Lecture 8
AGGREGATE DEMAND
AND AGGREGATE SUPPLY
PRINCIPLES OF MACROECONOMICS
Lecturer: Minh Huynh, PhD.
EASTERN INTERNATIONAL UNIVERSITY 1
Contents
1 Three Key Facts about Economic Fluctuations
1
2 Explaining Short-Run Economic Fluctuations
3 The Aggregate-Demand Curve
4 The Aggregate-Supply Curve
5 Two Causes of Economic Fluctuations
2
Objectives
● 8.1. List and discuss three key facts about economic
fluctuations.
● 8.2.
Explain how the economy’s behavior in the
short run differs from its behavior in the long
run.
Draw the model of aggregate demand and
aggregate supply and identify what variables on
the two axes are.
3
Objectives
● 8.3.
Explain the three reasons the aggregate-
demand curve slopes downward
Give an example of an event that would shift
the aggregate-demand curve. Which way would
this event shift the curve?
● 8.4. Use the model of aggregate demand and
aggregate supply to analyze the effect of events on
the economy.
4
Objectives
● 8.5.
Explain why the long-run aggregate-supply
curve is vertical.
Explain three theories for why the short-run
aggregate-supply curve is upward sloping.
Identify which variables shift both the long-run
and short-run aggregate-supply curves, and
which variable shifts the short-run aggregate-
supply curve but not the long-run aggregate-
supply curve.
5
Look for the answers to these questions:
● What are economic fluctuations? What are their
● What are the main types of financial institutions in
characteristics?
the U.S.
● How doeseconomy,
the modelandofwhat is their demand
aggregate function?and
● What aresupply
aggregate the three kindseconomic
explain of saving?fluctuations?
●●Why
What’s
doesthethe
difference between saving
Aggregate-Demand and slope
curve
investment?
downward? What shifts the AD curve?
●●What is thethe
How does slope of the
financial Aggregate-Supply
system curve
coordinate saving
andshort
in the investment?
run? In the long run?
What
● Howshifts the policies
do govt. AS curve(s)?
affect saving, investment,
and the interest rate?
6
INTRODUCTION
● Economic activity fluctuates from year to year.
In most years, production of goods and services
rises.
In some years, normal growth does not occur,
causing a recession.
oRecessions: periods of falling real incomes, and
rising unemployment.
oDepression: a severe recession.
● Short-run economic fluctuations are often called
business cycles.
7
3 KEY FACTS ABT. ECONOMIC FLUCTUATIONS
FACT 1: Economic fluctuations are
irregular and unpredictable.
14,000
12,000 U.S. real GDP,
10,000 billions of 2000 dollars
8,000
6,000 The shaded
bars are
4,000
recessions
2,000
0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
8
3 KEY FACTS ABT. ECONOMIC FLUCTUATIONS
FACT 2: Most macroeconomic
quantities fluctuate together.
2,500
Investment spending,
2,000
billions of 2000 dollars
1,500
1,000 The shaded
bars are
recessions
500
0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
9
3 KEY FACTS ABT. ECONOMIC FLUCTUATIONS
FACT 3: As output falls,
unemployment rises.
12
10 Unemployment rate,
percent of labor force
8
4
The shaded
2 bars are
recessions
0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
10
EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS
The Assumptions of Classical Economics
● The previous lectures are based on the ideas of
classical economics, especially:
The Classical Dichotomy, the separation of variables
into two groups:
Real – measured in units of physical quantities
Nominal – measured in units of money
The neutrality of money:
Changes in the money supply affect nominal but not
real variables.
11
EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS
The Reality of Short-Run Fluctuations
● Most economists believe classical theory describes
the world in the long run,
but not the short run.
● In the short run, changes in nominal variables (like
the money supply or P ) can affect real variables (like
Y or the u-rate).
● To study the short run, we use a new model.
12
EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS
The Model of Aggregate Demand and Aggregate
Supply
● The model of aggregate demand and aggregate
supply is used by economists to explain short-run
fluctuations in economic activity around its long-run
trend.
● The model focuses on the behavior of 2 variables:
The economy’s quantity of output, which can be
measured by real GDP.
The economy’s price level, which can be measured
by the CPI or the GDP deflator.
13
EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS
The 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 aggregate-supply curve shows the quantity of
goods and services that firms choose to produce and
sell at each price level.
14
Aggregate Demand and Aggregate Supply
P
The price
level
SRAS
“Short-Run
The model P1 Aggregate
determines the Supply”
eq’m price level “Aggregate
Demand” AD
and eq’m output Y
Y1
(real GDP).
Real GDP, the
quantity of output
15
The Aggregate-Demand Curve
Price
Level
The AD curve shows the
quantity of all goods
&services demanded in
the economy at any given
P
price level.
