieces of the economy fit together. Consumers receive disposable income, and either consume it or save it. Consumption goes directly into Aggregate Demand. The saving leaks out to the financial system, to be injected back into the system as Investment. The Government and Net Exports contribute to demand for goods and services. The production of goods and services makes up GDP which, after making some minor adjustments, is equal to national income. The national income is used to pay taxes to finance government expenditures, and it generates the disposable income that people use for consumption and saving.

• Aggregate Demand (AD) is the total amount that all consumers, firms, government, and foreigners wish to spend on final goods and services produced in the U.S. borders, given the price level.
  AD = C + I + G + NX.

• Consumption (C) is the total amount spent by consumers on newly produced goods and services. Consumption is for current enjoyment.

• Investment ( I ) is the total amount spent by firms on factories, machinery, plant and equipment, plus the expenditures of households on new homes. Investment must expand the production capacity of the economy.

• Government Expenditures (G) are the total amount of government purchases of newly produced goods and services.

• Net Exports (NX) are exports minus imports.

• In economics, the terms saving and investment are very distinct; they are not interchangeable. Saving (S) is disposable income not consumed. It is not a component of Aggregate Demand. Investment expands the productive capacity of the economy.

• The Aggregate Demand curve plots the level of Aggregate Demand at various price levels.

• The AD curve has a downward slope, reflecting the negative relationship between the price level (P) and Aggregate Demand.

• The AD curve slopes downward due to the wealth effect and the international trade effect.

• A change in the level of Aggregate Demand that is caused by a change in price level is referred to as a movement along the Aggregate Demand curve or a change in Aggregate quantity demanded. A change in any factor that changes the level of Aggregate Demand other than a change in the price level results in a shift of the Aggregate Demand curve.

• Any increase in an autonomous (non-income) component of Aggregate Demand shifts the AD curve to the right. This includes an autonomous increase in consumption, investment, government expenditures, or net exports.

• The Aggregate Supply curve is the total amount of output (Y) produced at various price levels.

• The short-run Aggregate Supply curve is upward-sloping because the costs of production are held constant.

• The long-run Aggregate Supply curve is a vertical line at the potential level of output. In the long-run there is no relationship between the price level and real output.

• A change in the level of Aggregate Supply that is caused by a change in the price level is referred to as a movement along the Aggregate Supply curve. A change in any factor that changes the level of Aggregate Supply other than a change in the price level results in a shift in the Aggregate Supply curve.

• A decrease in resource costs, an increase in technology, and a decrease in inflation expectations shift the Aggregate Supply curve to the right.

• The short-run equilibrium occurs where the AD curve crosses the short-run AS curve. The intersection of AD and AS gives both the price level the level of GDP in the economy.

• The long-run equilibrium can only occur where the AD curve crosses the long-run AS curve. In long-run, equilibrium output must equal potential output.

• Disequilibrium results when either Aggregate Demand exceeds Aggregate Supply, or when Aggregate Demand falls short of Aggregate Supply. In the first case, firms see inventories declining more than they desire, and respond by increasing output and prices until equilibrium is reached. In the second case, firms see unwanted inventories increasing and respond by decreasing production and prices. Again, the economy tends towards equilibrium.

• A demand-driven business cycle results from a shift in the Aggregate Demand curve. When the AD curve shifts, prices and output move in the same direction. This is the case in a "normal" business cycle.

• A supply-driven business cycle is driven by shifts in the Aggregate Supply curve. Prices and output move in opposite directions.

• A shift in the AS curve to the left produces stagflation, a period of economic stagnation coupled with high inflation.

• The Paradox of Thrift states that an increase in the desire of the economy as a whole to save more may lead to a decrease in output and employment, thus thwarting the attempt to save more.

• Whether an economy should consume or save depends upon the response of investment to saving and the time horizon. If investment increases as saving rises, then the paradox of thrift will not hold. Also, the longer the time period, the more likely it is that increased saving will lead to higher rates of investment and hence, higher rates of growth.