COORDINATING ECONOMIC ACTIVITY: AGGREGATE DEMAND AND SUPPLY COORDINATING ECONOMIC ACTIVITY:...

COORDINATING ECONOMIC COORDINATING ECONOMIC ACTIVITY:ACTIVITY:

AGGREGATE DEMAND AND AGGREGATE DEMAND AND SUPPLYSUPPLY

COORDINATING ECONOMIC COORDINATING ECONOMIC ACTIVITY:ACTIVITY:

AGGREGATE DEMAND AND AGGREGATE DEMAND AND SUPPLYSUPPLY

ECONOMIC FLUCTUATIONSECONOMIC FLUCTUATIONSECONOMIC FLUCTUATIONSECONOMIC FLUCTUATIONS

• Movements of GDP away Movements of GDP away from potential output;from potential output;

• Also referred to as business Also referred to as business cycles;cycles;

• Movements of GDP away Movements of GDP away from potential output;from potential output;

• Also referred to as business Also referred to as business cycles;cycles;

KEYNESIAN ECONOMICSKEYNESIAN ECONOMICSKEYNESIAN ECONOMICSKEYNESIAN ECONOMICS

• Models based on the idea that Models based on the idea that demand determines output in demand determines output in the short run;the short run;

• Short run -- The period of Short run -- The period of time when prices are fixed;time when prices are fixed;

• Models based on the idea that Models based on the idea that demand determines output in demand determines output in the short run;the short run;

• Short run -- The period of Short run -- The period of time when prices are fixed;time when prices are fixed;

REAL SHOCKS TO THE ECONOMYREAL SHOCKS TO THE ECONOMYREAL SHOCKS TO THE ECONOMYREAL SHOCKS TO THE ECONOMY

One cause of economic fluctuations: One cause of economic fluctuations:

• Developing countries dependent Developing countries dependent on agriculture, which suffer loss to on agriculture, which suffer loss to cash cropcash crop

• Sharp increases in the price of oil Sharp increases in the price of oil can hurt modern economiescan hurt modern economies

• Wars can devastate entire regions Wars can devastate entire regions of the worldof the world

One cause of economic fluctuations: One cause of economic fluctuations:

• Developing countries dependent Developing countries dependent on agriculture, which suffer loss to on agriculture, which suffer loss to cash cropcash crop

• Sharp increases in the price of oil Sharp increases in the price of oil can hurt modern economiescan hurt modern economies

• Wars can devastate entire regions Wars can devastate entire regions of the worldof the world

• Natural disasters can cause sharp Natural disasters can cause sharp reductions in GDP reductions in GDP

• Major shifts in technology leading Major shifts in technology leading to the birth of new industries have to the birth of new industries have profound effects on the economyprofound effects on the economy

• Natural disasters can cause sharp Natural disasters can cause sharp reductions in GDP reductions in GDP

• Major shifts in technology leading Major shifts in technology leading to the birth of new industries have to the birth of new industries have profound effects on the economyprofound effects on the economy

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INITIAL PATTERN OF DEMAND AND PRICESINITIAL PATTERN OF DEMAND AND PRICES

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INITIAL PATTERNS OF DEMAND AND PRICESINITIAL PATTERNS OF DEMAND AND PRICES

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DEMAND AND PRICES AFTER CHANGES IN TASTESDEMAND AND PRICES AFTER CHANGES IN TASTES

Suppose rollerblading starts to replace tennis. Demand shifts to DSuppose rollerblading starts to replace tennis. Demand shifts to DAA in the in the

market in tennis racquets and Dmarket in tennis racquets and DBB in the market for roller blades. in the market for roller blades.

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DEMAND AND PRICES AFTER CHANGES IN TASTESDEMAND AND PRICES AFTER CHANGES IN TASTES

Suppose rollerblading starts to replace tennis. Demand shifts to DSuppose rollerblading starts to replace tennis. Demand shifts to DAA in the in the

market in tennis racquets and Dmarket in tennis racquets and DBB in the market for roller blades. Prices of in the market for roller blades. Prices of

rollerblades will rise to Prollerblades will rise to PBB, prices of tennis racquets will fall to P, prices of tennis racquets will fall to PAA. .

