Aggregate Demand and

Supply
Aggregate Demand and Supply
Aggregate Demand (AD)
 AGGREGATE DEMAND
Defined:
•Amounts of Real Output
•Buyers Collectively Desire
•At Each Possible Price Level
Aggregate Demand Curve
Down Sloping Due To:
•Real-Balances Effect
•Interest-Rate Effect
•Foreign Purchases Effect
 Aggregate Demand
• The sum of all expenditure in the economy over a
period of time
• Macro concept – WHOLE economy
• Formula:
 AD = C+I+G+(X-M)
– C= Consumption Spending
– I = Investment Spending
– G = Government Spending
– (X-M) = difference between spending on
imports and receipts from exports (Balance
of Payments)

Graphically……
AGGREGATE DEMAND CURVE

Price level

AD

Real domestic output, GDP

CHANGES IN AGGREGATE DEMAND
Aggregate Demand
Can Increase
Price level

AD2

AD1

Real domestic output, GDP

CHANGES IN AGGREGATE DEMAND
Aggregate Demand
Can Increase
Price level …or Decrease

AD1
AD3

Real domestic output, GDP

DETERMINANTS OF AGGREGATE DEMAND

Change in Consumer Spending

•Consumer Wealth
•Consumer Expectations
•Household Indebtedness
 Consumption Expenditure

• Exogenous factors affecting consumption:

– Tax rates
– Incomes – short term and expected income over lifetime
– Wage increases
– Credit
– Interest rates
– Wealth
• Property
• Shares
• Savings
• Bonds
Change in Investment Spending
•Real Interest Rates
•Expected Returns
•Expected Future Business Conditions
•Technology
•Degree of Excess Capacity
•Business Taxes
 Investment Expenditure

• Spending on:
– Machinery
– Equipment
– Buildings
– Infrastructure
• Influenced by:
– Expected rates of return
– Interest rates
– Expectations of future sales
– Expectations of future inflation rates
 Government Spending

• Defence
• Health
• Social Welfare
• Education
• Foreign Aid
• Regions
• Industry
• Law and Order
Net Export Spending

•National Income Abroad

•Exchange Rates
 Aggregate Demand Curve
• Why does it slope down from left to right?
– Assume RBI sets short term interest rates
– Assume a rise in the price level will be met
by a rise in interest rates
– Any increase in interest rates will raise the
cost of borrowing:
• Consumption spending will fall
• Investment will fall
• International competitiveness will decrease –
exports fall, imports rise
• Therefore – a rise in the price level leads to lower
levels of aggregate demand
 Aggregate Demand Curve
Inflation Thea lower
This
At higher
level oflevel
rate
output
of
of
At an
will be inflation
inflation
National associated
(3.0%)
Income level
of 2%,
with
rising
requires the
ainterest ADrates
particular
fewer units
curve
level
mean
of labour gives
ofthat– C,aIlevel
and
3.0% of output
(X-M)
unemployment of Y1 rises
all have
which
negative
to 7% we shown
effects
will by
callon
UU=
= 5%
AD
7% – NY falls to Y2

2.0%

AD

Y2 Y1
U = 5%
Real National Income
U = 7%
 Shifts in the Aggregate Demand
Curve
This would
Shifts cause
in AD will be a
Inflation Any exogenous
rise in by
caused national
changes in
factor
factors causing
incomeaffecting
(economicC,C,
I,
IG or
andG(X-M)
growth) toand
rise,
leador
(exogenous
a
to trade factors)
surplus
a fall in
e.g. increasing
causes a shift (U
unemployment
income tax rates
to
=
the2%)
affect (and
right in vice
consumptionAD
versa)

2.0%

AD2
AD

Y1 Y2
U = 5% U = 2%
Real National Income
 Import Spending (negative)

• Goods and services bought from abroad – represents

an outflow of funds from the India (reduces AD)
 Export Earnings (Positive)

• Goods and services sold abroad – represents a flow of

funds into India (raises AD)
Key Variables
Macroeconomic Policy
 Fiscal Policy

• Government Income (taxes and borrowing)

• Government Spending
 Monetary Policy

• Interest Rates (RBI)

