Aggregate Demand and Aggregate Supply

Aggregate Demand and Aggregate Supply

• Economic fluctuations, also called business cycles,

are movements of GDP away from potential output.
• Insufficient demand for goods and services was a key
problem of the Great Depression, identified by British
economist John Maynard Keynes in the 1930s.
 Sticky Prices and Their Macroeconomic Consequences

• Led by Keynes, many economists since his

time have focused attention on economic
coordination problems.
• The price system does not always work
instantaneously. If prices are slow to adjust,
then the proper signals are not given quickly
enough to producers and consumers.
• In modern economies, some prices (auctions
prices) are very flexible, while others (custom
prices) are not. Like other input prices, the
price of labor adjusts very slowly.
 Sticky Prices and Their Macroeconomic

• If wages are sticky, firms’ overall costs will be

sticky as well. Sticky wages cause sticky
prices and hamper the economy’s ability to
bring demand and supply into balance in the
short run.
• The short run in macroeconomics is the
period in which prices don’t change or don’t
change very much. In the macroeconomic
short run, both formal and informal contracts
between firms mean that changes in demand
will be reflected primarily in changes in output,
not prices.
 The Aggregate Demand Curve

Note that
changes in prices
result in changes
in the quantity
demand.
 The Components of Aggregate Demand

• In our study of GDP accounting, we divided

GDP into four components:
– Consumption spending (C), investment
spending (I), government purchases (G), and
net exports (NX).
• These four components are also four parts
of aggregate demand because the
aggregate demand curve really just
describes the demand for total GDP at
different price levels.
 Why the Aggregate Demand Curve Slopes Downward

• First, we must consider the effects of a change in the

overall price level in the economy.
• As the price level or average level of prices in the
economy changes, so does the purchasing power of
your money. This is an example of the real-nominal
principle.

Real-Nominal PRINCIPLE
What matters to people is the real value of money or
income—its purchasing power—not the “face” value
of money or income.

• The change in the purchasing power of money will affect

aggregate demand.
 Why the Aggregate Demand Curve Slopes Downward

• The increase in spending that occurs because

the real value of money increases when the
price level falls is called the wealth effect.
• The interest rate effect: With a given money
supply in the economy, a lower price level will
lead to lower interest rates and higher
consumption and investment spending.
• The impact of foreign trade: A lower price
level makes domestic goods cheaper relative
to foreign goods.
Why the Aggregate Demand Curve is Downward-
Sloping?
Why the Aggregate Demand Curve is Downward-Sloping?
Why the Aggregate Demand Curve is Downward-Sloping?
Why the Aggregate Demand Curve Slopes Downward (1)
The Interest Rate Effect (2)
International Trade Effect
Nonprice Determinants: Changes in Aggregate Demand (1)
Nonprice Determinants: Changes in Aggregate Demand (2)
Nonprice Determinants: Changes in Aggregate Demand (3)
Factors that change aggregate demand
Factors that change aggregate demand
Shifting the Aggregate Demand Curve
 Shifting the Aggregate Demand Curve

Demand-pull
inflation: rapid
increases in AD
outpace the
growth of AS,
causing price
level increases
(inflation).
The Multiplier Makes the Shift Bigger

• Initially, the shift from A

to B equals the increase
in government spending.
• But after a brief period of
time, due to multiplier
effect, total aggregate
demand will increase by
more than the initial
increase in government
spending – shifts moves
to point C
 How the Multiplier Makes the Shift Bigger

• The ratio of the final shift in aggregate demand to the

initial shift in aggregate demand is known as the
multiplier.
• The logic of the multiplier goes back to Keynes. He
believed that as government spending increases and the
aggregate demand curve shifts to the right, output will
subsequently increase too. Increased output also means
increased income for households and higher
consumption. It is this additional consumption spending
that causes the further shift in the aggregate demand
curve.
 Aggregate Supply