PRICES AND ECONOMIC PRICES AND ECONOMIC COORDINATIONCOORDINATION

PRICES AND ECONOMIC PRICES AND ECONOMIC COORDINATIONCOORDINATION

• The change in tastes from tennis The change in tastes from tennis racquets to rollerblading has caused racquets to rollerblading has caused the economy to produce more roller the economy to produce more roller blades and fewer tennis racquetsblades and fewer tennis racquets

• The economy accomplishes this The economy accomplishes this through pricesthrough prices

• When roller blading became more When roller blading became more popular than tennis, the price of popular than tennis, the price of roller blades rose and the price of roller blades rose and the price of tennis racquets felltennis racquets fell

• The change in tastes from tennis The change in tastes from tennis racquets to rollerblading has caused racquets to rollerblading has caused the economy to produce more roller the economy to produce more roller blades and fewer tennis racquetsblades and fewer tennis racquets

• The economy accomplishes this The economy accomplishes this through pricesthrough prices

• When roller blading became more When roller blading became more popular than tennis, the price of popular than tennis, the price of roller blades rose and the price of roller blades rose and the price of tennis racquets felltennis racquets fell

• The producers of roller blades were The producers of roller blades were given a signal to step up given a signal to step up productionproduction

• The producers of tennis racquets The producers of tennis racquets were given a signal to cut back were given a signal to cut back their production their production

• Workers will leave tennis racquet Workers will leave tennis racquet industry to be employed by roller industry to be employed by roller blade industryblade industry

• The producers of roller blades were The producers of roller blades were given a signal to step up given a signal to step up productionproduction

• The producers of tennis racquets The producers of tennis racquets were given a signal to cut back were given a signal to cut back their production their production

• Workers will leave tennis racquet Workers will leave tennis racquet industry to be employed by roller industry to be employed by roller blade industryblade industry

FUTURE PRICESFUTURE PRICESFUTURE PRICESFUTURE PRICES• There is no price for automobiles to be There is no price for automobiles to be

delivered five years from now, so delivered five years from now, so automobiles do not receive any direct automobiles do not receive any direct signals that consumers wish to signals that consumers wish to purchase automobiles in the futurepurchase automobiles in the future

• Only a few commodities, such as Only a few commodities, such as metals and certain agricultural metals and certain agricultural commodities, can be traded for future commodities, can be traded for future delivery in worldwide marketsdelivery in worldwide markets

• There is no price for automobiles to be There is no price for automobiles to be delivered five years from now, so delivered five years from now, so automobiles do not receive any direct automobiles do not receive any direct signals that consumers wish to signals that consumers wish to purchase automobiles in the futurepurchase automobiles in the future

• Only a few commodities, such as Only a few commodities, such as metals and certain agricultural metals and certain agricultural commodities, can be traded for future commodities, can be traded for future delivery in worldwide marketsdelivery in worldwide markets

TOO LITTLE INFORMATIONTOO LITTLE INFORMATIONTOO LITTLE INFORMATIONTOO LITTLE INFORMATION• Prices may not always contain all the Prices may not always contain all the

information that producers needinformation that producers need• What matters to any firm is the What matters to any firm is the real pricereal price: :

its price relative to all other prices in the its price relative to all other prices in the economyeconomy

• Reality PrincipleReality Principle: : What matters to people What matters to people is the real value or purchasing power of is the real value or purchasing power of money or income, not its face valuemoney or income, not its face value

• Prices may not always contain all the Prices may not always contain all the information that producers needinformation that producers need

• What matters to any firm is the What matters to any firm is the real pricereal price: : its price relative to all other prices in the its price relative to all other prices in the economyeconomy

• Reality PrincipleReality Principle: : What matters to people What matters to people is the real value or purchasing power of is the real value or purchasing power of money or income, not its face valuemoney or income, not its face value

TOO LITTLE INFORMATIONTOO LITTLE INFORMATIONTOO LITTLE INFORMATIONTOO LITTLE INFORMATION

• Problems can occur if firms are Problems can occur if firms are uncertain about whether a change in uncertain about whether a change in their output price is an increase in the their output price is an increase in the real price or only on the nominal or real price or only on the nominal or dollar pricedollar price

• If producers believe demand for their If producers believe demand for their product has fallen, they will cut back product has fallen, they will cut back productionproduction

• If this happened throughout the If this happened throughout the economy, it would lead to a recessioneconomy, it would lead to a recession

• Problems can occur if firms are Problems can occur if firms are uncertain about whether a change in uncertain about whether a change in their output price is an increase in the their output price is an increase in the real price or only on the nominal or real price or only on the nominal or dollar pricedollar price

• If producers believe demand for their If producers believe demand for their product has fallen, they will cut back product has fallen, they will cut back productionproduction

• If this happened throughout the If this happened throughout the economy, it would lead to a recessioneconomy, it would lead to a recession

““STICKY” PRICESSTICKY” PRICES““STICKY” PRICESSTICKY” PRICES• If prices are “sticky” or not If prices are “sticky” or not

sufficiently flexible, prices will not sufficiently flexible, prices will not coordinate activity as efficientlycoordinate activity as efficiently

• In modern economies, some In modern economies, some prices are flexible, while others are prices are flexible, while others are notnot

• Auction Prices Auction Prices -- those determined -- those determined on nearly a daily basison nearly a daily basis

