AGGREGATE DEMAND
AND
AGGREGATE SUPPLY 8CHAPTER
A Way to View the Economy
We can think of an economy as consisting of two
major activities: buying and producing.
When economists speak about aggregate
demand, they are speaking about the buying
side of the economy.
When economists speak about aggregate
supply, they are speaking about the producing
side of the economy.
A Way to View the Economy
The framework of analysis we use is called aggregate
demand–aggregate supply (AD–AS).
That framework of analysis has three parts:
1. Aggregate demand (AD)
2. Short-run aggregate supply (SRAS)
3. Long-run aggregate supply (LRAS)
A Way to View the Economy
Aggregate Demand
Recall from the last chapter that households, firms, governments and
the rest of the world buy domestic goods and services.
Aggregate demand is the quantity demanded of these goods and
services, or the quantity demanded of Real GDP, at various price
levels, ceteris paribus.
For example, the following whole set of data represents aggregate
demand:
Aggregate Demand
An aggregate demand
(AD) curve is the
graphical representation
of aggregate demand.
AD is downward sloping
As the price level falls,
the quantity demanded
of Real GDP rises.
As the price level rises,
the quantity demanded
of Real GDP falls
Why Does the Aggregate Demand Curve Slope Downward?
This inverse relationship and the resulting downward slope of
the AD curve are explained by:
(1) The real balance effect
(2) The interest rate effect
(3) The international trade effect
Aggregate Demand
Real Balance Effect
When price level goes up, the real value of monetary wealth or
the value of a person’s monetary assets goes down.
This means that purchasing power of monetary assets go down,
that is, the quantity of goods and services that can be purchased
with a unit of money decreases.
As a result, ceteris paribus, people demand less.
In summary, a rise in the price level causes purchasing power to
fall, which decreases a person’s monetary wealth. As people
become less wealthy, the quantity demanded of Real GDP falls.
Aggregate Demand
Interest Rate Effect
The inverse relationship between the price level and the
quantity demanded of Real GDP is established through changes
in the part of household and business spending that is sensitive
to changes in interest rates.
As the price level rises, the purchasing power of the person’s
money decreases.
With less purchasing power (per unit of money), she cannot
purchase her fixed bundle of goods with the same amount of
money.
Aggregate Demand
Interest Rate Effect
If she wants to continue to buy the goods, she needs to
acquire more money.
To do that, she goes to a bank and requests a loan. In terms
of simple supply-and demand analysis, the demand for credit
increases. Consequently, the interest rate rises.
As the interest rate rises, households borrow less to finance,
say, automobile purchases, and firms borrow less to finance
new capital goods spending. Thus, the quantity demanded of
Real GDP falls.
Aggregate Demand
International Trade Effect
The international trade effect takes place through changes in
foreign sector spending due to changes in price level.
As the price level in Bangladesh rises, Bangladeshi goods
become relatively more expensive than foreign goods.
As a result, both Bangladeshis and foreigners buy fewer
Bangladeshi goods and more foreign goods, i.e. exports fall
and imports rise implying a fall in net exports.
The quantity demanded of Real GDP falls.
Aggregate Demand
An Important Word on the Three Effects
Keep in mind that what caused these three effects is a
change in the price level.
When discussing, say, the interest rate effect, we are talking
about the interest rate effect of a change in the price level.
Why is this point important?
The interest rate can change due to things other than the
price level changing. Other things that change the interest
rate lead to a shift in the AD curve instead of a movement
along the AD curve.
Aggregate Demand
A Change in Quantity Demanded of Real GDP vs. a Change
in Aggregate Demand
A change in the price level brings about a change in the quantity
demanded of Real GDP.
As the price level falls, the quantity demanded of Real GDP rises,
ceteris paribus.
When the aggregate demand curve shifts, the quantity demanded
of Real GDP changes even though the price level remains
constant.
Aggregate Demand
Aggregate Demand
Changes in Aggregate Demand: Shifts in the AD Curve
What can change aggregate demand? What can cause
aggregate demand to rise, and what can cause it to fall?
The simple answer is, if:
Spending increases at a given price level AD rises
Spending decreases at a given price level AD falls
Aggregate Demand
How Spending Components Affect Aggregate Demand
At a given price level if:
Aggregate Demand
Why Is There More Total Spending?
True or false?