• It shows the quantity of

real GDP produced at
different price levels.
• Short-run AS slopes
upward because an
increase in the price
level (while production
costs and capital are
held constant on the
short-run), means higher
profit margins—firms will
want to produce more.
Determinants of Aggregate Supply (1)
Determinants of Aggregate Supply (2)
Determinants of Aggregate Supply (3)
Changes in Aggregate Supply
 Effects of a Change in Aggregate Supply

Cost-push
inflation: cost
increases push
AS to the left
(relative to AD),
causing price
level increases
(inflation).
Changes in Short-Run Aggregate Supply
 How Short-Run Equilibrium In The Economy Is Achieved

• AD and SRAS determine the price level, real

GDP, and the unemployment rate in the short run.
• In instances of both surplus and shortage,
economic forces are moving the economy toward
the short-run equilibrium point.

• Ceteris paribus, we expect a higher real GDP

level to be associated with a lower unemployment
rate and a lower real GDP level to be associated
with a higher unemployment rate.
Short-Run Equilibrium
Changes in Short-Run Equilibrium in the economy
 Supply Shocks

Price level AS1975

• Adverse supply shocks
can cause a recession
AS1973 (a fall in output) with
increasing prices. This
phenomenon is known
as stagflation.
AD • A dramatic increase in
oil prices caused the
stagflation of the 1970s

Real GDP
How a Factor Affects the Price Level, Real GDP
and the Unemployment Rate in the Short Run
A Summary Exhibit of AD and SRAS
 The Shape of the Long-Run Aggregate Supply Curve

Price
• In the long run, the level Level
LRAS
of output, depends
solely on the supply
factors - capital, labor -
and the state of
technology.
• In the long run, the
economy operates at
full employment and
changes in the price
level do not affect this.
YF
Goods & Services
(real GDP)
 The Shape of Long-run AS (LRAS)

• Resource costs are NOT fixed.

– As prices rises, workers will want higher wages and will
eventually get them.
• The amount of capital is not fixed—firms can build
new plants and buy new equipment over the long-
run.
• In the long-run, AS is set by the production
possibilities curve —the capacity of the economy,
and is not affected by prices, hence is vertical.
 Long- and Short-Run Aggregate Supply

• Shifts in LRAS:
A long run change in aggregate supply indicates that it will be
possible to achieve and sustain a larger rate of output.

• A shift in the long run aggregate supply curve (LRAS) will

cause the short run aggregate supply (SRAS) curve to shift in
the same direction.

• Shifts in LRAS are an alternative way of indicating that there has

been a shift in the economy’s production possibilities curve.
 Shifts in LRAS Aggregate Supply

PPC

Factors that increase (decrease)

LRAS:
• Increase (decrease) in the supply of
resources.

• Improvement (deterioration) in technology

and productivity.

• Institutional changes that increase

(reduce) the efficiency of resource use.
 Shifts in Aggregate Supply

Price Price
Level Level

LRAS1 LRAS2 SRAS1 SRAS2

Goods & Services Goods & Services

YF1 YF2 (real GDP) (real GDP)

• Such factors as an increase in the stock of capital or an improvement in technology

will expand an economy’s potential output and shift LRAS to the right (note that when
the LRAS curve shifts, so too does SRAS).
• Such factors as a reduction in resource prices or favorable weather would shift SRAS
to the right (note that here the LRAS curve will remain constant).
Equilibrium States of the Economy
 Growth in Aggregate Supply

• Consider the impact Price LRAS1 LRAS2

that capital formation Level
or a technological SRAS1
advancement has on
an economy. SRAS2

• Both LRAS and SRAS

increase (to LRAS2
and SRAS2); P100
full employment output
expands from YF1 to P95
YF2.

• A sustainable, higher AD
Goods & Services
level of real output is YF1 YF2 (real GDP)
the result.
 Unanticipated Changes in Aggregate Demand

• In the short-run, output will deviate from full

employment capacity as prices in the goods
and services market deviate from the price level
that people expected.