• If prices are “sticky” or not If prices are “sticky” or not sufficiently flexible, prices will not sufficiently flexible, prices will not coordinate activity as efficientlycoordinate activity as efficiently

• In modern economies, some In modern economies, some prices are flexible, while others are prices are flexible, while others are notnot

• Auction Prices Auction Prices -- those determined -- those determined on nearly a daily basison nearly a daily basis

• Prices for fresh fish, vegetables, Prices for fresh fish, vegetables, and other food are very flexibleand other food are very flexible

• Custom Prices Custom Prices -- those that adjust -- those that adjust rather slowlyrather slowly

• Prices for industrial commodities, Prices for industrial commodities, such as steel rods or machine such as steel rods or machine tools, are custom pricestools, are custom prices

• Prices for fresh fish, vegetables, Prices for fresh fish, vegetables, and other food are very flexibleand other food are very flexible

• Custom Prices Custom Prices -- those that adjust -- those that adjust rather slowlyrather slowly

• Prices for industrial commodities, Prices for industrial commodities, such as steel rods or machine such as steel rods or machine tools, are custom pricestools, are custom prices

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STICKY PRICES IN THE MARKET FOR TENNIS RACQUETSSTICKY PRICES IN THE MARKET FOR TENNIS RACQUETS

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When demand falls to DWhen demand falls to DAA, prices are sticky and remain at P, prices are sticky and remain at P00. The result. The result

is unsold production measured by the distance between E and F.is unsold production measured by the distance between E and F.

WAGESWAGESWAGESWAGES

• Wages, the price of labor, adjust Wages, the price of labor, adjust extremely slowlyextremely slowly

• Workers often have long-term Workers often have long-term contracts that do not allow wages contracts that do not allow wages to change at all during a given yearto change at all during a given year

• Even unskilled, low-wage workers Even unskilled, low-wage workers are often protected from decreases are often protected from decreases in their wages by minimum wage in their wages by minimum wage lawslaws

• Wages, the price of labor, adjust Wages, the price of labor, adjust extremely slowlyextremely slowly

• Workers often have long-term Workers often have long-term contracts that do not allow wages contracts that do not allow wages to change at all during a given yearto change at all during a given year

• Even unskilled, low-wage workers Even unskilled, low-wage workers are often protected from decreases are often protected from decreases in their wages by minimum wage in their wages by minimum wage lawslaws

• For most firms, wages are the For most firms, wages are the single most important cost of single most important cost of doing businessdoing business

• If wages are sticky, their overall If wages are sticky, their overall costs will be stickycosts will be sticky

• Stickiness of wages reinforces Stickiness of wages reinforces stickiness of pricesstickiness of prices

• For most firms, wages are the For most firms, wages are the single most important cost of single most important cost of doing businessdoing business

• If wages are sticky, their overall If wages are sticky, their overall costs will be stickycosts will be sticky

• Stickiness of wages reinforces Stickiness of wages reinforces stickiness of pricesstickiness of prices

SHORT-RUN PRICES ARE SHORT-RUN PRICES ARE STICKYSTICKY

SHORT-RUN PRICES ARE SHORT-RUN PRICES ARE STICKYSTICKY

• Firms let demand determine level Firms let demand determine level of output in the short runof output in the short run

• Automaker may have higher Automaker may have higher demand if autos are popular or demand if autos are popular or lower demand if autos are lower demand if autos are unpopularunpopular

• Steelmaker who provides steel to Steelmaker who provides steel to automaker may provide more or automaker may provide more or less steel without adjusting priceless steel without adjusting price

• Firms let demand determine level Firms let demand determine level of output in the short runof output in the short run

• Automaker may have higher Automaker may have higher demand if autos are popular or demand if autos are popular or lower demand if autos are lower demand if autos are unpopularunpopular

• Steelmaker who provides steel to Steelmaker who provides steel to automaker may provide more or automaker may provide more or less steel without adjusting priceless steel without adjusting price

• The same principle applies to The same principle applies to workersworkers

• During good times a company will During good times a company will employ many workers and may employ many workers and may even require some to work even require some to work overtime with no wage changeovertime with no wage change• The short run in macroeconomics The short run in macroeconomics

is the period when prices are fixedis the period when prices are fixed

• The same principle applies to The same principle applies to workersworkers

• During good times a company will During good times a company will employ many workers and may employ many workers and may even require some to work even require some to work overtime with no wage changeovertime with no wage change• The short run in macroeconomics The short run in macroeconomics

is the period when prices are fixedis the period when prices are fixed

LONG-RUN PRICESLONG-RUN PRICESLONG-RUN PRICESLONG-RUN PRICES• In the long run, price adjust fully to In the long run, price adjust fully to

changes in demandchanges in demand

• Over short periods of time, the Over short periods of time, the presence of formal and informal presence of formal and informal contracts mean that demand will be contracts mean that demand will be reflected primarily in changes in reflected primarily in changes in output, not pricesoutput, not prices