P2
1. A decrease
Aggregate
in the price
demand
level . . .
0 Y Y2 Quantity of
Output
2. . . . increases the quantity of
goods and services demanded.
Copyright © 2004 South-Western
THE AGGREGATE-DEMAND CURVE
The four components of GDP (Y) contribute to
the aggregate demand for goods and services.
Y = C + I + G + NX
Why the AD Curve Slopes Downward
● Assume G fixed by govt. policy.
● To understand the slope of AD, we must
determine how a change in P affects C, I, and
NX.
17
Why the AD Curve Slopes Downward
The Price Level (P) and Consumption (C):
The Wealth Effect
● Suppose P falls.
● Consumers feel more wealthy, they spend
more (C increases).
● Result: the quantity of goods and services
demanded rises.
18
Why the AD Curve Slopes Downward
The Price Level (P) and Investment (I):
The Interest Rate Effect
● Suppose P falls.
● Households need less dollars to buy goods &
services, they try to reduce their holdings of
money by lending some of it out.
● More households lend money a lower interest
rate firms borrow more to invest I
increases.
● Result: the quantity of goods and services
demanded rises.
19
Why the AD Curve Slopes Downward
The Price Level (P) and Net Exports (NX):
The Exchange-Rate Effect
● Suppose P falls.
● VN interest rates falls (the interest-rate effect).
● Foreign investors desire less VN’s bonds.
● Lower demand for VND in foreign exchange market.
● VN exchange rate depreciates.
● VN exports become cheaper to people abroad, imports
more expensive to VN residents. NX rises.
● Result: the quantity of goods and services demanded
rises.
20
The Slope of the AD Curve: Summary
A decrease in P P
increases the quantity
of g&s demanded
P1
because:
the wealth effect (C
rises)
P2
the interest-rate
AD
effect (I rises)
the exchange-rate Y
Y1 Y2
effect (NX rises)
21
Why the AD Curve Might Shift
Any event that changes
C, I, G, or NX P
– except a change in P –
will shift the AD curve.
Example: P1
A stock market boom
makes households feel
AD2
wealthier, C rises,
AD1
the AD curve shifts to the
Y
right. Y1 Y2
22
Why the AD Curve Might Shift
Changes in C
Stock market boom/crash
Consumption/saving tradeoff
Tax hikes/cuts
Changes in I
Firms buy new computers, equipment, factories
Expectations, optimism/pessimism
Interest rates, monetary policy
23
Why the AD Curve Might Shift
Changes in G
Federal spending, e.g., defense
State & local spending, e.g., roads, schools
Changes in NX
Booms/recessions in countries that buy our
exports.
Appreciation/depreciation resulting from
international speculation in foreign exchange
market.
24
ACTIVE LEARNING 1
The Aggregate-Demand curve
What happens to the AD curve in each of the following
scenarios?
A. Fed decreases the money supply.
B. The U.S. exchange rate falls.
C. A fall in prices increases the real value of
consumers’ wealth.
D. State governments replace their sales taxes with
new taxes on interest, dividends, and capital
gains.
25
THE AGGREGATE-SUPPLY CURVE
The AS curve shows P LRAS
the total quantity of
g&s firms produce and SRAS
sell at any given price
level.
AS is:
upward-sloping
in short run
Y
vertical in
long run
26
The Long-Run Aggregate-Supply Curve (LRAS)
The natural rate of P LRAS
output (YN) is the
amount of output
the economy produces
when unemployment
is at its natural rate.
YN is also called
potential output
or Y
full-employment YN
output.
27
Why LRAS Is Vertical
YN is determined by P LRAS
the economy’s stocks of
labor, capital, and
natural resources, and
on the level of P2
technology.
P1
An increase in P
does not affect
any of these,
Y
so it does not YN
affect YN.
(Classical dichotomy)
28
Why the LRAS Curve Might Shift
P LRAS1 LRAS2
Any event that
changes any of the
determinants of YN
will shift LRAS.
Example: Immigration
increases L,
causing YN to rise.
Y
YN Y’
N
29
Why the LRAS Curve Might Shift
Changes in Labor
Immigration
Baby-boomers retire
Govt. policies reduce natural u-rate
Changes in K or H
Investment in factories, equipment
More people get college degrees
Factories destroyed by a hurricane
30
Why the LRAS Curve Might Shift
Changes in natural resources
Discovery of new mineral deposits
Reduction in supply of imported oil
Changing weather patterns that affect agricultural
production
Changes in technology
Productivity improvements from technological
progress
31
Using AD & AS to Depict LR Growth and Inflation
LRAS2000
•Over the long run, P LRAS1990
tech. progress shifts LRAS1980
LRAS to the right
and growth in the P2000
money supply shifts
P1990
AD to the right.
