Aggregate Demand

and Aggregate Supply.

Aggregate Demand
In a recessionary trend govt. adopts

expansionary monetary and fiscal policy to

tackle it.
Govt. takes these steps by carefully judging
the impact of expansionary aggregate
demand policy on the inflation rate against
the higher output and lower unemployment .
Any policy of the govt. either monetary or
fiscal will have impact on the output and price
level

contd

..

While developing the IS and LM model we had

basically presumed the price level to remain

constant.
But in fact price level of an economy
fluctuates along with the fluctuation in the
output.
Equilibrium level of output should be
developed along with the equilibrium price.
Here in this section we will develop AD and AS
model to determine the impact of fluctuated
price level on fluctuated output.

Aggregate Demand
The aggregate demand(AD) curve which is

downward sloping is derived from IS-LM model

and the aggregate supply (AS) will be upward
slopping, and at their intersection point
equilibrium level of output and price will be
determined.
Shift in either schedule will cause either the
inflationary or the deflationary pressure in the
economy.

AS
pric
e

E'

AD
AD

output

The intersection of AD and AS curve for the determination of

equilibrium output and price.

Aggregate Demand Curve.

AD curve shows the combination of the price

level and output where both the money

market and goods market will attain
equilibrium.
Why does AD curve slope downward?

Explanation of downward slope of AD.

Suppose the initial equilibrium output is at Yo

with the price level Po

Now suppose the price level falls with a given
nominal stock of money.
A fall in the price level will increase the
quantity of real balance in the economy.
This leads to reduction in the interest rate and
increase in investment demand, increase in
aggregate spending and increase in the
equilibrium income.

LM

i
1
i
2

LM

IS

OUTPUT
p
1
p2

AD

OUTPUT

Explanation of the Diagram

A fall in the price level from p1 to p2 will increase the real

money stock in the economy.

As a result of which LM curve shifts downward.
The money market will be cleared with reduction in the
rate of interest so that people will demand to hold more
cash balances.
To restore the equilibrium the investment will increase to
raise the output, so that in the economy the transaction
demand will increase.
So that , the equilibrium will be established with more
income.
In the lower panel accordingly we will get two different
equilibrium income at two different price level.
By joining these two points we will get a downward sloping
AD curve.

Shift in the AD curve.

Both the fiscal and monetary policy change

can shift the AD curve. This can be discussed

in the following diagram.

LM
interes
t

IS

IS
output
price

AD
AD
output
Effect of fiscal policy on AD curve.

Explanation of the diagram.

In the upper panel of the diagram, the initial IS

and LM curve corresponds to a given nominal;

quantity of money and price level Po . Equilibrium
is obtained at the point e and there is a
corresponding point on AD curve in the lower
panel.
Now suppose Govt. spending increases as a result
the IS curve will shift to the right with a new
equilibrium pt at E, with higher income and
higher rate of interest. Thus at the initial level of
price the equilibrium income and spending will be
higher, as a result of which the AD curve will shift
to right in the lower panel.

LM
intere
st

LM

IS

price

Po

A
D

AD

output
Impact of monetary expansion on the AD curve.

Explanation of the diagram.

In the upper panel the original equilibrium income is

at the pt. e, with the intersection of IS and LM curve.

When govt. adopts expansionary monetary policy the
nominal money stock increases, which increases the
real money balances at the given price level.
As a result the LM curve shifts to the left and in the
asset market interest rate is reduced inducing the
public to hold more liquid cash balance .
The decline in interest rate stimulates the the
investment so raises the equilibrium level of income.
Now at the same price level the economy will have
more AD and more output.
As a result of which in the lower panel the AD curve
will shift to the right.

Aggregate Supply
AS curve defines for each given price level,

the quantity of output the firms are willing to

supply.
The amount they are willing to supply
depends upon the prices they receive for their
goods and the amount they have to pay the
cost of the production; basically the labor cost
.

contd

So, AS curve reflects the condition in the

factor market and in the goods market.

AS curve is the locus of different price
level and output at which both the goods
and factor market are at equilibrium.
The AS curve is upward slopping because
of its relation ship with the factor market
and the wage.

