Aggregate Demand/Aggregate Supply

The basic model of short-run economic fluctuations

Aggregate Demand and Supply

The basic model of economic fluctuations

The basic model of aggregate demand and aggregate supply
Economists use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long run trend.

The basic model of economic fluctuations

The Basic Model of Aggregate Demand and Aggregate Supply
The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level.

The basic model of economic fluctuations

The Basic Model of Aggregate Demand and Aggregate Supply
The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.

Aggregate Demand and Aggregate Supply...

Price Level

Aggregate supply

Equilibrium price level

Aggregate demand

Equilibrium output

Quantity of Output

Aggregate Demand (AD)

THE AGGREGATE-DEMAND CURVE

The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX

The Aggregate-Demand Curve...

Price Level

P2 1. A decrease in the price level . . . 0 Y Y2 Aggregate demand

Quantity of Output

2. . . . increases the quantity of goods and services demanded.

Why the Aggregate-Demand Curve Is Downward Sloping

The Price Level and Consumption: The Wealth Effect

The Price Level and Investment: The Interest Rate Effect

The Price Level and Net Exports: The Exchange-Rate Effect

Why the Aggregate-Demand Curve Is Downward Sloping

The Price Level and Consumption: The Wealth Effect
A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more. This increase in consumer spending means larger quantities of goods and services demanded.

Why the Aggregate-Demand Curve Is Downward Sloping

The Price Level and Investment: The Interest Rate Effect
A lower price level reduces the interest rate, which encourages greater spending on investment goods. This increase in investment spending means a larger quantity of goods and services demanded.

Why the Aggregate-Demand Curve Is Downward Sloping

The Price Level and Net Exports: The Exchange-Rate Effect
When a fall in the U.S. price level causes U.S. interest rates to fall, the real exchange rate depreciates, which stimulates U.S. net exports.

The increase in net export spending means a larger quantity of goods and services demanded.

Why the Aggregate-Demand Curve Might Shift

The downward slope of the aggregate demand curve shows that a fall in the price level raises the overall quantity of goods and services demanded. Many other factors, however, affect the quantity of goods and services demanded at any given price level. When one of these other factors changes, the aggregate demand curve shifts.

Why the Aggregate-Demand Curve Might Shift

Shifts arising from
Consumption

Investment
Government Purchases Net Exports

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

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

Import Spending (negative)

Goods and services bought from abroad represents an outflow of funds from the country (reduces AD)

Export Earnings (Positive)

Goods and services sold abroad represents a flow of funds into the country (raises AD)

Key Variables

Macroeconomic Policy

Shifts in the Aggregate Demand Curve

Price Level

P1

D2
Aggregate demand, D1 0

Y1

Y2

Quantity of Output

Aggregate Supply (AS)

The Aggregate Supply Curve

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.

Keynesian & Classical Aggregate Supply Functions

THE AGGREGATE-SUPPLY CURVE

In the long run, the aggregate-supply curve is vertical.

In the short run, the aggregate-supply curve is upward sloping.

THE AGGREGATE-SUPPLY CURVE

The Long-Run Aggregate-Supply Curve
In the long run, an economys production of goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services. The price level does not affect these variables in the long run.

The Long-Run Aggregate-Supply Curve

Price Level Long-run aggregate supply P

P2 1. A change in the price level . . . 0

2. . . . does not affect the quantity of goods and services supplied in the long run.

Quantity of Output

Shifts in the LR-Aggregate Supply

Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve. The shifts may be categorized according to long-run changes in
Labor Capital Natural resources Technological knowledge

Why the Aggregate-Supply Curve Slopes Upward in the Short Run

In the short run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied. A decrease in the level of prices tends to reduce the quantity of goods and services supplied.

The Short-Run Aggregate-Supply Curve

Price Level

Short-run aggregate supply P

P2 1. A decrease in the price level . . .

2. . . . reduces the quantity of goods and services supplied in the short run.

Y2

Quantity of Output

Why the Aggregate-Supply Curve Slopes Upward in the Short Run

Macroeconomists focus on whether or not the economy as a whole is operating at full capacity. Even if firms are not holding excess labor and capital, the economy may be operating below its capacity if there is cyclical unemployment.

Shifts of the Short-Run Aggregate Supply Curve

A leftward shift of the AS curve could be caused by cost shocks.
A decrease in costs, economic growth, or public policy, can cause a rightward shift of the AS curve.

Factors That Shift the Aggregate Supply Curve Shifts to the Right Shifts to the Left
Increases in Aggregate Supply Lower costs lower input prices lower wage rates Economic growth more capital more labor technological change Public policy supply-side policies tax cuts deregulation Good weather Decreases in Aggregate Supply Higher costs higher input prices higher wage rates Stagnation Capital deterioration

Public policy waste and inefficiency over-regulation

Bad weather, natural disasters, destruction from wars

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

TWO CAUSES OF ECONOMIC FLUCTUATIONS

Shifts in Aggregate Demand
In the short run, shifts in aggregate demand cause fluctuations in the economys output of goods and services. In the long run, shifts in aggregate demand affect the overall price level but do not affect output.

Increase in AD Demand-Pull Inflation

An increase in aggregate demand when the economy is operating at low levels of output is likely to result in an increase in output with little or no increase in the overall price level.
As the economy approaches maximum capacity, firms respond to further increases in demand only by raising prices.

Decreases in AD: Recession and Unemployment

Price AS

In the short-run, decreases in AD will reduce equilibrium GDP and cause unemployment

P0

P1

AD0 AD1

Y1

Y0

Yf

Real National Income

LR Decrease in AD: no impact on output

AS Price P0

P1

AD0

AD1

Yf

Real National Income

Short Run Adverse Shift in AS

AS1

Price

AS0

In the short-run, decreases in AS will reduce equilibrium GDP and cause prices to rise.

P1 P0 AD0 AD1 Y1 Y
0

Real National Income

The Effects of a Shift in Aggregate Supply

Stagflation
Adverse shifts in aggregate supply cause stagflationa period of recession and inflation.
Output falls and prices rise. Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

Long Run Adverse Shift in AS

Price
AS1

AS0

In the long-run, decreases in AS will also reduce equilibrium GDP and cause prices to rise.

P1 P0 AD0 AD1 Y1 Y
0

Real National Income

END..