• Unanticipated changes in aggregate demand

often lead to such deviations.
 Unanticipated Increase in Aggregate Demand

• Impact of unanticipated increase in AD:

– Initially, the strong demand and higher price level in the
goods & services market will temporarily improve profit
margins.

– Output will increase, the rate of unemployment will drop

below the natural rate, and output will temporarily exceed the
economy's long-run potential.

– With time, however, contracts will be modified and resource

prices will rise and return to their competitive relation with
product prices.

– Once this happens, output will recede to

the economy's long-run potential.
 Increase in AD: Short Run

Price
• In response to an Level
unanticipated LRAS SRAS1
increase in AD for
goods
& services (shift Short-run effects of
from AD1 to AD2), P105 an unanticipated
prices rise to P105 increase in AD
P100
and output will
increase to Y2,
temporarily AD2
exceeding AD1
full-employment Goods & Services
YF Y2 (real GDP)
capacity.
 Increase in AD: Long Run

• With time, resource

Price
market prices, including Level SRAS2
labor, rise due LRAS
to the strong demand. SRAS1
Higher costs reduce
SRAS1 to SRAS2.
P110
• In the long-run, a new Long-run effects of
equilibrium at a higher P105 an unanticipated
price level, increase in AD
P110, and output P100
consistent with long-run
potential will occur.
• So, the increase in AD2
demand only AD1
temporarily expands Goods & Services
output. YF Y2 (real GDP)
 Unanticipated Decrease in Aggregate Demand

• Impact of unanticipated reduction in AD:

– Weak demand and lower prices in the goods &

services market will reduce profit margins. Many firms
will incur losses.

– Firms will reduce output, the unemployment rate will

rise above the natural rate, and output will temporarily
fall short of the economy's long-run potential.

– With time, long-term contracts will be modified.

– Eventually, lower resource prices and a lower real

interest rate will direct the economy back to long-run
equilibrium, but this may be a lengthy and painful
process.
 Decrease in AD: Short Run

• The short-run impact Price

of an unanticipated Level
reduction in AD (shift LRAS SRAS1
from AD1 to AD2) will
be a decline in output
(to Y2), and a lower
Short-run effects of
price level (P95). an unanticipated
reduction in AD
P100
• Temporarily, profit
margins decline, P95
output falls, and
unemployment rises
above its natural rate. AD2 AD1
Goods & Services
Y2 YF (real GDP)
 Decrease in AD: Long Run

• In the long-run, weak

Price
demand and excess Level
supply in the resource LRAS SRAS1
market leads to lower
resource prices
(including labor) SRAS2
resulting in an
expansion in SRAS Long-run effects of
(SRAS1 to SRAS2). an unanticipated
P100 reduction in AD
P95
• A new equilibrium at a
lower price level, P90, P90
and an output AD2 AD1
consistent with long- Goods & Services
run potential will Y2 YF (real GDP)

result.
 Unanticipated Changes in Short-Run Aggregate Supply

• Unanticipated changes in short-run aggregate supply (SRAS)

can catch people by surprise.
• Thus, they are often referred to as supply shocks.
• A supply shock is an unexpected event that temporarily
increases or decreases aggregate supply.
 Impact of Increase in SRAS

• SRAS shifts to the right – output temporarily exceeds the

economy's long-run potential.

• Since the temporarily favorable supply conditions cannot be

counted on in the future, the economy’s long-term production
capacity will not be altered.