Aggregate Supply (AS)
 Capacity of the Economy

• Costs of Production
• Technology
• Education and Training
• Incentives
• Tax regime
• Capital stock
• Productivity
• Labour Market
 AGGREGATE SUPPLY
Defined:
•Levels of Real Domestic Output
•At Each Possible Price Level
•Long-run Supply Curve
•Wages and Resource Prices
Match Price Level
•Short-run Supply Curve
•Wages and Resource Prices
Do Not Match Price Level
AGGREGATE SUPPLY
Long Run
P ASLR

Price level

Long-run
Aggregate Full-Employment
Supply

Qf Q
Real domestic output, GDP
AGGREGATE SUPPLY
Short Run
P AS
Aggregate
Supply
Price level Short-run

Full-
Employment

Qf Q
Real domestic output, GDP
 AGGREGATE SUPPLY
Changes in Aggregate Supply
P AS3
AS1
Decrease In AS2
Aggregate
Supply
Price level

Increase In
Aggregate
Supply

Q
Real domestic output, GDP
DETERMINANTS OF AGGREGATE SUPPLY
Input Prices
Domestic Resource Prices
•Labor
•Land
•Capital
Prices of Imported Goods
Market Power
DETERMINANTS OF AGGREGATE SUPPLY

Productivity
Total Output
Productivity =
Total Inputs
Legal-Institutional
Environment

•Business Taxes and

Subsidies
•Government Regulation
 Aggregate Supply
Inflation AS Between Y1 and Yf,
The shape of the ASY1
This
Yf
increasesshape
Anrepresents
output level
in
‘Full
of
capacity
curve
wouldissuggest
Employment important thein –
Output’
reflects
are
at possible
determining
economy
this point athe
is but the
working
Keynesian
nearer
outcome
economy
below fullthe
in the viewto
economy
iscapacity
working
gets
economy
full
of to Yf,
andcapacity
there
the AS the
and more
would be
curve.
problems
cannot
widespread are any
produce
Economy starts to overheat
more.
unemployment.
experienced with
acquiring resources
to boost production
(production
bottlenecks)
especially labour
skills shortages.

Y1 Yf
Real National Income
 Aggregate Supply
Inflation
AS1 AS2
Increases in
capacity can
occur as a
result of a
shift in AS
(akin to a
shift
outwards of
the
Production
Possibility
Frontier)
(PPF)
Yf1 Yf2 Real National Income
 Aggregate Supply
Inflation SRASrun
Short assumes
costs such
aggregate as
supply
(SRAS) assumes
overall wage
firms only able to
rate remain
SRAS 1 increase output at
fixed,costs
higher changes
(e.g.
overtime
in such costs
payments)
cause a shift
SRAS thereby
in
pushing
the SRAS
up price level
curve
SRAS 2 (exogenous
shocks – input
costs)

Real National Income

 Aggregate Supply
Inflation LRAS This is because
Classical
they believe that
economists
in the long
assume therun,
long
there will be no
run aggregate
unemployment
supply curve of
resources
(LRAS) is vertical
because
(perfectlymarkets
will clear, thus
inelastic).
whatever the
rate of inflation,
firms will supply
the maximum
capacity of the
economy.
Yf Real National Income
 Aggregate Supply
Inflation AS
For our analysis,
we will assume
the AS curve
looks like this!

Real National Income

 EQUILIBRIUM AND CHANGES
IN EQUILIBRIUM
P AS

Price Level

Equilibrium
100 Real Output
a b
92

AD
50 51 51
2 0 4 Q
Real Domestic Output, GDP
 INCREASES IN AD:
DEMAND-PULL INFLATION
P AD1 AD2 AS

Price Level

P2

P1

Qf Q1 Q2 Q
Real Domestic Output, GDP
DECREASES IN AD: RECESSION
& CYCLICAL UNEMPLOYMENT
AD2 AD1
P AS

Price Level

b
P1 a

Q1 Qf Q
Real Domestic Output, GDP
DECREASES IN AD: RECESSION
& CYCLICAL UNEMPLOYMENT
•Wage Contracts
•Morale, Effort, and
Productivity
•Efficiency Wages
•Minimum Wage
•Menu Costs
•Fear of Price Wars
 DECREASES IN AS:
COST-PUSH INFLATION
AS2
P AS1

Price Level

P2 b

P1 a

AD1

Q1 Qf Q
Real Domestic Output, GDP
 INCREASES IN AS:
FULL EMPLOYMENT
…With Price-Level Stability
P AS1 AS2
P3
b
Price Level
P2
P1 a