• In the long run, price adjust fully to In the long run, price adjust fully to changes in demandchanges in demand

• Over short periods of time, the Over short periods of time, the presence of formal and informal presence of formal and informal contracts mean that demand will be contracts mean that demand will be reflected primarily in changes in reflected primarily in changes in output, not pricesoutput, not prices

AGGREGATE DEMANDAGGREGATE DEMANDAGGREGATE DEMANDAGGREGATE DEMAND• The aggregate demand curve plots The aggregate demand curve plots

the total demand for GDP as a the total demand for GDP as a function of price levelfunction of price level

• The aggregate demand curve is The aggregate demand curve is downward slopingdownward sloping

• As the price level falls, the total As the price level falls, the total demand for goods and services demand for goods and services increasesincreases

• The aggregate demand curve plots The aggregate demand curve plots the total demand for GDP as a the total demand for GDP as a function of price levelfunction of price level

• The aggregate demand curve is The aggregate demand curve is downward slopingdownward sloping

• As the price level falls, the total As the price level falls, the total demand for goods and services demand for goods and services increasesincreases

PPPrice LevelPrice Level

AGGREGATE DEMANDAGGREGATE DEMAND

Real GDP, Y Real GDP, Y

AD: aggregate demandAD: aggregate demand

The aggregate demand curve plots the total demand for real GDP as a The aggregate demand curve plots the total demand for real GDP as a function of the price level. The aggregate demand curve slopes downward,function of the price level. The aggregate demand curve slopes downward,indicating that aggregate demand increases as the price level falls.indicating that aggregate demand increases as the price level falls.

REALITY PRINCIPLEREALITY PRINCIPLEREALITY PRINCIPLEREALITY PRINCIPLE

What matters to people is the What matters to people is the real value or purchasing real value or purchasing power of money or income, power of money or income, not its face value.not its face value.

What matters to people is the What matters to people is the real value or purchasing real value or purchasing power of money or income, power of money or income, not its face value.not its face value.

WEALTH EFFECTWEALTH EFFECTWEALTH EFFECTWEALTH EFFECT

• Increase in spending that Increase in spending that occurs because the real value occurs because the real value of money increases when the of money increases when the price level fallsprice level falls

• One of the key reasons that One of the key reasons that aggregate demand slopes aggregate demand slopes downwarddownward

• Increase in spending that Increase in spending that occurs because the real value occurs because the real value of money increases when the of money increases when the price level fallsprice level falls

• One of the key reasons that One of the key reasons that aggregate demand slopes aggregate demand slopes downwarddownward

TWO OTHER REASONS WHY DEMAND TWO OTHER REASONS WHY DEMAND CURVE SLOPES DOWNWARDCURVE SLOPES DOWNWARD

TWO OTHER REASONS WHY DEMAND TWO OTHER REASONS WHY DEMAND CURVE SLOPES DOWNWARDCURVE SLOPES DOWNWARD

• Interest rate effect Interest rate effect

With a given supply of money in With a given supply of money in the economy, a lower price level the economy, a lower price level will lead to lower interest rateswill lead to lower interest rates

As interest rates fall, demand for As interest rates fall, demand for investment goods in the economy investment goods in the economy increase.increase.

• Interest rate effect Interest rate effect

With a given supply of money in With a given supply of money in the economy, a lower price level the economy, a lower price level will lead to lower interest rateswill lead to lower interest rates

As interest rates fall, demand for As interest rates fall, demand for investment goods in the economy investment goods in the economy increase.increase.

• Effects from international tradeEffects from international trade

In an open economy, a lower price In an open economy, a lower price level will mean that domestic level will mean that domestic goods become cheaper relative to goods become cheaper relative to foreign goods and demand for foreign goods and demand for domestic goods will increasedomestic goods will increase

• Effects from international tradeEffects from international trade

In an open economy, a lower price In an open economy, a lower price level will mean that domestic level will mean that domestic goods become cheaper relative to goods become cheaper relative to foreign goods and demand for foreign goods and demand for domestic goods will increasedomestic goods will increase

SHIFTS OF AGGREGATE SHIFTS OF AGGREGATE DEMANDDEMAND

SHIFTS OF AGGREGATE SHIFTS OF AGGREGATE DEMANDDEMAND

• At any price level, an increase in aggregate At any price level, an increase in aggregate demand means that total demand for real demand means that total demand for real GDP has increased, and the curve shifts to GDP has increased, and the curve shifts to the rightthe right

• Factors that decrease the aggregate Factors that decrease the aggregate demand will shift the aggregate demand demand will shift the aggregate demand curve to the leftcurve to the left

• At any price level, a decrease in aggregate At any price level, a decrease in aggregate demand means that total demand for real demand means that total demand for real GDP has decreasedGDP has decreased

