11/8/2019

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Aggregate Demand and Aggregate Supply

Macro Economics Arjun Madan Ph D

Classical Viewpoint
Classical Economics -
Popularly accepted theory prior to the Great Depression of the 1930s.
Says the economy will automatically adjust to full employment.
Classical economists assume that:
Supply creates its own demand in an economy.
Wages and prices are flexible and increases or decreases to ensure that the economy operates at full employment.
Savings always equals investment, because changes in the interest rate bring savings and investment into equality.

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1
 AS and AD in Classical Economics

Aggregate Supply and Aggregate Demand in Classical Economics

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Keynesian Explanation of the Great Depression

Keynes argued that wages and prices were highly inflexible, particularly in a downward direction.
Thus, he did not think changes in prices and interest rates would direct the economy back to full employment.

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Aggregate Demand – Aggregate Supply Model
Generally referred to as AD-AS Model.
Explains fluctuation in output, price level and rate of inflation in an economy.
AD curve depicts the total output which households, firm and government are willing to buy at various price level.
It slopes downward to the right.
AS curves shows the quantity of aggregate output that firms of the economy produce and supply at each price level.
The AS curves generally slopes upwards to the right.

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Aggregate Demand – Aggregate Supply Model

P

The price level SRAS

“Short-Run Aggregate Supply”

The model determines the eq’m price level
P1

“Aggregate Demand”
AD

and eq’m output (real GDP). Y

Y1

Real GDP, the quantity of output

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 Shift in AD – AS Curve
Panel B
Y
Panel A
Y
AS

AS’
E’
P1
AS
E
P0 P'
P0
AD’

AD
AD
GM
Input Price
X X
Y0 Y1 Y’ Y0
Aggregate Output
Aggregate Output
Impact of increase in AD on price level and output
Impact of decrease in AD on price level and output
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Shift in AD – AS Curve
Changes in AD or AS will cause changes in equilibrium price and output.
Due to expansion of govt. expenditure (G) or in money supply AD curve will shift to the right, AS remaining same.
The level of output and price will increase.
Rise in price level depends on elasticity of AS and the magnitude of increase in AD.
If the price of inputs – wages, price of raw material, fuel, etc. rise, AS curve will shift to the left from AS to AS’ – AD remaining same.
Price level will rise from P0 to P’, but level of output will decline from Y0 to Y’ .

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 The Aggregate-Demand (AD) Curve
P
The AD curve shows the quantity of
all goods & services demanded
P2
in the economy at any given price level.

P1
AD

Y
Y2 Y1

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Why the AD Curve Slopes Downward

Y = C + I + G + NX P
Assume G fixed by govt policy.
To understand the slope of AD, P2
we must determine how a change in P
affects C, I, and NX.

P1
AD

Y
The Wealth Effect Y2 Y1
The Interest-Rate Effect
The Exchange-Rate Effect

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The Wealth Effect (P and C )
Suppose P rises.
The money people hold buy fewer goods & services, so real wealth is lower.
People feel poorer. Result: C falls.

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The Wealth Effect (P and C )

 A decrease in the price level makes consumers feel more

wealthy, which in turn encourages them to spend more.
 This increase in consumer spending means larger quantities of goods
and services demanded.
 Changes in price level directly affects the real value of
household wealth.
 The impact of price level on consumption is wealth-effect.

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 The Interest-Rate Effect (P and I )
Suppose P rises.
Buying goods & services requires more money.
To get these monies, people sell bonds or other assets.
This drives up interest rates. Result: I falls.
(Recall, I depends negatively on interest rates.)

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The Interest-Rate Effect (P and I )

 A higher price level will cause more demand for money to finance buying
and selling.
 This will drive up the interest rates, which in turn will raise the cost of
borrowing.
 Consumption will reduce.
 A lower price level reduces the interest rate, which encourages greater
spending on investment goods.
 This increase in investment spending means a larger quantity of goods
and services demanded.
 This impact of price level on investment is interest rate effect.

