Prepared by: Jamal Husein C H A P T E R 13 © 2005 Prentice Hall Business PublishingSurvey of...

© 2005 Prentice Hall Business Publishing© 2005 Prentice Hall Business Publishing Survey of Economics, 2/eSurvey of Economics, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin

Prepared by: Jamal Husein

C H A P T E R

1313

Aggregate Demand and Aggregate Supply

© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 2

Economic FluctuationsEconomic FluctuationsEconomic FluctuationsEconomic Fluctuations

Economic fluctuations are irregular, recurring movements of GDP away from potential output, also called business cycles.

Aggregate supply and aggregate demand curves are tools of analysis used for understanding key aspects of economic fluctuations in both the short run and the long run.


Economic FluctuationsEconomic FluctuationsEconomic FluctuationsEconomic Fluctuations The short run in macroeconomics refers

to a period of time during which prices change very little, or do not adjust fully to changes in demand.

The idea that demand determines output in the short-run will be examined.

In the long-run, underlying economic forces push the economy back towards full employment.

The level of output in the economy when it operates at full employment is called Potential output.


Economic FluctuationsEconomic FluctuationsEconomic FluctuationsEconomic Fluctuations

A depression is a prolonged period of decline in output, or a severe recession. During the Great Depression, 1929 through 1933, real GDP fell by over 33%, and unemployment rose to 25%.

In the U.S., there were 20 recessions prior to World War II, including two severe episodes in 1893 and 1929. After WWII the U.S. has had nine recessions.

A recession is a period when real GDP falls for two consecutive quarters. It starts at the peak of an increase in output, and ends at a trough.


Business Cycles & Economic FluctuationsBusiness Cycles & Economic FluctuationsBusiness Cycles & Economic FluctuationsBusiness Cycles & Economic Fluctuations


Ten Postwar RecessionsTen Postwar RecessionsTen Postwar RecessionsTen Postwar Recessions

Peak Trough Percent Decline in Real GDP

November 1948 October 1949 1.5

July 1953 May 1954 3.2

August 1957 April 1958 3.3

April 1960 February 1961 1.2

December 1969 November 1970 1.0

November 1973 March 1975 4.9

January 1980 July 1980 2.5

July 1981 November 1982 3.0

July 1990 March 1991 1.4

March 2001 -------- -------


Okun’s LawOkun’s LawOkun’s LawOkun’s Law

The relationship between changes in real GDP and the corresponding changes in unemployment is called Okun’s Law.

According to Okun’s law, for every percentage point that real GDP grows faster than the normal rate of increase in potential output, the unemployment rate falls by one-half of a percentage point.


Okun’s Law: ExampleOkun’s Law: ExampleOkun’s Law: ExampleOkun’s Law: Example

If the trend rate of real GDP growth is 3% per year and the unemployment rate is 5%, then ;

If real GDP grows by 4% a year (1% point above its trend), then the unemployment rate will decline by 0.5% to 4.5%.

If real GDP grows at only 2% per year (1% point below its trend), then the unemployment rate would rise 5.5%.


The Unemployment Rate During The Unemployment Rate During RecessionsRecessionsThe Unemployment Rate During The Unemployment Rate During RecessionsRecessions

During periods of recession, marked by the shaded bars, unemployment rises sharply.


Procyclical and Countercyclical MeasuresProcyclical and Countercyclical MeasuresProcyclical and Countercyclical MeasuresProcyclical and Countercyclical Measures

ProcyclicalProcyclical economic measures move in conjunction with real GDP. Investment spending, consumption spending and prices of stocks are all procyclical. The stock market always plunges sharply during recessions.

Economic measures that fall as real GDP rises are countercyclicalcountercyclical. Unemployment is countercyclical.

Recessions are unpredictable and can arise as a result of external shocks or changes in economic policy.


Sticky Prices & Demand-side EconomicsSticky Prices & Demand-side EconomicsSticky Prices & Demand-side EconomicsSticky Prices & Demand-side Economics

Prices give the correct signals to all producers in the economy so that resources are used efficiently. If consumers decide to consume fresh

fruit rather than chocolate, the price of fruit will rise and the price of chocolate will fall.

The economy will produce more fresh fruit and less chocolate on the basis of these price signals.



If prices are slow to adjust, then the proper signals are not given quickly enough to producers and consumers.

Arthur Okun classifies prices as: Auction pricesAuction prices, or prices that adjust

nearly on a daily basis, such as food products.

Custom pricesCustom prices, or prices that adjust slowly, or “sticky prices,” such as wages and some industrial commodities.



Wages are sticky because workers often have long-term contracts or are protected from wage decreases by minimum wage laws.

If wages are sticky, then firms’ costs and their prices will be sticky as well. Sticky prices get in the way of the economy’s ability to coordinate economic activity, and to bring demand and supply into balance.



Typically, firms let demand determine the level of output in the short run. In the long run, prices fully adjust to changes in demand.

In the short run, firms have negotiated contracts that keep input prices fixed. Sudden changes in demand will be met by changes in production with only small changes in prices.

Keynesian economics refers to the determination of output in the short run based strictly on changes in demand.


Aggregate Demand (AD)Aggregate Demand (AD)Aggregate Demand (AD)Aggregate Demand (AD)

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

The price level refers to the average of all prices in the economy, as measured by a price index.


