Previously we learned that total spending always equals total output in national income accounting. How can aggregate demand be different from aggregate supply in this lesson?- In national income accounting, unsold output is counted as a “sale” to the firm producing it. But aggregate demand reflects the true quantity demanded and so excludes unsold and unwanted output.
An economy produces bread and clothing. In 1980, bread cost $2 a loaf and clothing cost $20 a unit. In the same year, the economy produced 20,000 loaves of bread and 5,000 of clothing. In 1981, bread cost $1 and clothing $10.
a. If in 1981, the quantities of goods were produced, what happened to nominal income? To real income (letting 1980 be the base year)? To relative prices?
a. In 1980, nominal income was $140,000. With the same output, 1981’s nominal income was $70.000 but its real income was still $140,000 ($70,000/0.50, where 0.50 is the 1981 price level since prices are one-half of what they were in 1980). Relative prices did not change. For example, the relative price of a loaf of bread was one-tenth of a unit of clothing in both 1980 and 1981.
b. The lower price level in 1981 increased the real value of people’s nominal assets, causing people to demand more. The economy will move down and to the right along its aggregate demand curve.
According to some economists, the government can stimulate output growth with tax cuts. If this is the case, what will happen to the price level?
- The price level will fall.
A recent headline read “Renewed Growth Will Fuel More Inflation.” This headline reflects a common notion in the press that a high growth rate in GNP causes higher inflation rates. Use the aggregate demand and supply diagram to show when this is incorrect.
- An increase in output (growth) will cause inflation to decrease, not increase. So if the output growth it caused by an increase in aggregate supply; the headline is wrong. But if the output growth is caused by an increase in aggregate demand, the higher output will be accompanied by higher inflation, and the headline will be correct. So it is important to know whether output is going up because of an increase in aggregate demand or in aggregate supply. This is a distinction that many economic commentators ignore.
If aggregate supply shifts to the right each year due to technological progress, then what must be the government do to maintain a stable price level?
- If the government does nothing, then prices will fall when output grows. To keep prices stable, aggregate demand must be increased along with aggregate output (so both shift right by the same amount).
Many economic commentators state that “recessions cause prices to fall.” If they mean that reduced output (i.e., reduced aggregate supply) causes lower prices, are they correct?
- No. Reduced aggregate supply will increase the price level.
When will reduced output be accompanied by lower prices?
- When aggregate demand is reduced. The reduced output in this case is a result of a decrease in aggregate demand, not a cause of the reduced output.
What will happen if, at the same time, workers demand and get higher wages and consumers decide to increase their real consumption spending?
- The price level will rise. The effect on output cannot be predicted without more information as to how much aggregate demand and supply shift.
Copyright 2008 by Sujanto Rusli
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