• At any price level, an increase in aggregate At any price level, an increase in aggregate demand means that total demand for real demand means that total demand for real GDP has increased, and the curve shifts to GDP has increased, and the curve shifts to the rightthe right

• Factors that decrease the aggregate Factors that decrease the aggregate demand will shift the aggregate demand demand will shift the aggregate demand curve to the leftcurve to the left

• At any price level, a decrease in aggregate At any price level, a decrease in aggregate demand means that total demand for real demand means that total demand for real GDP has decreasedGDP has decreased

KEY FACTORS THAT SHIFT THE KEY FACTORS THAT SHIFT THE AGGREGATE DEMAND CURVEAGGREGATE DEMAND CURVE

KEY FACTORS THAT SHIFT THE KEY FACTORS THAT SHIFT THE AGGREGATE DEMAND CURVEAGGREGATE DEMAND CURVE

• Changes in the supply of Changes in the supply of moneymoney

• Changes in taxesChanges in taxes

• Changes in government Changes in government spendingspending

• other factorsother factors

• Changes in the supply of Changes in the supply of moneymoney

• Changes in taxesChanges in taxes

• Changes in government Changes in government spendingspending

• other factorsother factors

CHANGES IN THE SUPPLY OF MONEYCHANGES IN THE SUPPLY OF MONEYCHANGES IN THE SUPPLY OF MONEYCHANGES IN THE SUPPLY OF MONEY• An increase in the supply of money in the An increase in the supply of money in the

economy will increase aggregate demand economy will increase aggregate demand and shift the demand curve rightand shift the demand curve right

• At any price level, a higher supply of At any price level, a higher supply of money will mean more consumer wealth money will mean more consumer wealth and an increased demand for goods and and an increased demand for goods and servicesservices

• A decrease in the supply of money will A decrease in the supply of money will decrease aggregate demand and shift the decrease aggregate demand and shift the aggregate demand curve to the leftaggregate demand curve to the left

• An increase in the supply of money in the An increase in the supply of money in the economy will increase aggregate demand economy will increase aggregate demand and shift the demand curve rightand shift the demand curve right

• At any price level, a higher supply of At any price level, a higher supply of money will mean more consumer wealth money will mean more consumer wealth and an increased demand for goods and and an increased demand for goods and servicesservices

• A decrease in the supply of money will A decrease in the supply of money will decrease aggregate demand and shift the decrease aggregate demand and shift the aggregate demand curve to the leftaggregate demand curve to the left

CHANGES IN TAXESCHANGES IN TAXESCHANGES IN TAXESCHANGES IN TAXES

• A decrease in taxes will increase aggregate A decrease in taxes will increase aggregate demand and shift the aggregate demand demand and shift the aggregate demand curve to the rightcurve to the right

• Lower taxes will increase income available Lower taxes will increase income available to households and increase their spending to households and increase their spending on goods and serviceson goods and services

• Increases in taxes will decrease the Increases in taxes will decrease the aggregate demand and shift the aggregate aggregate demand and shift the aggregate demand curve leftdemand curve left

• A decrease in taxes will increase aggregate A decrease in taxes will increase aggregate demand and shift the aggregate demand demand and shift the aggregate demand curve to the rightcurve to the right

• Lower taxes will increase income available Lower taxes will increase income available to households and increase their spending to households and increase their spending on goods and serviceson goods and services

• Increases in taxes will decrease the Increases in taxes will decrease the aggregate demand and shift the aggregate aggregate demand and shift the aggregate demand curve leftdemand curve left

CHANGES IN GOVERNMENT CHANGES IN GOVERNMENT SPENDINGSPENDING

CHANGES IN GOVERNMENT CHANGES IN GOVERNMENT SPENDINGSPENDING

• An increase in government spending will increase An increase in government spending will increase aggregate demand and shift the aggregate aggregate demand and shift the aggregate demand curve rightdemand curve right

• Since the government is a source of demand for Since the government is a source of demand for goods and services, higher government spending goods and services, higher government spending naturally leads to an increase in total demand for naturally leads to an increase in total demand for goods and servicesgoods and services

• Decreases in government spending will decrease Decreases in government spending will decrease aggregate demand and shift the curve to the leftaggregate demand and shift the curve to the left

• An increase in government spending will increase An increase in government spending will increase aggregate demand and shift the aggregate aggregate demand and shift the aggregate demand curve rightdemand curve right

• Since the government is a source of demand for Since the government is a source of demand for goods and services, higher government spending goods and services, higher government spending naturally leads to an increase in total demand for naturally leads to an increase in total demand for goods and servicesgoods and services

• Decreases in government spending will decrease Decreases in government spending will decrease aggregate demand and shift the curve to the leftaggregate demand and shift the curve to the left