Components of Aggregate DemandComponents of Aggregate DemandComponents of Aggregate DemandComponents of Aggregate Demand

Demand for GDP comprises the demand for goods and services by all sectors of the economy:

the household sector (consumption),

the business sector (investment),

the government sector (government spending), and

the foreign sector (net exports)


Aggregate Demand Slopes DownwardAggregate Demand Slopes DownwardAggregate Demand Slopes DownwardAggregate Demand Slopes Downward

Aggregate demand slopes downward for several reasons. Among them are:

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

The wealth effect: as the price level falls, the real value of money increases and people find that they are wealthier. This concept is associated with the reality principle.




The interest rate effect: with a given money supply, a lower price level will lead to lower interest rates and higher consumption and investment spending.




The impact of international trade: a lower price level makes domestic goods cheaper relative to foreign goods; and a lower U.S. interest rate leads to a lower U.S. exchange rate which also makes domestic goods relatively cheaper than foreign goods.


Factors That Shift Aggregate DemandFactors That Shift Aggregate DemandFactors That Shift Aggregate DemandFactors That Shift Aggregate Demand

Decrease in the money supply

Increase in the money supply

Decrease in government spending

Increase in government spending

Increase in taxes

Decrease in taxes

Factors That Decrease Aggregate Demand

Factors That Increase

Aggregate Demand


Aggregate SupplyAggregate SupplyAggregate SupplyAggregate Supply

The aggregate supply curveaggregate supply curve depicts the relationship between the level of prices and real GDP.

We will consider two aggregate supply curves, one corresponding to the long run (the long run the long run aggregate supply curveaggregate supply curve), and one to the short run (the short run the short run aggregate supply curveaggregate supply curve).


The Long Run Aggregate Supply CurveThe Long Run Aggregate Supply CurveThe Long Run Aggregate Supply CurveThe Long Run Aggregate Supply Curve

The classical aggregate supply curve is the supply curve for the long run—when the economy is at full employment.

The level of full- employment output does not depend on the level of prices, but on supply factors—capital, labor and technology. This is why the classical AS curve is vertical.

Long Run AS



Combined with the aggregate demand curve, the intersection of the classical AS curve and the AD curve determines the price level and the full-employment level of output.

The position of the AD curve depends on the level of taxes, government spending, and the supply of money.

Long Run AS



An increase in aggregate demand does not change the level of output in the economy but only the level of prices.

The main result from the classical model is that, in the long run, output is determined solely by the supply of capital and labor—not by changes in demand.

Long RunAS


Crowding OutCrowding OutCrowding OutCrowding Out

If the level of output remains the same but government spending increases, some other component of demand (consumption, investment, or net exports) must decrease.

As we have seen, higher aggregate demand (i.e. higher government spending) in the classical model does not change the level of output.


Crowding OutCrowding OutCrowding OutCrowding Out

Increased government spending “crowds outcrowds out” other demands for GDP.

At full employment, the opportunity cost of increased government spending is some other component of GDP.

PRINCIPLE of Opportunity CostThe opportunity cost of something is what you sacrifice to get it.

PRINCIPLE of Opportunity CostThe opportunity cost of something is what you sacrifice to get it.


Competing Shares of GDPCompeting Shares of GDPCompeting Shares of GDPCompeting Shares of GDP


The Short Run Aggregate Supply CurveThe Short Run Aggregate Supply CurveThe Short Run Aggregate Supply CurveThe Short Run Aggregate Supply Curve

The Keynesian AS curve is relatively flat because, in the short run, firms adjust output more than they adjust prices.

Since an increase in demand is met mostly by an increase in output, we say that aggregate demand primarily determines the level of output in the short run.



The level of output where the Keynesian AS curve intersects the aggregate demand curve need not be the full-employment level of output.

Output may exceed the level of full employment when demand is very high, and fall short of full employment when demand is very low.



Because prices do not adjust fully over short periods of time, the economy need not always remain at full employment, or potential output.

Changes in demand will lead to economic fluctuations, away from full employment, with sticky prices and a Keynesian aggregate supply curve.

Only in the long run, when prices fully adjust, will the economy operate at full employment.


Adverse Supply ShocksAdverse Supply ShocksAdverse Supply ShocksAdverse Supply Shocks

Supply shocks are external events that shift the Keynesian aggregate supply curve.

Adverse supply shocks result in lower output, lower employment, and higher prices.


Favorable Supply ShocksFavorable Supply ShocksFavorable Supply ShocksFavorable Supply Shocks

Favorable supply shocks allow the economy to grow rapidly without incurring the risk of higher inflation.

Favorable supply shocks are also possible. They lead to the best of both worlds: higher output and lower prices.


From Short-run to Long-run EquilibriumFrom Short-run to Long-run EquilibriumFrom Short-run to Long-run EquilibriumFrom Short-run to Long-run Equilibrium

As firms compete for labor and raw materials, wages and prices will tend to rise over time.

This will cause the Keynesian aggregate supply curve to shift upward.

This situation will continue as long as output exceeds potential.

Long Run ASLong Run ASLong Run AS

Long Run AS

Long Run AS


From Short-run to Long-run EquilibriumFrom Short-run to Long-run EquilibriumFrom Short-run to Long-run EquilibriumFrom Short-run to Long-run Equilibrium

The Keynesian aggregate supply will keep rising upward until it intersects the aggregate demand curve at full employment.

Adjustments in wages and prices eventually take the economy from short-run Keynesian equilibrium to long-run classical equilibrium.

Long Run AS

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Prepared by: Jamal Husein C H A P T E R 13 © 2005 Prentice Hall Business PublishingSurvey of...

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