Aggregate demand and supply

What do we plan to examine?

• What are economic fluctuations? What are their
characteristics?

• How does the model of aggregate demand and

aggregate supply explain economic fluctuations?

• Why does the Aggregate-Demand curve slope

downward? What shifts the AD curve?
 Short-Run Economic Fluctuations
• Economic activity fluctuates from year to year. In some
years, the production of goods and services rises. In other
years normal growth does not occur, leading to recession.

• Short-run economic fluctuations are often called business

cycles.

• A recession is a situation of declining real GDP, falling

incomes and rising unemployment for two consecutive
quarters.
Depressions: severe recessions (very rare)
 Three Key Facts About Economic Fluctuations

 Economic Fluctuations are Irregular and

Unpredictable.
– Recessions occur with unpredictable frequency and
duration.

Most Macroeconomic Variables Fluctuate Together.

– Most macroeconomic variables are closely related and
move together.

As Output Falls, Unemployment Rises.

– Changes in real GDP and the unemployment rate are
inversely related.
 Three Facts About Economic Fluctuations
FACT
FACT1:
1: Economic
Economicfluctuations
fluctuationsare
areirregular
irregularand
and
unpredictable.
unpredictable.

$ 11,000
10,000
9,000 U.S.
U.S.real
realGDP,
GDP,
billions
billionsof
of2000
2000dollars
dollars
8,000
7,000
6,000
5,000 The
Theshaded
shaded
4,000 bars
barsare
are
recessions
recessions
3,000
2,000
1965 1970 1975 1980 1985 1990 1995 2000 2005
 Three Facts About Economic Fluctuations
FACT
FACT 2:
2: Most
Mostmacroeconomic
macroeconomicquantities
quantities
fluctuate
fluctuatetogether
together

$ 1,800

1,600
Investment
Investmentspending,
spending,
1,400 billions
billionsof
of2000
2000dollars
dollars
1,200
1,000
800
600
400
200
1965 1970 1975 1980 1985 1990 1995 2000 2005
 Three Facts About Economic Fluctuations
FACT
FACT3:
3: As
Asoutput
outputfalls,
falls,unemployment
unemploymentrises.
rises.

12

10 Unemployment
Unemploymentrate,
rate,
percent
percentof
oflabor
laborforce
force
8

0
1965 1970 1975 1980 1985 1990 1995 2000 2005
 Economic Fluctuations
• Although there remains some debate about
how to analyze short-run fluctuations, most
economists use the model of aggregate
demand and aggregate supply.
The Basic Model of Economic Fluctuations
• Two variables are used in developing a model to
analyze the short-run fluctuations:
1. The economy’s output of goods and services,
measured by real GDP
2. The overall price level, measured by the CPI or GDP
Deflator
• The Model: Aggregate Demand and Aggregate
Supply
 The Aggregate Demand and
Aggregate Supply Model
Price Aggregate
Level Supply

PE

Aggregate
Demand

QE Quantity of Output
Aggregate Demand and Aggregate Supply
• The Aggregate Demand Curve shows the quantity
of goods and services that households, firms and
the government are willing to buy at different
prices.

• The Aggregate Supply Curve shows the quantity

of goods and services that firms would be willing
to produce and sell at different prices.
 The Aggregate Demand Curve
• The aggregate demand for goods and services
may be referred to as:
Y = C + I + G + NX
• Why is the aggregate demand curve downward
sloping?
1. Pigou’s Wealth Effect
2. Keynes’ Interest Rate Effect
3. Real Exchange Rate Effect
 Three Reasons for the Downward Slope of the
Aggregate Demand
• Pigou’s Wealth Effect: “Consumers feel wealthier, which
stimulates the demand for consumption goods.”

– A decrease in the price level makes consumers feel

more wealthy, which in turn encourages them to
spend more.

– The increase in consumer spending means a larger

quantity of goods and services demanded.
 Three Reasons for the Downward Slope of the
Aggregate Demand
• Keynes’ Interest-Rate Effect: “The lower the price level,
the less money households need to hold to buy the
goods and services they want.”

– A lower price level reduces the interest rate,

encourages greater spending on investment goods,
and thereby increases the quantity of goods and
services demanded.
 Three Reasons for the Downward
Slope of the Aggregate Demand
• Real Exchange-Rate Effect: “When prices of Indian
goods go down, foreigners buy more of our goods
and we purchase less of their goods.”
– When a fall in the Indian price level causes the real
exchange rate to depreciate, this stimulates net
exports from India, thereby increasing the quantity of
goods and services demanded.
 The Slope of the AD Curve: Summary

An increase in P reduces the P

quantity of g&s demanded

because: P2

• the wealth
effect (C falls) P1
• the interest-rate effect (I
falls) AD

• the exchange- Y2 Y1
Y

rate effect (NX

falls)
 Factors that might shift the Aggregate
Demand Curve
• Shifts in the aggregate demand curve may arise
because of:
1. Changes in spending plans by consumers or firms.

2. Changes in fiscal or monetary policy.

“Anything that causes buyers to purchase more or less than before

will cause the aggregate demand schedule to shift.”
 Shifts in the Aggregate Demand Curve
Price Aggregate
Level Supply

AD
Aggregate Demand
AD
Quantity of Output
 Why does Aggregate Demand Curve Shift?
• Changes in Consumption
*improvement in Health Awareness, Investment in
Post-Retirement Benefit Scheme….fall in
Consumption.. qty demanded at given price
decline.. shift in Ag dd. curve to left.

*Stock Market Boom…People become richer….less

concerned about saving…Ag Dd shifts to right
Imposition of Tax….Consumption…Shift in Ag Dd
curve
 Why does Aggregate Demand Curve Shift?