• If individuals recognize that they will be unable to maintain their

current high level of income, they will increase their saving.
Lower interest rates, and additional capital formation may result.
 Unanticipated Increase in SRAS

• Consider an unanticipated, Price

temporary, increase in SRAS, Level
LRAS
such as may result from a SRAS1
bumper crop from good
weather. SRAS2
• The increase in aggregate
supply (to SRAS2) would lead
to a lower price level P95 and P100
an increase in current GDP to
Y2. P95

• As the supply conditions are AD

temporary, LRAS persists. Goods & Services
YF Y2 (real GDP)
 Supply Shock: Resource Market

Resource
• Suppose there is an Price S2 Market
adverse supply shock, Level
perhaps as the result of a
crop failure or a sharp S1
increase in the world price Pr2
of a major resource, such
as oil.
Pr1
• Here we show the impact
in the resource market:
prices
rise from Pr1 to Pr2.
D
Quantity of
Q2 Q1 resources
 Effects of Adverse Supply Shock

• If the adverse supply Price

shock is temporary, Level SRAS2 (Pr2 )
resource prices will LRAS
eventually fall in the SRAS1 (Pr1 )
future, shifting SRAS2
back to SRAS1, returning
equilibrium to (A). B
P110
• If the adverse supply P100 A
factor is permanent, the
productive potential of the
economy will shrink
(LRAS shifts left and Y2
becomes YF2) and (B) will AD
become the long-run Goods & Services
equilibrium Y2 YF (real GDP)
 Price Level, Inflation, and the AD-AS Model

• The basic AD-AS model focuses on how the general level of prices influence
the choices of business decision makers.

– Disequilibrium occurs when the actual price level is either greater than or
less than the anticipated level.

– The actual price level will also differ from the level people anticipated when
the rate of inflation differs from what is expected.

– When the inflation rate is greater than anticipated, this implies a higher than
anticipated price level. As a result, profit margins will be attractive and
business firms will respond with an expansion in output.

– When the inflation rate is less than anticipated, this implies a lower than
anticipated price level. As a result, profit margins will be unattractive and
businesses will reduce their output.
The Business Cycle -- Revisited

• Recessions occur because prices in the

goods and services market are low relative to
the costs of production and resource prices.

– The two causes of recessions:

• unanticipated reductions in AD, and,
• unfavorable supply shocks.

• An unsustainable economic boom occurs

when prices in the goods and services market
are high relative to resource prices and other
costs.
• The two causes of booms are:
– unanticipated increases in AD,
and,
– favorable supply shocks.
 Does the Market Have a Self-Corrective Mechanism?

• There are three means by which the economy seems to have a self-corrective
mechanism keeping it ‘on-track’:

– Consumption demand is relatively stable over the business cycle.

– Changes in real interest rates will help to stabilize aggregate demand

and redirect economic fluctuations.

• Interest rates tend to fall during a recession and rise during an economic
boom.

– Changes in real resource prices will redirect economic fluctuations.

• Real resource prices tend to fall during a recession and rise during an
expansion.
 Changes in Real Interest Rates and Resource Prices Over the Business Cycle

Price
Level
LRAS
Real interest rates fall Real interest rates rise
r (because of weak r (because of strong
demand for investment) demand for investment)

Real resource prices fall Real resource prices rise

Pr (because of weak demand Pr (because of strong demand
and high unemployment) and low unemployment)

Goods & Services

(real GDP)
YF
Unemployment greater Unemployment less
than Natural Rate than Natural Rate

• If aggregate output is less than full employment potential YF :

– weak demand for investment lowers real interest rates.
– slack employment in resource markets places downward
pressure on wages and other resource prices (Pr).
• Conversely, when output exceeds YF:
– strong demand for capital goods and tight labor market
conditions will result in both rising real interest rates
and resource prices (Pr).
Changing One Shot Inflation Into Continued Inflation
Thank You for your Attention

☺
 Literature

1 - John F Hall: Introduction to Macroeconomics, 2005

2 - Fernando Quijano and Yvonn Quijano: Introduction to Macroeconomics

3 - Karl Case, Ray Fair: Principles of Economics, 2002

4 - Boyes and Melvin: Economics, 2008

5 - James Gwartney, David Macpherson and Charles Skipton:

Macroeconomics, 2006

6 - N. Gregory Mankiw: Macroeconomics, 2002

7- Yamin Ahmed: Principles of Macroeconomics, 2005

8 - Olivier Blanchard: Principles of Macroeconomics, 1996