AD2000
P1980
Result:
ongoing inflation AD1990
and growth in AD1980
Y
output. Y1980 Y1990 Y2000
32
Why the SRAS Curve Slopes Upward
The SRAS curve P
is upward sloping:
Over the period SRAS
of 1-2 years, P2
an increase in P
P1
causes an increase
in the quantity of
g&s supplied. Y
Y1 Y2
33
Why the Slope of SRAS Matters
P LRAS
If AS is vertical,
fluctuations in AD P2
SRAS
do not cause
P2
fluctuations in output
or employment.
AD2
If AS slopes up, P3
then shifts in AD AD1
P3
do affect output and AD3
Y
employment. Y3 Y1 Y2
34
Three Theories of SRAS
In each,
some type of market imperfection
result:
Output deviates from its natural rate
when the actual price level deviates
from the price level people expected.
35
Three Theories of SRAS
1. The Sticky-Wage Theory
Imperfection:
Nominal wages are sticky in the short run,
they adjust sluggishly (slowly).
Due to labor contracts, social norms
Firms and workers set the nominal wage in
advance based on PE, the price level they expect
to prevail.
36
Three Theories of SRAS
1. The Sticky-Wage Theory
If P > PE,
revenue is higher, but labor cost is not.
Production is more profitable,
so firms increase output and employment.
Hence, higher P causes higher Y,
so the SRAS curve slopes upward.
37
Three Theories of SRAS
2. The Sticky-Price Theory
Imperfection:
Many prices are sticky in the short run.
Due to menu costs, the costs of adjusting prices.
Examples: cost of printing new menus,
the time required to change price tags.
Firms set sticky prices in advance based
on PE.
38
Three Theories of SRAS
2. The Sticky-Price Theory
Suppose the Fed increases the money supply
unexpectedly. In the long run, P will rise.
In the short run, firms without menu costs can raise
their prices immediately.
Firms with menu costs wait to raise prices.
Meantime, their prices are relatively low, which
increases demand for their products,
so they increase output and employment.
Hence, higher P is associated with higher Y,
so the SRAS curve slopes upward.
39
Three Theories of SRAS
3. The Misperceptions Theory
Imperfection:
Firms may confuse changes in P with changes
in the relative price of the products they sell.
If P rises above PE, a firm sees its price rise before
realizing all prices are rising.
• The firm may believe its relative price is rising,
and may increase output and employment.
So, an increase in P can cause an increase in Y,
making the SRAS curve upward-sloping.
40
What the 3 Theories Have in Common:
In all 3 theories, Y deviates from YN when
P deviates from PE.
Y = YN + a (P – PE)
Output Expected
price level
Natural rate
of output a > 0,
measures how Actual
(long-run) price level
much Y
responds to
unexpected
changes in P
41
What the 3 Theories Have in Common:
Y = YN + a (P – PE)
P
SRAS
When P > PE
the expected
PE
price level
When P < PE
Y
YN
Y < YN Y > YN
42
SRAS and LRAS
The imperfections in these theories are
temporary. Over time,
sticky wages and prices become flexible
misperceptions are corrected
In the LR,
P = PE
AS curve is vertical
43
Why the SRAS Curve Might Shift
Everything that shifts LRAS shifts SRAS, too.
Labor
Capital
Natural Resources.
Technology.
Also, PE shifts SRAS.
Expected Price Level.
44
Why the SRAS Curve Might Shift
If PE rises, workers &
P LRAS
firms set higher wages.
SRAS
SRAS
At each P, production is
PE
less profitable, Y falls,
SRAS shifts left.
PE
Y
YN
45
The Long-Run Equilibrium
In the long-run P LRAS
equilibrium,
SRAS
PE = P,
Y = YN ,
PE
and unemployment is
at its natural rate.
AD
Y
YN
46
A Contraction in Aggregate Demand
2. . . . causes output to fall in the short run . . .
Price
Level
Long-run Short-run aggregate
aggregate supply, AS
supply
AS2
3. . . . but over
time, the short-run
P A aggregate-supply
curve shifts . . .
P2 B
1. A decrease in
aggregate demand . . .
P3 C
Aggregate
demand, AD
AD2
0 Y2 Y Quantity of
4. . . . and output returns Output
to its natural rate.
TWO CAUSES OF ECONOMIC FLUCTUATIONS
● Economic fluctuations are caused by events that shift
the AD and/or AS curves.
● Four steps for analyzing economic fluctuations:
1. Determine whether the event shifts AD or AS.
2. Determine whether curve shifts left or right.
3. Use AD-AS diagram to see how the shift changes Y
and P in the short run.