“The price level falls and total spending rises. As a result of
total spending rising, aggregate demand in the economy
rises, and the AD curve shifts rightward.”
Aggregate Demand
Aggregate Demand
Why Is There More Total Spending?
The answers is: FALSE
Aggregate demand curve shifts to the right only if total spending
rises at a given price level.
Total spending can rise for one of two reasons.
The first deals with a decline in prices and leads to a movement
along a given AD curve.
The second deals with a change in some factor other than prices
and leads to a shift in the AD curve.
Aggregate Demand
Factors That Can Change C, I, G, and NX and Therefore
Can Shift the AD Curve
Consumption: C
Four factors can affect consumption:
1.Wealth
2.Expectations about future prices and income
3.Interest rate
4.Income taxes
Factors That Can Change C and Therefore Can Shift
the AD Curve
1. Wealth
Individuals consume not only on the basis of their present
income but also on the basis of their wealth.
Greater wealth makes individuals feel financially more secure
and thus more willing to spend.
Wealth C AD
Wealth C AD
Aggregate Demand
Factors That Can Change C and Therefore Can Shift
the AD Curve
2. Expectations About Future Prices and Income
Individuals’ expectations of future prices can increase or
decrease aggregate demand:
Expect higher future prices C AD
Expect lower future prices C AD
Similarly, expectations regarding income can affect aggregate
demand:
Expect higher future income C AD
Expect lower future income C AD
Aggregate Demand
Factors That Can Change C and Therefore Can Shift the
AD Curve
3. Interest Rate
Current empirical work shows that spending on consumer durables is
sensitive to the interest rate.
Buyers often pay for these items by borrowing; so an increase in the
interest rate increases the monthly payment amounts linked to the
purchase of durables and thereby reduces their consumption.
The reduction in consumption leads to a decline in aggregate demand.
Interest rate C AD
Interest rate C AD
Aggregate Demand
Factors That Can Change C and Therefore Can Shift
the AD Curve
4. Income Taxes
As income taxes rise, disposable income decreases. When people
have less take-home pay to spend, consumption falls.
Consequently, aggregate demand decreases.
A decrease in income taxes has the opposite effect; it raises
disposable income. When people have more take-home pay to
spend, consumption rises and aggregate demand increases.
Income taxes C AD
Income taxes C AD
Aggregate Demand
Factors That Can Change I and Therefore Can Shift the
AD Curve
Investments: I
Three factors can change investment:
1. The interest rate
2. Expectations about future sales
3. Business taxes
Aggregate Demand
Factors That Can Change I and Therefore Can Shift the
AD Curve
1. Interest Rate
As the interest rate rises, the cost of an investment project rises and
businesses invest less. As investment decreases, aggregate demand
decreases.
As the interest rate falls, the cost of an investment project falls and
businesses invest more. Consequently, aggregate demand increases.
Interest rate I AD
Interest rate I AD
Aggregate Demand
Factors That Can Change I and Therefore Can Shift the
AD Curve
2. Expectations About Future Sales
If businesses become optimistic about future sales, investment
spending grows and aggregate demand increases.
If businesses become pessimistic about future sales, investment
spending contracts and aggregate demand decreases.
Businesses become optimistic about future sales I AD
Businesses become pessimistic about future sales I AD
Aggregate Demand
Factors That Can Change I and Therefore Can Shift the
AD Curve
3. Business taxes
An increase in business taxes lowers expected profitability. With less
profit expected, businesses invest less. As investment spending
declines, so does aggregate demand.
A decrease in business taxes, on the other hand, raises expected
profitability and investment spending. This increases aggregate
demand.
Business taxes I AD
Business taxes I AD
Aggregate Demand
Factors That Can Change G and Therefore Can Shift
the AD Curve
Government Expenditure: G
Government expenditure usually rises due to expansionary Fiscal
policy – designed to reduce unemployment.
Government expenditure usually falls due to contractionary Fiscal
policy – designed to reduce inflation.
Expansionary Fiscal Policy G AD
Contractionary Fiscal Policy G AD
Aggregate Demand
Factors That Can Change NX and Therefore Can Shift
the AD Curve
Net Exports: NX
Two factors can change net exports:
1. Foreign real national income
2. The exchange rate
Aggregate Demand
Factors That Can Change NX and Therefore Can Shift the
AD Curve
1. Foreign real national income
As foreign real national income rises, foreigners buy more Bangladeshi
goods and services. Thus, exports rise. As exports rise, net exports rise,
ceteris paribus. As net exports rise, aggregate demand increases.