Macro Economics Arjun Madan Ph D

The Exchange-Rate Effect (P and NX )
Suppose P rises.
U.S. interest rates rise (the interest-rate effect).
Foreign investors desire more U.S. bonds.
Higher demand for $ in foreign exchange market.
U.S. exchange rate appreciates.
U.S. exports more expensive to people abroad, imports cheaper to U.S. residents.
Result: NX falls.

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The Exchange-Rate Effect (P and NX )

 When a fall in the price level causes interest rates to fall, the real exchange
rate depreciates, which stimulates India’s net exports.
 The increase in net export spending means a larger quantity of goods and
services demanded.
 This impact of price level on net export is international trade effect or
exchange-rate effect.

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 The Slope of the AD Curve:Summary
An increase in P reduces the quantity of g&s demanded
P because:
the wealth effect (C falls)
the interest-rate effect (I falls)
P2
the exchange-rate effect (NX falls)

P1
AD

Y
Y2 Y1

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Deriving the Aggregate Demand Curve

 P  Md   r   I   AE  Y 


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regate Expenditure and Aggregate Demand
re aggregate demand and aggregate expenditure related?

t every point along the aggregate demand curve, the aggregate quantity of output demanded is exactly equal to planned aggregate expen

C+I+G
rium condition

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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 wealthier, C rises,
the AD curve shifts right.
AD2
AD1
Y
Y1 Y2

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 Why the AD Curve Might Shift Contd …
Changes in C
Stock market boom/crash
Preferences: consumption/saving tradeoff
Tax hikes/cuts
Changes in I
Firms buy new computers, equipment, factories
Expectations, optimism/pessimism
Interest rates, monetary policy
Investment Tax Credit or other tax incentives

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Why the AD Curve Might Shift Contd …

Changes in G
Central Govt. 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

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 The Aggregate-Supply (AS) Curves

The AS curve shows the total quantity of P LRAS

g&s firms produce and sell at any given price level.
AS is: SRAS
upward-sloping in short run
vertical in long run

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The Long-Run Aggregate-Supply Curve (LRAS)

P
al rate of output (YN) is the amount of output the economy produces when LRAS
unemployment
ural rate.
alled potential output

oyment output.

Y
YN

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 Why LRAS Is Vertical
the economy’s stocks of labor, capital, and natural resources, level of technology.
P and on the LRAS

P2

P1
does not affect any of these, so it does not affect YN.

Y
YN

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Why the LRAS Curve Might Shift

P
Any event that changes any of the determinants of YN will shift LRAS. LRAS1LRAS2
Example: Population increases L,
causing YN to rise.

Y
YN Y’N

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 Why the LRAS Curve Might Shift
Changes in L or natural rate of unemployment
Population
Retirement / VRS
Govt policies reduce natural unemployment-rate
Changes in K
Investment in factories, equipment
More people get college degrees
Factories destroyed by a natural calamity

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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

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 Using AD & AS to Depict LR Growth and Inflation
LRAS2010

Over the long run, tech. progress shifts LRAS to the right LRAS2000
P
and growth in the money supply shifts AD to the right. LRAS1990
Result:
ongoing inflation and growth in output.
P2010
P2000 P1990

AD2010

AD2000
AD1990
Y1990Y2000 Y
Y2010

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Short Run Aggregate Supply (SRAS)

The SRAS curve is upward sloping: P

Over the period of 1-2 years,
an increase in P SRAS
causes an increase in the quantity of g & s supplied.
P2

P1

Y1
Y
Y2

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 Why the Slope of SRAS Matters
LRAS
P
If AS is vertical, fluctuations in AD does not cause
fluctuations in output or employment. Phi
Phi SRAS

ADhi
If AS slopes up, then shifts in AD Plo
do affect output and employment. AD1
Plo
ADlo
Y
Ylo Y1 Yhi

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RAS
rfection result: Output deviates from its natural rate when the actual price level deviates from the price level peop

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 1. The Sticky-Wage Theory
Imperfection:
Nominal wages are sticky in the short run, they adjust sluggishly.
 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.

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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.

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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.

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2. The Sticky-Price Theory

Suppose the RBI 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.

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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.

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