AD2
AD1

Q1 Q2 Q3 Q
Real Domestic Output, GDP
REVISION
 The AD/AS Model
• The AD/AS Model
– Explains short-run fluctuations in real GDP and
the Price level (inflation)
Aggregate Demand
• Aggregate demand is the
total demand for goods
and services in the
economy.
• The aggregate demand
(AD) curve is a curve
that shows the
relationship between the
price level and the
quantity of real GDP
demanded by households,
firms, and the
government.
•
Deriving the Aggregate Demand Curve
• The ADcurve is not a
market demand curve,
and it is not the sum
of all market demand
curves in the
economy. It is a
more complex
concept.
How are aggregate demand and
•
aggregate expenditure related?
At every point along the aggregate demand curve,
the aggregate quantity of output demanded is
exactly equal to planned aggregate expenditure.
Deriving the Aggregate Demand
Curve
The Impact of an Increase in the Price Level on the
Economy – Assuming No Changes in G, T, and Ms

↑ P → Md ↑ → r ↑ → I↓ → A ↓E → Y ↓ 47
 Aggregate Demand Curve
• Aggregate demand falls when the price level
increases because the higher price level
causes the demand for money to rise, which
causes the interest rate to rise.
• It is the higher interest rate that causes
aggregate output to fall.
• At all points along the AD curve, both the
goods market and the money market are in
equilibrium.
•
Reasons why AD is downward sloping
• The consumption link: The decrease in
consumption brought about by an increase in
the interest rate contributes to the overall
decrease in output.
• The real wealth effect, or real balance, effect:
When the price level rises, there is a
decrease in consumption brought about by a
change in real wealth.
•
Shifts in AD
• Changes in
Governmental
Policies
• Changes in Monetary
Policy
• Changes in Expectations
of Households and
Firms
The Aggregate Demand Curve:
A Warning
• A higher price level causes the
demand for money to rise,
which causes the interest rate
to rise.
• Then, the higher interest rate
causes aggregate output to
fall.
The Aggregate Demand Curve:
A Warning
• A higher price level causes the
demand for money to rise,
which causes the interest rate
to rise.
• Then, the higher interest rate
causes aggregate output to
fall.

52
The Aggregate Demand Curve:
A Warning
• At all points along
the AD curve,
both the goods
market and the
money market
are in equilibrium.

53
Other Reasons for a Downward-
Sloping Aggregate Demand
Curve
• The consumption link: The
decrease in consumption
brought about by an
increase in the interest
rate contributes to the
overall decrease in
output.

54
Other Reasons for a Downward-
Sloping Aggregate Demand
Curve
• The real wealth effect, or
real balance, effect is
the change in
consumption brought
about by a change in real
wealth that results from a
change in the price level.

55
Aggregate Expenditure
and Aggregate Demand

• At every point along the

aggregate demand
curve, the aggregate
quantity of output
demanded is exactly
equal to planned
aggregate
Y=C+I+G
expenditure.
equilibrium condition

56
Shifts of the Aggregate Demand
Curve
• An increase in the
quantity of money
supplied at a
given price level
shifts the
aggregate
demand curve to
the right.

57
Shifts of the Aggregate Demand
Curve
• An increase in
government
purchases or a
decrease in net
taxes shifts the
aggregate
demand curve to
the right.

58
Shifts of the Aggregate Demand
Curve
Factors That Shift the Aggregate Demand Curve
Expansionary monetary policy Contractionary monetary policy

Ms AD curve shifts to the right Ms AD curve shifts to the left

Expansionary fiscal policy Contractionary fiscal policy

G AD curve shifts to the right G AD curve shifts to the left

T AD curve shifts to the right T AD curve shifts to the left

59
The Aggregate Supply Curve

• Aggregate supply is
the total supply of
all goods and
services in the
economy.

60
The Aggregate Supply Curve

• The aggregate supply

(AS) curve is a graph
that shows the
relationship between the
aggregate quantity of
output supplied by all
firms in an economy and
the overall price level.
61
The Aggregate Supply Curve:
A Warning

• The aggregate supply

curve is not a market
supply curve or the sum
of all the individual
supply curves in the
economy.

62
The Aggregate Supply Curve:
A Warning
• Firms do not simply respond to
market-determined prices, but
they actually set prices. Price-
setting firms do not have
individual supply curves
because these firms are
choosing both output and
price at the same time.