OTHER FACTORSOTHER FACTORSOTHER FACTORSOTHER FACTORS• Any change in demand from households, Any change in demand from households,

firms, or the foreign sector will also firms, or the foreign sector will also change aggregate demandchange aggregate demand

• When shifts in aggregate demand are When shifts in aggregate demand are discussed, any changes that arise from discussed, any changes that arise from movements in the price level are movements in the price level are notnot to be to be includedincluded

• Any change in demand from households, Any change in demand from households, firms, or the foreign sector will also firms, or the foreign sector will also change aggregate demandchange aggregate demand

• When shifts in aggregate demand are When shifts in aggregate demand are discussed, any changes that arise from discussed, any changes that arise from movements in the price level are movements in the price level are notnot to be to be includedincluded

FACTORS THAT SHIFT FACTORS THAT SHIFT DEMANDDEMAND

FACTORS THAT SHIFT FACTORS THAT SHIFT DEMANDDEMAND

Factors That Increase Factors That Increase Factors That Factors That Decrease Aggregate DemandDecrease Aggregate Demand Aggregate Aggregate DemandDemand

Decrease in TaxesDecrease in Taxes Increase in TaxesIncrease in Taxes

Increase in Increase in Decrease in Government Decrease in Government SpendingSpending Government SpendingGovernment Spending

Increase in Money Increase in Money Decrease in Money Decrease in Money SupplySupply SupplySupply


SHIFTING AGGREGATE DEMANDSHIFTING AGGREGATE DEMAND

Output, Y Output, Y

Original aggregate demandOriginal aggregate demand



Output, Y Output, Y


Increased aggregate demandIncreased aggregate demand



Output, Y Output, Y



Decreases in taxes, increases in government spending, or an increase in Decreases in taxes, increases in government spending, or an increase in the supply of money all shift the aggregate demand curve to the right.the supply of money all shift the aggregate demand curve to the right.



Output, Y Output, Y


Decreased aggregate demandDecreased aggregate demand


Decreases in taxes, increases in government spending, or an increase in Decreases in taxes, increases in government spending, or an increase in the supply of money all shift the aggregate demand curve to the right.the supply of money all shift the aggregate demand curve to the right.



Output, Y Output, Y


Decreased aggregate demandDecreased aggregate demand


Decreases in taxes, increases in government spending, or an increase in Decreases in taxes, increases in government spending, or an increase in the supply of money all shift the aggregate demand curve to the right.the supply of money all shift the aggregate demand curve to the right.Higher taxes, lower government spending, or a lower supply of money Higher taxes, lower government spending, or a lower supply of money shift the curve to the left.shift the curve to the left.

AGGREGATE SUPPLYAGGREGATE SUPPLYAGGREGATE SUPPLYAGGREGATE SUPPLY

• Depicts the relationship between the Depicts the relationship between the level of prices and real GDPlevel of prices and real GDP

• Two different aggregate supply Two different aggregate supply curves, which correspond to the long curves, which correspond to the long run and the short run:run and the short run:

-- classical aggregate supply curve-- classical aggregate supply curve

-- Keynesian aggregate supply curve-- Keynesian aggregate supply curve

• Depicts the relationship between the Depicts the relationship between the level of prices and real GDPlevel of prices and real GDP

• Two different aggregate supply Two different aggregate supply curves, which correspond to the long curves, which correspond to the long run and the short run:run and the short run:

-- classical aggregate supply curve-- classical aggregate supply curve

-- Keynesian aggregate supply curve-- Keynesian aggregate supply curve

CLASSICAL AGGREGATE CLASSICAL AGGREGATE SUPPLY CURVESUPPLY CURVE

CLASSICAL AGGREGATE CLASSICAL AGGREGATE SUPPLY CURVESUPPLY CURVE

• Aggregate supply curve for the long run Aggregate supply curve for the long run when the economy is at full employmentwhen the economy is at full employment

• Full-employment output depends solely on Full-employment output depends solely on the supply of capital and labor and the state the supply of capital and labor and the state of technologyof technology

• full-employment output does not depend on full-employment output does not depend on the price levelthe price level

• Classical aggregate supply curve is plotted Classical aggregate supply curve is plotted as a vertical line ( unaffected by prices )as a vertical line ( unaffected by prices )

• Aggregate supply curve for the long run Aggregate supply curve for the long run when the economy is at full employmentwhen the economy is at full employment

• Full-employment output depends solely on Full-employment output depends solely on the supply of capital and labor and the state the supply of capital and labor and the state of technologyof technology

• full-employment output does not depend on full-employment output does not depend on the price levelthe price level

• Classical aggregate supply curve is plotted Classical aggregate supply curve is plotted as a vertical line ( unaffected by prices )as a vertical line ( unaffected by prices )

CLASSICAL AGGREGATE SUPPLYCLASSICAL AGGREGATE SUPPLY

pp

Pri

ceP

rice

ASAS

y *y * yyOutput, Output,

In the long run, the level of output y* is independent of the price level.In the long run, the level of output y* is independent of the price level.