This process works in reverse. As foreign real national income falls,
foreigners buy fewer Bangladeshi goods and exports fall. This lowers
net exports, reducing aggregate demand.
Foreign real national income BD exports BD net exports AD
Foreign real national income BD exports BD net exports AD
Aggregate Demand
Aggregate Demand
Factors That Can Change NX and Therefore Can Shift the AD
Curve
2. Exchange Rate
As the Taka depreciates, Bangladeshi goods become cheaper and foreign goods
become more expensive. Bangladeshis cut back on imported goods, and foreigners
increase their purchases of Bangladeshi exported goods. If exports rise and imports
fall, net exports increase and aggregate demand increases.
As Taka appreciates, Bangladeshi goods become more expensive and foreign goods
become cheaper, Bangladeshis increase their purchases of imported goods, and
foreigners cut back on their purchases of Bangladeshi exported goods. If exports fall
and imports rise, net exports decrease, thus lowering aggregate demand.
Taka depreciates BD exports and BD imports BD net exports AD
Taka appreciates BD exports and BD imports BD net exports AD
Can a Change in the Money Supply Change Aggregate
Demand?
Most economists would say that it does, but they differ on
how.
Most economists agree that an increase in money supply
increases aggregate demand and shifts aggregate demand
curve to the right.
Aggregate Demand
Short-Run Aggregate Supply
Aggregate demand is one side of the economy;
aggregate supply is the other.
Aggregate supply is the quantity supplied of all goods
and services (Real GDP) at various price levels, ceteris
paribus. Aggregate supply includes both short-run
aggregate supply (SRAS) and long-run aggregate supply
(LRAS).
Short-Run Aggregate Supply
Curve: What It Is
A short-run aggregate supply
(SRAS) curve shows the quantity
supplied of all goods and services
(Real GDP or output) at different
price levels, ceteris paribus.
the SRAS curve is upward sloping:
As the price level rises, firms
increase the quantity supplied of
goods and services; as the price
level drops, firms decrease the
quantity supplied of goods and
services.
Short-Run Aggregate Supply
Short-Run Aggregate Supply Curve: Why It Is Upward
Sloping (The sticky cost argument)
Think about an individual firm: firm A. It’s fair to assume that in the
short run the money wage rate and the prices of nonlabor inputs
remain unchanged (sticky). Now, if price of the good that firm A
produces rises with no change in these costs, then firm A can
increase profit by increasing production. Since any firm usually is
in business to maximize its profit, firm A will increase production.
Similarly, if price of the good produced by firm A falls while the
money wage rate and the prices of nonlabor inputs remain
unchanged, then firm A can reduce its losses (or profit reductions)
by decreasing production.
Short-Run Aggregate Supply
Short-Run Aggregate Supply
What’s true for firm A is true for the producers of all
goods and services. When all prices rise, the price level
rises. If the price level rises and the money wage rate
and other factor prices remain constant, all firms
increase production and the quantity of real GDP
supplied increases.
A fall in the price level has the opposite effect and
decreases the quantity of real GDP supplied.
What Puts the “Short Run” in the SRAS Curve?
The SRAS curve slopes upward because of the reason
explained in the previous slide.
Things are likely to change over time.
Wages will not be sticky forever (labor contracts will expire),
Factor costs will also not remain constant.
Only for a period of time—identified as the short run—are
these issues likely to be relevant.
Short-Run Aggregate Supply
Changes in Short-Run Aggregate Supply: Shifts in the
SRAS Curve
The factors that can shift the SRAS curve are:
1. Wage rates
2. Prices of nonlabor inputs
3. Productivity
4. Supply shocks
5. Expected price level
Short-Run Aggregate Supply
Changes in Short-Run Aggregate Supply: Shifts in the
SRAS Curve
1. Wage rates
Changes in wage rates have a major impact on the position of
the SRAS curve because wage costs are usually a firm’s major
cost item.
The impact of a rise or fall in equilibrium wage rates can be
understood in terms of the following equation:
Profit per unit = Price per unit - Cost per unit
Short-Run Aggregate Supply
Changes in Short-Run
Aggregate Supply: Shifts in
the SRAS Curve
Higher wage rates mean higher
costs and, at constant prices,
translate into lower profits and a
reduction in the number of units
(of a given good) that firms will
want to produce.