63
The Aggregate Supply Curve:
A Warning
• When we draw a firm’s supply
curve, we assume that input
prices are constant. In
macroeconomics, an increase
in the overall price level
means that at least some
input prices will be rising as
well.
• The outputs of some firms are
the inputs of other firms. 64
The Aggregate Supply Curve:
A Warning
• Rather than an aggregate
supply curve, what does exist
is a “price/output response”
curve — a curve that traces
out the price and output
decisions of all the markets
and firms in the economy
under a given set of
circumstances.
65
Aggregate Supply in the Short
Run
• In the short run, the
aggregate supply
curve (the
price/output
response curve)
has a positive
slope.

66
Aggregate Supply in the Short
Run
• At low levels of
aggregate output,
the curve is fairly
flat. As the
economy
approaches
capacity, the
curve becomes
nearly vertical. At
capacity, the
curve is vertical. 67
Aggregate Supply in the Short
Run
• Macroeconomists focus on
whether or not the economy
as a whole is operating at full
capacity.
• As the economy approaches
maximum capacity, firms
respond to further increases in
demand only by raising prices.

68
 Output Levels and
Price/Output Responses
• When the economy is operating at low
levels of output, an increase in
aggregate demand is likely to result in
an increase in output with little or no
increase in the overall price level.

69
The Response of Input Prices to
Changes in the Overall Price
Level
• There must be a lag
between changes in
input prices and changes
in output prices,
otherwise the aggregate
supply (price/output
response) curve would
be vertical.
70
The Response of Input Prices to
Changes in the Overall Price
Level
• Wage rates may increase
at exactly the same rate
as the overall price level
if the price-level increase
is fully anticipated. Most
input prices, however,
tend to lag increases in
output prices.
71
 Shifts of the Short-Run
Aggregate Supply Curve
• A cost shock, or supply shock, is a
change in costs that shifts the aggregate
supply (AS) curve.

72
The Aggregate Supply Curve

• The aggregate supply

(AS) curve is a graph
that shows the
relationship between the
aggregate quantity of
output supplied by all
firms in an economy and
the overall price level.
73
 Aggregate Supply
• Aggregate supply is the total supply of all
goods and services in the economy.
• The aggregate supply (AS) curve is a graph
that shows the relationship between the
aggregate quantity of output supplied by all
firms in an economy and the overall price
level.
•
 Aggregate Supply Curve
• The aggregate supply curve is not a market
supply curve and it is not the simple sum of
all the individual supply curves in the
economy.
– One reason is that firms do not simply respond
to market-determined prices, but they actually
set prices. Price-setting firms do not have
individual supply curves because these firms
are choosing both output and price at the
same time. We can add something that does
not exist!
•
 Aggregate Supply Curve
– Another reason is that when we draw a firm’s
supply curve, we assume that input prices are
constant. If the overall price level is rising,
there will be an increase in at least some input
prices.
• The outputs of some firms are the inputs of other
firms.
• As wage rates and other input prices rise, the
firms’ individual supply curves are shifting, so
we can not sum them to get an aggregate
supply curve.
•
 Aggregate Supply
Price Level
• In the short run, the
aggregate supply curve
AS (the price/output response
curve) has a positive
slope.
• At low levels of aggregate
output, the curve is fairly
flat. As the economy
approaches capacity, the
curve becomes nearly
vertical. At capacity, the
Real GDP curve is vertical.
Y •
 Shifts in the Short-run AS Curve
• A leftward shift of the • A decrease in costs,
AS curve could be economic growth, or
caused by cost public policy, can
shocks. cause a rightward
shift of the AS curve.
 Factors that shift the Aggregate Supply Curve
Factors That Shift the Aggregate Supply Curve
Shifts to the Right Shifts to the Left
Increases in Aggregate Supply Decreases in Aggregate Supply
Lower costs Higher costs
• lower input prices • higher input prices
• lower wage rates • higher wage rates

Economic growth Stagnation

• more capital •Capital deterioration
• more labor
• technological change

Public policy Public policy

• supply-side policies • waste and
• tax cuts inefficiency
• over-regulation
• deregulation

Good weather Bad weather, natural

disasters,
destruction b/ wars
The Equilibrium Price Level

• The equilibrium
price level is the
point at which the
aggregate demand
and aggregate
supply curves
intersect.