AGGREGATE DEMAND AND AGGREGATE DEMAND AND CLASSICAL AGGREGATE SUPPLYCLASSICAL AGGREGATE SUPPLY

pp

Pri

ceP

rice

ASAS


Output and prices are determined at the intersection of AD and AS.Output and prices are determined at the intersection of AD and AS.

Original AD Original AD

ClassicalClassical

COMBINING AGGREGATE DEMAND COMBINING AGGREGATE DEMAND AND AGGREGATE SUPPLYAND AGGREGATE SUPPLY


• The price level and level of output are determined by The price level and level of output are determined by the intersection of aggregate supply and aggregate the intersection of aggregate supply and aggregate demanddemand

• At that point, total amount demanded will just equal At that point, total amount demanded will just equal the total amount suppliedthe total amount supplied

• The position of the aggregate demand curve will The position of the aggregate demand curve will depend on the level of taxes, government spending, depend on the level of taxes, government spending, and the supply of moneyand the supply of money

• The full-employment output determines the classical The full-employment output determines the classical aggregate supply curveaggregate supply curve

• The price level and level of output are determined by The price level and level of output are determined by the intersection of aggregate supply and aggregate the intersection of aggregate supply and aggregate demanddemand

• At that point, total amount demanded will just equal At that point, total amount demanded will just equal the total amount suppliedthe total amount supplied

• The position of the aggregate demand curve will The position of the aggregate demand curve will depend on the level of taxes, government spending, depend on the level of taxes, government spending, and the supply of moneyand the supply of money

• The full-employment output determines the classical The full-employment output determines the classical aggregate supply curveaggregate supply curve

AGGREGATE DEMAND AND AGGREGATE DEMAND AND CLASSICAL AGGREGATE SUPPLYCLASSICAL AGGREGATE SUPPLY

pp

Pri

ceP

rice

ASAS


Output and prices are determined at the intersection of AD and AS.Output and prices are determined at the intersection of AD and AS.An increase in aggregate demand to a higher price level.An increase in aggregate demand to a higher price level.


ClassicalClassical

Increased ADIncreased AD

• An increase in demand will shift the An increase in demand will shift the aggregate demand curve rightaggregate demand curve right

• With a classical aggregate supply curve, the With a classical aggregate supply curve, the increase in aggregate demand will raise the increase in aggregate demand will raise the prices but leave the level of output prices but leave the level of output unchangedunchanged

• An increase in demand will shift the An increase in demand will shift the aggregate demand curve rightaggregate demand curve right

• With a classical aggregate supply curve, the With a classical aggregate supply curve, the increase in aggregate demand will raise the increase in aggregate demand will raise the prices but leave the level of output prices but leave the level of output unchangedunchanged



THE KEYNESIAN AGGREGATE SUPPLY THE KEYNESIAN AGGREGATE SUPPLY CURVECURVE

THE KEYNESIAN AGGREGATE SUPPLY THE KEYNESIAN AGGREGATE SUPPLY CURVECURVE

• The Keynesian aggregate supply curve is The Keynesian aggregate supply curve is horizontal in the short runhorizontal in the short run

• Firms are assumed to supply all output that is Firms are assumed to supply all output that is demanded at the current pricedemanded at the current price

• Formal and informal contracts commit Formal and informal contracts commit producers to supply all that is demanded at the producers to supply all that is demanded at the going pricegoing price

• The entire Keynesian supply curve can shift up The entire Keynesian supply curve can shift up or down as prices adjust to their long-run levelsor down as prices adjust to their long-run levels

• The Keynesian aggregate supply curve is The Keynesian aggregate supply curve is horizontal in the short runhorizontal in the short run

• Firms are assumed to supply all output that is Firms are assumed to supply all output that is demanded at the current pricedemanded at the current price

• Formal and informal contracts commit Formal and informal contracts commit producers to supply all that is demanded at the producers to supply all that is demanded at the going pricegoing price

• The entire Keynesian supply curve can shift up The entire Keynesian supply curve can shift up or down as prices adjust to their long-run levelsor down as prices adjust to their long-run levels

KEYNESIAN AGGREGATE SUPPLYKEYNESIAN AGGREGATE SUPPLY

pp

Pri

ceP

rice

yyOutput, Output,

Keynesian ASKeynesian ASpp00

AGGREGATE DEMAND AND AGGREGATE DEMAND AND KEYNESIAN AGGREGATE SUPPLYKEYNESIAN AGGREGATE SUPPLY

pp

Pri

ceP

rice

y y 00 yyOutput, Output,


Keynesian ASKeynesian ASEE0 0

pp00

AGGREGATE DEMAND AND AGGREGATE DEMAND AND KEYNESIAN AGGREGATE SUPPLYKEYNESIAN AGGREGATE SUPPLY

pp

Pri

ceP

rice

y y 00 yyOutput, Output,

With a Keynesian aggregate supply curve, shifts in aggregate demand With a Keynesian aggregate supply curve, shifts in aggregate demand lead to changes in output but no changes in prices.lead to changes in output but no changes in prices.