4. Use AD-AS diagram to see how economy
moves from new SR eq’m to new LR eq’m.
48
TWO CAUSES OF ECONOMIC FLUCTUATIONS
Shifts in Aggregate Demand
● In the short run, shifts in aggregate demand
cause fluctuations in the economy’s output of
goods and services.
● In the long run, shifts in aggregate demand
affect the overall price level but do not affect
output.
49
TWO CAUSES OF ECONOMIC FLUCTUATIONS
An Adverse Shift in Aggregate Supply
● A decrease in one of the determinants of
aggregate supply shifts the curve to the left:
Output falls below the natural rate of
employment.
Unemployment rises.
The price level rises.
50
The Effects of a Shift in AD
Event:
Stock market crash P LRAS
1. Affects C, AD SRAS1
2. C falls, so AD curve shifts
to the left P1 A SRAS2
3. SR eq’m at B.
P2 B
P and Y lower,
AD1
unemp higher P3 C
4. Over time, PE falls, AD2
SRAS shifts right, Y
Y2 YN
until LR eq’m at C.
Y and unemp back
at initial levels. 51
ACTIVE LEARNING 2
Working with the model
Draw the AD-SRAS-LRAS diagram
for the U.S. economy
starting in a long-run equilibrium.
A boom occurs in Canada.
Use your diagram to determine
the SR and LR effects on U.S. GDP,
the price level, and unemployment.
52
The Effects of a Shift in AD
Event:
Oil prices rise P LRAS
1. Increases costs, SRAS2
shifts SRAS
(assume LRAS constant) SRAS1
B
2. SRAS shifts left P2
3. SR eq’m at point B. A
P1
P higher, Y lower,
unemp higher
AD1
From A to B, stagflation,
Y
a period of falling output Y2 YN
and rising prices.
53
Accommodating an Adverse Shift in SRAS
If policymakers do nothing,
4. Low employment P LRAS
causes wages to fall, SRAS
SRAS2
shifts right,
until LR eq’m at A. P3 C SRAS1
B
Or, policymakers could P2
use fiscal or monetary P1 A
policy to increase AD AD2
and accommodate the
AS shift: AD1
Y
Y back to YN, but Y2 YN
P permanently higher.
54
SUMMARY
● All societies experience short-run
economic fluctuations around long-run
trends.
● These fluctuations are irregular and largely
unpredictable.
● When recessions occur, real GDP and other
measures of income, spending, and
production fall, and unemployment rises.
55
SUMMARY
● Economists analyze short-run economic
fluctuations using the aggregate demand
and aggregate supply model.
● According to the model of aggregate
demand and aggregate supply, the output of
goods and services and the overall level of
prices adjust to balance aggregate demand
and aggregate supply.
56
SUMMARY
● The aggregate-demand curve slopes
downward for three reasons: a wealth
effect, an interest rate effect, and an
exchange rate effect.
● Any event or policy that changes
consumption, investment, government
purchases, or net exports at a given price
level will shift the aggregate-demand curve.
57
SUMMARY
● In the long run, the aggregate supply curve is
vertical.
● The short-run, the aggregate supply curve is
upward sloping.
● The are three theories explaining the upward
slope of short-run aggregate supply: the
misperceptions theory, the sticky-wage theory, and
the sticky-price theory.
58
SUMMARY
● Events that alter the economy’s ability to
produce output will shift the short-run
aggregate-supply curve.
● Also, the position of the short-run
aggregate-supply curve depends on the
expected price level.
● One possible cause of economic
fluctuations is a shift in aggregate demand.
59
SUMMARY
● A second possible cause of economic
fluctuations is a shift in aggregate supply.
● Stagflation is a period of falling output and
rising prices.
60
HOMEWORK
Question 1: List and discuss three key facts about
economic fluctuations.
Question 2: How does the economy’s behavior in
the short run differ from its behavior in the long
run?
Draw the model of aggregate demand and
aggregate supply. What variables are on the two
axes?
61
HOMEWORK
Question 3:
Explain the three reasons the aggregate-demand curve
slopes downward
Give an example of an event that would shift the
aggregate-demand curve. Which way would this event
shift the curve?
Question 4: Suppose that the election of a popular
presidential candidate suddenly
increases people’s confidence in the future. Use the
model of aggregate demand and
aggregate supply to analyze the effect on the economy.
62
HOMEWORK
Question 5: Explain why the long-run aggregate-
supply curve is vertical.
Explain three theories for why the short-run
aggregate-supply curve is upward sloping.
What variables shift both the long-run and short-run
aggregate-supply curves? What variable shifts the
short-run aggregate-supply curve but not the long-
run aggregate-supply curve?
63
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