• Changes in Investment
*Firms optimistic about future demand for a product
(new computer system)…decides to invest. Increase in
qty dd….shifts Ag Dd curve

*Firms pessimistic about future business conditions….cut

back investment spending…shifts Ag dd curve to left

Decrease in Money Supply….increase in Rate of interest…

decline in Investment.. shift Ag dd to left
 Why does Agg Dd Curve Shift ?
• Changes in Government Purchases
– Investment in Infrastructure (Road, Building….. Increase in Ag
Dd.

• Changes in Net Exports

(In Recession…Dd for Foreign good falls. Can be decline in Net
Exports at every price level…shifts the ag demand.
Recovery…..Increase in Net Exports…Shift in Ag Demand.
 The Long-Run Aggregate-Supply Curve (LRAS)

The natural rate of output (YN)

P LRAS
is the amount of output
the economy produces when
unemployment
is at its natural rate.
YN is also called potential
output
or
full-employment output.

Y
YN
 Why LRAS Is Vertical

YN depends on P LRAS

the economy’s
stocks of labor,
capital, and natural P2

resources, and on
P1
the level of
technology.
An increase in P
does not affect Y
any of these, YN
so it does not
affect YN.
 Why the LRAS Curve Might Shift?
P LRAS1 LRAS2
Any event that changes any of the
determinants of YN will shift
LRAS.
Example: Immigration
increases L(workers),
causing YN to rise.

Y
YN Y’
N
 Why the LRAS Curve Might Shift?
• New govt policies reduce the natural rate of unemployment:
the % of the labor force normally employed rises, LRAS shifts
right
• Investment in factories or equipment:
K rises, Output increase..LRAS shifts right

• More people get college degrees:

Human capital rises, LRAS shifts right
• Earthquakes or hurricanes destroy factories:
K falls, LRAS shifts left
 Using AD & AS to Depict LR Growth and Inflation
Over the long run, tech.
progress shifts LRAS to the
right LRAS2000
P LRAS1990
LRAS1980

and growth in the money P2000

supply shifts AD to the right.
P1990

P1980
Result:
ongoing inflation and AD1990
growth in output . AD1980
Y
Y1980 Y1990 Y2000
 The Aggregate-Supply (AS) Curves
The AS curve shows the total
quantity of
P LRAS
g&s firms produce and sell at
any given price level.
SRAS

In the short run,

AS is upward-
sloping.

In the long run, Y

AS is vertical.
The Long-Run Aggregate Supply Curve
Price Aggregate
Supply
Level

Output at
Full Employment

Aggregate
Demand

Quantity of Output
 Short Run Aggregate Supply (SRAS)

The SRAS curve P

is upward sloping:
Over the period
of 1-2 years, SRAS
an increase in P
P2

causes an increase in
the quantity of g & s P1
supplied.

Y
Y1 Y2
 Why the Slope of SRAS Matters?
P
If AS is vertical, fluctuations in
AD Phi
do not cause fluctuations in SRAS
output or employment.
Phi

ADhi
Plo
If AS slopes up,
then shifts in AD AD1
do affect output and Plo
ADlo
employment . Y
Ylo Y1 Yhi
 Three Theories of SRAS
In each,
– some type of market imperfection
– result:
Output deviates from its natural rate
when the actual price level deviates
from the price level people expected.
Reasons for the Upward Slope of the Aggregate
Supply Curve in short run
– New Classical Misperceptions Theory

– The Keynesian Sticky-Wage Theory

– The New Keynesian Sticky-Price Theory

 Why supply curve slopes upward in short run?
• The Keynesian Sticky-Wage Theory:
– Nominal wages are slow to adjust, or are “sticky”
in the short-run, thus a lower price level makes
employment and production less profitable, which
induces firms to reduce production.
Why supply curve slopes upward in short run?
• The New Keynesian Sticky-Price Theory:
• Prices of some goods and services adjust sluggishly in
response to changing economic conditions due to
menu costs (cost of printing, distributing catalogs,
time required to change price tag).
 Why supply curve slopes upward in the short run?
• The New Classical Misperceptions Theory:
‘Changes in the overall price level can temporarily mislead suppliers about
what is happening in the individual markets in which they sell their output
(Mankiw)’.

• “A higher price level signals to each firm a greater demand for their product
inducing them to produce more.”
 Equilibrium in the Long-Run
• Equilibrium output and price level are
determined by the intersection of the
aggregate demand curve and the long-run
aggregate supply curve.

• Output is at its natural rate and the short-run

aggregate supply curve passes through the
point of intersection.
 Long Run Equilibrium
P LRAS
In the long-run equilibrium,
PE = P, SRAS
Y = YN ,
and unemployment is at its
natural rate. PE

Natural Rate of Unemployment:

Unemployment rate which would AD
prevail in an economy with a
constant rate of inflation Y
YN
 John Maynard Keynes, 1883-1946
• The General Theory of Employment,
Interest, and Money, 1936

• Argued recessions and depressions can

result from inadequate demand;
policymakers should shift AD.
• Famous critique of classical theory:
The long run is a misleading guide to
current affairs. In the long run, we are all
dead. Economists set themselves
too easy, too useless a task if in
tempestuous seasons they can only tell us
when the storm is long past,
the ocean will be flat.
 Let us sum up……
• Short-run fluctuations in GDP and other
macroeconomic quantities are irregular and
unpredictable. Recessions are periods of
falling real GDP and rising unemployment.
• Economists analyze fluctuations using the
model of aggregate demand and aggregate
supply.
• Aggregate Demand & Aggregate Supply are
determined by several factors.
Thanks