The Classical Supply curve

The classical AS curve is vertical because it is

based on the assumption that the labor

market is always in equilibrium with full
employment of labor force.
The labor market equilibrium underlying the
vertical schedule is assumed to be
maintained by speedy adjustment of the
nominal wage.
Because when the economy is in equilibrium
and AD curve shifts to the right to compete
to attract the labor the firms will raise the
wage and this in turn increase the price level.

Keynesian AS curve.
The Keynesian AS curve is horizontal

indicating that firms will supply whatever

goods demanded at the existing price
level.
The basic logic behind is that because
there is unemployment firms can obtain
as much labor they want at the existing
wage so, the AC of the product is assumed
to not to be changed at all. So they can
supply as much goods as they can at the
existing price level.

Modern version of AS curve.

Both the versons of AS curve are two

extreme cases. But in reality AS curve is

upward slopping.
It is derived from the link between the
wages, employment, prices and output.
The modern models though they have
different starting points but they conclude
that, AS curve is positively slopped in the
short run but vertical in the long run.

..contd
We will begin with an examination of the

mechanics of the AS curve.

We than look at some of the economics
that underlie the mechanics.
The price output relation along the AS
curve is built up from the links among
wages, prices, employment and output.
The link will be explained by the help of
the Phillips curve.

AS curve and the price adjustment mechanism.

t=0

Y0

contd
The horizontal AS curve is short run AS

curve.
The long run AS curve is vertical AS
curve.
AS curve rotates counter clock wise with
the passage of time.
If AD is greater than potential output ,
then after a years time the prices would
have increased enough to push back GDP
to potential level.

contd..
The diagram above explains the

relationship between AS and Price by the

following equation.
P t+1 = Pt [ 1 +(Y Y0)]
The equation explains that if the output is
above the potential level , then prices will
rise in the next period and if output is
below the potential level , prices will fall
and be lower in the next period.

..contd
Prices will continue to rise or fall over

time until output returns to potential

output.
The speed of price adjustment is
controlled by the parameter , if is
large the AS curve moves quickly or
equivalently otherwise price adjusts very
slowly.
Price adjustment depends upon the
movement of wage and rate of
unemployment ; by Philips curve.

The Phillips curve.

The Phillips curve is an inverse relationship

between the rate of unemployment and the

rate of increase in money wage.
The higher the rate unemployment lower is
the rate of wage inflation and the viceversa.

Contd

Phillips curve states that , wages will fall

when unemployment is more than the

natural rate and wages will rise when
unemployment is less than the natural
rate.
Wages and prices adjusts slowly to the
change in AD.

Contd

Wage rate increases with the decrease in

the rate of unemployment but not

proportionately.
Wages are sticky by nature or wage
adjustment is sluggish because it moves
slowly over time so as to ensure full
employment at every point of time.
Wage of this time period depends upon
the wage of previous time period and the
level of unemployment.

Contd..
If the level of employment is more than

the level of full employment then the

wage rate will increase and the vice
versa.
wn

wage

wn
W

wn

N
employment

explanation
Phillips curve implies that WN relationship

shifts overtime. If there is over employment

in this period then WN curve will shift upward
in the next period to WN. If there is less than
full employment than this period, then WN
curve will shift downward to WN.
Shift in the AD alters the rate of
unemployment this period and this will have
effects in the wages in the subsequent
periods.
The adjustment of wage is dynamic so it
takes place over time.

AS curve.
AS basically depends upon three factors:
The relation ship of the output with the

labor(The production function.)

Relationship between cost and prices.
Relationship between unemployment and
wage: (The Phillips curve)

Contd

When AD shifts it is required to increase the

output. Output being a function of labor

unemployment rate decreases in this present
time period.
Firms will be willing to supply that output at
that price which will at least cover the cost of
production.
With the rise in employment rate the wage
rate will increase leading to higher supply
price.
Firms in an economy can supply more G/S
with higher price.
This will make the AS curve upward slopping.

contd..
AS curve is upward slopping under conditions

in which wages are less than fully flexible.

AS schedule is flatter the smaller the impact
of output and employment change on current
wage.
The position of the AS curve depends upon
the past price level, and the schedule passes
through the full employment level of output.
The AS schedule shifts over time. If output is
maintained above the full employment level
then AS schedule shifts upward, like the WN
curve.

price

AS
AS
AS

Y*
output

price
AS
AS
AS
AS

AD
AD
output

Adjustment process