80
 Equilibrium in AD/AS
• P0 and Y0 correspond to
Price Level
equilibrium in the
goods market and the
AS money market and a
set of price/output
decisions on the part
P0 of all the firms in the
economy.
AD •
Y0
Real GDP Y
 Long-Run AS Curve
• LRAS- is a curve that • Remember in the long
shows the run capital is not
relationship in the fixed.
long-run between the • LRAS represents
price level and the potential GDP (what
quantity of real GDP the economy could be
supplied. doing if all resources
• Changes in the price are being used
level do not affect the efficiently, & the
level of aggregate economy is
supply in the long- experience full
run. Therefore it is employment.
vertical.
Graphical Presentation of LRAS

LRAS LRAS

Price Level

Decrease Increase

Real GDP
 The Long-Run
Aggregate Supply Curve
• Costs lag behind
price-level
changes in the
short run, resulting
in an upward-
•Costs
sloping ASprice
and the curve.
level
move in tandem in the
long run, and the AS
curve is vertical.

84
The AS/AD Model Together
Shift in AD
• Output can be pushed
above potential
GDPby higher
aggregate demand.
The aggregate price
level also rises.
• Eventually, this pressure
will ease, and we'll
return back to
potential.
 The Long-Run
Aggregate Supply Curve
• When output is pushed
above potential, there is
upward pressure on
costs, and this causes
the short-run AS curve to
the left.
•Costs ultimately increase by the same
percentage as the price level, and
the quantity supplied ends up back
at Y0.

87
 The Long-Run
Aggregate Supply Curve
• Y0 represents the
level of output that
can be sustainedin
the long run
without inflation. It
is also called
potential output
or potential GDP.

88
 Aggregate Demand, Aggregate
Supply, and Monetary and Fiscal
Policy
•AD can shift to the right for a number of
reasons, including an increase in the
money supply, a tax cut, or an
increase in government spending.

• Expansionary policy works

well when the economy is
on the flat portion of the
AS curve, causing little
change in P relative to the
output increase.
89
 Aggregate Demand, Aggregate
Supply, and Monetary and Fiscal
Policy
•On the steep portion of the AScurve,
expansionary policy does not work
well. The multiplier is close to zero.

• When the economy is

operating near full
capacity, an increase in
AD will result in an
increase in the price level
with little increase in
output.
90
 Long-Run Aggregate
Supply and Policy Effects
• If the AS curve is vertical in
the long run, neither
monetary policy nor fiscal
policy has any effect on
aggregate output.
•In the long run, the multiplier effect of a
change in government spending or
taxes on aggregate output is zero.

91
The Simple “Keynesian”
Aggregate Supply Curve
• The output of the economy
cannot exceed the
maximum output of YF.
• The difference between
planned aggregate
expenditure and aggregate
output at full capacity is
sometimes referred to as
an inflationary gap.

92
 Causes of Inflation

• Inflation is an increase in
the overall price level.
• Sustained inflation occurs
when the overall price
level continues to rise
over some fairly long
period of time.

93
 Causes of Inflation
• Demand-pull inflation is •Cost-push, or supply-side,
inflation is inflation caused by an
inflation initiated by an increase in costs.
increase in aggregate
demand.

94
Cost-Push, or Supply-Side
Inflation
•Stagflation occurs when
output is falling at the
same time that prices
are rising.
•One possible cause of
stagflation is an
increase in costs.

95
Cost-Push, or Supply-Side
Inflation
• Cost shocks are bad
news for policy
makers. The only
way to counter the
output loss is by
having the price
level increase
even more than it
would without the
policy action. 96
Expectations and Inflation

• If every firm expects every other

firm to raise prices by 10%,
every firm will raise prices by
about 10%. This is how
expectations can get “built into
the system.”
•In terms of the AD/AS diagram, an
increase in inflationary expectations
shifts the AS curve to the left.

97
Money and Inflation

• Hyperinflation is a
period of very
rapid increases in
the price level.

98
Money and Inflation

•An increase in G with

the money supply
constant shifts the AD
curve from AD0 to
AD1. This leads to an
increase in the interest
rate and crowding out
of planned investment.

99
Money and Inflation

•If the Fed tries to prevent

crowding, it will increase
the money supply and
the ADcurve will shift
farther and farther to the
right. The result is a
sustained inflation,
perhaps hyperinflation.

100