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AGGREGATE DEMAND INCREASE, SHORT-RUN AGGREGATE MARKET:
A shock to the short-run aggregate market caused by an increase in aggregate demand, resulting in and illustrated by a rightward shift of the aggregate demand curve. An increase in aggregate demand in the short-run aggregate market results in an increase in the price level and an increase in real production. The level of real production resulting from the shock can be greater or less than full-employment real production. While a wide range of specific aggregate demand determinants can cause an increase in the four aggregate expenditures and thus an increase in aggregate demand, the following rank among the more important:
- An increase in consumer confidence brought on by periods of prosperity that prompts the household sector to spend a larger proportion of disposable income on consumption.
- Expectations of higher inflation rates in the near future that entice the household sector to increase consumption expenditures in the present before prices rise.
- A decline in interest rates associated with natural business-cycle activity or specifically induced by expansionary monetary policy from the Federal Reserve System that induces the household and business sectors to increase consumption and investment expenditures.
- Prosperity in other nations that induces the foreign sector to increase the purchases of domestic exports, thus increasing net exports.
- An increase in purchases and/or a decrease in taxes by the federal government resulting from expansionary fiscal policy.
- An increase in state or local government purchases, and/or a decrease in state or local taxes.
The short-run aggregate market presented in the graph to the right sets the stage for analyzing the effect of an increase in aggregate demand resulting from a change in any aggregate demand determinant. The vertical axis measures the price level (GDP price deflator) and the horizontal axis measures real production (real GDP). The negatively-sloped curve, labeled AD, is the aggregate demand curve and the positively-sloped curve, labeled SRAS, is the short-run aggregate supply curve. The current short-run equilibrium, found at the intersection of the AD and SRAS curves, is a price level of 10 and real production of $100 billion.
Short-Run Aggregate Market
Consider what happens to this short-run aggregate market with an increase in aggregate demand. Suppose, for example, that the Federal Reserve System undertakes a bit of expansionary monetary policy, which causes a decline in interest rates, which then prompts the household and business sectors to increase consumption and investment expenditures. The result of this action is a rightward shift of the AD curve. Click the [AD Increase] button to illustrate.
The result of this rightward AD curve shift is that a new short-run equilibrium is achieved at a higher price level (11) and a larger amount of real production ($110 billion). This result is comparable to that for a standard market. An increase in market demand results in a higher equilibrium price and a larger equilibrium quantity. The key difference, of course, is that this "market" is the aggregate product market for the entire economy and not the market for a specific good.
A comparative static analysis of the original equilibrium and the new equilibrium is useful and important. However, it is also instructive to dissect the adjustment process.
- First, the AD curve shifts rightward due to the increase in consumption and investment expenditures induced by lower interest rates. This "extra" aggregate demand creates an imbalance in the aggregate market. At the existing price level (which has NOT yet changed), producers are willing and able to sell $100 billion worth of real production. Buyers, however, are now willing and able to purchase more, something like $120 billion worth of real production. This creates economy-wide product market shortages.
- Second, motivated to satisfy this extra demand and to fill these shortages, producers increase production. In the short run they can do so, even if the original real production level is full employment, by tapping into frictional and structural unemployment and paying resources higher prices that create a temporary imbalance in real resource prices, which leads to an increase in the quantity of resources supplied. These actions, however, cause product prices and the price level to rise.
- Third, with the rising price level, producers are able to increase real production, but buyers are induced to decrease aggregate expenditures. The combination of producers increasing real production and buyers decreasing aggregate expenditures act to reduce the existing economy-wide product market shortages. In fact, as long as economy-wide product market shortages persist, producers increase production, which causes the price level to rise, which then decreases aggregate expenditures. Eventually the rising real production and falling aggregate expenditures meet at the new short-run equilibrium price level of 11 and real production of $110 billion.
AGGREGATE DEMAND INCREASE, SHORT-RUN AGGREGATE MARKET, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: February 27, 2024].
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