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Aggregate Demand & Aggregate

Supply
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 AD curve is not
a market demand
curve, and it is not
the sum of all
market demand
curves in the
economy. It is a
Howmore complex
are aggregate
concept.
demand and aggregate
expenditure related?

At every point along the aggregate


demand curve, the aggregate quantity
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
Increase in Aggregate Demand

Demand-Pull AS
Inflation
Price Level

P2

P1
AD1
AD

Qf Q1 Q2 2. Decrease in Aggregate Demand


Real Domestic Output, GDP (The result is Recession and Cyclical
Unemployment)
3 Decrease in Aggregate Supply leads
to Cost-Push Inflation.

4. Increase in Aggregate Supply leads


to Full Employment
DETERMINANTS OF AGGREGATE DEMAND

Change in Consumer Spending

• Consumer Wealth
• Consumer Expectations
• Consumer Indebtedness
• Taxes

Change in Investment Spending

• Real Interest Rates


• Expected Returns
• Expected Future Business Conditions
• Technology
• Degree of Excess Capacity
• Business Taxes
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 (the price/output
response curve) has a positive
AS 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
curve is vertical.

Real GDP
Y
Shifts in the Short-run AS
Curve
• A leftward shift of • A decrease in
the AS curve could costs, economic
be caused by cost
shocks. growth, or public
policy, can 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
Equilibrium in AD/AS
• P0 and Y0 correspond
Price Level to 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
shows the relationship long run capital is
in the long-run between not fixed.
the price level and the
quantity of real GDP • LRAS represents
supplied. potential GDP (what
• Changes in the price the economy could
level do not affect the be doing if all
level of aggregate resources are being
supply in the long-run. used efficiently, &
Therefore it is vertical.
the economy is
experience full
employment.
Graphical Presentation of
LRAS
LRAS LRAS

Price Level

Decrease Increase

Real GDP
The AS/AD Model Together
Shift in AD
• Output can be
pushed above
potential GDP by
higher aggregate
demand. The
aggregate price level
also rises.
• Eventually, this
pressure will ease,
and we'll return back
to potential.
Shifts in AS
• When output is pushed
above potential, there is
upward pressure on costs.
Rising costs push the short-
run AS curve to the left.
• If costs ultimately increase
by the same percentage as
the price level, the quantity
supplied will end up back at
Y0.