Increased ADIncreased AD

Keynesian ASKeynesian AS

y y 11

EE0 0 EE11

pp00

AGGREGATE DEMAND AND KEYNESIAN AGGREGATE DEMAND AND KEYNESIAN AGGREGATE SUPPLY CURVESAGGREGATE SUPPLY CURVES

AGGREGATE DEMAND AND KEYNESIAN AGGREGATE DEMAND AND KEYNESIAN AGGREGATE SUPPLY CURVESAGGREGATE SUPPLY CURVES

• The intersection of AD and AS curves determines The intersection of AD and AS curves determines the price level and the level of output at point Ethe price level and the level of output at point E

• Since aggregate demand is horizontal, aggregate Since aggregate demand is horizontal, aggregate demand totally determines the level of outputdemand totally determines the level of output

• As aggregate demand increases, the new As aggregate demand increases, the new equilibrium will be at the same price pequilibrium will be at the same price p00, but output , but output

will increase from ywill increase from y00 to y to y11

• The Keynesian aggregate supply curve need not The Keynesian aggregate supply curve need not correspond to full-employment outputcorrespond to full-employment output

• Changes in demand will lead to economic Changes in demand will lead to economic fluctuations with sticky prices and a Keynesian fluctuations with sticky prices and a Keynesian aggregate supply curveaggregate supply curve

• The intersection of AD and AS curves determines The intersection of AD and AS curves determines the price level and the level of output at point Ethe price level and the level of output at point E

• Since aggregate demand is horizontal, aggregate Since aggregate demand is horizontal, aggregate demand totally determines the level of outputdemand totally determines the level of output

• As aggregate demand increases, the new As aggregate demand increases, the new equilibrium will be at the same price pequilibrium will be at the same price p00, but output , but output

will increase from ywill increase from y00 to y to y11

• The Keynesian aggregate supply curve need not The Keynesian aggregate supply curve need not correspond to full-employment outputcorrespond to full-employment output

• Changes in demand will lead to economic Changes in demand will lead to economic fluctuations with sticky prices and a Keynesian fluctuations with sticky prices and a Keynesian aggregate supply curveaggregate supply curve

SUPPLY SHOCKSSUPPLY SHOCKSSUPPLY SHOCKSSUPPLY SHOCKS• External disturbances that shift the External disturbances that shift the

aggregate supply curveaggregate supply curve

• Most important illustrations of supply Most important illustrations of supply shocks for the world economy have been shocks for the world economy have been sharp increases in the price of oil that sharp increases in the price of oil that occurred in 1973 and 1979occurred in 1973 and 1979

• -- When oil prices increased sharply, firms -- When oil prices increased sharply, firms would no longer sell all the goods and would no longer sell all the goods and services that were demanded at the current services that were demanded at the current priceprice

• -- To maintain their profit levels, firms -- To maintain their profit levels, firms raised their prices raised their prices

• External disturbances that shift the External disturbances that shift the aggregate supply curveaggregate supply curve

• Most important illustrations of supply Most important illustrations of supply shocks for the world economy have been shocks for the world economy have been sharp increases in the price of oil that sharp increases in the price of oil that occurred in 1973 and 1979occurred in 1973 and 1979

• -- When oil prices increased sharply, firms -- When oil prices increased sharply, firms would no longer sell all the goods and would no longer sell all the goods and services that were demanded at the current services that were demanded at the current priceprice

• -- To maintain their profit levels, firms -- To maintain their profit levels, firms raised their prices raised their prices

A SUPPLY SHOCKA SUPPLY SHOCK

pp

Pri

ceP

rice

yyOutput, Output,

AD AD

pp00AS (before the AS (before the

shock)shock)

yy00


pp

Pri

ceP

rice

yyOutput, Output,

An adverse supply shock, such as an increase in the price of oil, will An adverse supply shock, such as an increase in the price of oil, will shift up the AS curve. shift up the AS curve.

AD AD

AS (after the AS (after the shock)shock)


shock)shock)

yy00


pp

Pri

ceP

rice

yyOutput, Output,

An adverse supply shock, such as an increase in the price of oil, will An adverse supply shock, such as an increase in the price of oil, will shift up the AS curve. The result will be higher prices and a lower levelshift up the AS curve. The result will be higher prices and a lower levelof output.of output.

AD AD

AS (after the AS (after the shock)shock)


shock)shock)

pp11

yy11 yy00

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