Lower wage rates mean lower
costs and, at constant prices,
translate into higher profits and
an increase in the number of
units (of a given good) firms will
decide to produce.
Short-Run Aggregate Supply
Changes in Short-Run Aggregate Supply: Shifts in the
SRAS Curve
2. Prices of nonlabor inputs
There are other inputs to the production process besides
labor.
Changes in the prices of nonlabor inputs affect the SRAS curve
in the same way as changes in wage rates do.
An increase in the price of a nonlabor input (e.g., oil) shifts the
SRAS curve leftward; a decrease in their price shifts the SRAS
curve rightward.
Short-Run Aggregate Supply
Changes in Short-Run Aggregate Supply: Shifts in the
SRAS Curve
3. Productivity
Productivity is the output produced per unit of input employed
over some period of time.
Let’s consider the labor input. An increase in labor productivity
means businesses will produce more output with the same
amount of labor, causing the SRAS curve to shift rightward.
A decrease in labor productivity means businesses will produce
less output with the same amount of labor, causing the SRAS
curve to shift leftward.
Short-Run Aggregate Supply
Changes in Short-Run Aggregate Supply: Shifts in the
SRAS Curve
Many factors lead to increased labor productivity. Some
examples:
A more educated labor force
A larger stock of capital goods
Technological advancements
Short-Run Aggregate Supply
Changes in Short-Run Aggregate Supply: Shifts in the
SRAS Curve
4. Supply shocks
Major natural or institutional changes that affect aggregate supply
are referred to as supply shocks.
Supply shocks are of two varieties. Adverse supply shocks shift the
SRAS curve leftward.
A long drought can have severe impact on the production of
paddy in Bangladesh.
A major cutback in the supply of oil coming to the United
States from the Middle East.
Short-Run Aggregate Supply
Changes in Short-Run Aggregate Supply: Shifts in the
SRAS Curve
Beneficial supply shocks shift the SRAS curve rightward.
A major oil discovery or unusually good weather
leading to increased production of a food staple
These supply shocks can be reflected in resource or
input prices.
Short-Run Aggregate Supply
Changes in Short-Run Aggregate Supply: Shifts in the
SRAS Curve
5. Expected price level
A change in expected price level can lead to a shift in the SRAS
curve. When prices of most goods and services are expected to rise,
the price level is expected to rise, and vice versa.
Suppose producers expect the price level to decline. If the price
level is expected to fall in the future, current supply increases and
the supply curve shifts rightward.
Suppose individuals expect the price level to rise. If the price level is
expected to rise in the future, current supply decreases and the
supply curve shifts leftward.
Short-Run Aggregate Supply
Changes in Short-Run Aggregate Supply: Shifts in the
SRAS Curve
Short-Run Aggregate Supply
Putting AD and SRAS Together: Short-
Run Equilibrium
How Short-Run
Equilibrium in the
Economy is Achieved
At 𝑃1, the quantity supplied of Real
GDP is greater than the quantity
demanded. As a result, the price level
falls and firms decrease output.
At 𝑃2, the quantity demanded of Real
GDP is greater than the quantity
supplied. As a result, the price level
rises and firms increase output.
Short-run equilibrium occurs at point E,
where the quantity demanded of Real
GDP equals the (short-run) quantity
supplied. This is at the intersection of
the AD curve and the SRAS curve.
Changes in Short-Run Equilibrium in the Economy
Putting AD and SRAS Together: Short-
Run Equilibrium
Putting AD and SRAS Together: Short-
Run Equilibrium
In Dollars and in Oil
In November 2007 the barrel price of oil was rising. On
November 1, 2007, it had risen to $96 a barrel.
In the same month the value of the dollar was falling in foreign
exchange markets. In fact, the value of the dollar had been
falling for some time. Although the value of $1 was €0.83 in
January 2006, it had fallen to €0.69 by November 1, 2007.
How would Real GDP and Price change?
Putting AD and SRAS Together: Short-
Run Equilibrium
In Dollars and in Oil
We know that the falling value of the dollar would lead to
greater U.S. exports, and this is exactly what was
happening at the time. As a result, U.S. net exports were
rising, pushing the AD curve in the economy to the right.
But because oil prices were rising, the SRAS curve in
the economy was shifting to the left.
How would these two changes affect Real GDP?
Putting AD and SRAS Together: Short-
Run Equilibrium
In Dollars and in Oil
The answer depends on the relative shifts of the AD and SRAS curves.
There are the three possibilities:
1. If the AD curve shifted rightward more than the SRAS curve shifted
leftward, then Real GDP will rise.
2. If the AD curve shifted rightward by less than the SRAS curve shifted
leftward, then Real GDP would fall.
3. If the AD curve shifted rightward by the same amount as the SRAS
curve shifted leftward, then Real GDP would remain unchanged.
In all three cases, though, the price level would increase. Rising
aggregate demand, combined with falling short-run aggregate supply,
always results in a rising price level.
An Important Exhibit
Expected Price Level
1. Expansionary Fiscal Policy
2. Contractionary Fiscal Policy
Long-Run Aggregate Supply
Going from the Short Run to the Long Run
Remember that an upward-sloping SRAS curve is explained by sticky
wages and constant factor costs. When these conditions hold, short-
run equilibrium identifies the Real GDP that the economy produces.
In time, though, wages become unstuck and costs of other factors
change in the direction of the price change. In that event, the economy
is said to be in the long run. In other words, these conditions do not
hold in the long run.
Most economists argue that, in the long run, the economy produces the
full-employment Real GDP, Potential Real GDP or the Natural Real
GDP (𝑄𝑁). The aggregate supply curve that identifies the output the
economy produces in the long run is the long-run aggregate supply
(LRAS) curve.
Long-Run Aggregate Supply
Going from the Short Run
to the Long Run
Long-run equilibrium identifies the
level of Real GDP the economy
produces when wages, other factor
costs and prices have adjusted to
their final equilibrium levels and
when workers have no relevant
misperceptions.
Graphically, this occurs at the
intersection of the AD and LRAS
curves. Further, the level of Real
GDP that the economy produces in
long-run equilibrium is the Natural
Real GDP (𝑄𝑁).
Long-Run Aggregate Supply
Short-Run Equilibrium, Long-
Run Equilibrium, and
Disequilibrium
In this Exhibit, the economy is at
point 1, producing 𝑄1 amount of
Real GDP. At point 1, the quantity
supplied of Real GDP (in the short
run) is equal to the quantity
demanded of Real GDP, and both
are 𝑄1. The economy is in short-
run equilibrium.
Long-Run Aggregate Supply
Short-Run Equilibrium,
Long-Run Equilibrium, and
Disequilibrium
In this Exhibit, the economy is
at point 1, producing 𝑄𝑁. In
other words, it is producing
Natural Real GDP. The
economy is in long-run
equilibrium when it produces
𝑄𝑁.
In both short-run and long-
run equilibrium, the quantity
supplied of Real GDP
equals
the quantity demanded.
So what is the difference
between short-run
equilibrium and
Short-Run Equilibrium, Long-Run Equilibrium, and
Disequilibrium
In both short-run and long-run equilibrium, the quantity supplied of
Real GDP equals the quantity demanded.
So what is the difference between short-run equilibrium and long-run
equilibrium?
In long-run equilibrium, the quantities supplied and demanded of Real
GDP equal Natural Real GDP. But in short-run equilibrium, the
quantities supplied and demanded of Real GDP are either more or
less than Natural Real GDP.
Long-Run Aggregate Supply
Long-Run Aggregate Supply
Short-Run Equilibrium, Long-Run Equilibrium, and
Disequilibrium
Let’s illustrate that difference with numbers. Suppose
𝑄𝑁 = $9.0 trillion. In long-run equilibrium, the quantity
supplied of Real GDP equals the quantity demanded:
$9.0 trillion.
In short-run equilibrium, the quantity supplied of Real
GDP equals the quantity demanded, but neither
equals $9.0 trillion. For example, the quantity supplied
of Real GDP could equal the quantity demanded of
Real GDP at $8.5 trillion.
Short-Run Equilibrium, Long-Run Equilibrium, and
Disequilibrium
When the economy is in neither short-run nor long-run
equilibrium, it is said to be in disequilibrium.
Essentially, disequilibrium is the state of the economy as
it moves from one short-run equilibrium to another or
from short-run equilibrium to long-run equilibrium.
In disequilibrium, the quantity supplied and the quantity
demanded of Real GDP are not equal.
Long-Run Aggregate Supply